Excerpt from the Growth Company Guide 4.0
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Antidilution Provisions are agreements that entitle an investor to obtain additional equity in a company without additional cost when a later investor purchases equity at a lower cost per share. Many investors insist on some sort of antidilution protection to protect themselves against the dilutive effects of future sales of stock at lower prices. Because these provisions can result in protected investors receiving free shares of stock when a future funding is at a lower price, antidilution provisions disproportionately reduce the percentage ownership of shareholders who are not protected. These unprotected shareholders usually include the company’s founders and management.

Antidilution protections can appear as provisions of a financing agreement, in the conversion terms of a convertible preferred stock, in a warrant or option, in an investors rights agreement, in a shareholders' agreement, or in any other agreement between an investor and a company. One form of antidilution provision provides that the percentage of a company owned by an investor will not be reduced until some future event occurs. The event could be the passage of time, the funding of an additional sum of money or some other occurrence. Any stock issued by the company before the future event occurs would entitle the protected investor to receive more shares, either for free or for some agreed-upon price.

Another more common form of antidilution provision requires a company to give an investor "free" stock if it sells shares to a later investor at a lower price. For example, an investor who purchased 100,000 shares for $2 a share would be given more shares at no charge if the company later sold stock to another investor for $1 per share. If the earlier investor receives enough free shares to reduce his average cost per share to the price paid by the new investor (100,000 shares in this example), his antidilution right would be called a "ratchet." If he receives fewer shares, he probably has a "weighted average" antidilution provision.

Another type of antidilution provision allows an investor to purchase additional stock if later share prices are lower or if more than a certain number of shares are sold. These antidilution provisions are called preemptive rights. Provisions that entitle investors to obtain a percentage of outstanding stock in the future instead of a fixed number of shares, are also antidilutive. There are many other variations of antidilution provisions. Any agreement that tends to insure an investor his relative price advantage or percentage ownership is an antidilution provision.

Issues to consider when negotiating an antidilution provision include:

• Type. Is it a ratchet, a weighted average provision, or something different all together? Ratchets dilute unprotected shareholders more than weighted average provisions. Some weighted average provisions are more dilutive than others.

• Term. How long does the provision apply? When and under what circumstances does it expire? Does it terminate with the conversion of the investor’s security or with a sale or public offering of the business? Will it expire after a fixed period of time or the accomplishment of some agreed upon goal?

• Exceptions. Does the provision apply to all sales of stock, all sales of stock at lower prices or only some future sales of stock? Are shares granted under the company’s stock option plan included or excluded?

• Impact. Who will be impacted? Is it just management or does it impact other owners of common stock? If the provision guarantees a fixed percentage for a period of time, the other shareholders will bear all the risk of dilution.

• Control. Who will be in control of the decision to issue future shares than might trigger an antidilution provision? If it is not the shareholders who bear the brunt of the dilution, is the provision fair?

To protect management, all antidilution provisions should stipulate an expiration date. Under no circumstances should antidilution provisions be allowed to survive a public offering of the company's stock or the sale or merger of the company. The survival of these provisions can hamper the ability of management to raise funds in the public market or to close a favorable merger or sale of the company. Also, whenever possible, investor antidilution rights should exclude the issuance by management of a number of shares for use in an incentive stock option plan or other employee incentive plan to help the company attract and retain key personnel.

See: Convertible Preferred Stock, Dilution (Percentage), Equity Penalties, Financing Agreements, First Refusal Rights (Shareholder), ISOs (Incentive Stock Options), Preemptive Rights, Ratchets, Weighted Average Antidilution.