Antidilution provisions are used to preserve the economic value and voting interest of preferred in the event of issuances of additional shares of stock at a lower price per share than that paid by the holder of preferred stock. This protection is provided at the expense of the holders of common stock and is accomplished by increasing the rate at which the preferred stock converts into common stock. Convertible preferred stock is typically convertible into common stock using a conversion ratio which is determined by dividing the purchase price of the stock by the conversion price, which is initially the same as the purchase price. If new stock is issued for a lower price than the holders of preferred paid, an anti-dilution adjustment is effected by reducing the conversion price, thereby causing an increase in the conversion ratio and, accordingly, the number of shares of common stock into which the preferred stock is convertible.

There are two main types of antidilution protections, weighted average and full ratchet. Weighted average antidilution protection is the most common type and is the most favorable to a company's founders and other holders of common stock. Weighted average protection takes into account the number of the shares issued at the lower-priced as well as the price per share when determining the conversion price. In contrast, full ratchet anti-dilution protection (the most-investor friendly form of such protection) provides that if the company sells one share of its stock to someone for a price lower than the price previously paid for the preferred stock having such protection, the conversion price of the preferred stock will be reduced to that lower price per share. This protection guarantees that a preferred investor will always have the benefit of the lowest purchase price paid for any issuances of common stock.

The following example illustrates how each of these types of antidilution provision work:

The Dilutive Issuance

Assume that Company A has the following capitalization:

The price per share paid for the preferred stock, and the initial conversion price, is $1.00, resulting in a conversion ratio of 1:1. Therefore, the preferred stock is convertible into an aggregate 2,000,000 shares of common stock.

Company A later issues 2,000,000 shares to a new Investor at $0.50 per share, which results in an anti-dilution adjustment.

Application of "Weighted Average" Antidilution Protection
 

where:

Using this formula,

The resulting conversion ratio is approximately 1.077 ($1.00 / $.9286), and the 2,000,000 shares of preferred stock are now convertible into 2,153,778 (2,000,000 * 1.077) shares of common stock.

Application of "Full Ratchet" Antidilution Protection

The full ratchet adjustment reduces the conversion price of the preferred stock to the price per share paid in the new issuance ($0.50). The resulting conversion ratio is therefore 2.0 ($1.00 / $.50), and the 2,000,000 shares of preferred stock are now convertible into 4,000,000 (2,000,000 * 2.0) shares of common stock.

Post-adjustment capitalization:

The following table compares the impact of weighted average and full ratchet anti-dilution adjustments on the capitalization of the company (on a converted-to-common basis) following the new issuance: