Any issuance of new shares in the company has a dilutive effect for the existing shareholders. This dilution is a legitimate dilution necessary for raising capital to fund the operations of the company. However, a new investment in the company in a valuation that is lower than the previous investment (“Down Round“) has a greater dilutive effect simply because the price per share is lower, and new investors receive more shares for their investment than previous investors for the same invested capital. VCs typically require protection against such event either by issuing them additional shares or, much more commonly, lowering the conversion price of their existing preferred shares so that each preferred share can convert into more common shares. This adjustment to conversion ratio is called “Anti Dilution Protection“. Broadly speaking there are two forms of protections:
A Full Ratchet Anti Dilution Protection – Full ratchet anti-dilution protection gives the original investor rights to that number of shares of common stock as if such investor paid the current round’s lower price. The adjustment happens by reducing conversion price will be reduced to the price at which the new shares are issued.
A Weighted Average Anti Dilution Protection – The weighted average approach to anti-dilution is more moderate and reasonable, and better for the founder, than full ratchet. Unlike full ratchet, weighted average employs a formula that takes into account not only the share price of the new issuance, but also the number of shares issued, so that if only a small number of shares are issued in the new round, the adjustment to the conversion price is also small.