Anti-dilution protection with full ratchet method pertains to a situation where in a subsequent round of investment, the valuation of the company dips and the shares are issued at a price which is lower than the price paid by the existing investors of the company, then the price of the shares of the existing investors would be amended and altered to the price at which the new shares have been issued. While this method of anti-dilution protection may be the most favoured by the existing investors, the founders often suffer the collateral damage whose shares would be diluted disproportionately while the existing investors escape unscathed.

Basis the illustration above, the investment amount of INR 5 million shall be adjusted to the price of INR 750 per share. Accordingly, the number of shares to be issued to the investor shall be 6666 (5 million divide by 750), in place of 5000 shares which are already issued against the receipt of investment. The new number of the shares issued to the investor shall be 1666 (6666 minus 5000).

This method does not simply adjust the pricing of shares for issue of the new shares, but averages the pricing by taking into consideration the number of shares held by the current shareholders and the number of shares issued in the subsequent round of investment. In this method, the conversion price of the shares is fixed by taking into consideration the number of new shares issued, the shares outstanding before the issue of new shares, the price of shares held by the pre-existing investors, and the price at which the shares are being issued to the new investor.

This method helps in reducing the impact of dilution on the existing shareholders, and therefore, it is advantageous as well as equitable from the company’s, as well as the investor’s point of view. Apart from the broad based weighted average method, there is another method called narrow-based weighted average method which focuses solely on the outstanding shares of the company and excludes the convertible securities like stock options, preferred stocks, warrants etc., which are included in the broad based weighted average method and is rarely used in the transactions.

The broad based weighted average anti-dilution formula is as follows:

CP₂ = CP₁ × [(A)+(B ÷ CP₁)] ÷ (A+C)

Where, CP₂ = New Conversion Price

CP₁ = New Investors’ Price ÷ Existing Investors’ Price

A = No. of Shares outstanding prior to down round/ new issue

B = Total consideration from the down round/ new issue

C = Number of new shares issued

Now, applying the above methodology in the abovementioned illustration to calculate the number of new shares to be issued pursuant to the down round:

CP₂ = CP₁ × [(A)+(B ÷ CP₁)] ÷ (A+C)

CP₂ = 0.75 × [105000+(1500000÷0.75)] ÷ (105000+2000)

CP₂ = 0.75 × 2105000 ÷ 107000

CP₂ = 14.75

No. of shares to be allotted to the Existing Investor (including IS₀) = IS₀ × (CP₁ ÷ CP₂)

Where, for illustration purposes,

IS₀ = no. of Shares already issued to Existing Investor = 5000

No. of shares to be allotted = IS₀ × (CP₁ ÷ CP₂)

= 5000 × (0.75 ÷ 14.75)

= 254

Such adjustment of shares, whether by way of a full ratchet or weighted average method, can be given effect to, by adjustments to the conversion price. However, there are other mechanisms to such adjustments including: (a) issuance of additional shares at the prevailing price for free to the existing investor, (b) transfer of additional shares from founder(s) at the lowest permissible price to the existing investor.

Alternatively, the investors may also adopt the mechanism to block such down rounds as opposed to exercising anti-dilution rights. As a typical early-stage protection, anti-dilution provisions are usually available to an investor for a limited number of years or across limited investment rounds, after which the industry expects the investors to absorb dilutive issuances as a business risk.

While the full ratchet is most favoured by the existing investors who escape unaffected, where founders suffer collateral damage through disproportionate dilution. However, it has a deterrent effect on the new investors looking to invest in subsequent rounds as it gives enormous protection to the existing investors.

On the other hand, the broad based weighted average method is beneficial for the company and the new investors since this methodology averages out the down round across parties, and thus is more preferred by the companies and the investors in an investment transaction.

The NDI rules as enacted by the Government of India read with the Master Directions on the foreign direct investments issued by the Reserve Bank of India, under Foreign Exchange Management Act 1999, provides for the issuance of the equity instruments to the foreign investor at a value which is not less than the fair value of such equity instruments. The underline object of which is the foreign investors to pay the fair value as the minimum value for any equity instrument acquired, and since such investor has invested in equity, it shall be participating in both profits and losses. Thus, the Anti-dilution rights which is a protection against the loss to the equity instruments or the down round is prohibited to the foreign investor. Therefore the foreign investor to look for other rights or modes to protect its investments.

Authors: | Abhishek Bansal, Partner (abhishek.bansal@acumenjuris.com) | Parag Priyesh Vatsa Associate (Parag.vatsa@acumenjuris.com) | ACUMEN JURIS |

Practice Areas: | Acquisitions and Investments | Corporate & Commercial | Security Laws & Capital Markets |

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