Anti-Dilution Adjustment Clause
A clause safeguarding shareholders by offering new shares to current stockholders before making them publicly available
What is the Anti-Dilution Adjustment Clause?
The anti-dilution adjustment clause safeguards current investors by offering shares to current stakeholders before making them publicly available. Companies use this method to protect the ownership rights of existing investors.
- When a company issues new stock in the market, the total number of stocks increases, which may cause current investors' ownership to decline.
- Equity dilution occurs when new shares are issued, decreasing the percentage ownership of earlier investors. This can sometimes result in a decrease in the value of shares issued previously.
- This clause considers the existing shareholders' interests.
When new stock enters the market, the percentage share of the company held by existing holders decreases, lowering the cumulative value of the stock owned; to compensate investors, this clause provides them with stock at a lower price, saving existing investors from losing the value of their stock.
In a nutshell, this serves as a buffet for current investors.
Anti-Dilution Adjustment Clause in Equity Financing
When a company needs financing, some choose to use a technique termed 'equity financing.' This involves selling shares in the company to raise funds.
There are two issues:
1. The decline in the percentage of stocks held by existing investors.
Consider the following scenario: Investor A owns 40% of WSO's 100 stocks. WSO eventually decides to issue additional stock (say 100 more).
The significance of Investor A's stake was reduced dramatically. Eventually, Investor A will own no more than 20% of WSO's stock.
2. Variation in the value of stock
Consider the following scenario: Investor A bought his stock initially for $100/share. Eventually, the company chose to issue more at $90/share.
This is a loss for Investor A since, had he waited a little longer to buy the stocks of WSO, he would've saved his money. This will create dissatisfaction among current investors.
To avoid such issues, such a clause exists.
How do you protect shares from dilution? The clause protects shares from dilution. In addition to affecting existing shareholders, dilution damages a company's reputation in the market.
- In the absence of the clause, devaluation of potential investors' stocks could occur, causing them to lose interest in that company.
- On the other hand, if a company has provisions like the anti-dilution adjustment clause to protect the interests of investors, other potential investors gain a sense of confidence in the company.
Types of Anti-Dilution Provisions
There are two types of anti-dilution adjustment clause provisions
- Price-based anti-dilution adjustment clause provisions
- Contractual anti-dilution adjustment clause provisions
Price-Based Anti-Dilution Adjustment Clause Provisions
Possibly, when a company issues stock in the market, it will issue at a lower price than before. Existing investors may have purchased the stock at a higher price, so their stock value may decrease.
As a result, anti-dilution adjustment clause provisions have been created to protect investors.
1. Full Ratchet and Anti Dilution Adjustment Clause
A full ratchet provision protects investors by giving them the right to use the devalued price to buy more stock of the same company.
The provision must give investors a hold on their percentage of ownership to keep their interest entwined with the business.
2. Example
Investor A purchased 100 shares at $10/share, which cost $1,000. Since the company is issuing new shares at $5/share, the value of Investor A's share will decrease by $500.
This loss of $500 will be compensated by offering Investor A the chance to buy more shares worth $500. By using existing share capital, investors buy more shares when the value of the shares declines.
3. Weighted Average
The weighted average method allows investors to keep the devalued stocks with the weighted average price. Unlike the full ratchet method, this method takes away the value of the shares of existing investors but provides a small incentive.
The weighted average formula used is,
New Conversion Price = O x (A + B) / (A + C)
Where,
- O – Old conversion price
- A – Shares outstanding before new issue
- B – Consideration received with the new issue
- C – New shares issued
Example
Assume that 1,000 preferred shares are issued at $5 per share during a first proposition and are convertible at a 1:1 ratio. Next, assume the company issues another 1,000 shares at a new price of $3 per share.
To calculate the new conversion price using the weighted average method, plug the numbers into the formula above.
The new conversion price would be = $5 * (2,000 + $3,000) / (2,000 + $5,000) = $3.57
Previously, the price per share was $5. Later, the price per share was $3. This means that existing shareholders were losing $2 per share.
As a result, the weighted-average method in the adjustment clause aids in restoring some of the value of existing investors' stocks.
This allows them to convert their stocks to $3.57 instead of $3.
Contractual Anti-Dilution Adjustment Clause Provisions
When an investor wishes to purchase a company's stock, they may stipulate the percentage of stock held by them, which should not be reduced due to future funding attempts.
A contract exists to bind both the company and the investors legally. Such a contract protects existing investors from dilution.
The following is a brief YouTube video explaining the Anti-Dilution Adjustment Clause:
Importance of the Anti-dilution Adjustment Clause
The various benefits are as follows:
1. Secures investors’ capital
- The market is dynamic, and continuous funding is crucial for every business to survive. When investors invest their money into any business, they also expect returns.
- To make an equilibrium with all the factors, it is essential to have an anti-dilution adjustment clause to save investors’ capital.
- The various requirements under this clause keep the existing investors interested while attracting new investors.
- Such adjustments also control the right to ownership. Therefore, new investors won’t overpower existing investors by buying the same shares at a lesser price.
2. Acts as a layer of protection for the company’s stocks
Incorporating an anti-dilution adjustment clause into the corporate charter encourages companies to obtain better valuations in subsequent financing rounds.
It also serves as an incentive for the company to consistently meet investor-determined milestones such as revenue targets and other growth objectives to increase the value of its stock.
How does the clause mechanism work as ‘The corporate loop’?
According to various pieces of research, it has been found that this clause is a method used by companies to get more capital from existing investors.
Investors realize that their stake in the company might decrease with the issuance of new shares.
Therefore, they are more likely to buy more stocks offered to them at discounted prices.
When companies need bridge financing or feel the need to negotiate terms with investors, such practice is incorporated.
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