Anti-dilution clauses as an investor protection mechanism

Anti-dilution clauses as an investor protection mechanism

The ‘startup universe’ is suffering a complex year after the absolute investment record reached by the Spanish entrepreneurial ecosystem in 2021. 

The harsh adjustments marked by the continuous interest rate hikes by the European Central Bank together with the wave of layoffs (2,500 per day in 2023) suffered by large global technology firms and other aspects such as inflation seem to have resulted in a significant drop in investment in emerging projects (venture capital) in our country. 

The current situation in our country highlights the importance of protecting the investment of those who finance our project. This is achieved by articulating in the shareholders’ agreements what are known as ‘anti-dilution clauses’, which we will discuss below.

Introduction to anti-dilution clauses: investor protection in start-ups

Dilution in capital is the effect by which the incorporation of new partners through rounds of capital in a company implies a reduction in the percentage shareholding of the previous partners. 

In order to avoid this loss of percentage in the company’s capital, investment partners seek to protect themselves through clauses that regulate a mechanism whereby an individual is granted new shares in a company, but without the company being subject to dilution. In this way, their capital remains the same as when they joined the company.

Consequently, the anti-dilution clause is configured as an extra protection for the shareholder of the company, and its recognition in favour of investor shareholders is a common practice.

Types of anti-dilution clauses and their application in investment agreements 

Different models of anti-dilution clauses can be applied. One of the most common forms found between companies and partners are the following:

FULL RATCHET

This is the most aggressive clause for the founders and partners without anti-dilution protection, and, in return, the most beneficial for the investor. 

Under this clause, Investor A receives the units to which it would have been entitled had it applied the down round (Series B) price per unit to its initial subscription of units, rather than the higher price it paid.

In addition, the creation of new units for Investor A will also have an impact on Investor B’s shareholding, since the new units created as a result of the application of the Anti-Dilution Clause will be considered fully diluted (FD) capital for the purpose of calculating the price of the units to be taken up by Investor B in the down round.

WEIGHTED AVERAGE PRICE:

In the clauses drafted under this mechanism, the new price per unit for the Series A is calculated by weighting the value of the company before the down round against the down round amount.

How to draft an anti-dilution clause?

As a general rule we will find an anti-dilution clause worded as follows:

“In the event that the company makes a new issue of shares at a price per share (including issue premium) lower than those subscribed by the investors, the latter shall be entitled to the issue of new shares to compensate for the effect of the increase“.

At Letslaw by RSM we are experts in commercial law. So we will bring you all the help that you might need when it comes to negociate clauses between founders and investors within the framework of a shareholders’ agreement.