Anti-Dilution Basics

Anti-dilution implicates two separate concepts, which tend to get muddled (like many words in the street glossary of financing, "dilution" has multiple meanings. Half of the expertise is being hip to the lingo).

First we have anti-dilution as the term is technically defined in term sheets, etc.: the proportional adjustment of stock ownership for a) internal recapitalizations (stock splits, stock dividends) or b) some exogenous transaction (i.e., a merger or, most significantly for this discussion, subsequent financing rounds). Within the context of the latter it means an angel's investment is protected from a future transaction in which the price-per-share is LOWER than the price-per-share they paid. It ONLY applies when the company's valuation GOES DOWN after the original investment. In VC parlance, it is "price-based protection" in the event of a "down-round."

Here's the relevant application: an angel investor has preferred stock (worth say $1.00 per share). The Company then creates and sells new stock (to say a VC) BUT at a price less than that (say $0.75 per share). Absent anti-dilution protection, there are now more shares in circulation and the average value of each share has gone down (to somewhere between 1 and .75 per share) so mathematically the angel's preferred stock has decreased in value.FN1

Anti-dilution mechanisms, however, work to give the angel FREE shares to compensate for the new stock being sold to the VC.FN2 The precise number of FREE shares depends on the anti-dilution mechanism (the most common being "full ratchet" and "weighted average" - the former is far more investor friendly) but the upshot is that the "value" of the original investor's investment will be maintained (or at least not lowered too much) despite the fact the market feels the company is performing more poorly than before (as evidenced by the lower valuation).

Note that the angel investor doesn't gain anything here. He just doesn't lose anything.FN3 Note also that this kind of anti-dilution is built (and usually only applies to "preferred" stock) into the charter documents.

Second, there are "pre-emptive rights" to participate in subsequent financing rounds - sometimes referred to as "right of first refusal" provisions - which effectively allow an angel investor to maintain his ownership PERCENTAGE by investing MORE money. In the parlance, this is the "right to maintain proportionate ownership”.

This right, as the parlance suggests, has a ceiling  - typically "pro rata" to their existing ownership. Thus, if an investor has 10% ownership of a company and there is a new round of investment the investor has the right to invest enough money to maintain his 10% ownership but no more.

Pre-emptive rights are extraordinary rights which will not be inherent in a company's charter but rather provided (if at all) as part of a separate agreement (usually called an investor rights agreement) which accompanies the stock purchase (usually in connection with a Series A deal).

Note that if an angel lacks pre-emptive rights and the company valuation in a future round of financing increases, then anti-dilution does not apply. The angel's percentage ownership will necessarily be diluted due to the additional shares being put into circulation (i.e., a new claimant to the assets and/or income of a company reduces the percentage interests of the existing claimants), however, the overall value of his shares is going UP, due to the inflow of more capital, which naturally increases (at least for a time) the value of the company and any proportionate share in the company.

FN1. This presumes the net book/market value per share diminishes as a result of the financing. It's technically possible that the price per share paid by the VC investor for preferred was for some reason unaligned with the resulting book/market value of the common. This is unlikely but goes to show that the issue of dilution depends on what criteria are used to calculate the value.

FN2. The traditional mechanism by which this happens to angels is that the “Conversion Price” that determines the number of common shares the investor is entitled to receive upon conversion of the “preferred” stock is adjusted downward (by some pre-determined calculus), such that at the time of the future conversion, this investor will receive more shares in common stock (to compensate for the share value going down).

FN3. Somebody of course is losing - the founders and employees (or anyone else who owns the common stock). These parties are being diluted twice: once by the issuance of the shares to the new stockholders and a second time as a result of the adjustment to the conversion price of the preferred stock.