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Dilution protection and its role on initial investors’ stakes

A provision involving contracts aims to restrict a corporation’s power to lessen an investor’s stake in the company. This happens later after funding rounds or if there is new equity issued. We call it “dilution protection.” It enters the picture when a company’s behavior looks like it will lessen an investor’s total claim on its assets.

Let us say that Investor A’s stake is 25%. This is the initial stake. The company is responsible for offering discounted shares to the investor before it initiates a subsequent funding round. This is to mitigate a dilution in Investor A’s total ownership stake. This action is also famous as “Anti- Dilution Protection.” We can often encounter this in venture capital funding agreements.

Let’s start with dilution protection.

Let us say that a company issues new shares, which made the existing stockholders’ company ownership percentage decline. We refer to this situation as “Dilution.” We can also encounter this when stock options holders like company employees or other optionable securities holders exercise their options. An increasing number of outstanding shares may mean that every existing stockholder of a company percentage becomes smaller and diluted. Hence, it makes the share value lesser.

Dilution protection refers to any contractual obligations that preserve a shareholders’ existing ownership percentage stake. We will encounter a lot of it in the venture capital space, especially in early-stage startups.

But why do some companies dangle dilution protection measures? Some companies think that risky ventures will spark the interest of investors. However, this only affects the later funding rounds. There are plenty that will offer this feature because they might not even last long enough to see them in the later rounds if they do not have enough initial funding to launch operations. On the other hand, anti-dilution provisions come with convertible preferred stocks and several issues of stock options. They do this to protect the investments of the existing investors from losing their value.

Tell me more about it.

A company will always have funding and investing agreements. In those agreements, we will find a standard anti-dilution provision that protects convertible stocks or securities in the company. They mandate adjustments to the conversion if ever there are more share offers. For instance, a company sells a massive share at a lower price. The dilution protection will act and make a downward adjustment in the convertible securities’ price.

After conversion, the existing investor’s dilution protection would have more company shares. Hence, they can retain the original ownership stake percentage. Now, anti-dilution provisions have two main types: full ratchet and weighted average. They are different in their aggressiveness in protecting each investor’s ownership percentage.

The ones who will most likely expect dilution protection measures are the people with high net worth. They are the ones who know that their money is in high demand.

Important things to note before we end

While dilution protection might interest early investors, a company that uses this might find it hard to maintain the interests of these said investors. They will not be too happy to have the same risk protection for their purchased shares in the succeeding funding rounds. This is the reason why some venture capitalists hesitate or decline to dilution protection rights. They avoid hampering later funding rounds. Also, they want to increase their chances of adopting the company’s success in the long run.

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