Meaning
Contractual provision in investment documents that adjusts the rate at which preferred stock converts into common stock to protect an investor against equity dilution. An anti-dilution protection ensures that if a company issues new shares at a lower price than a previous round, the conversion ratchets increase the number of common shares the original investor receives. This protects the percentage of ownership held by early backers.
Most venture capital deals include either a full or a weighted average version of this mechanism.
Anti-dilution Shield
Investors demand these terms to mitigate the risk of a down round. When conversion ratchets are triggered, the effective price per share for the protected investor is lowered. This happens automatically upon the closing of the subsequent dilutive financing.
Adjustment Calculation
Full protection brings the conversion price down to the exact price of the new, cheaper shares regardless of how few are issued. Broad-based weighted average conversion ratchets consider the total number of shares outstanding to make the adjustment less punitive for the founders. The formula balances the interests of the new investors with the existing stakeholders to keep the cap table manageable.
Boards of directors often negotiate the specific components of the weightings to ensure the company can still attract future capital. Without these protections, an investor might find their stake greatly diminished by a small issuance at a low valuation. Administrators use the resulting data to calculate the final impact of the down round.
Ownership Waterfall
The final share of proceeds is determined by the total conversion of preferred instruments. If conversion ratchets have operated, the common shareholders receive a smaller portion of the total value. This shift in the waterfall affects the returns for employees and founders.
