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Protecting your Stake: A Guide to ESOP Anti-Dilution for Investors & Founders

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  • Harvey John Hrithik DasConsultant
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Updated: 09 July, 2024
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Editor's Note:-This article gives a detailed and thorough explanation of anti-dilution protection for Employee Stock Ownership Plans (ESOPs). It explores the various forms of protection from dilution, such as weighted average, full ratchet, and contractual protection. Moreover, it also delves into essential factors to consider during negotiations related to protection from dilution for ESOPs.

Anti-dilution protection is how investors protect themselves in a down round.

ESOPs can be offered without dilution by utilizing secondary shares or cash-based options, thus preserving the current ownership proportions. On the other hand, ESOPs' anti-dilution provisions safeguard investor interests by readjusting the conversion price of their shares, if new shares are offered at a cheaper price, thereby stopping any decrease in their ownership share.

It’s obvious that just going through the above information isn’t enough to learn about this terminology. Therefore, let's grasp the concept of Anti-Dilution Protection in detail to understand it with clarity.

What is Anti-Dilution Protection?

An anti-dilution clause is set off when the conversion price for a subsequent funding round is lower than the conversion price of the preceding round, which is usually the same as the price per share (PPS) of the preferred stock issued in that round. This provision typically increases the number of common shares each preferred share converts into during a new capital raise.

The main thing about this is that investors have two ways to leave the stock outcome: They can convert their favorite stocks into shares and get a percentage of the income, or they can buy the favorite to get preference earlier of shareholders. Of course, investors will always choose higher dividends. Additionally, hedging allows investors to maintain their percentage of ownership, allowing them to receive more distributions than they transfer into the business.

What are the types of Anti-Dilution Protections?

  • Price-based Anti-Dilution - If a company holds a funding round where the stock value is less than in prior rounds, it is considered to reduce the value of shares held by early investors. Investors often negotiate for anti-dilution clauses during their investment to offset the negative impact of potential future down rounds.

  • Contractual Anti-Dilution - Sometimes, stockholders may negotiate for the right to receive additional shares of stock at no extra charge, which will protect them from dilution of their shareholding in the company that may result from the issuance of new shares, regardless of the price of such new shares.

Now, let’s understand how the different types of anti-dilution protections work in detail

How does Price-Based Anti-Dilution Work?

Price-based anti-dilution provision is included in the company's charter, which automatically changes the conversion rate of preferred stock to common stock during a down round. At first, preferred stock converts to common stock at a 1:1 ratio, affecting voting rights, the distribution of proceeds in a company sale, and the number of shares held by investors after an IPO. Once a price-based anti-dilution adjustment takes place, the conversion ratio rises to more than 1:1, causing a modification in the common stock equivalent number in the company's capitalization table .

There are two types of Price-Based Anti-Dilution: Weighted-Average Anti-Dilution and Full Ratchet Anti-Dilution

Weighted average: To offset the decrease in share value resulting from a new funding round at a lower price, this protection mechanism adjusts the conversion ratio. This readjustment is calculated using a formula that compares the number of shares that would have been given to new investors at the initial price to the number of shares issued to them at the discounted price.

  • Broad-based weighted average formula is utilized, which factors in the company's total fully diluted capitalization, thereby minimizing the dilution impact on common shareholders.

  • Narrow-based weighted average formula is used in scenarios where only the existing outstanding shares are taken into account, which tends to be more favorable to early investors.

How to Calculate Weighted Average Anti-Dilution Protection

For weighted average protection, the conversion price is not automatically lowered to the lowest share price. Instead, it’s modified based on the increase in the number of shares the company issued.

There are two ways to calculate weighted average anti-dilution: broad-based and narrow-based. The formulas are identical, aside from the number used for outstanding shares.

  • Broad-based Weighted Average Anti-Dilution Protection

Typically, investors and founders will come to an agreement on a broad-based weighted average dilution protection. This type of protection is seen as more fair and balanced because it does not solely place the burden of dilution on shareholders who do not have these protections. It takes into account several factors, including the original investment's valuation, the amount to be raised in a down-round, and the proposed number of shares to be issued.

The Adjusted Conversion Price is determined on the basis of the following Anti-dilution formula:

Adjusted Conversion Price = CP x (A + B) / (A + C), where:

Adjusted Conversion Price

= 100 x (1,00,000 + 10,000) / (1,00,000 + 20,000) = INR 91.67.

Variable
What it represents
In our example (in INR)
CP
Existing conversion price
100
A
Total number of existing shares on a fully diluted basis prior to the down-round
1,00,000
B
Number of shares issuable for the amount raised in the down round at the CP
((20,000 x 50) / 100) = 10,000
C
Number of shares issuable in the down round
20,000

Accordingly, applying for a broad-based weighted average protection, the Investor's ownership in the Company (on a fully diluted basis) would be 43,635 shares (40,000 *100 / 91.67) and the share capital table would be as follows:

Shareholder
Number of Shares (on a fully diluted basis)
Shareholding percentage
Founder 1
25,000
20.22%
Founder 2
25,000
20.22%
Investor
43,635
35.29%
New Investor
20,000
16.18%
ESOP (unissued notional pool)
10,000
8.09%
Total
1,23,635
100%
  • Narrow based Weighted Average Anti-Dilution Protection

A narrow-based weighted average protection is nearly identical to the previously mentioned broad-based weighted average protection, utilizing the same formula. The distinction is that when determining the outstanding shares (referred to as variable 'A' in the aforementioned formula), a more restricted method is implemented. This includes only the existing and issued shares while excluding unissued stock options, warrants, shares issued upon conversion/exercise of debt, and other comparable instruments.

Therefore, in the above example, Variable A will be equal to 90,000, excluding the unissued notional ESOP pool of 10,000.

Adjusted Conversion Price

= 100 x (90,000 + 10,000) / (90,000 + 20,000) =

INR 90.91

Accordingly, applying for a narrow-based weighted average protection, the Investor's ownership in the Company (on a fully diluted basis) would be 44,000 shares (40,000 *100 / 90.91) and the share capital table would be as follows:

Shareholder
Number of Shares (on a fully diluted basis)
Shareholding percentage
Founder 1
25,000
20.16%
Founder 2
25,000
20.16%
Investor
44,000
35.48%
New Investor
20,000
16.13%
ESOP (unissued notional pool)
10,000
8.07%
Total
1,24,000
100%

Full Ratchet: The full ratchet anti-dilution method reduces the purchase price of protected stocks to the same level as the price paid in the subsequent financing round that had a lower valuation. Compared to a weighted average provision, a full ratchet provision will always result in a more substantial adjustment to the conversion rate, which is disadvantageous to founders and other common stockholders. Here, the new conversion price adjusts to the lowest conversion price implied by any financing round. The formula is:

Number of common shares = (Number of preferred shares) x (Original share price/Conversion Price)

Let’s look at an example based on the aforementioned sample company.

Source:learn.angellist

If there was a non-dilution protection, converting your 3M preferred shares to common shares would be at the original price of $1.00 per share, resulting in 3M common shares, each currently worth $0.83, reducing your ownership stake to 12.5% from the initial 25% ownership of the company.

However, with full-ratchet protection, you have the option to convert your 3M preferred shares to common shares at the new lower price of $0.83 per share, similar to what Series B investors paid. This would give you around 3.6M shares, each valued at $0.83, maintaining the original worth of your investment while still facing the consequences of dilution in terms of ownership percentage.

How does Contractual Anti-Dilution Work?

A standard form of protection sees the company commit, through a contract, to grant extra shares to a specific shareholder to ensure that the latter's percentage of ownership in the company remains constant until the company secures a certain amount of financing. This arrangement dilutes the proposed shareholder's percentage of interest in the company, irrespective of the share price.

However, if the protection does not end automatically once the subsequent round of financing is raised, new venture capital or angel investors may insist that the company obtains the agreement of the holder of such rights to terminate them before they agree to invest.

Key Considerations When Negotiating Anti-Dilution Protection

1. Preferred shareholders' increased shareholding results in decreased ownership for common stockholders, such as founders and employees. In other words, stronger investor dilution protection leads to greater potential dilution for founders.

2. Founders often oppose these protection clauses and advocate for broad-based weighted averages, with the final decision being influenced by each party's negotiating power.

3. Anti-dilution provisions are negotiable and vary based on different parties' perspectives in each financing round.

4. Full-ratchet anti-dilution provisions are uncommon as they can deter future investors and undermine founders' ownership stakes.

5. Disputes among investors can arise when prior investors' dilution protections are negotiated away, potentially delaying or preventing future financing rounds.

6. Investors may agree to fewer protections in order to maintain the company's ability to raise funds or prevent dilution for founders and employees.

7. Customizable protection provisions include 'pay-to-play' terms, negotiated by some founders, requiring investor participation in future financing rounds for protection.

8. Anti-dilution provisions are typically absent in convertible notes or SAFEs, as the valuation cap or discount rate serves as protection upon conversion to preferred shares.

Rounding Off

Investors should not neglect anti-dilution protection when negotiating financing terms, as it is a significant factor. Generally, a weighted average anti-dilution method is the fairest solution, providing protection for investors while limiting dilution for founders and common stockholders. However, the final terms will depend on the negotiating power of each party. Giving up anti-dilution rights in future negotiations can lead to conflicts, so all stakeholders should thoroughly consider the potential implications before agreeing to any anti-dilution clauses.

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