Anti-Dilution Provision: Definition, How It Works, Types, and Formula
Convertible preferred stocks and some other securities include “anti-dilution provisions” that protect investors from their investments possibly losing value. Equity dilution can happen when fresh issuance of a stock trade for less than what previous investors paid for the same shares. Anti-dilution clauses, subscription rights, subscription privileges, and preemptive rights are other names for anti-dilution provisions.
How to Interpret Anti-Dilution Provisions
Anti-dilution clauses serve as a buffer to guard investors from having their stock-holding interests reduced in value or diluted. This can occur when an owner’s ownership interest declines due to a rise in outstanding shares. Due to additional shares being issued during a round of equity financing, the total number of shares outstanding may rise. When stock option holders, such as firm workers or owners of other optionable securities, exercise their options, this can also result in dilution.
There are instances where the firm obtains enough money in return for the shares that the rise in share value cancels out the negative impacts of dilution, but this is not always the case.
Workplace Anti-Dilution Provisions
When further offerings of the same stock enter the market at a lower price, preferred shareholders of venture capital investments may have their stock ownership eroded, which can be frustrating. By adjusting the conversion price between convertible securities, such as corporate bonds or preferred shares, and common stocks, anti-dilution measures can prevent this. Anti-dilution clauses can preserve an investor’s initial ownership stake in this way.
Action of Dilution
Consider an investor who owns 200,000 shares of a corporation with 1,000,000 outstanding shares as a basic illustration of dilution. If the share price is $5, the investor owns a $1,000,000 interest in the $5,000,000 corporation. The investor owns 20% of the firm.
Next, the business raises money in a new round and issues 1,000,000 more shares, bringing the total number of outstanding shares to 2,000,000. The investor now has a $1,000,000 investment in a $10,000,000 corporation at the same $5 per share pricing. The shareholding of the investors has been instantly reduced to 10%.
Anti-Dilution Provisions: Types
Full ratchet and weighted average are the two types of anti-dilution provisions most frequently used.
The conversion price of the current preferred shares is reduced when a complete ratchet provision is present to the price at which new shares are issued in subsequent rounds. The investor’s original conversion price would change to $2.50 if the conversion price initially adjusted to $5 and $2.50 in a subsequent round.
The formula used by the weighted average provision to calculate new conversion prices is as follows:
Where: C2 = C1 x (A + B) / (A + C)
The new conversion price is C2.
Old conversion price: C1
A is the total number of shares outstanding before a fresh issuance.
B is the total consideration the corporation has received for the new issuance.
C = the number of newly issued shares.
Conclusion
- Convertible preferred stocks sometimes have anti-dilution measures to protect investors from the possibility of their investment losing value.
- Dilution can happen when a drop in an owner’s ownership interest in a corporation results from a rise in the total number of outstanding shares.
- Anti-dilution clauses, subscription rights, subscription privileges, and preemptive rights are other names for anti-dilution provisions.
