What it means
The clause exists because an investor who paid $2.00 a share would otherwise sit alongside a new investor paying $1.00 for the same economics. Rather than refunding money, the contract restores the earlier investor's relative position by increasing their share count on conversion.
That is why it is often called anti-dilution protection. There are two main forms, and the difference between them is enormous.
Full ratchet resets the earlier investor's conversion price all the way down to the new, lower price regardless of how few shares were issued, which is punishing for everyone else. Weighted average, the far more common form, adjusts the conversion price only partly, in proportion to how much new cheap stock was actually issued.
Weighted average itself comes in broad-based and narrow-based versions, which differ in what counts as shares outstanding in the formula. Broad-based includes options and other convertible securities, producing a smaller adjustment and a friendlier outcome for founders, while narrow-based counts only preferred shares and moves the price further.
Broad-based weighted average is the market standard in most venture deals. Price-based protection is separate from pre-emption rights, which simply let an existing investor buy their share of any new issue to hold their percentage.
Investors often have both, and confusing them leads to bad negotiation, since one costs money to use and the other is automatic. Most clauses also carve out issues that do not trigger adjustment, such as employee options, shares issued on acquisitions and shares to lenders or landlords.
The practical effect is that a down round costs founders and employees more than the headline valuation suggests, because the anti-dilution adjustment reallocates ownership before any new money is counted. Modelling this before signing a lower-priced round, rather than after, avoids some very uncomfortable board meetings.
In practice
Real-world examples.
Example
A seed investor holding broad-based weighted average protection sees a bridge round priced 30% below their entry. Their conversion price falls modestly, adding about 6% to their share count, and the founders absorb the difference.
Example
A private equity fund insists on full ratchet protection in a distressed carve-out because it doubts management's forecasts. When the follow-on round prices at half the original level, the fund's stake roughly doubles and management's stake is halved.
Example
A startup's lawyers negotiate carve-outs so that shares issued for an acquisition and up to 1,500,000 employee options do not trigger the anti-dilution clause. Two years later the company acquires a competitor in shares, and the investor's conversion price is unaffected.
Formula
Calculation
Broad-based weighted average new conversion price: NCP = OCP x (A + B) / (A + C), where OCP is the old conversion price, A is shares outstanding before the new issue, B is the number of shares the new money would have bought at the old price, and C is the number of shares actually issued.
A Series A investor bought 2,000,000 preferred shares at $2.00 each, investing $4,000,000, with a conversion price of $2.00. The company has 10,000,000 shares outstanding on a fully diluted basis. It then raises $2,000,000 in a down round at $1.00 a share, issuing 2,000,000 new shares.
B = $2,000,000 / $2.00 = 1,000,000 shares.
C = $2,000,000 / $1.00 = 2,000,000 shares.
NCP = $2.00 x (10,000,000 + 1,000,000) / (10,000,000 + 2,000,000) = $2.00 x 11,000,000 / 12,000,000 = $1.8333, or $1.83 rounded.
Shares on conversion = $4,000,000 / $1.8333 = 2,181,818, an increase of 181,818 shares over the original 2,000,000.
Under full ratchet instead, the conversion price would drop straight to $1.00, giving $4,000,000 / $1.00 = 4,000,000 shares, an increase of 2,000,000. The full ratchet outcome hands the investor eleven times as many extra shares as the weighted average result, which is why founders resist it.Case study
Seen in the real world.
Northgate Sensors is an illustrative, fictional industrial technology company that raised $6,000,000 at $3.00 a share, with the investor holding broad-based weighted average protection. Eighteen months later, with revenue behind plan, the only available term sheet priced new shares at $1.50.
The board modelled the round properly before signing. With 14,000,000 shares outstanding and $4,000,000 of new money at $1.50, the earlier investor's conversion price fell from $3.00 to $2.76, lifting their conversion from 2,000,000 shares to about 2,174,000. Founders and employees carried that adjustment on top of the ordinary dilution from the new money, which together took the founding team from 38% to about 32%.
Management then asked the new investor for a refreshed option pool to keep the senior team, which diluted everyone slightly further but stabilised the business. The illustrative point is that the true cost of a down round is the new money plus the anti-dilution adjustment plus the retention equity, and boards that model only the first are always surprised.
Watch out
Common mistakes.
- Agreeing to full ratchet protection because it appears in a first draft, without modelling how severely it reallocates ownership in a modest down round.
- Confusing anti-dilution price protection with pre-emption rights, which merely allow an investor to buy into a new issue at the new price.
- Overlooking the carve-out list, so routine option grants or acquisition shares accidentally trigger a conversion price adjustment.
Questions
People also ask.
Who pays for dilution protection?
Existing ordinary shareholders, mainly the founders and employees, since the extra shares issued to the protected investor reduce everyone else's percentage.
Does the protection apply if the company raises at a higher price?
No, it only operates on issues below the protected investor's conversion price.
What is the difference between broad-based and narrow-based weighted average?
Broad-based counts options and convertibles in the share base, producing a smaller adjustment, while narrow-based counts fewer shares and moves the price further in the investor's favour.
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