Dilution Protection

What Is Dilution Protection?

Dilution protection refers to contractual provisions that seek to restrict a corporation's power to reduce an investor's stake in the company after later funding rounds or new equity issuance occur. Dilution protection kicks in when a company's actions threaten to diminish an investor's overall percentage claim on the company's assets.

For example, if an investor's initial stake is 20%, before the company initiates a subsequent funding round, it must first offer discounted shares to that investor, in order to preemptively mitigate the dilution of his or her overall ownership stake. Sometimes referred to as anti-dilution protection, dilution protection is common in venture capital (VC) funding agreements.

Understanding Dilution Protection

Dilution occurs when a company issues new shares that result in a decrease in existing stockholders' ownership percentage of that company. 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.

Dilution protection is the broad term for any contractual obligation that aims to preserve a shareholder's existing ownership percentage stake in a company. Dilution protection is most common in the venture capital space — particularly with early-stage startups.

In order to entice investors into risky ventures, companies dangle dilution protection measures that affect later funding rounds. Of course, many companies willingly offer this feature because there's a high probability they won't survive long enough to see those later rounds unless they secure sufficient initial funding with which to launch their operation.

Anti-dilution provisions are also built into convertible preferred stocks and some issues of stock options to help shield existing investors from their investment potentially losing value.

Full Ratchet and Weighted Average Dilution Protection

Outlined in a company's funding and investment agreements, the most common form of anti-dilution provision protects convertible stock or other convertible securities in the company, by mandating adjustments to the conversion if more shares are offered. For example, if a company sells more shares at a lower price, the dilution protection provision will make a downward adjustment in the conversion price of the convertible securities.

Consequently, upon conversion, existing investors with dilution protection would receive more shares of the company, thereby letting them maintain their original ownership stake percentage. Anti-dilution provisions come in two main varieties: full ratchet and weighted average anti-dilution protection. The difference between the two is signaled by how aggressively each protects the investor’s ownership percentage.

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:

Dilution protection measures are typically expected by sophisticated investors and high-net-worth individuals, who realize that their money is in high demand.

Drawbacks of Dilution Protection

Although dilution protection is an attractive measure to early investors, companies that offer this provision may struggle to attract later investors, who will not enjoy the same risk protection on the shares they purchase in later funding rounds. Venture capitalists who fear this potential downside may decline to offer dilution protection rights, to avoid hampering later funding rounds and increase the odds of fostering a company's long-term success.

Furthermore, some start-ups offer dilution protection, but only for the first several years of the company's life. In these situations, companies are banking on the fact that early investors will become more actively involved in the company, by doing their part to help attract the capital needed to grow.