Anti-dilution clauses: comparison between Full Ratchet and Weighted Average Price

Anti-dilution clauses: comparison between Full Ratchet and Weighted Average Price

In investment agreements between startups and investors, especially during the early stages of business development, anti-dilution clauses play a crucial role. These contractual provisions are designed to protect the economic value of investors in the event that the company carries out a capital increase at a lower rate than in previous funding rounds. The way this protection is structured can vary, resulting in different types of clauses that have very distinct impacts on both investors and founders.

Below is a detailed analysis of what anti-dilution clauses are, the most common mechanisms (Full Ratchet and Weighted Average Price), and how they affect corporate balance within a growing company.

What is an anti-dilution clause?

An anti-dilution clause is a legal mechanism included in shareholders’ agreements and investment contracts to protect certain investors against the loss of value their shares may suffer if, in a future funding round, new shares are issued at a lower price than what they originally paid.

In such cases, known as down-rounds, the previous investor’s stake is devalued not only in percentage terms but also economically. Anti-dilution clauses aim to compensate for that loss through adjustments that typically involve issuing additional shares in favor of the protected investor, without requiring additional contributions.

These should not be confused with the pre-emptive subscription rights recognized under Spanish law for all shareholders during a capital increase. Anti-dilution is an additional contractual protection that only applies to those who have explicitly agreed to it and has very different effects.

This type of clause is usually introduced when a professional investor—such as a venture capital funds the company’s share capital and demands certain guarantees to minimize the risk associated with the company’s future performance.

Types of anti-dilution clauses

Anti-dilution clauses can be structured in different ways. In the Spanish commercial context, the two most commonly used forms are known as Full Ratchet and Weighted Average Price. Both aim to adjust the price per share of the investor affected by dilution but do so using different methods, which lead to varying consequences for the other shareholders.

Full Ratchet

The Full Ratchet clause offers complete protection to the investor. If, in a subsequent round, shares are issued at a lower price than the one the investor originally paid, the price per share is retroactively adjusted to the lower price, regardless of how many shares were issued in that round.

This results in the investor receiving an additional number of shares to match the new price, thereby compensating for the loss in value. The impact on other shareholders, particularly the founders, is significant, as their ownership percentage is considerably diluted.

This clause is the most favorable for the investor, but also the most demanding and potentially harmful to unprotected shareholders. It may even discourage future funding rounds if new investors perceive the capital structure as unfair.

Weighted Average Price

The Weighted Average clause is based on calculating a weighted average price between the original price paid by the protected investor and the new issuance price. It considers factors such as the total number of shares before and after the new round, resulting in a less aggressive adjustment.

Unlike Full Ratchet, here the investor does not match the lowest price per share but instead receives partial compensation in the form of additional shares based on the new average price. This system is considered more balanced and fairer, as it spreads the burden of dilution proportionally.

There are variations within this model—such as broad-based or narrow-based—which apply different criteria for calculating the adjustment, including or excluding certain types of shares (e.g., stock options, preferred shares, etc.).

Impact on investors and founders

Including an anti-dilution clause has significant practical consequences, both financially and in the governance structure of the company. Its impact varies depending on the party involved.

Impact on investors

From the investor’s perspective, anti-dilution clauses are a key protection tool. In highly uncertain environments, such as early-stage startups, these clauses help reduce the risk of devaluation if growth projections are not met or if future rounds close at lower valuations.

The degree of protection will depend on the type of clause agreed upon. A Full Ratchet provides complete coverage but may create internal tensions and jeopardize the project’s sustainability. For this reason, many investors prefer weighted formulas, which, while not eliminating the risk entirely, offer a more reasonable solution.

Impact on founders

For founders, the main consequence of these clauses is the additional dilution they suffer if a down round is triggered. This dilution affects not only their percentage of ownership but may also compromise their ability to control and make decisions within the project.

Additionally, the psychological impact of excessive dilution can negatively affect the founding team’s motivation, especially if the capital imbalance occurs during critical growth stages.

Therefore, it is essential to negotiate such clauses carefully during initial investment rounds. The key lies in striking a balance between legitimate investor protection and maintaining a healthy corporate environment that encourages founder commitment and supports future funding rounds.