Anti-Dilution
What does anti-dilution mean in a venture term sheet?
Anti-dilution provisions protect investors from future funding rounds priced below their original price per share (a down round). When triggered, they adjust the investor's preferred share conversion price downward, giving them more common shares on conversion and preserving a greater ownership percentage. The mechanism is codified in the NVCA model certificate of incorporation.
What are the two main anti-dilution mechanisms?
| Mechanism | How it works |
|---|---|
| Full ratchet | Investor conversion price resets entirely to the new lower round price regardless of round size. Most punishing for founders. |
| Broad-based weighted average | Conversion price adjusts proportionally to the size of the down round vs total shares outstanding. Market standard. |
| Narrow-based weighted average | Same formula but uses a narrower share count in the denominator. Slightly more favourable to existing investors. |
Why is broad-based weighted average anti-dilution the market standard?
Broad-based weighted average produces a moderate adjustment proportional to the severity of the down round. A small price reduction triggers a small conversion price adjustment; a severe collapse triggers a larger one. This is fairer than full ratchet, which treats a $0.01 price reduction identically to a 90% collapse. The NVCA recommends broad-based weighted average as the standard position in its model certificate of incorporation.
How does broad-based weighted average anti-dilution work in a down round?
Broad-based weighted average anti-dilution adjusts the conversion price of existing preferred shares downward when new shares are issued at a lower price per share. The adjustment formula blends the old and new prices weighted by the number of shares outstanding and newly issued, rather than simply adjusting to the new lower price (which would be the more aggressive full-ratchet method). In practice, the adjustment gives existing investors some additional shares without giving them as many as full-ratchet would. A Series A investor who invested at $1.00 per share and whose company raises a Series B at $0.60 per share will receive additional shares calculated by the weighted average formula, partially compensating for the valuation decline without wiping out founders and employees with full-ratchet severity.
What is the practical difference between broad-based and narrow-based anti-dilution?
The distinction lies in what shares are included in the "broad base" used to calculate the weighted average. Broad-based anti-dilution includes all outstanding shares (common, preferred, options, warrants) in the denominator of the adjustment formula, which produces a smaller adjustment (fewer additional shares to protected investors). Narrow-based anti-dilution includes only outstanding preferred shares in the denominator, producing a larger adjustment and more dilution for common holders. Broad-based is the standard in US venture markets and is required by most institutional investors via the NVCA model term sheet. Narrow-based anti-dilution is rare in competitive markets but may appear in corporate strategic investments or international venture deals. Always verify which method applies before accepting a term sheet.
What do founders get wrong with anti-dilution provisions?
The most common mistake is not modelling the anti-dilution adjustment before agreeing to a down round price. The adjustment is a formula, not a fixed number, and it depends on the ratio of old and new prices plus the number of shares issued in the down round. Founders who agree to a down round price without calculating the anti-dilution adjustment often find that the actual dilution to common holders is significantly higher than the new share issuance alone suggests, because the anti-dilution adjustment generates additional shares that also dilute the common.
A second error is not distinguishing which preferred classes have anti-dilution protection. In multi-round companies, earlier rounds may have anti-dilution rights but later rounds may have been issued without them (or with different formulas). When a down round occurs, founders need to know exactly which investors receive anti-dilution adjustments and which do not, to calculate total common dilution accurately.
Third: founders sometimes mistakenly believe that pay-to-play provisions are incompatible with anti-dilution protection. They are not necessarily incompatible, but pay-to-play provisions typically convert non-participating investors' preferred to common, which eliminates their anti-dilution protection for that class of shares. Understanding the interaction between pay-to-play and anti-dilution is essential when negotiating a down round term sheet.
How it works in practice
Case example: Broad-based weighted average in a down round
A SaaS company raised Series A at $2.00/share (10M shares outstanding post-round). The Series A investor bought 3M shares. The company later raises a Series B at $1.20/share (a 40% down round) and issues 4M new shares.
Broad-based weighted average formula: New conversion price = Old price x (shares before + new shares) / (shares before + new shares x old price / new price). = $2.00 x (10M + 4M) / (10M + 4M x $2.00/$1.20) = $2.00 x 14M / 16.67M = $1.68/share.
Result: Series A investor's conversion price adjusts from $2.00 to $1.68, their 3M preferred shares now convert to 3.57M common shares instead of 3M. They are partially protected from the down round dilution without receiving full ratchet protection, which would have set their conversion price to $1.20 and given them 5M common shares.
Frequently asked questions
When is anti-dilution triggered?
Only in a priced down round, a qualifying financing where new preferred shares are issued at a price per share lower than the investor's original purchase price. Anti-dilution is not triggered by option pool increases, conversion of existing instruments, or acquisitions.
Can anti-dilution provisions be waived?
Yes. Investors can waive their anti-dilution rights for a specific round. This is sometimes negotiated as a condition of closing a bridge or inside round where a down round price is unavoidable and waiving anti-dilution makes the economics workable for new investors.
Does anti-dilution apply to SAFEs?
SAFEs typically include a valuation cap that functions as a form of anti-dilution protection. If a priced round values the company below the SAFE cap, the SAFE holder converts at the cap price, receiving more shares than a new investor paying the priced round price.
What is a pay-to-play provision and how does it interact with anti-dilution?
Pay-to-play requires existing investors to participate in a down round to retain their anti-dilution rights and other preferred share protections. An investor who does not invest their pro rata share in the down round loses anti-dilution, often having their preferred shares converted to common. Pay-to-play provisions are more common in difficult market conditions.
What is full-ratchet anti-dilution and when is it used?
Full-ratchet anti-dilution adjusts the conversion price of existing preferred shares down to the price of any new share issuance, regardless of how many shares are issued at the new price. It is the most investor-protective and most founder-punishing form of anti-dilution. If one share is issued at $0.10 in a down round, full-ratchet converts all existing preferred at $0.10, even if the previous price was $1.00. Full-ratchet is very rare in standard US venture deals and is considered aggressive even in down round negotiations. Its appearance on a term sheet is a significant red flag.
Related glossary terms
- Down Round, the trigger event that activates anti-dilution provisions
- Pre-Money Valuation, the price-per-share benchmark that determines whether a new round is a down round
- Waterfall Analysis, shows how anti-dilution adjustments change the preference stack and exit economics
Explore related Fintera content
- How to Prepare Financials for a Series A Raise, the diligence process where existing preferred share terms including anti-dilution are reviewed
- Interim CFO vs Fractional CFO vs Contract CFO, which CFO model is appropriate when navigating complex shareholder rights negotiations
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