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JT LEGAL LLC | CORPORATE LAW AND COMMERCIAL LAWYERS IN SINGAPORE

Articles

April 07th, 2021

7/4/2021

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

o   During the 2nd 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

With a full ratchet anti-dilution clause, the conversion price of the existing preference shares is reduced to the conversion price for the down-round Mr. B’s Initial Conversion Price: S$1.00/share
 Mr. B’s New Conversion Price: S$0.50/share
 

 

 

 

 

 


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

In the case of broad-based weighted average, the conversion price after a down-round is adjusted upwards by taking into account all ordinary shares outstanding on an as-converted basis, thereby using all previously issued securities as the base.
 
 In the case of narrow-based weighted average, the adjustment accounts for narrower scope of previously issued securities, e.g., only preference shares (as opposed to including the exercise of options and the conversion of other securities), or ordinary shares issuable on conversion of a particular series of shares.
 ,Formula:
 CP2 = CP1 x (A + B) ÷ (A + C)
 ,CP1 = New Conversion Price
 CP2 = Conversion Price during prior round 
 A = All ordinary shares outstanding on an as-converted basis (broad-based) OR ordinary shares issuable on conversion of a particular series of shares (narrow-based)
 B = Total consideration received by the company divided by the price per share for a particular round
 C = Number of shares issued in new round
 

 

 

 

 

 

 

 

 

 

 

 


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

CP2 = S$1.00 x (2,000 + S$1000/S$1.00) ÷ (2,000 + 2,000)
  = S$1.00 x 3,000 ÷ 4000
  = S$0.75
 

 

 

 

 

 


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

Using broad-based weighted average, the ordinary shares currently held by Mr. A are also included in the calculation. Where there have been options issued (e.g., employee share options) or convertible loans, these securities will also be included in the calculation of A as if they have been exercised of converted (as the case may be).
CP2 = S$1.00 x (5,000 + S$1000/S$1.00) ÷ (5,000 + 2,000)
  = S$1.00 x 6,000 ÷ 7000
  = S$0.85
 

 

 

 

 

 

 


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

FRIENDLINESS TO EXISTING INVESTORS

 

 

 

 

 


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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