Anti-Dilution Provisions: Full Ratchet vs. Weighted Average

Anti-dilution provisions protect investors if you raise money at a lower valuation than they paid—a "down round." The protection comes in the form of extra shares issued to earlier investors, which dilutes founders and employees.

There are two main types: full ratchet and weighted average. The difference between them can mean millions of dollars in founder dilution.

Why Anti-Dilution Exists

Imagine an investor pays $10M for 20% of your company at a $50M valuation. A year later, the market tanks and you need to raise at a $25M valuation—a 50% drop.

Without anti-dilution protection, that investor's $10M investment is now worth $5M on paper. Anti-dilution provisions adjust their ownership to compensate for this loss.

The question is: how much adjustment is fair?

Full Ratchet: The Nuclear Option

Full ratchet is the most aggressive form of anti-dilution. It adjusts the investor's share price to match the new lower price, as if they had invested at that price all along.

Example:

• Series A: Investor pays $5/share for 1M shares = $5M for 20% of the company
• Series B (down round): New investors pay $2/share
• Full ratchet adjustment: Series A investor is now treated as if they paid $2/share
• New shares: $5M / $2 = 2.5M shares (instead of original 1M shares)

The Series A investor gets 1.5M additional shares—for free. Those shares come from diluting everyone else: founders, employees, and even new investors.

Why it's dangerous: Full ratchet doesn't consider how much money was raised in the down round. Whether you raise $100K or $10M at the lower price, the adjustment is the same. This can be devastating.

Weighted Average: The Market Standard

Weighted average anti-dilution adjusts the share price based on how much money was raised at the lower price. The more money raised at the lower price, the more adjustment—but it's never as severe as full ratchet.

The formula considers:

• How many shares were outstanding before
• How many new shares are being issued
• What price was paid for each

There are two flavors:

Broad-Based Weighted Average

Includes all outstanding shares (common, preferred, options, warrants) in the calculation. This is the most founder-friendly and is now market standard.

Narrow-Based Weighted Average

Only includes outstanding preferred stock. This results in more investor-friendly (more dilutive) adjustments.

Real-World Comparison

Let's see how these play out:

Setup:

• Series A: $5M at $5/share = 1M shares, 20% ownership
• Company has 5M shares total after Series A
• Series B down round: Raising $2M at $2/share

Full Ratchet:

• Series A repriced to $2/share
• Investor gets 2.5M shares (was 1M)
• Massive dilution to everyone else

Broad-Based Weighted Average:

• New price = somewhere between $2 and $5 (depends on formula)
• In this case, approximately $4.14/share
• Investor gets ~1.2M shares (was 1M)
• Much less dilution

The difference: Full ratchet gave the investor 1.5M extra shares. Weighted average gave them only 200K extra shares. That's 1.3M shares (worth millions of dollars) that stayed with founders and employees instead of going to investors.

What to Negotiate

1. Always push for broad-based weighted average. This is market standard for good reason. Never accept full ratchet without extreme circumstances (and even then, think twice).

2. Watch the definition of "broad-based." Make sure the calculation includes all outstanding shares, options, and warrants—not just common stock.

3. Consider carve-outs. Some term sheets exclude certain issuances from triggering anti-dilution (like small option grants or strategic partnerships). These carve-outs protect you.

4. Pay-to-play provisions. These require investors to participate in down rounds to keep their anti-dilution protection. This aligns incentives—investors can't just sit back and get free shares while refusing to support the company.

When Anti-Dilution Gets Triggered

Anti-dilution typically triggers when:

• You raise equity at a lower valuation (down round)
• You issue shares below the current conversion price

It usually does not trigger for:

• Option grants to employees
• Shares issued in acquisitions
• Shares issued for strategic partnerships (often carved out)

Make sure these carve-outs are clearly defined in your term sheet.

The Bottom Line

Anti-dilution provisions protect investors at founders' expense. The key principles:

• Full ratchet is unacceptable in nearly all circumstances
• Broad-based weighted average is market standard—don't accept narrow-based without a fight
• Read the carve-outs carefully—they matter more than you think
• Consider pay-to-play—it keeps investors invested in your success

Down rounds are hard enough without giving away massive amounts of equity. Negotiate smart anti-dilution provisions upfront.