It’s no time to be shy when negotiating investment terms

It is a tough time to raise capital. Debt availability is tight and inaccessible for many, while equity investors are very cautious.

Those equity investors prepared to invest are naturally looking to do so at lower valuations than applied in the good times, valuations which reflect current depressed earnings and lower earnings multiples. For existing shareholders who don’t participate in a new equity round proportionate to their shareholding, their shareholding percentage will be diluted. The greater the price discount compared to previous issue prices, the greater the dilutive effect. Existing shareholders might be effectively “washed out” if the discount is significant enough.

Against this background the fear of dilution in the future is top of mind for both company founders and investors.

In this article, Andrew Lewis considers the case for anti-dilution protection from the respective perspectives of founders, investors and the company itself.


It is not unheard of for founders or investors to insist on inclusion of a provision in the company’s constitution or a shareholders agreement which prohibits the company issuing shares at a lower price than the price they paid. However such a provision ignores commercial reality and is not in the company’s best interests.

The value of any company will change from time to time, whether the shares are being traded or not. This is inevitable as the key determinants of company value, (recent earnings performance, NTAV and future prospects), do not stand still. Accordingly, the underlying value of a company’s shares will rarely be the same as the original issue price. If the value of a company and its shares has gone down, then it is very unlikely that the company will be able to raise additional equity capital at the original issue price. Yet that is often the very circumstance when a company needs new capital as factors which reduce value (eg. poor trading) often result in the company needing additional capital to survive or recover its market position.

Even where a company seeking to raise new capital is optimistic that the required capital can be raised from existing shareholders without having to go out to find new investors, it will want to make any rights issue as attractive as possible, particularly if it is uncertain whether all shareholders will take up their proportionate share. The lower the issue price, the greater the dilution will be for non-participating shareholders and the more incentivised shareholders will be to participate. Shareholders who support the company through the hard times should receive some relative benefit compared to those who don’t and they certainly should not pay more than fair market value at the time they give their support (taking full account of the risk profile and uncertainties which exists at that time).

If a company’s constitution prohibits a down-round then, in most cases that will just pose an additional procedural hurdle to issuing shares at a discounted price. The down-round issue can still proceed if the requisite majority support required to change the constitution is achieved (usually 75%). However any required waiver of a similar prohibition in a shareholders agreement will normally require unanimity (at least of the shareholders who are party to that agreement).

If a down-round is to be restricted, it is more sensible for the constitution or any collateral shareholders agreement to specify any “super majority” or other special shareholder approvals which are required for it to occur than try to prohibit it. This at least avoids the additional procedural steps associated with a change to the constitution or an amendment to a shareholders agreement.

When setting any “super majority” threshold or framing other special approval requirements, careful consideration should be given to the effective veto rights created and whether the parties who can block a down round are likely to exercise that right responsibly with regard to the company’s interests and not just their own.


Rather than trying to prohibit or restrict a down-round, it is more common and logical for investors to seek protection against the dilutionary effects of a down-round. The legal provisions which provide this protection are usually called “anti-dilution” provisions and typically operate by requiring additional shares to be issued at nominal value to the shareholders who have the protection, thereby reducing the dilution suffered when a down-round occurs. All existing shareholders will still be diluted if new shareholders subscribe for shares, but the anti-dilution provisions will reduce the dilution in shareholding value which is suffered by the protected shareholders when new shares are issued at a reduced price.

Such provisions usually provide either full ratchet protection or weighted average ratchet protection, depending on the extent to which they reduce the average share price paid by the shareholders who benefit from the protection.

Under a full ratchet, the protected shareholders receive such number of additional shares as will reduce the average price they have paid for shares in the company to the lower price at which shares are issued in the down round.

There are a number of variations for weighted average ratchets (some are narrow while others are broad based), but commonly the protected shareholders receive such number of additional shares as will reduce their average price to a weighted average of different issue prices. A narrow weighted average is typically a weighted average, according to relative amounts invested at the different prices, of the protected shareholders’ previous average share price and the lower price for the new issue, while a broadly based weighted average will provide an average across a wider equity spectrum, (possibly inclusive of options).


To demonstrate how these clauses operate and the difference in the protection afforded by the different types of clause, consider the example of protected shareholders who invested, say, $1 million to subscribe for 1 million shares at $1 per share, where the company subsequently raises a further $1 million by issuing 2 million shares at 50 cents per share.

Under a full ratchet provision the protected shareholders will be issued an additional 1 million shares at nominal value, reducing their average price per share to the down round price of 50 cents (they will then have 2 million shares for $1 million invested).

Under a narrow weighted average ratchet the protected shareholders might be issued an additional 500,000 shares, reducing their average price to 66 cents, which is the weighted average where the company will have raised $2 million in total over the two issues by issuing 3 million shares (before the issue of the “free shares” under the anti-dilution provision).

In some cases the additional shares are issued contemporaneously or immediately after the down- round while in others, typically when the protected shareholders hold preferred shares, the protection only operates through the conversion formula if and when the preferred shares are converted to ordinary shares.


Ant-dilution provisions protect one category of shareholders at the expense of others (usually they protect investors who invested after the founders at the expense of the founders). Simply put, the dilution in shareholding value which would have been suffered by the protected shareholders (but for the anti-dilution protection) is shifted to the shareholders who don’t have that protection, so they suffer not only their own dilution (based on pro rata shareholding) but also much of the value dilution which would otherwise have been suffered by the protected shareholders.

Depending on the size and price differential of the down-round the effects can be quite dramatic for the unprotected shareholders. The value of their shareholding can effectively be “washed out” by the combined effect of the down-round and the issue of free shares to the protected shareholders.

Anti-dilution provisions rarely operate in the company’s best interests. They generally make it more difficult to raise new capital in the future and can adversely affect the company’s future prospects, particularly if the founders who suffer the increased dilution include key people who remain important to the company achieving its growth objectives. However the company may have no choice but to confer anti-dilution protection in order to raise required capital and immediate capital requirements invariably take precedence over potential future implications. Where investors insist on anti-dilution protection the company should, if possible, try and introduce a “pay to play” condition so the investors have to participate in a new investment round in order to receive the protection.

Usually anti-dilution protection is conferred on investors who are paying more for their shares than the company founders and are investing based on the future potential of the company (as opposed to current earnings). If that value is not borne out by subsequent company performance and the company needs to raise more capital at a lower price, the investors effectively have an opportunity through the anti-dilution mechanism to retrospectively re-price their shares downwards. For the founders who paid less for their shares in the first place (and who may have got a large chunk of their shareholding for “sweat equity” or like, rather than hard cash) this might only mean that they lose the paper gain which accrued on the value of their shares when shares were initially issued to the investors at a premium.

While anti-dilution protection may well be justified at the time it is granted (based on the above factors) the protected investors should be realistic about whether they will actually receive the benefit of the protection when a down-round occurs. If the company is sufficiently desperate for new capital that it is forced to offer shares at a lower price to new investors, those new investors will hold the negotiating power and may impose an investment condition that any anti-dilution provisions are waived, particularly if they feel that the resultant additional dilution of the founders will be against the company’s best interests (which, as noted above, may well be the case if founder support and alignment are still considered important for the future success of the company and the additional dilution will deprive them of meaningful shareholdings which will ensure they remained sufficiently aligned with the company’s interests). The previous investors who have the anti-dilution protection may have little choice but to waive that protection if the company needs the new capital and they are not in a position to provide it.

Alternatively the new investors may be happy for the anti-dilution provisions to be applied, but only if the dilutionary effect on the key people amongst the founders is neutralised by the issue of shares or options under an employee share plan. This will also neutralise the anti-dilution protection to some extent, but will have the advantage of re-targeting incentives and the alignment of founders, concentrating on the people who really are important going forward.

Where the new investors allow the anti-dilution provisions to be applied they will take full account of the negative impact on share value these provisions will have (where the company’s value will be spread across more shares) and factor that into the price per share they are prepared to pay. Accordingly, the down-round share price will be lower again where anti-dilute provisions operate (reflecting the additional dilutive effect such provisions will have on shareholding value).


Whether traded or not the true underlying value of a company’s shares will change regularly. Unless a company needing additional equity capital is able to offer shares at fair value (or less) at the relevant time, then it is unlikely it will be able to raise that capital.

Anti-dilution provisions do not prevent a company issuing shares at a lower price than a previous issue but they can make it more difficult for a company to raise capital and can operate against the company’s best interests by further diluting the founders to a point where they cease to be sufficiently aligned with the company.

Anti-dilution protection can be justified where investors are paying more for their shares than the effective price at which founders or other existing shareholders have invested, particularly where the founders have received “founder equity” or “sweat equity”.

From a company and existing shareholder perspective, it is preferable for any anti-dilution protection to take the form of a weighted average ratchet (rather than full ratchet) and to make that protection conditional on the relevant investors participating in the future investment round for which the protection is applied. However the company’s ability to negotiate these provisions will depend on the strength of its negotiating position, how desperately it needs the new capital and whether it has alternative sources for that capital.


Andrew Lewis Law specialises in investment transactions which fund growth companies. We leverage our international and local experience to provide solutions which combine the best international practice with localised solutions for the particular risks and factors which apply.

Andrew Lewis Law

October 2011