1. INTRODUCTION

Anti-dilution or valuation protection rights are commonly accorded to financial investors, such as venture capital or private equity investors, in connection with their investments in portfolio companies. In simple terms, an anti-dilution right protects investors from the dilution of their ownership in a company which subsequently raises funds when its overall valuation dips.

These rights are intended to protect investors from future capital-infusion rounds at a valuation which is lower than the valuation at which they had invested, commonly known as a 'down-round'. Accordingly, in a down-round, investors benefit in the form of an increased ownership in the company, by way of an adjustment to the conversion price or conversion ratio of the convertible securities held by them.

Broadly, there are three widely-accepted anti-dilution protection mechanisms:

  • Full Ratchet Anti-Dilution Protection;
  • Broad-Based Weighted Average Anti-Dilution Protection; and
  • Narrow-Based Weighted Average Anti-Dilution Protection.

In this article, we explain in brief, with illustrative examples, how each of these protection mechanisms operate.

  1. ILLUSTRATION

Let us assume that the current capital table of ABC Pvt. Ltd. (the "Company") is as follows:

Shareholder

Number of Shares

(on a fully diluted basis)

Shareholding percentage

Founder 1

25,000

25%

Founder 2

25,000

25%

Investor

40,000

40%

ESOP (unissued notional pool)

10,000

10%

Total

1,00,000

100%

Based on the pre-money valuation of the Company, the investor (the "Investor") subscribed to 40,000 convertible securities at a per share price of INR 100. Accordingly, the total investment amount by the Investor was INR 40,00,000.

Due to a decline in the overall valuation of the Company, it now proposes to issue 20,000 new shares at a per share price of INR 50 to a new investor (the "New Investor"), for a total consideration of INR 10,00,000. In the absence of any anti-dilution protection in favour of the Investor, the share capital table pursuant to the investment by the New Investor would be as follows:

Shareholder

Number of Shares

(on a fully diluted basis)

Shareholding percentage

Founder 1

25,000

20.83%

Founder 2

25,000

20.83%

Investor

40,000

33.33%

New Investor

20,000

16.67%

ESOP (unissued notional pool)

10,000

8.34%

Total

1,20,000

100%

Let us now examine the share capital table, in the event the Investor had any of the following Anti-Dilution Rights.

2.1 Full Ratchet Anti-Dilution Protection

From any investor's point of view, a full-ratchet protection is most favorable, since the existing investor's shareholding is adjusted based on the reduced per-share price offered as a part of the down-round, i.e., by modifying the conversion price and the conversion ratio of the securities held by the investor. In other words, it will be assumed that the investor had also originally invested at the down-round valuation and its shareholding will be adjusted appropriately.

Accordingly, in the example above, the conversion price of the securities held by the Investor would be reduced from INR 100 to INR 50 and the new conversion ratio will be 1:2. Applying a full ratchet anti-dilution protection, the Investor would get an additional 40,000 shares upon conversion, without paying any extra consideration. The post-adjustment share capital table would be as follows:

Shareholder

Number of Shares

(on a fully diluted basis)

Shareholding percentage

Founder 1

25,000

15.63%

Founder 2

25,000

15.63%

Investor

80,000

50%

New Investor

20,000

12.5%

ESOP (unissued notional pool)

10,000

6.25%

Total

1,60,000

100%

2.2 Broad-Based Weighted Average Anti-Dilution Protection

Typically, a broad-based weighted average protection is most commonly consented to by both investors and founders, as it is a more balanced and fair mechanism, in which the dilution impact is not entirely absorbed by the shareholders who do not have anti-dilution protections. It takes into account several factors, including the valuation at which the original investment was made, amount to be raised in the down-round, number of shares proposed to be issued, etc. and thereafter, a revised conversion price is determined (the "Adjusted Conversion Price"), which will consequently drive up the shareholding percentage of an existing investor in a down-round.

The Adjusted Conversion Price is determined basis the following formula:

Adjusted Conversion Price = CP x (A + B) / (A + C), where:

Variable

What it represents

In our example (in INR)

CP

Existing conversion price

100

A1

Total number of existing shares on a fully diluted basis prior to the down-round

1,00,000

B

Number of shares issuable for the amount raised in the down round at the CP

((20,000 x 50) / 100) = 10,000

C

Number of shares issuable in the down round

20,000

Adjusted Conversion Price = 100 x (1,00,000 + 10,000) / (1,00,000 + 20,000) = INR 91.67.

Accordingly, applying a broad-based weighted average protection, the Investor's ownership in the Company (on a fully diluted basis) would be 43,635 shares (40,000 *100 / 91.67) and the share capital table would be as follows:

Shareholder

Number of Shares

(on a fully diluted basis)

Shareholding percentage

Founder 1

25,000

20.22%

Founder 2

25,000

20.22%

Investor

43,635

35.29%

New Investor

20,000

16.18%

ESOP (unissued notional pool)

10,000

8.09%

Total

1,23,635

100%

2.3 Narrow-Based Weighted Average Anti-Dilution Protection

A narrow-based weighted average protection is very similar to the broad-based weighted average protection mentioned above and uses the same formula. However, the only difference is that while calculating the outstanding shares (i.e., variable "A" in the above formula), a narrower approach is adopted, i.e., unissued stock options, warrants or shares to be issued upon conversion/exercise of debt and other similar instruments are excluded, and only those shares which are currently issued and outstanding are taken into consideration.

Therefore, in the above example, Variable A will be equal to 90,000, excluding the unissued notional ESOP pool of 10,000.

Adjusted Conversion Price = 100 x (90,000 + 10,000) / (90,000 + 20,000) = INR 90.91.

Accordingly, applying a narrow-based weighted average protection, the Investor's ownership in the Company (on a fully diluted basis) would be 44,000 shares (40,000 *100 / 90.91) and the share capital table would be as follows:

Shareholder

Number of Shares

(on a fully diluted basis)

Shareholding percentage

Founder 1

25,000

20.16%

Founder 2

25,000

20.16%

Investor

44,000

35.48%

New Investor

20,000

16.13%

ESOP (unissued notional pool)

10,000

8.07%

Total

1,24,000

100%

  1. PAY TO PLAY

In transactions involving growth-stage companies, founders often tend to negotiate anti-dilution clauses with a pay-to-play condition, i.e., investors are required to invest in proportion to their shareholding as a part of future financing rounds in order to be entitled to certain rights, including their anti-dilution protection. This condition is aimed at incentivizing existing investors to participate in future down-rounds, rather than simply deriving the benefit of the anti-dilution protection without any follow-on investments.

  1. REGULATORY CONDITIONS APPLICABLE TO FOREIGN INVESTORS

Acquisition of equity instruments2 of an unlisted Indian company, by a non-resident investor, is subject to the pricing guidelines (the "FMV")3 prescribed under the Foreign Exchange Management Act, 1999, read with the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 ("FEMA").

The pricing guidelines under FEMA mandate that the price or conversion formula of convertible equity instruments are determined upfront at the time of issue of such instruments. Further, the price at the time of conversion should not be lower than the FMV worked out at the time of issuance of such instruments. Applying this to the example above, if the FMV at the time of issuing shares to the foreign Investor was INR 95, the Adjusted Conversion Price cannot be lower than INR 95. Since foreign investors are constrained by pricing guidelines, enforceability of contractually agreed commercials relating to price may sometimes pose a challenge, especially in cases where there is a significant reduction in the company's valuation.

  1. CONCLUSION

As part of investment transactions, anti-dilution rights are heavily negotiated, and it becomes material for both founders and investors to understand the metrics behind the formula and the true impact of these clauses before contractually agreeing to them. With a dip in company valuations due to the economic downturn in the COVID-19 pandemic, and with companies raising money at lower valuations, discussions and enforceability of these clauses are likely to spring into action.

Footnotes

1 In this method, the total outstanding share capital of the Company is arrived at by including all issued convertible securities and equity shares and such shares to be issued upon conversion/exercise of debt, warrants and other similar outstanding instruments.

2 As per FEMA, 'equity instruments' includes equity shares, convertible debentures, preference shares as well as share warrants issued by the Indian company.

3 The price of equity instruments of an unlisted Indian company, issued to a non-resident, should not be less than the fair market value calculated as per any internationally accepted pricing methodology for valuation on an arm's length basis duly certified by a Chartered Accountant or a Merchant Banker registered with SEBI or a practicing Cost Accountant.

Originally published 09 July, 2020

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.