What is dilution in capital companies?
In finance and corporate matters, dilution refers to the decrease or loss of theoretical value of a company’s shares as a result of a capital increase without an issuance premium. The new investor or an existing partner does not acquire new shares, which results in a smaller percentage of ownership in the company.
For example, in a first round of investment, 7,000 new shares are created (adding to the 3,000 shares issued at the company’s incorporation) at a price of €10, and the new investor takes 1,000 of them. Therefore, their ownership in the company will be 10% (1,000/10,000). In a second round, the capital is increased to 20,000 shares (creating 10,000 new shares) where the investor does not acquire any. As a result, their percentage of ownership in the company would drop to 5%. Therefore, their stake would be smaller, reducing their decision-making power and dividend entitlement.
Ways to avoid dilution
Preemptive subscription rights
This dilution protection mechanism, which can be found in Article 304 of the Spanish Companies Act, is one of the key concepts in the business field. Essentially, it gives shareholders the right to “keep” a proportion of the new shares or participations issued when a capital increase is carried out through cash contributions. Specifically, they can take on or subscribe to a percentage of the new shares or participations equal to their current percentage in the capital. In this way, the law ensures that shareholders can always maintain their ownership percentage and avoid dilution.
However, in practical reality, this right may prove to be less effective than expected. First, shareholders may not always have the necessary financial resources to take advantage of this opportunity in the event of a capital increase, which could result in a dilution of their ownership in the company. Additionally, it is crucial to note that this right does not apply to capital increases involving non-monetary contributions or the compensation of debts.
What is an anti-dilution clause?
Anti-dilution clauses are a privilege granted to the investor in the event that the company in which they have invested capital conducts a new round of investment with a valuation lower than the one at which the shares or participations were issued when the investor first became part of the capital. Their purpose is to prevent the investor’s ownership percentage in the company from being affected. This right is usually established in the shareholders’ agreement as one of the clauses to regulate the governance of the company for the benefit of the shareholders.
The inclusion of these clauses in the shareholders’ agreement has the main objective of safeguarding the investor’s interests in case the pre-money valuation of a new funding round is lower than the post-money valuation at which the investor initially joined the project. These clauses are intrinsically linked to the pre-money valuation process of the startup and primarily to the prospects for the valuation of the capital invested by the investor in the event of a future funding round.
When the valuation of the startup increases between successive funding rounds, the dilution of the shareholders’ participation does not harm the initial investment, as this dilution is offset by the higher total value of the startup and, therefore, its equity.
However, the situation becomes unfavorable for the investor when the pre-money valuation in a new funding round is lower than the post-money valuation of the round in which they initially invested. This can be due to two different reasons:
1. The investor entered the startup at an excessively high pre-money valuation, meaning that at the time of their entry, they should have acquired a more substantial stake in the startup than they actually did.
2. The investor paid the true price of the startup, but the company failed to achieve the anticipated growth in its business plan, which led to the new funding round being based on the startup’s valuation at that specific moment.
Therefore, it is common for investors to seek the inclusion of clauses when they accept a pre-money valuation set by the entrepreneur but consider the valuation to be excessive or the growth prospects described in the startup’s business plan to be unrealistic.
There are two different types of anti-dilution clauses: “Full Ratchet” and “Weighted Average Price.”
1) Full Ratchet Clause
It involves automatically adjusting the price at which investors purchased their shares or participations in a company to a lower price if new shares are issued at a lower price in future funding rounds. This clause aims to ensure that investors do not suffer significant dilution in their ownership when the company issues shares or participations at a price lower than the price at which the original investors acquired them.
In other words, if an investor has a Full Ratchet clause in their investment agreement and the company conducts a new funding round at a lower price per share or participation than the price at which the initial investor entered the capital, the clause allows the investor to adjust their original purchase price to the new lower price. As a result, the investor receives more shares for the same initial investment amount.
Practical example: Let’s assume that an investor “A” invests €100,000 in a startup with a valuation of €1,000,000 at a price of €1 per share/participation. As a result, A acquires 10% of the company. In a second round, the same issuance of shares/participations is carried out, but this time at €0.50 per share/participation. If there were no Full Ratchet clause in the shareholders’ agreement, A’s participation would be diluted by half (5%) in the new funding round.
The Full Ratchet clause allows A to adjust the price at which they purchased their initial shares to the price at which the new shares are issued. In other words, the price at which A bought the shares is adapted to the new price by dividing the total value of the shares acquired in the first investment round by the new value assigned to the shares in the second round. This ensures that there is no possibility of dilution. (100,000€/€0.50 = 200,000 shares/participations)
2) Weighted Average Price
The key feature of the Weighted Average Price anti-dilution clause is that it uses a weighted average calculation to adjust the price at which investors acquired their original shares. The objective is to provide more equitable protection for investors and
founders of the growing company, rather than extreme protection like that offered by the Full Ratchet clause.
The calculation of the weighted average price generally takes into account the price per share in the new funding round and the price per share at which the original investors purchased their shares. This calculation seeks to balance the interests of all parties involved and avoid excessive dilution of the ownership of the founders and other existing shareholders.
There are 2 types of methods for this calculation: (i) Broad Based Weighted Average Price and (ii) Narrow Based Weighted Average Price.
The formula for its calculation is as follows: [(PPSa x PMS) + (PPSb x NS)] / (PMS + NS). First, we need to understand these variables in order to comprehend how they work:
PPSa = Price Per Share of the 1st Issuance.
PMS = Number of Pre-money Shares – 1st Issuance.
PPSb = Price Per Share of the 2nd Issuance.
NS = New shares from the 2nd issuance issued in the down-round.
à (i) Broad Based Weighted Average Price
When setting the PMS, this mechanism takes into account the outstanding shares (= legal capital) as well as stock options and other shares resulting from the exercise of conversion rights, which is referred to as fully diluted capital.
à (ii)Narrow Based Weighted Average
In this case, the PMS will only take into account the outstanding shares (= legal capital).
Practical example:
PPSa=1€
PMS=100.000
PPSb= 50 cents
NS=100.000
Stock Options=20.000
BBWAP= [(1€+120.000) + (0,50 c x 100.000)]/120.00+100.000=0,77c
NBWA= [(1€ x 100.000) + (0,50 c x1000.000)]/100.000+100.000=0,75c
Conclusion
The NBWA is simpler to calculate and may be more beneficial for existing preferred shareholders if they want greater protection against dilution, as it tends to result in a higher average price compared to the BBWAP. However, the BBWAP is more precise and may be preferred in situations where a more detailed calculation based on the most recent market data is desired. The choice depends on the specific needs and agreements between the parties involved in the financing agreement.
If you believe you should protect yourself at the corporate level in matters related to dilution of capital, feel free to get in touch with us.
