What it means
Imagine an investor buys preferred shares that can later be converted into ordinary shares at a set price. If the company then sells new shares at a lower price, a down round, the investor's holding is diluted and its value falls.
Anti-dilution clauses cut the conversion price so the investor converts into more shares and recovers some of the lost value. A weighted average formula softens the adjustment compared with a full ratchet, which resets the price to the new, lower price.
It takes into account both the price of the new shares and how many new shares are issued relative to the existing share count. A small issue at a low price therefore causes a smaller adjustment than a large one.
The difference between broad-based and narrow-based lies in what counts as the existing share count. The broad-based method includes all ordinary shares plus options, warrants and convertible securities, while the narrow-based method counts only a smaller group, such as the outstanding preferred shares or just the ordinary shares.
A smaller base means the new shares weigh more heavily, so the conversion price falls further. That makes narrow-based protection more investor-friendly and more costly to founders and existing shareholders.
Founders usually negotiate for the broad-based version, since it dilutes them less. The choice is a key term in the term sheet, the document that sets out the main terms of the investment.
Always read the definition in the legal documents. Parties sometimes use the words loosely, and the exact list of included shares can change the result noticeably.
In practice
Real-world examples.
Example
A venture capital fund invests $8,000,000 in a software start-up at a conversion price of $10. The contract uses narrow-based protection, so when the company later raises money at $5, the fund's conversion price drops to $9.00 and it converts into about 888,889 shares instead of 800,000.
Example
Founders of a medical device company negotiate their term sheet. They accept a lower valuation but insist on broad-based, not narrow-based, anti-dilution, because the broad version would cost them less if future funding rounds are priced lower.
Example
A lawyer at a growth equity firm audits a portfolio company's cap table after a difficult funding round. She recalculates the conversion prices using the narrow base specified in the documents and finds that the company had applied the broad base by mistake. The error is corrected before the next financing round, which avoids a dispute at closing.
Formula
Calculation
New conversion price = Old conversion price x (A + B) / (A + C)
A = shares outstanding on the chosen base (narrow-based counts only a limited group)
B = shares that the money raised would have bought at the old conversion price
C = new shares actually issued
An investor holds preferred shares with an old conversion price of $10. On the narrow base, A = 1,600,000 shares. The company raises $2,000,000 by selling new shares at $5, so C = $2,000,000 / $5 = 400,000 shares, and B = $2,000,000 / $10 = 200,000 shares.
New conversion price = $10 x (1,600,000 + 200,000) / (1,600,000 + 400,000) = $10 x 1,800,000 / 2,000,000 = $9.00.
With a broad base of A = 10,000,000 shares, the price would be $10 x 10,200,000 / 10,400,000 = $9.81, a much smaller adjustment.Case study
Seen in the real world.
Lumenfield Robotics is an illustrative, fictional start-up that raised its first round from an investor holding $8,000,000 of preferred shares convertible at $10. The documents specified narrow-based weighted average protection, a point the founders had not studied closely.
When growth stalled, the company raised $2,000,000 at $5 a share. The new conversion price fell to $9.00, and the investor's stake rose from 800,000 to about 888,889 shares on conversion.
In this illustrative story the founders realised that the broad-based version would have given the investor fewer extra shares. They resolved to negotiate that clause first in future rounds, and to ask their lawyers to model the effect of each wording before signing.
Watch out
Common mistakes.
- Assuming all weighted average anti-dilution works the same way, when the narrow or broad base changes the result.
- Confusing weighted average protection with a full ratchet, which is far harsher on founders.
- Forgetting to recalculate after every down round, which can leave the cap table wrong.
Questions
People also ask.
Which is better for the investor, narrow-based or broad-based?
Narrow-based, because the smaller base makes the adjustment to the conversion price larger.
Does the clause apply to every new share issue?
Not always, as documents usually exclude certain issues, such as employee option grants approved by the board.
Who benefits from anti-dilution protection?
Investors holding the protected shares gain, while founders and other shareholders bear the extra dilution.
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