Anti-Dilution

How to model anti-dilution for equity shareholders in the Cap Table and Exit Waterfall Tool

Dilution is normal. Down rounds are not.

Dilution has a worse reputation than it deserves. When a company raises a round, it issues new shares, the total share count goes up, and everyone who already owned shares owns a smaller slice. That is dilution, and it is the normal price of raising money. If the new round is priced higher than what you paid, your slice is smaller but each share is worth more, and you have come out ahead.

A down round is the case that actually hurts. A down round happens when a company raises at a premoney valuation below the postmoney valuation of a prior round, so the new shares are priced lower than the old ones. Past the math, down rounds take a real toll on morale and on how a company sees itself.

Anti-dilution protection exists for that case.

What is anti-dilution?

Anti-dilution provisions are clauses in shareholder agreements that protect existing shareholders from one of two different problems.

Ownership dilution is when an investor's equity percentage falls because the company issues new shares, options, or warrants. Rights of first offer, also called pre-emptive rights, address this.
Value dilution is when the value of an investor's stake falls because new shares are issued at a premoney valuation below the prior round's postmoney. Anti-dilution provisions address this.

The two problems have two different remedies.

Ownership dilution is fixed by issuing more shares. A right of first offer lets an investor buy into the new round to hold their percentage. Some terms instead issue shares outright, for free or for a nominal amount, until the investor's fully-diluted percentage is back where the agreement says it should be. How far up depends entirely on terms that are negotiated and custom, so read them.

Value dilution is fixed by changing the conversion ratio. Agreements can require the company to issue new shares, but adjusting the conversion ratio is far more common. These "price-based anti-dilution adjustments" change the price at which preferred converts into common, which changes how many common shares each preferred share is worth. Issued and outstanding shares don't move; the fully-diluted, as-converted count does. The rest of this doc is about that mechanism.

How the conversion ratio works

Normally one preferred share converts to one common share, a conversion ratio of 1.00. The ratio is the original equity issue price divided by the conversion price, and when those are equal it comes out to 1.00.

Conversion ratio = Original equity issue price / Conversion price

In a down round, if the preferred had anti-dilution protection, the conversion price resets to something lower, which pushes the ratio above 1.00. One preferred share now converts into more than one common share, offsetting the value dilution.

Anti-dilution comes in two flavors, and the difference is how protective they are.

Full ratchet is the best outcome for the investor and the harshest for common. It reprices the protected preferred all the way to the new round's price. Very dilutive to founders and employees, and rare.
Weighted average gives partial protection. The new conversion price lands between the original issue price and the new, lower share price, weighted by how many shares were issued at the lower price relative to the rest of the cap table. Broad-based uses fully-diluted shares in that weighting; narrow-based uses only issued and outstanding, excluding options and warrants. Narrow-based protects the investor more; broad-based is the more common term today.

The formulas

Every version computes a new conversion price, then plugs it into the same ratio.

New conversion ratio = Original equity issue price / New conversion price

Full ratchet sets the new conversion price equal to the new financing price:

New conversion price = New equity issue price

Weighted average blends the old and new prices:

New conversion price = Prior conversion price * (FD shares prior to the down round + shares that would have been issued in the new round at the prior conversion price) / (FD shares prior to the down round + shares actually issued in the new round at the new price)

Broad-based uses fully-diluted shares throughout; narrow-based swaps in issued and outstanding.

Worked example with sample cap tables: Allen Latta's Anti-Dilution Protection: An Overview.

There is no substitute for reading the actual agreement. Anti-dilution clauses get shaped, expanded, and limited with extra terms in ways the vanilla descriptions never capture, including carve-outs for option grants and other excluded issuances, and sometimes a requirement that the investor participate in the down round to keep the protection at all. Read the shareholder agreement, then turn what it says into the math.

Impact on cap tables

A cap table can be read two ways: issued and outstanding (shares actually issued) or fully-diluted (issued plus shares reserved for options and warrants).

Value-based anti-dilution changes the conversion ratio, which changes the fully-diluted, as-converted count but leaves issued and outstanding untouched. That's why a conversion ratio column belongs between the two views: at 1.00 nothing has happened, and any other number means anti-dilution has fired.

Impact on exit waterfalls

Calculating preferred returns in a liquidity event means deciding, for each preferred holder, whether they keep their preferred and take the liquidation preference or convert to common and take the common distribution, with any participation rights layered in.

Anti-dilution does not change the liquidation preference. That stays at the original price paid. It does change the conversion ratio, so use the adjusted ratio when you calculate proceeds to preferred and the fully-diluted share count.

Terms and calculations: Modeling Exit Waterfalls

How the Cap Table and Exit Waterfall Tool calculates anti-dilution

The free Cap Table and Exit Waterfall Tool includes a sheet with prebuilt anti-dilution (beta). A few things to know:

A conversion ratio column sits between issued and outstanding and fully-diluted.
The anti-dilution section takes an input for the prior price paid per preferred share.
When enabled, it calculates full ratchet, broad-based, and narrow-based, and a dropdown selects which one to apply.
The original preferred purchase price is a manual input. The model doesn't pull it from prior rounds, so you can run anti-dilution off a prefinancing cap table without modeling the full history.
By default only old equity gets the adjusted ratio. If a shareholder invested in multiple rounds, split them across rows.
If investors bought in at different prices, replicate the anti-dilution calculation for each class and link each conversion ratio back into the cap table.
The exit waterfall already used the conversion ratio; the update enabled the keep-vs-convert test per shareholder, using proceeds per share to common.

Where this lives in your legal docs

Anti-dilution mechanics live in the Certificate of Incorporation, in the section defining each preferred series' conversion price and conversion ratio. The trigger conditions, the exclusions (carve-outs for option grants, employee stock plans, and the like), and the choice of full ratchet vs broad-based vs narrow-based are all spelled out there. The NVCA Certificate of Incorporation is the standard template.