What is Stock Dilution?
‘Stock Dilution’ generally occurs when a Company allots new equity shares upon infusion of capital; resulting in increase in total paid up capital and corresponding total outstanding shares, which in turn reduces and dilutes the percentage ownership of the non-participating existing shareholders. ‘Stock Dilution’ is also commonly referred to as Equity Dilution, Share Dilution or Start-up Dilution.
Illustration 1:
Pre-allotment shareholding Pattern
| No of shares | % of ownership |
Shareholder A | 10,000 | 50% |
Shareholder B | 10,000 | 50% |
Total | 20,000 | 100% |
Post Allotment Share Holding Pattern
| No of shares | % of ownership |
Shareholder A | 10,000 | 25% |
Shareholder B | 10,000 | 25% |
Shareholder C | 25,000 | 50% |
Total | 45,000 | 100% |
In the next round of funding, upon allotment of 20,000 shares to C, the percentage ownership of A & B would be diluted to 25 % from 50 %.
Consequence of Stock Dilution: Good, bad and the ugly:
In the start-up space fresh capital infusion and investment is a norm and a necessity for ensuring sustainability as well as growth of the start-up; and to ensure this various round of funding are undertaken.
This fresh infusion in the subsequent rounds can either be done at a higher valuation than the previous round of investment or at a lower valuation than that the previous round of investment, also commonly referred to as ‘Down Round’. In the former scenario even though the percentage ownership in the company [i.e. Total Investment of shares / Total Number of shares in the Company) *100] decreases as a result of issuance of fresh equity but the value of the investment increases thereby resulting in notional profit to the existing investors and therefore not detrimental as such. Thus, it can be seen that ‘Stock Dilution’ is not always bad for the investor, unless maintaining a minimum shareholding percentage in the company is of prime importance. Having said that, reduction in percentage ownership in the company may give rise to other concerns for the investor such as reduction below 10 % holding in the company resulting in the investor losing her status as a minority shareholder under the ambit of Companies Act 2013 and its attached benefits.
Illustration 2:
Pre-allotment shareholding Pattern
To understand this let us take the same case as in illustration 1 and add another attribute, share value and company value to it.
| No. of Shares | % | Value |
Shareholder A | 10,000 | 50% | 1,00,00,000 |
Shareholder B | 10,000 | 50% | 1,00,00,000 |
Total | 20,000 | 100% | 2,00,00,000 |
Now since the company valuation has increased from 2 crores to 8 crores in the next round of funding; even though the share percentage has been diluted to half, the value of the shares has doubled, resulting in a profit for the investor.
| No. of Shares | | Value |
Promoter A | 10,000 | 25% | 2,00,00,000 |
Investor B | 10,000 | 25% | 2,00,00,000 |
Investor C | 20,000 | 50% | 4,00,00,000 |
Total | 40,000 | 100% | 8,00,00,000 |
However, in the case of a ‘Down Round’, since the new equity is being issued at the price per share lower than the earlier rounds same shall not only result in decrease of shareholding in the company but also in the value of existing investment and which could result in new investors acquiring similar or greater stake in the company, relative to the existing investors, at a lower price. This usually sidelines the existing investors, angel investors, founders and seed investors in terms of their percentage ownership and voting rights in the company. Anti dilution protection is precisely the tool to prevent this avoidable scenario.
Protection: Type of Anti Dilution Protection Mechanism:
Anti-dilution protection can be ensured by adopting one of the following mechanisms and incorporating the same in the Definitive Agreement.
1. Pre-emptive Rights: A Pre-emptive right affords an existing investor in the company the right, but not the obligation, to acquire fresh share issued by the Company, in the same proportion as their existing holding before such fresh issuance of equity. This allows existing investors to maintain their percentage ownership as before and prevent any dilution by way of follow-up investment and participation in future funding.
This is the most common, fair and preferred Anti-Dilution Protection mechanism of all. This right can be enforced at the option of the investor not only in the case of a Down Round’ but also in a situation where the company is raising funds at a higher valuation than before and the investor wants to be part of such future profits and growth while maintaining the same percentage of ownership.
2. Full Ratchet: This protection mechanism is available to the investor in case of a ‘Down Round’ and where the investor holds convertible stocks (being Convertible Debentures / Preference Shares to be converted to Equity Shares at a later date and at a pre-determined conversion ratio); whereby the conversion ratio would be fully adjusted to incorporate and account for the difference in price per share before and after the new the investment and increase in number of outstanding shares.
Illustration:
For example suppose Investor A bought a convertible instrument at Rs. 100 per share and thereafter in the next round of funding stocks are issued at Rs. 50 per share, i.e. ‘Down Round’. In such case if the Full Ratchet provision is triggered Investor A’s conversion price will be adjusted to Rs. 50 per share. This means each convertible share are now converted into 2 common shares, as against 1 common share as per earlier conversion rate.
This mechanism offers the maximum protection to the investor at the cost and burden of other shareholders; though it is not the most preferred option for the Co-founder and/or the subsequent investors.
3. Weighted Average: This protection is also available to the investor holding convertible stocks and can only be triggered during a ‘Down Round’ only. Under this mechanism as well, the conversion ratio is adjusted, though not fully, in light of fresh issuance of equity duly calculated as per the given formula:
CP2 = CP1 * (A+B) ÷ (A+C) CP2 = Conversion price after down round CP1 = Conversion price before down round. A = Fully-diluted capitalization of the company prior to the down round, including the assumed exercise of outstanding options and warrants and conversion of preferred stock to common, but not giving effect to any securities converting in the down round B = Total consideration received by the company in the down round divided by the Series A per share purchase price. C = Number of shares of stock issued in the down round
Unlike Full Ratchet, weighted Average method doesn’t offer 100 percentage protection against dilution, but is a gentler mechanism for handling dilution, which harmonizes the interests of both the investor and the founders in a Start-up, to a certain extent if not fully. To offset the rigidity of ‘Full Ratchet’ and ‘Weighted Average’ methods, sometimes the founders may insist upon inclusion of a ‘Pay-to-Play’ clause. A ‘Pay-to-Play' clause requires the investor to participate in the subsequent rounds of funding to keep the protective clauses alive and enable the investor to take benefits of such protective clauses like Anti-Dilution Protection clause. That is to say, in case the investor refuses to participate in the follow-up investment rounds she may lose the benefit of the Anti-Dilution protection clause under the ‘Full Ratchet’ or ‘Weighted Average’, as the case may be. Also there is another caveat attached to the enforceability of the Full Ratchet and Weighed Average clause, as they have not been thoroughly tested under the Indian Legal System. It’s implementation and implications remain to be seen especially under the various statutes, more specifically, the Income Tax Act, 1961 and Companies Act, 2013 and FEMA Act, 1999 etc.
OTHER CONSIDERATIONS FOR ADOPTING A SUITABLE MECHANISM
Even though Anti-Dilution Protection is important for an angel investor, founders and other early investors; it is not necessary to enforce it every time in case of a down round as the investors need to assess the future prospects and potential of the start-up and plan its exit, if required, before deciding to commit for any follow up investment in the Start-Up. It also needs to be considered that unfair clauses in favor of earlier investors including Anti-Dilution rights (Full Ratchet) make subsequent investments in the Start Up unappealing and can fend off and become a glaring red flag for the future investors, which would hurt the investor’s and company’s cause of profits and growth alike. Keeping this in mind the founder and the investor should ensure inclusion of Anti-Dilution protection clause in the definitive agreement (Share Holder Agreement, Co-founder Agreement etc.) and negotiate the terms suiting their collective goals, being growth of the company. Therefore, at the time of finalizing the Anti-Dilution Protection Clause both the founders and the investors should not be rigid and understand that there is a symbiotic relationship between them and not an adversarial one.