Downside protection
Anti-dilution protection
Also called Ratchet, Price protection
A provision that adjusts preferred shareholders' conversion price downward if the company later issues shares more cheaply, giving them additional shares at the expense of ordinary holders.
In plain English
Anti-dilution is price protection, not percentage protection. It does not stop you being diluted by new money; it compensates you if the new money arrives at a lower price than you paid. The mechanism is a reduction in the conversion price of your preferred shares, which means each preferred share converts into more ordinary shares than before.
Two formulas dominate. Broad-based weighted average — the standard and the reasonable one — adjusts the price partially, weighting the old and new prices by the number of shares involved on a fully diluted basis. A full ratchet adjusts the conversion price all the way down to the new round price, regardless of how few shares were issued at it. A full ratchet triggered by a small down round can transfer an enormous number of shares.
There is also narrow-based weighted average, which uses a smaller denominator — typically only issued preferred — and therefore produces a bigger adjustment than the broad-based version. It sits between the two extremes and is worth identifying by name.
The extra shares come from somewhere: ordinary shareholders. Founders, employees and any angel holding ordinary shares pay for the adjustment. This is why anti-dilution is a downside term for you unless you are the one holding the protected shares.
What it means for your cheque
If you hold preferred shares in the same class as the lead, you get this protection automatically and it is genuinely valuable in a down round. If you hold ordinary shares, anti-dilution is a cost you bear at exactly the moment things are going badly — the double hit described under down rounds.
What you can influence, even as a small holder, is the formula. Broad-based weighted average is standard, defensible and much gentler than a full ratchet. If a term sheet you are shown contains a full ratchet, saying so out loud is useful; founders often have not registered the difference and the lead is rarely willing to defend it publicly.
Do the arithmetic
Full ratchet versus broad-based weighted average
Investors bought 2,000,000 preferred shares at $2.00 in a round that valued the company at $20m. There are 8,000,000 shares fully diluted. The company now issues 1,000,000 shares at $1.00.
| Original conversion price | $2.00 |
|---|---|
| New issue price | $1.00 |
| Full ratchet — new conversion price | $1.00 |
| Full ratchet — shares the preferred now convert into | 4,000,000, double their original |
| Broad-based weighted average — new conversion price | about $1.89 |
| Broad-based — shares on conversion | about 2,120,000 |
| Extra shares created, and who pays | 2,000,000 versus 120,000 — ordinary shareholders in both cases |
The full ratchet created almost seventeen times as much dilution for ordinary shareholders as the weighted average, in response to a $1m issue. This is why the formula is worth more attention than the fact that protection exists.
At the table
What to negotiate
- Broad-based weighted average is the standard. Ask for it by name and check the definition uses a fully diluted denominator.
- Reject full ratchets outside genuinely distressed circumstances — and even then, ask for a sunset after one round.
- Check the carve-outs: option grants, warrants to lenders, shares issued on acquisitions and conversions of existing convertibles should not trigger the adjustment.
- Ask whether pay-to-play applies, which conditions the protection on participating in the down round.
- If you hold ordinary shares, understand that this term operates against you and price it into what you are willing to pay.
Anti-dilution protection: common questions
Does anti-dilution protect me from ordinary dilution?
Which formula should I expect at seed?
Who pays for the anti-dilution adjustment?
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