A Founder’s Guide to Anti-Dilution Clauses

When a startup raises venture capital, it issues new shares to investors. Each new funding round dilutes existing shareholders, and that’s normal.

Ideally, each new funding round happens at a higher valuation than the previous one. When that happens, founders may own a smaller percentage, but their shares become more valuable.

But sometimes, a company may raise its next round at a lower valuation than its previous round. This is called a down round, where new investors buy shares at a lower Price Per Share (PPS) than earlier investors paid. 

In that situation, earlier investors face both dilution in ownership and a drop in the value of their investment. 

To manage this risk, investors negotiate an anti-dilution clause.

What is an anti-dilution clause?

An anti-dilution clause is a provision in a shareholder agreement that protects earlier investors if the company issues new shares at a lower price in a future financing round (a down round).

If a down round happens, the anti-dilution clause adjusts the conversion terms so the investor receives more shares to maintain the value of their original investment. This helps offset the loss in value caused by the lower share price.

How a down round impacts investors 

Let’s see how a down round affects an existing investor:

Series A

• Pre-money valuation: $10M
• Investment: $2M
• Post-money valuation: $12M
• Existing shares before investment: 10M
• Price per share: $1

Series A investor invests $2M at $1 per share and receives 2M shares, resulting in 16.67% ownership.

Now the company struggles and raises a down round.

Series B (down round)

• New pre-money valuation: $9.6M
• New investment: $4M
• New price per share: $0.80 ($9.6M ÷ 12M shares)

The Series B investor invests $4M at $0.80 ($4M ÷ $0.80) and receives 5M new shares.

Total shares after Series B (without anti-dilution protection for Series A investors):

The Series A investor still holds 2M shares and is diluted to 11.76% ownership, but the economic value of their investment has gone down (2M shares × $0.80 = $1.6M).

Series A investor ownership after Series B (down round)

This illustrates the economic risk anti-dilution provisions are designed to mitigate.

Types of anti-dilution clauses

There are two main types: full-ratchet and weighted average. 

1. Full-ratchet anti-dilution

Full-ratchet anti-dilution resets the earlier investor’s share conversion price to match the new lower price.

• Series A investor paid $1.
• Series B price is $0.80.

Under full-ratchet, the conversion price for the Series A investor resets to $0.80, resulting in the investor receiving 2.5M shares ($2M ÷ $0.80) instead of 2M.

The Series A investor now owns 14.29% of the company, and the economic value of the investment is $2M.

Series A investor’s ownership before and after full-ratchet anti-dilution protection:

Full-ratchet restores the investor’s original economic value at the new share price, with the resulting additional dilution borne by the founders and employees.

2. Weighted average anti-dilution

Weighted average anti-dilution adjusts the conversion price using a formula rather than fully resetting it.

It calculates a blended conversion price between the old price and the new lower price, based on how many discounted shares are issued.

This results in a partial adjustment rather than a complete reset.

Here’s how:

New conversion price = Old price × (A + B) ÷ (A + C)

Where:

• A = Shares before new round (12M including Series A)
• B = Shares that would have been issued at old price
• C = Actual new shares issued

Using our example:

Shares before Series B = 12M
If $4M were invested at $1 → 4M shares
Actual shares issued at $0.80 → 5M shares

New conversion price:
1 × (12M + 4M) ÷ (12M + 5M)
= 16M ÷ 17M
= $0.94

Recalculated Series A shares:
$2M ÷ $0.94 ≈ 2.13M shares

New total shares:

Series A ownership:
2.13M ÷ 17.13M ≈ 12.43%

Series A investor’s ownership before and after weighted average anti-dilution protection:

Weighted average restores some value, but not all. It balances investor protection with founder fairness.

Here’s how both types of anti-dilution clauses compare to having no protection after a down round:

Broad-based vs narrow-based weighted average

There are two types of weighted average anti-dilution: broad-based and narrow-based.

The difference lies in how the formula defines the number of existing shares (A) used in the calculation, which directly affects how much the conversion price adjusts in a down round.

1. Broad-based weighted average

Broad-based calculates ‘A’ as the number of shares before the new round on a fully diluted basis. It includes the total number of a company’s common shares, both outstanding shares (currently held by shareholders) and shares that could be obtained from the conversion of preferred shares, stock options, warrants, SAFEs, convertible notes, etc.

In our example, the 12M pre-round shares already reflect the total number of shares on a fully diluted basis. 

Assume that, out of the 12M shares, 2M belong to the ESOP pool and are included.

Calculation:

New conversion price =
1 × (12M + 4M) ÷ (12M + 5M)
= 16M ÷ 17M
= $0.94

Series A shares after adjustment:
$2M ÷ $0.94 ≈ 2.13M shares

Ownership after Series B:
2.13M ÷ 17.13M ≈ 12.43%

2. Narrow-based weighted average

Narrow-based includes only outstanding (common and preferred) shares and excludes :

• Unexercised ESOP pool
• Warrants
• Convertible notes

Here, out of the 12M shares, 2M belong to the ESOP pool and are excluded. 

That means A = 10M instead of 12M.

Calculation:

New conversion price =
1 × (10M + 4M) ÷ (10M + 5M)
= 14M ÷ 15M
= $0.93

Series A shares after adjustment:
$2M ÷ $0.93 ≈ 2.15M shares

Ownership after Series B:
2.15M ÷ 17.15M ≈ 12.54%

In the case of broad-based weighted average, since the denominator includes more shares, investors receive fewer additional shares, and founder dilution is lower.

The denominator is smaller for narrow-based weighted average. So, the reduction in conversion price is larger. Investors receive more additional shares, increasing founder dilution.

Key considerations in anti-dilution clauses

When you review an anti-dilution clause, consider the following:

1. Consider broad-based weighted average over full-ratchet

Full-ratchet is aggressive and can materially increase investor ownership in a down round. Broad-based weighted average provides proportional protection and is typically more balanced.

2. Add a pay-to-play requirement

A pay-to-play clause obligates investors to participate in the new financing round in order to retain their anti-dilution protection. If they opt not to invest, they may forfeit these anti-dilution rights.

3. Protect ESOP pool expansions

As you grow, you will likely expand your ESOP pool to hire senior talent. If increases in the pool size trigger anti-dilution adjustments, the founders absorb additional dilution beyond the financing round.

Make sure board-approved ESOP grants and pool expansions are excluded from triggering anti-dilution. This protects hiring flexibility.

4. Model the downside before you sign

The impact often becomes clear only if a down round occurs.

Before signing, review ownership outcomes under:

• A moderate valuation drop
• A severe valuation drop
• An ESOP pool expansion alongside a down round

Anti-dilution vs pre-emptive rights

Anti-dilution rights and pre-emptive rights both aim to protect investors from dilution, but they operate in different ways and apply in different situations.

Anti-dilution rights adjust the economic terms of an investor’s existing shares if the company raises capital at a lower valuation in a future round (a down round). Instead of requiring the investor to invest more money, the clause typically adjusts the conversion price of their shares, allowing them to receive additional shares and partially or fully offset the value loss.

Pre-emptive rights, on the other hand, give existing shareholders the right (but not the obligation) to participate in future funding rounds. This allows them to purchase additional shares in proportion to their current ownership to maintain their percentage stake. However, they must invest additional capital to exercise this right.

Final thoughts

An anti-dilution clause is a risk allocation tool. The important thing is not to view anti-dilution as inherently good or bad. It is a negotiated term, and like all financing terms, its real impact depends on how it is structured and how future rounds unfold.

FAQs

1. When is an anti-dilution clause triggered?

It is typically triggered when a company issues new shares at a price lower than the investor’s original purchase price in a future financing round.

2. Does anti-dilution protect ownership percentage?

Not exactly. It protects economic value by adjusting the conversion price, but ownership may still change depending on the structure of the round.

3. What happens if an investor does not participate in a down round?

If the agreement includes a pay-to-play clause, the investor may lose anti-dilution protection or have their preferred shares converted into ordinary shares.

4. Can anti-dilution protection expire?

Yes. Some agreements include sunset clauses where anti-dilution rights terminate after a fixed period or upon achieving milestones such as profitability or an IPO.