Two of the tools investors can use to minimize the risks they take and preserve their holding percentage in a company are the anti-dilution protection and pre-emptive rights. These very important rights are customarily included in investment agreements, particularly for early-stage investors. These rights provide some certainty to investors with regard to their holding percentage in a company when the company launches a fundraising round (whether at a company value higher or lower than during the previous round), resulting in a decrease in value of the investor’s shares. By exercising these rights, investors are guaranteed some protection against the dilution of their holding percentage.
What is Anti-Dilution Protection?
An anti-dilution provision protects investors in a situation whereby the company raises capital in the future at a lower price per share than the price per share they originally paid. The fact the company issues shares at a lower price per share means the value of an investor’s shares decreases. An anti-dilution provision enables investors to preserve the value of their holdings by allotting additional shares according to a predefined mechanism. Investors that purchase preferred stock usually obtain this protection. There are two customary mechanisms for determining the anti-dilution compensation.
Full ratchet provision
This provision enables existing shareholders to receive additional shares as if they had invested at the lowest price offered in the most recent investment round. Thus, the investor has protection in the event the new share price is lower than the price it invested in the investment agreement. For example, if an investor invested in a company at a price per share of USD 10 and the company is now allotting shares at a price per share of USD 5, the investor is entitled to receive additional shares as if it had invested the original investment sum at a price per share of USD 5. Thus, as a result of this anti-dilution mechanism, the investor will receive double the number of shares it received in the original investment agreement.
Weighted average provision
There are several different mechanisms for calculating the weighted average, but they all have the same principle. This principle calls for the allotment of additional shares in the event the new share price is lower than the price the investor invested in the investment agreement, according to the calculation of the average between the price per share at which the investor invested and the new share price, taking into account the differences in the sums of money invested and the number of company shares. All the calculations will result in a lower share price than the price paid by the investor in its investment agreement, and thus additional shares will be allotted to the investor.
What are Pre-Emptive Right?
A pre-emptive right gives existing shareholders the opportunity to purchase additional shares before offering the shares to a new investor. This right is usually granted to early-stage investors or to investors that are willing and intend to invest higher sums in the company at later stages. Like with the anti-dilution provision, a pre-emptive right enables existing shareholders to preserve a particular holding percentage (and sometimes even to increase their holding percentage). However, unlike anti-dilution provisions, existing shareholders must invest additional funds into the company according to the proposed new company value. In most instances, a pre-emptive right allows investors to invest a sum through an investment transaction in the company that will enable them to preserve the holding percentage they had prior to the new investment round in the company. In other words, if a company raises USD 1 million, an existing shareholder (earlier investor) holding 5% of the company may invest a sum that will enable it to maintain that 5% holding percentage subsequent to the investment round (a sum of about USD 50,000).
It is important to emphasize that the pre-emptive right does not guarantee a shareholder will preserve its holding percentage in the company but grants it the right to purchase new shares that the company will allot in order to preserve (or sometimes increase) its holding percentage in the company.
What’s the Difference?
As stated, both anti-dilution and pre-emptive rights give existing shareholders an opportunity to preserve their holding percentage in a company, but there are differences between them. Anti-dilution protects the shareholder from dilution in a situation whereby the company allots shares at a company value lower than that of the previous round. Conversely, pre-emptive rights give existing shareholders an opportunity to purchase additional shares during future allotments at the share price offered during that round (whether higher or lower than in the previous round).
These rights are typically included in investment agreements (usually within the framework of the company’s articles of association, as amended and adopted within the framework of the investment round). The inclusion of one of these rights in an investment agreement improves the investor’s position, but only including both will give the investor (almost) full anti-dilution protection.
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Barnea Jaffa Lande’s Corporate Department has extensive experience advising investors during investment transactions in startups and early-stage ventures. We are at your service to answer any questions in this regard.
Adv. Dana Ben Yehuda is an associate in the department.