What is dilution in the business world?
In corporate terms, dilution of a shareholder occurs when the percentage of a company’s capital held by the shareholder is reduced due to the creation of new shares as a result of a capital increase.
What are anti-dilution clauses?
But what are anti-dilution clauses? What are anti-dilution clauses? The main purpose of anti-dilution clauses is to protect investors in situations where the company carries out a capital increase at a lower price per share than they initially paid.
These clauses seek to compensate investors in downround scenarios , where the valuation falls compared to the investor’s initial entry. Specifically, it ensures that future capital increases do not fall below the valuation of previous rounds in which investors participated.
That is, in the event that the company creates new shares at a lower valuation than agreed with the investor partner at the time of entry, the investor has the right to request the creation of new shares to compensate for the loss in value or to restructure the capital to bring it in line with what the investor should have received initially.
How does the dilution of a shareholder affect the company?
Since dilution changes the percentage of share capital held by a shareholder, it directly affects the rights associated with that shareholder and may therefore be reflected in the future decision making of the company. It is therefore crucial to consider how this effect can have significant impacts on the shareholding and control of the company.
Example of dilution
To understand this better, let us consider a hypothetical example where a shareholder owns 250,000 shares in a company with a total of 1,000,000 shares, valued at 10€ each. Initially, the partner’s shareholding is 25%, equivalent to €2,500,000 on a total valuation of €10,000,000. If the company creates 750,000 new shares, at the same price, the share capital held by this shareholder will be reduced to 14%, despite retaining his 250,000 shares. This 11% decrease clearly illustrates the impact of dilution at the time of the capital increase.
In the world of corporate investment, especially in start-ups and emerging companies, investors deploy various strategies to protect their contribution and prevent the possible entry of new investors from significantly affecting their share in the share capital. These include drag-along rights, pre-emptive liquidation rights and, in particular, anti-dilution clauses.
Full ratchet and weighted average: main anti-dilution clauses
The main anti-dilution clauses are known as full ratchet and weighted average.
In the case of the full ratchetclause, the conversion price of existing preference shares will be adjusted to the price at which new shares will be created in subsequent investment rounds. This clause is perceived as the one that generates the most dilution for those investors and shareholders who do not have clauses protecting them against their reduction in the percentage of share capital.
In other words, by applying this formula, the investor receives the shares that would have corresponded to him if he had applied the downround price per share in his initial share subscription , instead of the higher price he paid.
Weighted average – how does it work?
The weighted average provision , on the other hand, calculates a weighted average between the original valuation and the new valuation. It adjusts the valuation of the preference shares by considering the initial investment, the price per share at that time, the current investment of the new round and the price per share at this time.
This methodcalculates a new average price for the investor, which is always lower than the initial entry price of the investor. The total amount invested by the investor divided by this new average price will determine the total number of shares to which the investor is entitled and thus the number of additional shares the investor will receive.
Similarly, in order to avoid immediate payouts, investors may require the creation of a reserve for the exercise of the anti-dilution right. This would allow the investor to receive the new shares free of charge by means of a capital increase from available reserves. In some cases, investors may also negotiate call rights with founders or other reference partners who entered at lower valuations, which may affect the application of these formulas.
Anti-dilution clauses: conclusions
In summary, anti-dilution clauses emerge as highly effective tools for investors, allowing them to mitigate the negative impacts of investment rounds at lower valuations. The specific choice of which clause to use will largely depend on the individual circumstances, especially the initial entry valuation and the capital structure of the company.
It should be borne in mind that, when incorporating such clauses in shareholders’ agreements, it is vital to include the express waiver by other shareholders of their right of first refusal in favour of the protected investor. In the context of investments in Spain, where venture capital operations are usually carried out in limited liability companies, the obligation for the nominal value of the new shares to be fully subscribed according to the Capital Companies Act must be taken into account.
Ultimately, the impact of these formulas will vary depending on the specific conditions, underlining the importance of careful planning and negotiation in designing anti-dilution clauses that effectively protect investors’ interests in the changing corporate investment environment.
Article written by
Álvaro Ferra
Attorney – Corporate and M&A
About Metricson
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