Understanding anti dilution protection clauses for Venture Capitalists: A Cheat Sheet for HealthTech Founders

As a founder in the HealthTech space, securing venture capital (VC) funding is a critical milestone. However, the term sheets you receive often contain complex clauses that can have a significant impact on your company's future ownership structure. Among the most crucial of these are anti-dilution provisions. This cheat sheet is designed to help HealthTech founders understand what anti-dilution protection is, why VCs use it, and the different types they might encounter.

What is Anti-Dilution Protection?

In simple terms, anti-dilution protection is a contractual right given to investors that protects them from the dilution of their ownership stake in a company due to a future funding round at a lower valuation. This lower valuation round is often called a "down round."

Imagine your HealthTech startup, "Medi-Innovate," raises a Series A round at a $20 million post-money valuation. A VC firm invests $5 million for a 25% stake. If, in a later Series B round, the company's valuation drops to $10 million, the VC's original investment would be worth less, and their percentage ownership would be diluted if new investors come in at the lower price. Anti-dilution clauses are designed to prevent this by adjusting the conversion price of the VC's preferred stock, effectively giving them more shares to maintain their original ownership percentage or value.

Why Do VCs Insist on Anti-Dilution?

VCs are primarily concerned with two things: return on investment and risk mitigation. Anti-dilution clauses serve both purposes:

Protecting Investment Value: In a down round, the value of the VC's investment would decrease. Anti-dilution clauses ensure their stake maintains its value relative to the new, lower valuation.

Mitigating Risk: They act as a form of insurance against the company underperforming or facing a difficult market, which would necessitate a down round. This is particularly relevant in the HealthTech sector, which can be sensitive to regulatory changes, clinical trial outcomes, and market shifts.

Types of Anti-Dilution Protection

There are three primary types of anti-dilution protection you will likely encounter. They vary in severity and are a key point of negotiation. 

1. Full Ratchet Anti-Dilution (Most Favourable to VCs)

How it works: This is the most aggressive form of protection. If a down round occurs, the conversion price of the investor's preferred stock is reduced to the new, lower price per share. It's as if they invested at the lowest price of the down round, regardless of the original price.

 
Impact on founders: This is the most dilutive type of provision for founders and employees. The investor gets a massive increase in their share count, significantly reducing the ownership percentages of all other shareholders.

 
Example: A VC invests $5 million for 1 million shares at $5/share. In a down round, new shares are sold for $2/share. With a full ratchet, the VC's shares are now converted as if they originally paid $2/share. Their original $5 million investment now converts into 2.5 million shares ($5M / $2), significantly increasing their ownership percentage and diluting the founders and other shareholders.

2. Broad-Based Weighted Average (Most Common & Fair)

How it works: This is the most common and generally more equitable method. It calculates a new weighted average price for the investor's shares, taking into account both the original investment and the new shares sold in the down round. This calculation dilutes the VC's shares, but to a lesser degree than a full ratchet. 
 
Impact on founders: This is a much more founder-friendly approach. While it still results in some dilution, it is proportional to the number of new shares issued and the severity of the down round, rather than being a wholesale repricing of the original investment.

Formula: The formula can be complex, but the key variables are:

New Conversion Price = Original Conversion Price * ((Original Shares + New Shares) / (Original Shares + New Shares at New Price))
New Shares at New Price is the number of shares that would have been issued if the new price was applied to the original investment.

3. Narrow-Based Weighted Average (Less Common)

How it works: Similar to the broad-based method, but the calculation is more limited. It only considers the shares sold in the down round, not all outstanding shares. This results in a slightly more aggressive adjustment than broad-based but is still less severe than a full ratchet. 

Negotiating Anti-Dilution Protection

As a HealthTech founder, it is crucial to negotiate these clauses. Here are some key points to consider:

Aim for Broad-Based Weighted Average: This is the industry standard and a much fairer compromise. A full ratchet provision should be a major red flag, as it can be incredibly punitive.

Understand the Cap on Conversion: Some agreements may cap the total number of shares an investor can receive from the anti-dilution clause, which can protect you from extreme dilution.

Exemptions: Negotiate for exemptions to the anti-dilution clause. Common exemptions include:

i) Shares issued for employee stock option plans (ESOPs).

ii) Shares issued in a stock split or dividends

iii) Shares issued in connection with a merger or acquisition.

Get Legal Counsel: Do not sign a term sheet without a lawyer specializing in venture capital.

They can help you understand the long-term implications of these clauses and negotiate on your behalf.

Example Scenario: The Impact

Let's revisit our "Medi-Innovate" HealthTech startup.

Series A: VC invests $5M for 25% of the company at a $20M post-money valuation. Share price = $5. The VC receives 1,000,000 shares.

Series B Down Round: Due to a delayed FDA approval, the company raises $2M at a $10M post-money valuation. New share price = $2.

Conclusion

Anti-dilution clauses are a standard part of venture capital funding. While they may seem intimidating, understanding their mechanics and negotiating for the most equitable option—the broad-based weighted average—is essential for protecting your and your team's equity. By preparing and seeking expert legal advice, you can navigate these complex negotiations and ensure your HealthTech venture is on a solid foundation for future growth.

To discuss any of these points and how Nelson Advisors can help your Healthtech company, please email [email protected]