When starting a company in the United States, some partners may request the introduction of an anti-dilution clause in the shareholders’ agreement. This clause may sometimes be disadvantageous to existing shareholders when raising capital. For this reason, it is important to understand the mechanism of the anti-dilution clause in the shareholders’ agreement.
The anti-dilution clause protects the existing shareholders from a dilution of their shareholding
Dilution occurs when the stake of the existing shareholder’s ownership decreases as a result of the company increasing in the number of shares issued to investors.
Dilution arises usually during the second or third round of capital raising. The anti-dilution clause protects the investors from dilution when the company issues new shares at a lower price than initially paid. Anti-dilution clauses can take two main forms – they can be either full ratchet or weighted average ratchet.
A full ratchet anti-dilution clause provides the greatest protection for investors. Nonetheless, it is a restrictive clause. This type of clause protects existing shareholders from dilution when there is a new stock issuance at a lower price than originally paid by the existing shareholder. Practically, the full ratchet anti-dilution ensures that existing shareholders maintain their percentage ownership without incurring additional costs if the company creates additional rounds of funding. This is achieved by reducing the conversion price to allow existing shareholders to convert their preferred shares into a given percentage of ordinary shares. In such circumstance, the shareholder receives more shares for their initial investment.
A weighted average ratchet anti-dilution clause is a more standard type of clause that is frequently found in shareholders’ agreements
With this mechanism, a shareholder can increase the value of their shareholding at the new share issuance price. The formula adjusts the rate of conversion of preferred shares into common shares based upon the amount raised before the new round and the average price per share at which it was raised and the amount being raised in the subsequent round and the price per share at which the new capital is being raised.
It is important to mention that anti-dilution clauses cannot be applied in every case
Partners can negotiate the existence of such clause only for specific circumstances. Further, this means that the anti-dilution clause can protect one shareholder while being disadvantageous to another. This is especially dangerous when it is unfavorable to the founding partner. For instance, when the shares of a founding partner are diluted, this dilution may affect the business and be an impediment for the growth of the company.
There are several other clauses that may be better than the anti-dilution clause. For example, a “pay to play” provision may be healthier for the company than an anti-dilution clause. A pay to play provision protects investors from dilution only when they participate in rounds of capital raising. It protects both the shareholders and their initial stake and the ownership interest in the company when looking for additional capital.
In conclusion, when considering raising additional capital, initial shareholders should have in mind the impact that an anti-dilution clause can have on their business. As discussed, a “pay to play” clause may produce better results.
Our business lawyers in Miami, Florida USA successfully plan and prepare shareholders’ agreements. Contact us, your business attorney in Miami, Florida USA to help you with drafting an anti-dilution clause or other relevant provisions in the shareholders agreement or schedule a consultation.
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