Finance: What are anti-dilution provisions?

What are anti-dilution provisions? Often seen in venture capital and developmental stage companies, anti dilution provisions refer to subscription privileges or other methodologies to prevent dilution of early investors during subsequent financing rounds. For example, if an early investor owns 300,000 shares out of 1 million total for $1 per share on a $1 million evaluation and the company is able to create a prototype that attracts new investors at $5 per share, an anti dilution provision may either give the investor a proportionate number of additional shares to maintain the 30% stake or if there are conversion ratios against preferred shares or other structures, they would be adjusted accordingly in order for the first investor to suffer no net reduction percentage in equity.

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Transcript

00:30

future flying cars everywhere in just two years well she thinks that her first

00:35

round of investment capital is a bargain at $1 a share and she is certain that

00:40

the next round of investing which she expects to happen in two years will be [Investment round 2 brain planes stock at 10 dollars a share]

00:44

at $10 a share so that's the vision of rose-colored glasses very fast uptake in

00:50

demand for telepathically controlled flying cars no big regulatory hurdles no

00:55

major accidents and no headaches but the vision of Manny milesonhistires is

01:00

very different he thinks that the dollar a share he's investing at is a gift a [Manny thinking of a gift]

01:07

gift to the company way too rich, way too expensive, a very high price to pay for a

01:13

stock with zero proven track record Manny believes the long term vision that

01:18

telepathically controlled flying cars are in fact the future Manny just

01:22

believes that it'll take longer for the masses to adopt this new way of doing

01:27

things and you know iron out the bugs ouch Manny thinks that rose will miss [Iron squishes a bug]

01:32

all of the financial projections she has made on her projected income statement

01:37

you know as part of her business plan and normally he'd just wait around until

01:40

the next round to then invest likely at a cheaper price he thinks but he knows

01:45

that if he doesn't invest now well he'll be iced out of the next round which he

01:50

thinks will be at 50 cents a share meaning half of the dollar he's putting

01:53

in so to protect his shareholders the people who gave Manny the money to invest

01:58

on their behalf in the first place his limited partners Manny gets an anti [Shareholders give Manny money]

02:02

dilution provision in his contract that is he invests at a dollar a share to buy a

02:08

third of the company a million shares got it a buck each

02:12

million shares...then time passes sure enough cars

02:18

do crash into trees, cars crash into each other, cars crash into buildings cars [Car crashes into building]

02:23

just crash okay and while texting and driving you have a very bad idea

02:28

and of course Rose is forced to do the next round of funding sheepishly at

02:32

fifty cents a share well if there were originally two million shares of common

02:37

stock that belonged to Rose as the founder and Manny bought a million of

02:41

them for a dollar with the company now raising 1.5 million dollars at 50 cents

02:46

a share while the company would have a total of 6 million shares outstanding

02:49

the original 3 million shares in the first round plus 3 million shares now at

02:54

50 cents each see we're doing the math of the dilution here for you it's scary

02:59

but Manny originally bought a third of the company for his million bucks for a

03:02

million shares, Manny still owns that million shares he bought at a buck each

03:07

only now his ownership stake has been massively diluted he owns a million out [Manny's shares highlighted]

03:13

of a total of six million shares outstanding or 1/6 of the company way

03:18

down from the one third he originally bought well his current stake is roughly

03:23

just 17 percent of the company so his anti-dilution provision kicks in and his

03:29

original million bucks gets essentially repriced to the 50 cents that the new

03:35

round was set for...so what actually happens here well basically he is issued

03:39

more shares to "true him up" unquote to owning a third of the company again [1/3 ownership circled]

03:45

why a third, because that's what his anti-dilution provision stipulated in

03:49

the contract he had bought a million shares owned one out of six million and

03:53

to be undiluted he needs to own 2 out of 6 million or said another way Rose is

03:59

forced to print more shares to give to him so that he now owns one-third of the

04:04

company which is what he originally signed out to own when he put in the

04:07

million bucks with this second round the company has 6 million shares out and if

04:11

another million is printed and given to him well then he'd own 2 million shares

04:15

but there would be 7 million shares now outstanding so depending on how brutally

04:20

the anti-dilution contractual language was written Rose might have to print [Paper printing]

04:25

even more shares to cover his anti-dilution clause

04:29

at the cost of her dilution and yeah note in all of this just how much Rose

04:35

has now been diluted from owning a hundred percent of the company the day

04:39

she started it while she now after just two rounds still owns her two million

04:43

shares that comprise all of the company at the beginning only now there are some

04:48

seven million shares outstanding and likely many many more to come as she

04:53

raises more and more capital so at this point she only owns two sevenths of the

04:56

company and of course none of this will matter if the flying car biz doesn't [Rose driving a flying car]

05:00

take off or maybe takes off a little too quickly if you know if you catch our

05:04

drift [Car floating into space]