Anti-Dilution Provisions Explained: Full Ratchet vs Weighted Average

Anti-dilution provisions protect investors when a company raises money at a lower valuation than their previous investment—what's called a "down round." While these provisions are standard in venture capital, the type you agree to can dramatically affect founder ownership.

What Triggers Anti-Dilution?

Anti-dilution kicks in when:

• The company issues new securities (equity, convertible notes, SAFEs)
• The price per share is lower than what the previous investor paid

This is called a down round. In a down round, early investors would own a smaller percentage of the company if nothing else changed. Anti-dilution provisions adjust their share count to compensate.

Full Ratchet: The Aggressive Option

Full ratchet is the most investor-friendly (and founder-unfriendly) anti-dilution protection. It recalculates the investor's price as if they had invested at the new, lower price.

Example: You raise $2M at $10/share (200,000 shares). Later, you raise another $2M at $5/share.

Without anti-dilution: Series A investor now owns 200,000 / 1,400,000 = 14.3%

With full ratchet: Series A investor's $2M is now treated as if bought at $5/share = 400,000 shares. They get an additional 200,000 shares to compensate.

New ownership: Series A = 400,000 / 1,600,000 = 25%

Founders just gave away an extra 10.7% of the company because of full ratchet.

Weighted Average: The Balanced Approach

Weighted average is more balanced. It adjusts the conversion price based on the size of the down round relative to the company's overall capitalization.

Example: Same scenario:

• Old price: $10
• New price: $5
• Old shares (pre-down round): 1,000,000
• New shares issued: 400,000

Series A investor's $2M now converts at $7.78/share = 257,000 shares (vs. 200,000 originally).

New ownership: 257,000 / 1,457,000 = 17.6%

Compared to full ratchet (25%), weighted average is much less severe on founders.

Broad-Based vs Narrow-Based Weighted Average

Within weighted average, there's another distinction:

• Broad-based: Includes all outstanding shares (common, preferred, options, SAFEs)
• Narrow-based: Only includes outstanding preferred shares

Broad-based is more founder-friendly because the denominator is larger, resulting in less adjustment. Narrow-based dilutes founders more.

Using our example with broad-based (including 100,000 options):

The price adjustment is slightly less severe than narrow-based.

Exceptions and Exclusions

Well-negotiated term sheets include exceptions where anti-dilution doesn't apply:

• Issuances to employees, advisors, consultants (option grants)
• Convertible notes/SAFEs that convert in the round (if structured correctly)
• Founder shares issued as part of compensation
• Strategic partnerships where equity is issued at a discount for non-cash consideration

Pay-to-Play Provisions

Some term sheets include "pay-to-play" provisions alongside anti-dilution:

• Investors who participate in the down round keep full anti-dilution protection
• Investors who skip the down round lose some or all of their anti-dilution rights

This encourages investors to support the company through tough times rather than sitting on the sidelines while their anti-dilution kicks in.

What to Negotiate

1. Target: Broad-based weighted average with standard exclusions
2. Acceptable: Narrow-based weighted average (common in early stage)
3. Negotiate hard: Full ratchet (unless it's a very distressed situation)
4. Also negotiate:
   • Exclusions for employee equity
   • Exclusions for convertible securities
   • Pay-to-play provisions
   • Basket size (minimum trigger amount)

Real-World Impact

Consider a startup that raises:

• Seed: $2M at $10M pre-money
• Series A: $8M at $40M pre-money (up round, no issue)
• Series B: $5M at $30M pre-money (down round!)

With broad-based weighted average, Series A gets a modest adjustment. With full ratchet, Series A's effective purchase price drops dramatically, and founders lose significantly more ownership.

Bottom Line

Anti-dilution provisions are standard, but the type matters. Broad-based weighted average is the industry standard for a reason—it balances investor protection with founder fairness. Full ratchet should be a red flag unless you're in a truly distressed fundraising situation.