Anti-dilution protection: full ratchet vs weighted average

What is anti-dilution protection?

Anti-dilution protection shields an investor from a drop in the price of the company's shares. Suppose an investor buys shares at ₹500 each. A year later the company is short of cash and sells new shares at ₹250. Without protection, the early investor's shares are simply worth less. With protection, the investor's terms are adjusted so they end up with more shares, as if they had paid a lower price.

The clause only matters in a down round, which is a round at a lower valuation than the one before. In India, the investor usually holds compulsorily convertible preference shares (CCPS), and the adjustment is made by changing the ratio at which those preference shares turn into ordinary shares. The investor's money does not change. The number of shares they get for it does.

What triggers the clause?

The trigger is a new issue of shares or convertible instruments at a price below the investor's conversion price. Usually the clause lists exceptions. Shares issued under an approved employee option plan, shares issued when preference shares convert, shares issued in a stock split or bonus, and shares issued to lenders or in an acquisition approved by the board are commonly left out.

Convertible instruments can also trigger it. If a company issues a convertible note or a SAFE-style instrument with a valuation cap below the investor's price, the lower price may count when the note converts. This is why founders should read the clause together with any bridge financing. A small short-term note raised in a hurry can quietly set off a large adjustment later.

How does full ratchet work?

Full ratchet is the strongest form of protection. If any new shares are sold at a lower price, the investor's conversion price is reset to that lower price, no matter how few shares are sold or how much money is raised.

In the example below, an investor paid ₹500 a share, and the company later sells just a few shares at ₹250. Under full ratchet, all of the investor's shares convert as if they had been bought at ₹250, doubling the number. This can be severe for founders. Even a tiny round at a low price triggers a big adjustment. Because of this, full ratchet is uncommon in healthy deals in India and is mostly seen in rescue financing or when an investor has a lot of leverage.

How does weighted average work?

Weighted average is gentler and far more common. It sets the new conversion price using a formula that takes into account both the lower price and how many shares were sold at it. A small sale at a low price moves the investor's price only a little. A large sale at a low price moves it more.

The usual formula is: new price equals old price multiplied by (A plus B) divided by (A plus C). Here A is the number of shares counted before the new round, B is the number of shares the new money would have bought at the old price, and C is the number of shares actually issued in the new round. The result always lands between the old price and the new price.

What is the difference between broad-based and narrow-based?

The weighted average formula comes in two versions that depend on what is counted in A. Broad-based counts all shares, including ordinary shares, preference shares as if converted, and the option pool. Narrow-based counts only some of them, for example only the preference shares.

A broad base makes A larger, so the adjustment is smaller. That is better for founders. A narrow base makes the adjustment bigger and favours the investor. When you read a term sheet, find which base is named. Broad-based weighted average is the most widely used standard in venture deals, and it is the usual middle ground for both sides.

Why do investors ask for it?

Investors pay a price based on a forecast. If the forecast fails and the company must raise money at a lower price, the investor feels the loss twice: the value of their stake has fallen, and new investors are buying in cheaper. Anti-dilution gives back part of the second loss.

Founders often see the clause as unfair, and in a rescue round it can feel heavy. But it is a normal term, and it is one reason investors are willing to pay a high price in the first place. A founder who gives a fair anti-dilution clause may get a better valuation or fewer other conditions in return, so it should be weighed against the rest of the deal and not looked at alone.

Who pays for anti-dilution?

Extra shares for one investor have to come from somewhere. They dilute everyone else who has not got the same protection: the founders, the employees with options, and often earlier or later investors without the clause. In a down round, founders therefore face two hits at once: the new investors take their share, and the protected investor's conversion adjusts upward.

Other investors may also hold anti-dilution rights. If each series has them, the adjustments stack up, and the cap table becomes complicated quickly. Founders sometimes negotiate carve-outs, called exempted issues, so that shares issued to employees under an option plan, to lenders as warrants, or in an acquisition do not trigger the clause.

When several series each carry anti-dilution rights, each is adjusted separately against its own price. The order of events matters, so lawyers model the cap table before and after each possible round. Founders should ask for this model before they accept the clause and not after a down round has begun.

How do you negotiate the clause?

Ask for broad-based weighted average. Ask for exemptions for option grants and for shares issued on conversion of existing instruments. Ask for a 'pay-to-play' provision in place of heavy protection: this says an investor keeps anti-dilution rights only if they put money into the down round too. That rewards investors who stay supportive.

Also ask whether the clause can be waived by a majority of the preference shareholders. In a rescue round, a new investor will often ask the existing ones to waive their rights, and a majority waiver is how that gets done. The clause lives in the shareholders' agreement and the articles of association of the company, and both need to match.

Does anti-dilution matter in India today?

It matters because many Indian startups raised at high valuations between 2020 and 2022 and later raised again at lower prices. Where earlier investors had protection, the effect showed up in the cap table. Indian practice also has a pricing wrinkle: for shares issued to non-residents, FEMA rules set a floor on the price, which can limit how a protection clause is built when foreign investors are involved.

This guide is general information, not legal advice. Have a lawyer read the clause before you sign.

Read next

• What is a down round?
• The term sheet, clause by clause
• Dilution: why founders own less after every round
• Liquidation preference, explained with numbers
• Pro-rata rights and follow-on investing