Anti-Dilution Protection

What it protects. If the company later sells shares below the price a preferred investor paid, the investor’s conversion price is reduced, so their preferred converts into more common than it would have. It does nothing when a later round is priced higher, and it does nothing about the ordinary dilution of a new round; it compensates for having paid a price the market later undercut.

Broad-based weighted average, the standard form. New conversion price = old price × (A + B) ÷ (A + C), where A is the fully diluted shares outstanding before the down round (including options, hence broad-based), B is the number of shares the new money would have bought at the old price, and C is the number of shares it actually bought. Worked: 10,000,000 shares out, Series A paid $2.00, a Series B raises $4m at $1.00. B = 2,000,000, C = 4,000,000. New price = $2.00 × 12,000,000 ÷ 14,000,000 = $1.714. The Series A’s $2m of stock now converts into 1,166,667 common rather than 1,000,000. Narrow-based excludes options from A, which makes the adjustment larger.

Full ratchet. The conversion price simply becomes the new round’s price, regardless of how much was raised. In the example the Series A converts at $1.00 into 2,000,000 common, doubling its claim on the company because one dollar of stock was sold cheaply. The dilution falls on the founders and employees, who hold no such protection, which is why a full ratchet in an earlier round can make a later financing impossible to price.