Anti-Dilution Protection
Anti-dilution protection is a contractual right granted to preferred shareholders — typically venture capital investors — that adjusts the conversion price of their preferred stock downward if the company subsequently issues shares at a lower price, preserving the economic value of their investment against down-round dilution.
Anti-dilution protection is one of the most consequential economic terms in venture capital financing agreements. When a VC investor purchases preferred stock, the shares convert to common stock at a specified conversion price (initially equal to the purchase price per share). If the company later issues stock at a lower price — a down round — anti-dilution provisions adjust the conversion price downward, giving the investor more common shares upon conversion and compensating for the dilution.
There are two main types of anti-dilution protection. Full ratchet anti-dilution is the most aggressive: the conversion price is reset to the new lower issuance price, regardless of how many shares are issued at that lower price. Even a single share issued at a lower price triggers a full reset. Full ratchet provisions are relatively rare in normal market conditions because they can be severely punishing to founders and employees who hold common stock.
Broad-based weighted average anti-dilution is the most common form in venture capital. It adjusts the conversion price using a formula that accounts for both the new lower price and the number of shares issued at that price relative to total capitalization. The adjustment is less severe than full ratchet because a small issuance at a lower price only modestly affects the weighted average. Narrow-based weighted average uses a smaller denominator (typically only outstanding preferred shares) and produces a more aggressive adjustment than broad-based.
Anti-dilution provisions include carve-outs for issuances that do not trigger adjustment — typically employee option pool grants, conversions of existing preferred stock, stock splits, and certain strategic issuances. These carve-outs are negotiated as part of the term sheet.
For founders and common shareholders, anti-dilution provisions in a down round can be highly dilutive. When preferred holders' conversion prices are reset down, they receive significantly more common shares upon a liquidity event, reducing what founders, employees, and common shareholders receive. Understanding the anti-dilution mechanics is essential when modeling cap table outcomes.