⚖️ Understanding Anti-Dilution Clauses

Understanding Anti-Dilution Clauses in a Term Sheet

When a founder raises money from a venture capitalist (VC), one key provision that might appear in the term sheet is the anti-dilution clause. Anti-dilution clauses protect the VC’s investment in case the company raises future funding at a lower valuation (a "down round"). There are three main types of anti-dilution protection: Full Ratchet, Broad-Based Weighted Average, and Narrow-Based Weighted Average. Each has different implications for both the founders and investors.

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Types of Anti-Dilution Protection

• Full Ratchet: This is the most investor-friendly option. It allows investors to convert their shares as if they had paid the lower down round price, giving them more equity. For example, if an investor buys shares at $10 each and a future round is priced at $5, they can adjust all of their original shares to reflect the $5 price. While protecting the investor, this can significantly dilute the founder's equity.

• Broad-Based Weighted Average: This method offers a compromise. It adjusts the conversion price of the investor’s shares based on both the new lower price and the total number of shares outstanding, minimizing dilution for founders. It’s considered more balanced, often preferred in negotiations as it limits the downside for both parties.

• Narrow-Based Weighted Average: This method is similar to the broad-based version but only accounts for the company’s fully diluted shares (such as those granted through stock options), leading to more dilution for founders than the broad-based method but less than the full ratchet.

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Negotiating Anti-Dilution Clauses

For founders, negotiating anti-dilution protection is crucial because it affects how much equity they retain in the company. Full Ratchet clauses are highly unfavorable for founders as they can lead to significant dilution. Founders should push for Broad-Based Weighted Average protection, which balances investor protection while limiting their own dilution in future rounds. Additionally, founders should be mindful of the company’s long-term financing strategy and ensure they understand the potential impact of these clauses in various fundraising scenarios.nd retain as much ownership as possible while still attracting necessary investment.

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