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Anti-Dilution Rights in a Shareholder's Agreement (SHA)

In the ever-changing world of startups and venture capital, securing investments is crucial for fueling growth and innovation. However, investors often face the risk of their ownership stake being diluted when a company issues new shares at a lower price than they initially paid. This is where anti-dilution provisions come into play.


Understanding Anti-Dilution Rights


Anti-dilution rights are protective measures included in a shareholder's agreement (SHA) that safeguard investor's ownership percentage in the company. These provisions ensure that the value of an investor's investment is not diminished when new shares are issued at a lower price per share than the original investment price.


Down round - A “down round” is a Funding Round in which a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier funding Rights.


So case any down round is done then the Anti-Dilution Rights protect the ownership percentage of the earlier investor to an extent.


Below are Three Methods for Anti-Dilution Protection:

· Full Ratchet Anti-Dilution Protection;

· Broad-Based Weighted Average Anti-Dilution Protection; and

· Narrow-Based Weighted Average Anti-Dilution Protection.

Let’s Explain to you one by one with an illustration:


Scenario 1: During the Downround company do not have an Anti-Dilution Right Clause

​Shareholder



​Number of Shares


​% Holding


Founder 1

20,000

20%

Founder 2

20,000

20%

Investor A

50,000

50%

ESOP (unissued pool)

10,000

10%

Total

1,00,000

100%

In this case, Investor A had invested in the company at a Pre-Money Valuation of Rs 1 Crore. Thereby he is issued 50,000 Shares of Rs. 100 Each


Now, down-round is proposed to be done, where Investor B will Invest at a Pre-Money Valuation of Rs 60 Lakhs and they will acquire 25,000 shares at Rs 60 Each.


In the absence of any Anti-Dilution Protection Rights to Investor A, the Cap Table will be as follows:


Shareholder

​Number of Shares

% Holding


​Founder 1


​20,000


16%


Founder 2

20,000

16%

Investor A

50,000

40%

Investor B

25,000

20%

ESOP (unissued pool)

10,000

8%

Total

1,25,000

​100%

Here you can see Investor A brought in Rs 50 Lakhs to gain 50% of the Company and then Investor B brought in Rs. 15 Lakhs to get 20% of the shares due to down-round


Type 2: Full Ratchet Anti-Dilution Protection


The existing investor's shareholding is adjusted based on the reduced per-share price offered as a part of the down-round. It will be like the existing investor had also originally invested at the down-round valuation and its shareholding will be adjusted appropriately


In scenario two if the company have Full Rachet Anti-Dilution Protection, then Cap Table would be as follows:


Shareholder

Number of Shares

​% Holding

Founder 1

20,000

12.6%

Founder 2

20,000

12.6%

​Investor A

83,333

52.6%

Investor B

25,000

​15.8%

ESOP (unissued pool)

10,000

6.3%

Toal

1,58,333

100%


In this case, Investor A shares are calculated by considering the latest issue price of Rs 60 as the Conversion Price i.e. Rs 50 Lakhs / Rs. 60 = 83,333 Shares.


Full Ratchet Anti-Dilution Protection

Full Rachet Protection is most preferred by early-stage investors however during negotiations it does not go through as it can be harsh to founders and new incoming investors.


Type 3: Broad-Based Weighted Average Anti-Dilution Protection


Broad-Based Weighted Average Protection is preferred by investors and founders, as it is a more balanced and fair method. In Broad-Based Weighted Average dilution is not entirely taken hit by the Founders or Shareholders without anti-dilution protections. It takes into account factors like the initial valuation, down-round value, initial amount raised, amount to raise in down-round, number of shares


New Conversion Price of the Existing Investor =


Existing Conv. Price X (Existing No. of Shares + Shares to Issue for Amount Raised in Down Round at CP)

____________________________________________

(Existing Number of Shares + No. of Shares Issue in Down Round at Down Round Price)

In this Example:

Existing Conversion Price = Rs. 100 (Price at which Investor A Subscribed)

Existing No. of Shares = 1,00,000 Shares

Shares to Issue for Amount Raised in Down Round at CP = 15 Lakhs / 100 = 15,000 Shares

No of Shares Issue in Down Round at Down Round Price = 25,000 Shares


Thus, New Conversion Price = 100 * (1,00,000 + 15,000) / (1,00,000+ 25,000) = Rs.92 per Share

No. of Shares to Investor A will be now = Rs 15 Lakhs / 92 = Rs. 54,348/-


Captable will be as follows :


Shareholder

​Number of Shares

​% Holding

​Founder 1

​20,000

​15.46%

​Founder 2

​20,000

​15.46%

​Investor A

​54,348

​42.02%

​Investor B

​25,000

​19.33%

​ESOP (unissued pool)

​10,000

​7.73%

​Total

1,58,333

​100%

Thus, here 4348 shares will be additionally issued to Investor A as part of the Broad-Based Weighted Average Anti-Dilution Right Protection Clause


Type 4: Narrow-Based Weighted Average Anti-Dilution Protection


This is a variant of the Broad-Based Weight Average only different is that unissued shares/options / warrants are excluded while calculating the existing number of shares


Type 4: Pay to Play


A pay-to-play provision in a term sheet requires investors to participate, at the company’s request, in subsequent financing rounds on a pro-rata basis. If an investor does not participate when requested, they face consequences that can range from losing some privileges like anti-dilution protections to having their preferred stock wholesale converted to common stock.

Pay-to-play provisions are extremely rare in technology investment deals. But they are absolutely common in biotechnology or life sciences deals because those types of companies require such a large amount of capital to get a product to market. Early investors in biotechnology or life sciences companies need to be prepared to pony up cash in future financings and go the distance.


Conclusion

Anti-dilution rights serve as a cornerstone of investor protection in the startup ecosystem. By safeguarding investors' ownership stake, these provisions foster confidence and encourage continued investment in promising ventures. Understanding and effectively utilizing anti-dilution provisions is essential for both investors and entrepreneurs to navigate the complexities of startup financing.

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