We tend to overlook some important clauses in the Shareholders Agreement. We’ll talk about one such clause today. It’s important that you learn about the anti dilution provisions & their impact on your ownership. The anti dilution provisions are designed to prevent dilution of the shareholders’ ownership interest in the case of a decrease in the number of shares or an increase in their price.

anti dilution is a clause that is incorporated in every Shareholders’ Agreements with investors. It can also be found under different names such as “Prevention of Dilution” or “Anti Dilution Provisions”. But a lot of entrepreneurs are uninformed about the impact of such key terms in case things go south. In case you find it difficult to understand the complex legal terminology of the anti dilution clauses, we are here to simplify it for you.

What are Anti dilution provisions for startups?

Anti dilution protects investors from downsizing their investment during the next series of funding. In the next series of funding, if the entity is valued at a lower price, then new shares will be issued at a lower premium. This in turn will dilute the value of holding by the existing investor. Therefore, to maintain the value of the investment, anti dilution clauses are inserted. The investors’ value is safeguarded by issuing new shares or by making adjustments to the issue price. 

Anti dilution rights can be typically categorised in two models:

  1. Full Ratchet
  2. Weighted Average

Full Ratchet:

In this case, when new shares are issued at a lower price, the existing investor will be issued new shares for the surplus investment made by him at a lower price. 

Example: Let’s assume that in Series A, the shares are valued at Rs. 100 wherein the price is reduced to Rs. 90 in Series B. In such a case, the investor who bought shares at Rs. 100 will be issued new shares for his surplus investment amount (i.e. Rs. 10 x no. of shares invested). In this scenario, the percentage holding of the existing investor will be intact. However, the promoter’s shareholding will be diluted extensively, which is why this model is considered to be one-sided. 

Weighted Average:

This model is lenient compared to the Full Ratchet model. When the Weighted Average anti dilution clause is triggered, the Company issues new shares at an adjusted price. The price is adjusted by the weighted average of the issue price for the existing investment, outstanding and new shares to be issued, and the aggregate consideration received. Let’s understand that with the same example as above.

Series A Funding at Rs. 100/- per shareNo. of SharesInvestment Value% of holding
Promoters90,00090,00,00090%
Existing Investor10,00010,00,00010%
Total1,00,0001,00,00,000100%

Let’s say the new investor is offered shares at Rs. 90/- and he invests Rs. 9,00,000 for acquisition of 10,000 shares with 10% equity. Now, in order to protect the interest of the existing investor, a weighted average formula will be applied to find the consideration price for Series B funding:

Consideration B = Consideration A*(No. of outstanding shares + No. of shares to be issued in Series B at Consideration A)/ (No. of outstanding shares + No. of shares to be issued in Series B at Consideration B)

=100[1,00,000+(9,00,000/100)]/[1,00,000+(9,00,000/90)]

=100[1,00,000+9000]/[1,00,000+10,000]

=99.09

Based on the new consideration price, the existing investor will be issued 92 shares approximately. Here, promoters’ holding will also be diluted, but not significantly as compared to the Full Ratchet model. 

Pricing Guidelines and Regulations:

As per provisions under the Companies Act, 2013, the price per share should not be less than the fair price determined by an Independent Valuer in the further issue. In case the adjusted price per share is lower than the fair price recommended, the enforceability of the provisions can be challenging. It’s always advisable to get the assistance of experts in such legal matters. You can rest assured that our team of professionals at LegalWiz.in is at your rescue. Connect with our experts now!