Introduction to the concept of Anti-Dilution
An investor’s decision to invest in a company is, usually, driven by the company’s future
potential. If it is subsequently found that the company has failed to meet its expected
potential, a valuation dip occurs. This often leads to a down round which refers to the
issuance of shares at a lower price. Consequently, the investment made by investors suffers as
the value of shares held by such investors witnesses a downfall.
In consideration of the decrease in the investor’s shareholding percentage owing to fresh
investment in the company by new investors at a lower price, anti-dilution provisions are
negotiated by the investors prior to making an investment in the company. However, anti-
dilution provisions are significant not only from the investor’s perspective but also from that
of the company point of view. Often, anti-dilution protection is offered by companies to
attract investors in the equity round to ensure long-term investment. In other words, without
providing anti-dilution protection, it might be difficult for companies to find investors and
raise funds.
Anti-dilution protection is a standard clause in transactional agreements, however, it is
critical for both, the investor and the company, to negotiate its terms. Generally, there are two
types of anti-dilution: (i) Full Ratchet, being especially investor favouring; and (ii) Weighted
Average.
- Full Ratchet Method
Under the Full Ratchet method, the shareholding of the existing investor is adjusted on the
basis of the reduced per share price offered by the Company as part of the down round. In
other words, the price of the shares or conversion price of the existing investor will be revised
to the per share price at which the new shares are being issued in the down round.
Consequently, additional shares are issued to the existing investor to cover for the price
adjustment without requiring the investor to make any further payments towards such
additional shares being issued. Thus, the effect of this method would be such that the existing
investor is assumed to have originally invested in the Company at the down round valuation
and its shareholding percentage is accordingly adjusted.
It is pertinent to note that under this method, neither the number of shares held by the existing
investor nor the number of shares offered to the new investors are considered. The only factor
that is taken into account is the new per share price at which shares are offered to the new
investors. Then, the new per share price is applied to all shares held by the existing investor.
Additionally, it is noticed that under the Full Ratchet method, the existing investors will
benefit from an anti-dilution clause and the company will be compelled to issue more and
more shares in order to protect the existing investor’s shareholding percentage.
Under this method, the company, over time, may lose control over issuance of shares.
Therefore, this method is considered investor-friendly and harsh on the company. Further, it
may lead to dilution of the founders’ shareholding percentage to a great extent. In light of
this, the Full Ratchet method of anti-dilution is rarely implemented.
2. Weighted Average Method
In comparison to the Full Ratchet method, companies prefer the Weighted Average method to
provide anti-dilution protection to its investors. The rationale behind this is that the Weighted
Average method uses a systematic formula for adjustment of shares, thereby, limiting dilution
in a manner that is beneficial to both, the existing investors and the company. It can be
considered as a mechanism wherein the shares of the Investor are converted based upon the
conversion price which is the average between the existing share price and down round share
price. Thus, this method is viewed as a more balanced and fair mechanism.
Factors like the original per share price at which shares were issued to the existing investors,
and the number of shares offered to the existing and new investors are taken into account in
the formula to determine the appropriate price adjustment. The concerned adjusted
conversion price is, then, used to drive up the existing investors’ shareholding percentage in a
down round. The adjustment, usually, is very modest if the number of shares offered to the
new investor are less and vice versa if the number is more.
Further, the Weighted Average method is classified into two methods namely, (i) Broad-
based Weighted Average method; and (ii) Narrow Weighted Average method. The basic
difference between the two methods is that the former takes into account the entire amount of
outstanding shares for the adjustment, whereas, the latter may be tailored to exclude certain
classes of shares. Moreover, Broad-based Weighted Average method is commonly used as
there is a larger down round adjustment under Narrow Weighted Average method.
Implementation of an Anti-Dilution Provision
Even though it is considered standard to have an anti-dilution provision in the definitive
agreement, the implementation of the provision has led to the occurrence of several complex
legal implications for the concerned company to deal with.
It may be noted that any further issue of shares by an Indian company shall occur pursuant to
the provisions of the Companies Act, 2013 (the “Act”) and, if applicable, also pursuant to the
provisions of the Foreign Exchange Management Act, 1999 along with its rules and
regulations. Wherein any share is issued to a foreign investor, the same has to be issued in
compliance with the pricing guidelines under Foreign Exchange Management (Transfer or
Issue of Security by a Person Resident Outside India) Regulations, 2017
(“FDI Regulations”). As per FDI Regulation’s pricing guidelines, such capital instruments
has to be priced as per any internationally accepted pricing methodology for valuation on an arm’s length basis and duly certified by a chartered accountant or a SEBI registered merchant
banker or a practicing cost accountant in case of an unlisted company.
On the other hand, while we look into the case of issuance of convertible instruments, it may
be observed that the price/conversion formula of the convertible instrument has to be
determined upfront at the time of issue and that the price at the time of conversion should not
in any case be lower than the fair value, at the time of issuance of such instruments, in
accordance with the FDI Regulations.
In consideration to the aforementioned observations, it may be crystal clear that the
enforcement and implementation of anti-dilution provisions whilst issue of shares pursuant to
the same (especially in case of foreign investors) carries a lot of complexities. Furthermore,
there may also exist critical complexities and high taxability obligations in these types of
transaction. Hence, one is always suggested to consult experienced professional prior to
entering into and conducting such transaction deals.
Conclusion
In light of the COVID-19 pandemic, our country’s economy has been hit hard resulting in a
downfall of company valuations. Such circumstances have forced companies to issue shares
at lower prices, therefore, diluting the shareholding percentage of existing investors. The
situation demands heavy diligence on part of investors while negotiating anti-dilution rights.
It has become extremely significant for both the investors and companies, to hypothecate
different scenarios and comprehend the true impact of distinct types of anti-dilution
provisions.
Further, it is pertinent for investor to note that, may it be the less preferred Full Ratchet
method or the company-friendly Weighted Average method, protection from dilution can be
provided using different mechanisms. In this regard, companies may choose adjustment by
way of: (a) issuance of additional shares to the existing investors; (b) transfer of shares from
founders to the investor; (c) in case of convertible instruments, by adjusting the conversion
price as per previous prices; (d) buy back of shares held by existing investors; or (e) by
reducing the sale proceeds of the promoters or other shareholders. However, the most
commonly used mechanism is issuance of additional shares to the existing investor.
Author: Dippyaman Bhattacharya, Associate.
Disclaimer: The content of this article is intended to provide a general guide to the subject matter and that the same shall not be treated as legal advice. For any queries, the author can be reached at dippyaman@samistilegal.in
