Why You Should Be Anti Anti-Dilution

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A client, who had already raised some money and thus had a few people on his cap table, came in recently with a term sheet whereby the prospective investor had requested “anti-dilution” protection. If you’re not familiar with anti-dilution, it basically means that the investor’s ownership stake in the company cannot be diluted by subsequent financing activities.

This particular client was still learning about the nuances of raising capital, and was willing to consider accepting the term because the other terms were right and the investor was a strong strategic fit. He knew that “anti-dilution” was likely not a good thing, but he had discussed putting himself on equal footing with the new investor regarding anti-dilution. He figured this was a reasonable solution, they would now both have anti-dilution rights, and wanted to move forward with the term sheet.

I told him that the term would be a death knell for his business.

First of all, he would infuriate his current investors because future rounds would only dilute the old investors, not the founder or the new investor. Secondly, it would be impossible for him to raise money in the future for the exact same reason – later investors would not want to join a cap table where someone will reap the benefit of their investment dollars without being diluted.

I further explained that the prospective investor should not want to jeopardize the company’s ability to raise capital in the future and would likely surrender the request once I was able to clarify the term.

We called the prospective investor and were quickly able to agree to a compromise: a “right of first offer” aka a “pre-emptive right,” which would allow the prospective investor to invest his pro-rata share in subsequent rounds so that he could always maintain his ownership stake. This is a typical venture financing term for larger investors and later rounds and a great solution for the circumstances here.

Now, please understand that “anti-dilution” rights are a common venture term. But these are very rarely full-ratchet anti-dilution (like described above) and are generally a way to protect investor interests in the event of a down round. Consult with your venture attorney before agreeing to anything.

Some kind of “anti-dilution” protection can be reasonable when done correctly. But full blown anti-dilution rights, whereby an investor can never be diluted, should not be part of your financing strategy. In closing, be cognizant of anti-dilution terms. They could be dangerous to your company and usually there is a much more innocuous way for your investor to protect her interests.

About the Author
Kevin Vela

Kevin is the managing partner at Vela Wood. He focuses his practice in the areas of venture financing, M&A, fund representation, and gaming law.

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