Anti-Dilution Clauses in Venture Capital

The purpose of this document is to provide our readers with the basic concepts of dilution, in order to support them in the negotiation of investment contracts that include clauses related to this concept.

What is Dilution?

Dilution is an effect that accompanies a start up when it raises its capital through the issuance of shares, consisting in the decrease of “ownership” or shares of the shareholders of a company. Dilution implies that the total capital of the company has not increased proportionally to the increase in the number of shares issued, so the value per share is reduced. The investor maintains the same number of shares, however, the individual value of each share is adjusted and becomes lower.

Anti-dilution clauses are provisions that the parties agree in investment contracts (SAFEs, Notes, SPAs) that protect investors from a decrease in their percentage of participation in the company derived from future financing rounds being carried out taking a lower valuation of the company, which is known in the Venture Capital ecosystem as “down-round financing”.

There are 3 types of clauses that seek to protect the investor from dilution:

• Full Ratchet: Full anti-dilution clause, the conversion price is adjusted to the lower price of the new shares issued in future rounds. This means that if shares are issued at a lower price in a new round, the conversion price of the existing preferred shares is reduced to the new lower price. It is the most aggressive form of anti-dilution protection for investors.

• Weighted Average: Partial anti-dilution clause, the conversion price is adjusted based on a formula that considers the number of shares issued and their price in the corresponding round. A new average price is calculated for the investor, always lower than the entry price. There are two types of this type of clause:

• Broad based weighted: it includes all outstanding shares. In this sense, it is recommended to clearly define in the shareholders’ agreement the number of shares to be considered as the total number of shares. This modality is the least dilutive, therefore it grants a greater benefit to the founders.

Formula: Average price = total shares x price B + capital increase + additional shares.

Price B” being the price agreed upon through the valuation of the new investment round.

o Narrow based weighted average price: In this mode only preferred shares are included. This benefits the investor, since by considering only preferred shares, the average price decreases, so the investor will receive a greater number of shares.

• Pay to play: This modality requires investors to participate in future rounds, since only in this way can the anti-dilution clause be made valid, thus incentivizing investors to continue supporting the company.

A recent phenomenon links these provisions to specific performance objectives in terms of the company’s income, if the company does not reach certain goals, an adjustment in the conversion price of the shares is automatically triggered, however, although this may be a motivation for the fulfillment of the company’s objectives, some experts warn that the practice of this trend may affect the company in the long term in relation to the changes that may be generated in the market.

Applicability in Mexico

The clauses described in the previous section are a protection mechanism, originated in common law; however, in countries with Latin traditions, a mechanism known as the right of first offer, right of first refusal or right of first refusal prevails. Although both seek to mitigate the risk associated with future investment rounds and changes in the company’s valuation, it is important to be clear that they are not assimilable mechanisms. Anti-dilution clauses automatically adjust the value of the shares in the event of new issues. On the other hand, the right of first refusal, based on the principle of equity in civil law, gives investors the option to maintain their proportional shareholding, allowing them to maintain the percentage of ownership through additional investments and thus can participate in future investment rounds, thus avoiding dilution by buying new shares, but with an additional investment, in a manner similar to Pay to Play.

It is extremely important that both founders and investors understand the differences in these mechanisms, as they significantly influence the capital structure, negotiations and future development of venture capital start-ups.

Anti-dilution clauses play a fundamental role in the venture capital world, as they act as a bridge between the interests of investors and the potential growth of start-ups. Seeking to incentivize the founder to achieve a higher valuation in its next round and protecting to a certain extent the value of the investor’s capital.

It is important to have the advice of expert lawyers in this area to avoid falling into common mistakes when negotiating this kind of clauses.

This document does not represent a legal opinion or analysis. For further information or clarification of any doubts, our team is ready to assist you in the contact below.