Anti-Dilution Provision

What Is an Anti-Dilution Provision?

Anti-dilution provisions are clauses built into convertible preferred stocks and some options to help shield investors from their investment potentially losing value. When new issues of a stock hit the market at a cheaper price than that paid by earlier investors in the same stock, then equity dilution can occur. Anti-dilution provisions are also referred to as anti-dilution clauses, subscription rights, subscription privileges, or preemptive rights.

Understanding Anti-Dilution Provisions

Anti-dilution provisions act as a buffer to protect investors against their equity ownership positions becoming diluted or less valuable. This can happen when the percentage of an owner's stake in a company decreases because of an increase in the total number of shares outstanding. Total shares outstanding may increase because of new share issuance based on a round of equity financing. Dilution can also occur when holders of stock options, such as company employees, or holders of other optionable securities exercise their options.

When the number of shares outstanding increases, each existing stockholder owns a smaller, or diluted, percentage of the company, making each share less valuable.

Sometimes the company receives enough cash in exchange for the shares that the increase in the value of the shares offsets the effects of dilution; but often this is not the case.

Anti-Dilution Provisions at Work

Dilution can be particularly vexing to preferred shareholders of venture capital deals, whose stock ownership may become diluted when later issues of the same stock hit the market at a cheaper price. Anti-dilution provisions can discourage this from happening by tweaking the conversion price between convertible securities, such as corporate bonds or preferred shares, and common stocks. In this way, anti-dilution clauses can keep an investor's original ownership percentage intact.

Dilution in Action

Types of Anti-Dilution Provisions

The two common types of anti-dilution clauses are known as "full ratchet" and "weighted average."

With a full ratchet provision, the conversion price of the existing preferred shares is adjusted downward to the price at which new shares are issued in later rounds. Very simply, if the original conversion price was $5 and in a later round the conversion price is $2.50, the investor's original conversion price would adjust to $2.50.

The weighted average provision uses the following formula to determine new conversion prices: