Anti-Dilution Provisions

An anti-dilution clause is a provision in an option, insurance, or acquisition agreement that gives the investor the right to retain his or her percentage of company ownership by acquiring an appropriate number of shares in any future security issue. When new stock issues enter the market at a lower price than that paid by previous investors in the same stock, then dilution of equity will occur. There are two kinds of provisions for anti-dilution: full ratchet and weighted average. Often referred to as anti-dilution clauses, subscription rights, subscription protections, or preemptive rights are anti-dilution provisions.

Anti-dilution provisions shield a financial specialist’s value stake from dilution. It’s going about as a support to ensure speculators against their value proprietorship positions getting weakened or less important. Anti-dilution provisions are now and then called “membership rights”, “preemptive rights”, or “membership advantages.” Anti-weakening arrangements are especially significant for convertible favored stock. This can happen when, due to a rise in the total number of shares outstanding, the percentage of an owner’s interest in a company decreases. Therefore, the percentage of control of the investor in the company would decline. Due to new share issuance based on a round of equity financing, total outstanding shares can increase.

(Example of Anti-Dilution Provisions)

The cash that a company receives for shares can offset the impact in some instances. Dilution may also occur when options are exercised by holders of stock options, such as company staff, or by holders of other optional securities. There would typically, however, be a decrease in the value of the outstanding securities. An anti-dilution provision allows a financial specialist the option to change over their favored offers at the new cost. Anti-dilution provision shield speculators from the danger of seeing new offers gave at a lower cost than the financial specialists recently got.

Dilution refers to a shareholder’s stake declining as a consequence of the issuance of new shares. For preferred shareholders in venture capital deals whose stock ownership may be reduced when later issues of the same stock reach the market at a cheaper price, dilution may be especially vexing. You will have a 25 percent interest if you held 25 shares in a company with 100 outstanding shares. Your stake would, however, be cut in half if the company were to issue 100 more shares. Earnings per share (EPS) will also be decreased by issuing new stock, as the total number of shares increases. Companies can attempt to offset the adverse effects by buying back their shares.

The two common types of anti-dilution clauses are known as “full ratchet” and “weighted average.”

The full ratchet provision gives current shareholders the right to purchase shares at the new lower price. Therefore, if the new offering price is lower than the exchange price for the investor’s shares, they are covered. Very clearly, if the initial conversion price was $5 and the conversion price was $2.50 in a later round, the original conversion price of the investor would be changed to $2.50.

The weighted-average provision gives shareholders the right to buy shares at a price which reflects the change in the prices of the old and new offerings. In order to establish new conversion prices, the following formula is used:

C2 = C1 x (A + B) / (A + C)

Where:

C2 = new conversion price

C1 = old conversion price

A = number of outstanding shares before a new issue

B = total consideration received by the company for the new issue

C = number of new shares issued

For owners of preferred shares, the complete ratchet method will always be more beneficial, as it gives them the right to convert at the lowest available price. Some of the value of their preferred shares will help protect the weighted average method. The conversion price will always, however, be better than with a complete ratchet provision.

 

Information Sources:

  1. investinganswers.com
  2. investopedia.com
  3. corporatefinanceinstitute.com