What is dilution protection?
Corporations come with power. In fact, they can reduce an investor’s company stake after later funding rounds or freshly issued equities. So, a provision called dilution protection or anti-dilution protection was made to protect an investor. This contractual provision restricts the power of a corporation. Sometimes, a company may threaten an investor to diminish his percentage claim on the company assets. Dilution protection reduces or eliminates that occurrence.
How does dilution protection this work?
Let us say that an investor has an initial 20% stake. The company must offer the discounted shares to the investor first before it initiates the subsequent funding round. This will remove all the dilution of the investor’s total ownership stake. We can almost always encounter this in venture capital funding agreements.
Dilution, companies, investors, and ownership
A company may issue a new share. This decreases the current ownership percentage of a stockholder in a particular company. Sometimes, this happens to stock options holders like company employees or other optionable securities holders when they try to exercise their options. As the amount of shares outstanding increases, every current stockholder gets a smaller or a diluted percentage in the company. Hence, every share decreases in value.
When we say dilution protection, we are actually referring to a general term. It is any contractual obligation that preserves the existing ownership percentage stake of a shareholder in the company. This has become prevalent in the venture capital space, especially in the freshest startups. Companies need to show off dilution protection measures that impact later funding rounds to spark investors’ interest. They need to do these things because they are new, and investing in new companies is considered a risky venture. Many companies will be willing to offer this because they are not even sure if they will survive for a long time to reach the later rounds. On the other hand, they actually can, but only if they have enough funds to start their operations. Convertible preferred stocks and other stock options issues come with anti-dilution features to protect investors so their investment will not have the probability of losing its value.
What are the downsides of dilution protection?
Dilution is known effective to attract initial investors. However, it may be hard for companies to sustain this attraction in the long run for later investors. Why? They will not appreciate that the same risk protection if they buy shares in the later funding rounds. Some venture capitalists hesitate because of this fact. This disadvantage may decline to give dilution protection rights. Why? The reason may be selfish. For instance, it may be to avoid hampering later funding rounds and raise the possibility of obtaining a company’s long-term success. Some startups offer dilution protection for the first few years of the company’s life. So, they bank on the fact that initial investors will be more heavily involved in the company in these situations. They can contribute by trying to attract the capital needed for growth.