Term sheet
Anti-dilution protection
If a later round is priced lower, anti-dilution protection gives earlier preferred investors more shares on conversion. The formula decides how much more.
Anti-dilution protection adjusts the price at which preferred stock converts into common if the company later sells shares at a lower price (a "down round"). Preferred shares convert into common at their conversion price, which starts equal to the price the investor paid. If anti-dilution lowers the conversion price, each preferred share converts into more common shares, so the protected investor gives up less of its ownership, and the common holders (founders and employees) absorb more of the down round.
It applies only to price-based dilution. Ordinary dilution from new rounds at higher prices, or from the option pool, does not trigger it, and standard terms exclude routine issuances such as employee options.
Broad-based weighted average: the usual form
Most U.S. venture deals use the broad-based weighted-average formula, as in the NVCA model charter. The new conversion price is a blend of the old price and the new, weighted by how many shares the new round issues compared with the company's size:
CP2 = CP1 × (A + B) ÷ (A + C) CP1 = conversion price before the new issue A = shares outstanding before the new issue (broad-based: fully diluted, including options and convertible securities as converted) B = shares the new money would have bought at CP1 (new money ÷ CP1) C = shares actually issued in the new round
Example. Series A investors hold 5,000,000 shares bought at $1.0000. The company has 20,000,000 shares fully diluted when it sells 2,000,000 new shares at $0.6000 in a down round ($1.2 million).
- B = $1,200,000 ÷ $1.0000 = 1,200,000 shares.
- CP2 = $1.0000 × (20,000,000 + 1,200,000) ÷ (20,000,000 + 2,000,000) = $0.9636.
- The Series A's 5,000,000 preferred shares now convert into 5,000,000 × $1.0000 ÷ $0.9636 = 5,188,679 common shares, 188,679 more than before.
The adjustment is modest because the down round is small compared with the company: issuing 10% more shares at 40% below the old price moves the conversion price by under 4%.
Narrow-based weighted average
The same formula, but with a smaller A: typically only the outstanding preferred (or common and preferred, excluding options). A smaller A makes each new share weigh more, so the adjustment is larger. With A = only the Series A's 5,000,000 shares in the example above, CP2 = $1.0000 × (5,000,000 + 1,200,000) ÷ (5,000,000 + 2,000,000) = $0.8857, and the Series A would convert into 5,645,161 shares. "Narrow" has no single definition, so read what A includes in the charter.
Full ratchet
Full ratchet resets the conversion price to the new, lower price, regardless of how many shares the down round issues. In the example, the conversion price falls to $0.6000 and the Series A converts into 8,333,333 shares, as if it had bought in the down round. Even a tiny down round triggers the full adjustment. Full ratchets are rare in early-stage rounds and are generally treated as investor-favorable terms to resist.
| Method | New conversion price | Series A converts into |
|---|---|---|
| No protection | $1.0000 | 5,000,000 |
| Broad-based weighted average | $0.9636 | 5,188,679 |
| Narrow-based (Series A only) | $0.8857 | 5,645,161 |
| Full ratchet | $0.6000 | 8,333,333 |
Our weighted-average and full-ratchet arithmetic reproduces a published law-firm example exactly (see validation).
Calculator
With the inputs shown: weighted-average conversion price $0.9636, full ratchet $0.6000; 5,000,000 preferred shares convert into 5,188,679 (weighted average) or 8,333,333 (full ratchet) common shares. Turn on JavaScript to recalculate with your own numbers.
What to watch
- "Broad-based weighted average" stated, with A defined to include options and the pool.
- Standard carve-outs: employee options under the plan, conversion of existing securities, stock splits, shares issued in acquisitions or to lenders and partners approved by the board.
- A "pay-to-play" provision, if any: investors who do not take part in a later round may lose their anti-dilution protection or be converted to common.
- Whether a majority of the preferred can waive the adjustment for everyone; in a rescue round that waiver is often the practical solution.
Sources
- Model Legal Documents (term sheet, certificate of incorporation, investors' rights, voting and ROFR/co-sale agreements), National Venture Capital Association. Cited for structure; not reproduced.