Startup and video game law, from a Canadian and U.S. perspective
Avoid Absolute Anti-Dilution Protection
Anti-dilution protections are frequently granted to investors and forgotten by founders until their friendly lawyer brings it up. In many cases, anti-dilution protections are reasonable but in other cases can impose a substantial burden on the company, even impacting the appeal of the company to future investors.
Generally, anti-dilution protections protect an investor from the dilution of the investor’s interest. When VC’s speak about anti-dilution they are usually referring to price-based anti-dilution protections, which protect from a decrease in share price in a future financing (known as a “down-round”) by, ultimately, increasing the number of shares issued to previous round investors. This down-round protection is seen in Series A financings and Brad Feld has a great post covering the details.
What is FAR less common, and almost universally viewed as inappropriate, is an absolute anti-dilution clause. This type of dilution protection guarantees the investor a certain percentage of the company, usually for a fixed time. For example:
Startup hereby agrees to issue additional shares of Common Stock (for no additional consideration) to maintain Investor’s ownership interest at 10% of the total capital stock (calculated on a fully-diluted basis, including all options, warrants, convertible securities and other rights to acquire capital stock).
In the above case, the investor maintains a 10% interest in the company without a need to make additional payments. What if the company sells shares to a new investor? New shares are issued to the previous investor. What if the company issues options to employees? New shares are issued to the previous investor. The absolute anti-dilution clause is viewed as inappropriate as it protects the investor against ALL dilutive events, including those every investor expects to occur, rather than a limited set of dilutive events, such as a down-round.
The absolute anti-dilution clause also runs the risk of rendering your company less appealing to investors. An investor may reconsider an investment knowing that they will be immediately diluted by the previous investor’s absolute anti-dilution clause. This is especially the case if the new investor is increasing the company share price and, in turn, the value of the previous investor’s shares.
I usually encounter these absolute anti-dilution clauses in connection with an accelerator program investment. In this scenario, clients tend to accept the terms as acceptance to the program is viewed as worth the cost (which is a reasonable position to take). Nonetheless, it’s important for companies to understand the impact of absolute anti-dilution clauses and to weigh the pros and cons of any investment in light of an absolute anti-dilution clause before proceeding further.