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Anti-dilution provisions shield holders of convertible preferred stocks or options from losing money when more shares are offered at a discount to the initial purchase price. They give investors the option to change the conversion price of their securities to the new price, preserving their ownership stake and preventing dilution.
Dilution happens when there are more shares outstanding overall, which lowers the ownership percentage and share price per share. This can occur when a business generates additional funds by issuing new shares or when those who have stock options use their rights to purchase shares. The earnings per share (EPS) and voting power of existing shareholders may suffer as a result of dilution.
Anti-dilution provisions often fall into one of two categories: full ratchet or weighted average. The best option for investors is full ratchet, which reduces the conversion price to coincide with the lowest price of any ensuing share issuance, regardless of the number of shares issued. The weighted average reduces the conversion price based on a formula that takes into consideration the quantity and cost of the new and old shares, making it more common and balanced.
Assume, for instance, that a shareholder purchases 100 preferred shares at a price of $10 each, with a conversion ratio of 1:1, meaning that each preferred share is convertible into one common share. The business then issues 200 additional shares for $5 apiece. In the absence of an anti-dilution clause, the investor's ownership would decrease from 10% (100/1000) to 6.67% (100/1500), and their investment would be reduced to just $500.
A full ratchet provision would allow the investor to reduce the conversion price to $5 and raise the conversion ratio to 2:1, which would allow the conversion of each preferred share into two common shares. The investment would still be worth $1,000 and the investor's equity would be 13.33% (200/1500).
With a weighted average provision, the investor could lower their conversion price using the following formula:
New conversion price = Old conversion price x (A + B) / (A + C)
Where:
A = Number of old shares
B = Number of new shares x New share price / Old conversion price
C = Number of new shares
Plugging in the numbers, we get:
New conversion price = $10 x (1000 + 200 x $5 / $10) / (1000 + 200)
New conversion price = $10 x (1200) / (1200)
New conversion price = $8.33
Now, each preferred share can be changed into 1.2 common shares, or 1.2:1, according to the new conversion ratio. In that case, the investor would own 8% of the company (120/1,600), and their initial investment would be worth $666.67.
As you can see, anti-dilution provisions are crucial instruments for investors to use in order to safeguard their interests and prevent value loss when new shares are issued at a reduced price. Furthermore, they encourage businesses to keep up their financial performance and refrain from issuing cheap shares that would dilute their current shareholders.
