Introduction

In the fast-moving investment environment in India, where startups and other new-age companies often seek many rounds of funding, investors must protect their stake. Anti-dilution provisions are a valuable way for an investor to minimize risk since they protect an investor from losing a significant portion without the investor having to expect it. In this article, we will discuss the definition of anti-dilution, its protections, and how it is applied, focusing on Indian investors in private equity and venture capital transactions.

Understanding Anti-Dilution: The Fundamental Meaning

In a nutshell, anti-dilution refers to a contractual provision that prevents the decline of the investor's shares or investment value by issuing new shares. In India's Venture Capital world, where companies often raise funding to grow, dilution happens when additional shares are issued, reducing existing shareholders' proportional ownership. For example, if a firm has 10 lakh shares outstanding and issues an additional 5 lakh shares, an investor who owned 2 lakh shares would be diluted from 20% ownership to approximately 13.3% ownership.

The anti-dilution has to do with the ability to be fair. Generally, convertible instruments such as CCPS or CCDs, which convert into common equity, will have anti-dilution provisions in the terms. When the company issues new shares at a price per share below that paid by the existing investors, they are usually priced as part of a "down round", often due to economic pressures. This will trigger potential adjustments that will bring the value of the investment back to its original basis. Commonly seen in private equity and venture capital investment agreements, while SEBI guidelines emphasise disclosure and transparency where applicable.

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The Function of Anti-Dilution Protection

Anti-dilution protection protects against dilution by adjusting the conversion feature of equity securities to limit the effects of dilution. The purpose is to have existing investors retain a meaningful part of the company while the total number of shares increases. For example, employees exercising their options to purchase shares or financing from a new entity cause an increase in the total number of shares outstanding. If nothing is done, there is a reduced value per share since more shares are issued unless compensation is provided.

In practical terms, anti-dilution clauses in shareholders' agreements empower early backers (angel investors or venture funds in India's tech centres like Bengaluru or Mumbai) by making it more difficult for companies to underestimate a new issuance and develop bad financial habits. These clauses are not without limits. While they help protect investors, they also encumber companies by often limiting flexibility when raising funds.

Types of Anti-Dilution Provisions

The two general types of anti-dilution provisions provide different levels of protection.

1. Full Ratchet Anti-Dilution: Full Ratchet Anti-Dilution provides the most protection by providing the lowest price at which ordinary shares are issued, and resetting the conversion price to this lowest price. For example, if the investor purchased convertible preferred shares for ₹100 each and the company issued shares at ₹50, the conversion price would drop to ₹50, and the investor would convert for twice as many common shares. While this maximises security for investors, it can strain company relations with new funders, as it heavily dilutes common shareholders. In India, full ratchet is rarer in mature firms but appears in high-risk early-stage deals.

2. Weighted Average Anti-Dilution: A more equitable approach, this type moderates the adjustment by factoring in the volume and price of both old and new shares. It comes in broad-based (considering all outstanding shares) and narrow-based (focusing on investor-held shares) variants. This method softens the impact, making it company-friendly while offering solid anti-dilution protection.

Understanding the anti-dilution formula:

The distinguishing feature of weighted average anti-dilution provisions is the formula that calculates the new conversion price:

CP(2)=CP(1)×(A+B/post-money valuation)

where

In symbols: CP(2)=CP(1)×(A+C)

• A: Total shares in the company - outstanding before the New Issue.

• B: The amount raised by the issuance is divided by my new share price (the equivalent of the initial price).

• C: Actual new shares issued.

For example, if a Company has one million shares (A) at 100 (CP1), which then issues 100,000 new shares (C) at 40, raising 40 million, then B = 40 million / 100 = 40,000. So, CP2 = 100 x (1,000,000 + 40,000)/(1,000,000 + 100,000) = 95. You can see how the conversion price is diluted. This is an example of how weighted average anti-dilution protects existing investors in a down round.

Conclusion

Anti-dilution provisions are an invaluable part of India's equity ecosystem, providing durable anti-dilution protection from loss of ownership. With an understanding of the meaning of anti-dilution, its types, and its formula, investors can negotiate a better position in their shareholders' agreements. The industry (fintech or e-commerce) will encourage sustainable growth through these anti-dilution provisions. At Motilal Oswal, we believe in the value of education to help you design resilient portfolios, no matter what you do. Conduct your diligence to last in the game.