Anti-dilution terms protect an investor’s ownership percentage if the value of its shares declines in a financing round relative to a previous round. These terms provide formulas for calculating an investor’s ownership if the company raises additional capital at a lower valuation.

There are two commonly used anti-dilution structures: broad-based weighted average and full-ratchet. The math associated with each of these scenarios is somewhat complicated; your lawyer should be able to ensure that the methodology proposed is industry standard. What you need to understand is the conceptual impact of the terms on the other shareholders in these situations.

Broad-Based Weighted Average
While broad-based weighted average anti-dilution (also referred to as weighted average anti-dilution) effectively reduces the percentage ownership of an investor, the investor’s ownership percentage declines by less than the percentage by which the value of the company declined.

This has an important implication for you the entrepreneur. First, you should understand that the presence of anti-dilution provisions will result in your ownership being disproportionately diluted in down rounds. If you are key to the company’s operation, subsequent to a highly dilutive financing, the board may elect to issue you additional options to keep you motivated, you should be aware of the consequences of raising money at an unsustainable valuation. If you expect to need additional capital in the future and are raising money in a boom period in the venture market, you should be careful about raising capital at a valuation that is not sustainable in more typical fundraising environments.

It is important to understand that broad-based weighted average dilution is a commonplace term used in the industry by sophisticated investors.

Full-Ratchet
The full-ratchet anti-dilution term maintains the value of the investor’s investment in the event of a down-round. Simply put, if the VC invested $1 million at $1 per share (giving them an ownership of 1 million shares) and the company’s value is cut in half, the VC would then own 2 million shares that are valued at $0.50 a share. The value of their ownership remains consistent.

The impact of this provision on other shareholders is severe in highly-dilutive situations, substantially increasing the effective dilution of down rounds on other shareholders.

This term is less commonly seen in deal documents than weighted average anti-dilution. It does, however, have a role in the investor ecosystem. In situations where entrepreneurs have sought very aggressive valuations, investors may require the right of full-ratchet anti-dilution protection to ensure that their investment is protected if the company’s valuation proves unsustainable.