Terms sheets use anti-dilution clauses to protect the investors. Anti-dilution comes into play during down rounds in which the founders raise funding at a lower valuation than a previous round. There are three scenarios:
No Anti-Dilution Protection – Investors and founders share in dilution from any follow on rounds funding.
Full Ratchet Anti-Dilution – With full ratchet, the investor’s share price is adjusted all the way down to the level needed so that two things happen:
a. The new investor gets their percentage.
b. The current preferred share investor with full ratchet anti-dilution protection maintains their ownership percentage in the startup,
A full-ratchet scenario dilutes founders ownership dramatically, so this method is unfavorable to founders.
Weighted Average Anti-Dilution – The Weighted Average method takes into account the total number of shares outstanding. The more shares owned by an investor, the less dilution they receive. This method is favorable to founders. Founders get diluted, but not as much as in a full ratchet scenario. Preferred share investors get diluted a little bit, as opposed to not at all in a full ratchet scenario.
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Hall T Martin is the director of Investor Connect, which is a 501(c)(3) nonprofit dedicated to the education of investors for early-stage funding. All opinions expressed by Hall and podcast guests are solely their own opinions and do not reflect the opinion of Investor Connect. This podcast is for informational purposes only and should not be relied upon for the basis of investment decisions.