Insight

April 07th, 2021

7/4/2021

	JT LEGAL LLC

ANTI-DILUTION PROVISIONS
Ensuring that your rights stay protected from dilution so that you can concentrate on other matters

Mr. Joshua Tan		+65 6809 5145 \| joshua@jtlegal.com.sg \| jtlegal.com.sg

INTRODUCTION		TYPES OF ANTI-DILUTION PROVISIONS 1. Full Rachet 2. Narrow-Based Weighted Average 3. Broad-Based Weighted Average

What are anti-dilution provisions?
Anti-dilution provision are clauses which are included in agreements to protect investors from dilution. Dilution occurs when an investor’s potential stake in the company decreases because of an increase in the total number of shares outstanding. The increase in the total shares outstanding may be due to a new share issuance based on a new round of equity financing. Dilution is inevitable as companies, particularly start-ups, seek to raise new capital through equity financing.

		How do the provisions work?
		Anti-dilution provisions are mostly invoked when companies encounter down-round financing. A down-round involves new shares or convertible instruments being issued at a lower price than the round that the investor in question came in. While there are several types of anti-dilution rights commonly seen, they all have one thing in common – each of them allows for the adjustment of the number of shares to be issued (whether in the case of a convertible instrument or an option) to decrease the dilutive effect on an investor’s stake, albeit to different extents. However, a pertinent point to note is that this protection against dilution comes at an expense. The more anti-dilution protection an investor is afforded, the more a founder’s own stake is diluted. To illustrate this, we have included a simple case study.

Types of investments

Anti-dilution provisions are usually used in relation to the following types of securities: 1. Convertible preference shares 2. Convertible loans 3. Options

SCENARIO

· Mr. A, the founder of XYZ Pte. Ltd., initially held 3,000 ordinary shares.

· XYZ Pte. Ltd. had two (2) rounds of fundraising.

o During the 1^st round, 2,000 convertible preference shares were issued at S$1.00/share to Mr. B

o During the 2^nd round, 2,000 convertible preference shares were issued at S$0.50/share to Ms. C

How many ordinary shares will Mr. B be entitled to under each type of anti-dilution provision?

#1: NO ANTI-DILUTION PROVISION

	Investment	Preference Shares	Conversion Price	No. of ordinary shares (post-conversion)	Ownership

Mr. A	-	-	-	3,000	42.86%

Mr. B	S$2,000	2,000	S$1.00	2,000	28.57%

Ms. C	S$1,000	2,000	S$0.50	2,000	28.57%

#2: FULL RATCHET

	Investment	Preference Shares	Conversion Price	No. of ordinary shares (post-conversion)	Ownership

Mr. A	-	-	-	3,000	33.33%

Mr. B	S$2,000	2,000	S$0.50	4,000	44.44%

Ms. C	S$1,000	2,000	S$0.50	2,000	22.22%

#3: WEIGHTED AVERAGE

For the narrow-based weighted average, we have assumed that A is the number of ordinary shares issuable on the conversion of preference shares issued in the 1st round of fundraising. As such, the value of A is 2,000, as only 2,000 preference shares were issued in the 1st round of fundraising. #3A: NARROW-BASED WEIGHTED AVERAGE

	Investment	Preference Shares	Conversion Price	No. of ordinary shares (post-conversion)	Ownership

Mr. A	-	-	-	3,000	39.13%

Mr. B	S$2,000	2,000	S$0.75	2,666	34.78%

Ms. C	S$1,000	2,000	S$0.50	2,000	26.09%

#3B: BROAD-BASED WEIGHTED AVERAGE

	Investment	Preference Shares	Conversion Price	No. of ordinary shares (post-conversion)	Ownership

Mr. A	-	-	-	3,000	41.00%

Mr. B	S$2,000	2,000	S$0.85	2,666	32.00%

Ms. C	S$1,000	2,000	S$0.50	2,000	27.00%

CHOOSING BETWEEN THE 3 DIFFERENT TYPES OF PROVISIONS

	Full Rachet	Narrow-Based Weighted Average	Broad-Based Weighted Average	No Anti-Dilution Provision

Mr. A	33.33%	39.13%	41.00%	42.86%

Mr. B	44.44%	34.78%	32.00%	28.57%

FOUNDER FRIENDLINESS

Existing Investors

A full ratchet anti-dilution provision is the most favourable for existing investors, as it allows the conversion price to be disproportionately decreased in the event of a down round.

New Investors

Prior to an investment, an investor may wish to thoroughly assess a company and other investments which may have been made into a company. This will help an investor determine whether the amount that he or she is investing will give them the desired end result, e.g., a particular percentage shareholding of the company.

Founders

In a simplistic scenario like the scenario above, no anti-dilution provision will be the most preferable for a founder. However, to attract investors, a founder will have to weigh the costs and benefits of the various anti-dilution provisions. Other factors, such as the bargaining power of the new investor or the value that an investor may represent to a start-up (e.g., network, resources) will also come into play.

General

A stakeholder should remember that an anti-dilution provision is just one provision in an entire agreement or investment document; there may be other rights or restrictions to consider. For example, an investor may seek to include a restriction on transfers of shares by the founder or may also wish to have board appointment rights. Other considerations include dividend policies, redemption rights of shares, and liquidation preference.

Ultimately, some degree of negotiation and compromise may be necessary, as what is beneficial to one party may not necessarily be beneficial to all other parties. As such, an in-depth review of the term sheet or other investment documents is recommended so that a founder or other stakeholder may make an informed decision.

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Deadlock Clauses

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April 07th, 2021

JT LEGAL LLC

Deadlock Clauses

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