Financial Glossary
Anti-dilution clause
An anti-dilution clause is a contractual provision in a preferred stock purchase agreement that protects investors from the economic impact of future equity issuances at a lower valuation (a down round) by adjusting the conversion price at which their preferred shares convert to common stock. The two primary mechanisms are: broad-based weighted average anti-dilution, which recalculates the conversion price based on a weighted average of all shares outstanding and the new issuance price, resulting in a moderate adjustment; and full ratchet anti-dilution, which resets the conversion price to match the new, lower round price regardless of volume, maximally protecting the investor but severely diluting founders and employees. Anti-dilution provisions are standard in institutional venture deals and negotiate-able in angel and seed financings.
Problem & Application
A startup raised a Series A at $5 per share on a $10M pre-money valuation. The Series A investor purchased 1,000,000 preferred shares convertible to 1,000,000 common shares at the $5 conversion price. The company subsequently raises a Series B at $3 per share (a down round). Under full-ratchet anti-dilution, the Series A conversion price adjusts to $3, meaning the 1,000,000 preferred shares now convert to $5 million divided by $3 = 1,666,667 common shares -- the investor effectively receives more shares without paying more, diluting everyone else. Under broad-based weighted average, the adjustment is proportional: if 10,000,000 shares were outstanding pre-Series B and 2,000,000 new shares are issued at $3, the formula blends the old and new prices based on volume, resulting in a conversion price of approximately $4.60 -- a smaller but still meaningful adjustment. A fractional CFO or startup attorney modeling a down-round term sheet would run the dilution table for both scenarios, showing founders and the board how much of their equity is consumed by the anti-dilution mechanism before deciding whether to accept the new round's terms or seek alternative financing.
In Short
Anti-dilution clauses provide critical protection for investors, ensuring fair ownership retention while fostering trust in startup investments.