Anti-Dilution Protection

What does anti-dilution protection mean?

Anti-dilution protection refers to contractual provisions that give investors compensation if the company later issues new shares at a lower price than the investors themselves paid per share. The clause is also called an anti-dilution clause. What is protected is not the percentage holding but the entry price. In a GmbH, the protected investors generally receive additional shares at nominal value, that is, at the euro amount for which a share is issued, usually EUR 1.

The idea resembles a low-price guarantee in retail: if the price falls after the purchase, the earlier buyer receives a credit, here in the form of additional shares.

Anti-dilution protection is agreed in the term sheet and set out in the investment agreement and the shareholders' agreement. Like the liquidation preference, it is one of the preferential rights that venture capital investors regularly demand in financing rounds. It gains practical significance only in a down round, that is, a round at a lower price per share than in an earlier round. It then decides how the burden of the lower price is distributed among protected investors, founders and other shareholders.

Trigger and mechanics of anti-dilution protection

The protection is triggered by an issue of new shares or share rights at a price below the relevant entry price of the protected investor. The yardstick is the price per share, not the stated valuation. A split of shares or a capital increase from company reserves does not trigger compensation. In the latter, reserves are converted into share capital, and all shareholders receive new shares in proportion to their percentage holding. In both cases, only the entry price is adjusted to the new number of shares.

Comparing the old and the new price yields an adjusted entry price. The investor is placed as if the investor had invested the original amount at this adjusted price.

Formula: compensation shares = investment amount / adjusted entry price minus shares already held

Full ratchet and weighted average

Under a full ratchet, the new, lower price replaces the entry price entirely, regardless of how many shares are issued at that price. Under a weighted average (weighted average), the old and the new price are combined into an average whose weights are the number of existing shares and the number of newly issued shares.

The weighted average is agreed with a broad or a narrow calculation base. The broad base (broad-based) counts all shares on a fully diluted basis. The narrow base (narrow-based) counts only a part of them, depending on the contract, for example only the issued shares or only the shares of the protected round. The smaller the base, the stronger the adjustment. In German financing rounds, the broad-based weighted average is common and the full ratchet the exception.

Implementation of anti-dilution protection in the GmbH

In the US market, investors hold preferred shares that can be converted into common shares. There, compensation consists of a lower conversion price, so that each preferred share is converted into more common shares. A GmbH has no such mechanism. Instead, the protected investor may take over further shares in a capital increase and pays only the nominal value for them. The nominal value is also the lower limit, because shares may not be issued below their nominal value.

The compensation shares usually arise in the same capital increase as the new shares of the down round, in some cases in a separate capital increase. The resolution requires three quarters of the votes cast and notarial recording (Section 53 of the German Limited Liability Companies Act, GmbHG), and the takeover of each new share a declaration that is notarially recorded or certified (Section 55 GmbHG). Because the other shareholders do not take part in the issue at nominal value, their subscription right is excluded to that extent, or they expressly waive it. The compensation shares take effect, like any capital increase, only upon entry in the commercial register. A new list of shareholders is then filed showing the investor with the additional shares.

Cooperation duties of the other shareholders

The investor cannot bring about the compensation alone. The other shareholders therefore undertake, already in the investment agreement or the shareholders' agreement, to vote for the capital increase, to waive their subscription right and to make all necessary declarations. Such voting undertakings are in principle permissible in a GmbH and, if necessary, enforceable in court, which helps little in a round that is under way, however.

As a safeguard, authorised capital under Section 55a GmbHG is sometimes created, that is, an authorisation in the articles of association that allows the management to issue the compensation shares without a new shareholder resolution. It applies for at most five years and at most up to half of the existing share capital. Some agreements provide that the founders assign shares of their own to the investor if the capital increase fails. Such an obligation must be notarially recorded under Section 15(4) GmbHG. Whether the issue of shares at nominal value has tax consequences, for example for the investor's acquisition costs or from a gift tax perspective, is to be clarified with the tax adviser before implementation.

Exceptions and time limits

Exceptions (carve-outs) are usual, under which an issue below the entry price does not trigger compensation:

• Shares and share rights under the agreed employee programme, including the pool provided for it
• Conversions of convertible loans and comparable instruments on terms that were already fixed at the protected round
• Compensation shares arising from the anti-dilution protection itself
• Issues approved by a specified majority of the protected investors, who waive the compensation for them

The protection is often limited in time. It expires with an IPO or exit, in some cases also after a fixed period or with the next round at a higher price. Many agreements tie the protection to a pay-to-play rule: anyone who does not subscribe their share in the down round loses it.

Who bears the burden of anti-dilution protection

The compensation shares dilute all shareholders without corresponding protection in proportion to their percentage holdings. Affected are founders, business angels, earlier investors without this clause and, economically, also the holders of virtual shares. New investors often have the compensation shares taken into account already when calculating their price, so that their own percentage does not fall. The burden then shifts entirely to the unprotected existing shareholders. In due diligence, investors and acquirers examine whether compensation claims from earlier rounds have arisen that have not yet been satisfied.

Worked example: calculating anti-dilution protection in a down round

A GmbH has 90,000 shares with a nominal value of EUR 1 each. The founders hold 55,000, a business angel without anti-dilution protection 10,000 and the Series A investor 25,000, for which it paid EUR 3 million. In addition there are 10,000 virtual shares. A broad-based weighted average has been agreed. In the follow-on round, a new investor wants to invest EUR 3 million at EUR 60 per share.

• Entry price of the Series A investor: EUR 3 million / 25,000 = EUR 120; the new price of EUR 60 is below it, so the protection applies
• New shares: EUR 3 million / EUR 60 = 50,000; at the old price the same amount would have given EUR 3 million / EUR 120 = 25,000 shares
• Adjusted price on a broad base of 90,000 shares and 10,000 virtual shares, together 100,000: 120 × (100,000 + 25,000) / (100,000 + 50,000) = EUR 100
• Compensation shares: EUR 3 million / EUR 100 = 30,000, less the 25,000 held gives 5,000 new shares, taken over at the nominal value of EUR 5,000 in total
• Capital increase for the new investor: EUR 50,000 nominal value, plus a premium of 50,000 × EUR 59 = EUR 2,950,000 into the capital reserve
• Capital increase for the compensation shares: EUR 5,000 nominal value without a premium; share capital afterwards 90,000 + 50,000 + 5,000 = EUR 145,000
• Fully diluted percentages without protection, on 150,000 shares: founders around 36.67%, business angel around 6.67%, Series A investor around 16.67%, new investor around 33.33%, virtual shares around 6.67%
• Fully diluted percentages with protection, on 155,000 shares: founders around 35.48%, business angel around 6.45%, Series A investor around 19.35%, new investor around 32.26%, virtual shares around 6.45%
• For comparison: a full ratchet would give EUR 3 million / EUR 60 = 50,000 shares and thus 25,000 compensation shares, a weighted average on a narrow base of only the 25,000 Series A shares 12,500

The compensation raises the Series A investor's fully diluted percentage from around 16.67% to around 19.35%. The shift is borne by the founders, the business angel, the holders of virtual shares and here also the new investor, whose price was set without regard to the compensation. The Series A investor is not made whole: its 30,000 shares are worth EUR 1.8 million at the new price, on an investment of EUR 3 million.

Distinction: anti-dilution protection, subscription right and dilution

• Subscription right (pre-emptive rights): protects the percentage holding by allowing proportional participation in capital increases. Against a lower issue price it helps only if the investor invests further itself.
• Dilution: any reduction of the percentage holding, including in rounds at a rising price. Anti-dilution protection concerns only the case of a lower price.
• Cramdown: a round at a very low price that heavily dilutes shareholders who do not take part.

Common mistakes

• Trigger defined unclearly. Whether conversions, option rights or allocations to employees trigger the protection must be regulated expressly in the clause. Otherwise disputes arise over claims from events that no one had understood as a down round.
• Calculation base left open. The wording “weighted average” without specifying the base leaves open a difference that in the example lies between 5,000 and 12,500 compensation shares.
• Implementation not adapted to the GmbH. Clauses modelled on the US that adjust a conversion price come to nothing if capital increase, waiver of subscription rights and voting duties are not regulated.
• No exception for the employee programme. Without one, even the allocation of virtual shares at a low base price can count as an issue below the entry price.
• Effect not calculated. Anyone who signs the clause without calculating it for a price below the last round does not know the percentage holding that remains in the unfavourable case.

Frequently asked questions

Does anti-dilution protection also apply in a round at a higher price?

No. It applies only if new shares are issued below the protected investor's entry price. Against the proportional dilution in an up round, only the subscription right protects.

What forms of anti-dilution protection are there?

Two basic forms: full ratchet and weighted average. The full ratchet lowers the entry price entirely to the new price, while the weighted average lowers it only to an average that takes the size of the new issue into account. In the worked example, the full ratchet gives 25,000 compensation shares and the broad-based weighted average 5,000.

Do founders also receive anti-dilution protection?

As a rule not. Founders have usually acquired their shares at nominal value on formation and not at a round price that could be protected.

What does the investor pay for the compensation shares?

Only the nominal value, at the usual denomination EUR 1 per share. In the worked example, the Series A investor takes over 5,000 compensation shares for EUR 5,000 in total. At the new price of EUR 60 they are worth EUR 300,000. The difference of EUR 295,000 is the actual compensation, which the other parties bear economically.

Can an investor waive its anti-dilution protection?

Yes, for a particular round or altogether. Waivers are often negotiated in down rounds because the compensation shares make the round more expensive for new investors. It is usually declared by resolution of the protected investors with the agreed majority.

The Roemer Capital view

Roemer Capital calculates existing anti-dilution clauses before every financing round for several prices, including a price below the last round. This establishes, before the first discussions, which compensation shares would arise in the unfavourable case.

In new term sheets, Roemer Capital looks for a broad-based weighted average, clear exceptions for the employee programme and agreed conversions, and an implementation that suits the GmbH. At the same time, it advises against valuations that the company is unlikely to be able to confirm in the next round, because only a down round makes the clause expensive. The law firm drafts the clauses; Roemer Capital supplies the calculations and helps negotiate the economic key points.