Anti-dilution protection mechanisms: The what and the why of a ratchet?

When startups and scaleups are in the process of raising funds with professional investors, the topic of anti-dilution protection mechanisms will unquestionably be put on the table at some point.

Why provide for anti-dilution protection?

The basic principle of such anti-dilution protection mechanisms is simple : protect investors if the company raises funds at a lower price per share than the prie per share retained for their investment, i.e. a future down round.

Because raising funds usually results in the issuance of new shares, this process dilutes the existing shareholders’ equity, especially early investors and founders. To protect their investment, investors frequently request that the company implements anti-dilution mechanisms. Such clauses safeguard the value of its beneficiaries’ holdings during subsequent funding rounds, preventing or limiting the effects of dilution when shares are issued in the framework of a future down round.

What is a ratchet?

A ratchet is the most common type of anti-dilution protection, either in the form of a full ratchet or weighted average ratchet. This mechanism mitigates the impact of a down round by retroactively adjusting the subscription price (the price paid to subscribe to a share of the company) paid by the concerned investors at the time of their original investment. Hence ensuring that the early investors’ equity participation remains stable or is less affected by the down round.

Triggering conditions of the mechanism

Even though there are different methods of implementing a ratchet, it is usually triggered by a down round. It however remains of the upmost importance to properly define the conditions for its activation, in order to exclude unwarranted triggering events related to other convertible securities or employee incentive plans.

Investors should keep in mind that an anti-dilution protection that is overly strong risks it quite difficult for a company to find new investors in a context where the company is in distress. As an investment in such circumstances would most likely constitute a down round, thus triggering the anti-dilution protection and therefore lead to the issuance of new shares, diluting everyone (including the new investor) but the beneficiaries of the anti-dilution protection. As this will likely not be an option for the new investor, the sole option is often convincing the anti-dilution protection beneficiary of waiving its application.

Duration and limitations of protection

Anti-dilution protection mechanisms are always limited in time, with their duration being dependent on the business plan of the company and the investors involvement. After a certain period of time the investors should take responsibility for a company’s failure to raise money at a better valuation as they have either been actively involved themselves – and thus influenced the direction of the company – or this failure stems from external circumstances, whose consequences should not be borne by the other shareholders alone.

FAQ

What is anti-dilution protection in a fundraising?

Anti-dilution protection is a contractual mechanism designed to protect investors if the company later raises funds at a lower price per share than the price retained for their own investment.

Because a fundraising generally involves the issuance of new shares, existing shareholders (including early investors and founders) are diluted.

Anti-dilution protection limits the impact of that dilution for its beneficiaries when a future down round occurs.

What is a ratchet clause?

A ratchet is the most common form of anti-dilution protection. It can take the form of a full ratchet or a weighted average ratchet.

The mechanism mitigates the impact of a down round by retroactively adjusting the subscription price paid by the investors concerned at the time of their original investment.

As a result, their shareholding is preserved or diluted less than it would have been without the ratchet.

What is a down round?

A down round is a fundraising carried out at a price per share lower than the price retained for an earlier investment. It is the event that typically triggers anti-dilution protection.

The agreement should, however, define the triggering conditions carefully so that other events (such as the issuance of convertible securities or shares under employee incentive plans) do not trigger the protection unintentionally.

Can anti-dilution protection be too strong for the company’s own good?

Yes. If the protection is overly strong, it can make it difficult for a company in distress to attract new investors. A new investment in those circumstances may be made at a lower valuation and therefore trigger the anti-dilution mechanism. This itself results in additional shares being issued to the protected investors and further dilutes the other shareholders, including the new investor.

As that prospect is rarely acceptable for a new investor, the only way out is often to persuade the beneficiary to waive the protection.

How long does anti-dilution protection last?

Anti-dilution protection should always be limited in time. Its duration will depend on factors such as the company’s business plan and the level of involvement of the investors. After a certain period, the rationale for continuing to protect the investors against a lower future valuation becomes weaker, particularly where they have been actively involved and influenced the company’s development, or where the lower valuation results from external circumstances whose consequences should be borne by all shareholders.