What is Anti-Dilution Protection?

Anti-dilution protection is a term in an investor's contract that gives the investor extra shares if the company later sells shares for less than the investor paid. It works by recounting the money already paid at the lower price. An investor pays $1M for 500K shares at $2.00 a share, and the next round goes out at $1.00. Under the strictest form, the $1M is recounted at $1.00 and now stands for 1M shares. Those extra shares shrink everyone else's percentage, the new investors' included. The difference is that the new investors saw the term before they set their price, and priced it in.

Anti-dilution protection is a term written into an investor's contract, and it acts on one event only: the company later sells shares for less than that investor paid. An early investor pays a high price, and if the company later has to raise money at a lower price, the same slice of the company goes to the next investor for less. The protection recounts the early money at a lower price, so each of the investor's shares converts into more ordinary shares than before. Take a company with 2M shares. An investor paid $1M at $2.00 for 500K of them, a 25% stake; founders and staff hold the other 75%. The company then raises $1M at $1.00, which is 1M new shares. With no protection the investor falls to 16.7% and the founders to 50%. The usual form, called a weighted average, moves the investor's price to $1.67, so the $1M now stands for 600K shares: 19.4% for the investor, 48.4% for the founders. The strictest form, called full ratchet, recounts the whole $1M at $1.00: 1M shares and 28.6%, more than the investor held before the cheap round, with the founders down to 42.9%. The weighted average also weighs how big the cheap round is. Raise only $250K at $1.00 and the price moves to $1.89, worth about 529K shares rather than 600K. Whichever form applies, the extra shares shrink everyone else's percentage, the new investors' included. The new investors, though, saw the anti-dilution term before they set their price and priced it in, which leaves founders and staff carrying the real cost. Two things the protection is not. It is not triggered by a round at a higher price, even though the investor's percentage still falls. And it is not a pre-emption right, the right to buy into the next round, which works at any price and costs the investor money. One more limit. If the company is later sold for a poor price, the investor usually takes the $1M back first, under its liquidation preference, and never converts, so the extra shares are never used. They are used when the company sells well enough that the investor's percentage of the price is worth more than the $1M, and that is where the recount pays: 28.6% of the sale instead of 16.7%.

A new sports league is selling team slots, and each team's cut of the league's TV and merchandise money follows what it paid in. Nobody knows yet what the league will earn, so a slot is a slice of an unknown pot. The first team owner pays $120M. Fans stay away, the league needs cash, and the next slot goes for $60M. The first team owner's contract has a line for exactly this: if a later slot ever sells cheaper, the $120M is recounted at the new price. Two slots' worth of the pot now carry that owner's name, and every other team's cut shrinks, the new owner's included. A gentler line would give the first owner only part of that. The line plays the part of anti-dilution protection, and the $60M slot plays the part of the cheaper round. Where the picture bends: real leagues usually split the pot equally per team, not by what each owner paid.