Glossary 11 – Dilution

In private equity investments (PE), dilution is a critical concern that investors must address when negotiating investment terms. Dilution occurs when the ownership percentage of existing shareholders decreases due to the issuance of additional shares, typically during subsequent financing rounds or the exercise of convertible securities. Understanding dilution on a fully diluted basis is essential for investors to assess the potential impact on their ownership stake and investment value.

The importance of considering dilution on a fully diluted basis lies in its implications for investor returns and control rights. Setting investment terms based on fully diluted ownership ensures transparency and fairness, protecting investors from unforeseen dilution events that could diminish their economic interests. To safeguard against dilution, investors often negotiate anti-dilution clauses in investment agreements.

Anti-dilution clauses, such as full ratchet, narrow-based weighted average, and broad-based weighted average, serve as protective mechanisms for investors. Full ratchet anti-dilution provisions provide investors with the most favorable adjustment to the conversion price in the event of a down-round, effectively minimizing dilution. Weighted average anti-dilution is the protection mechanism whereby the conversion rate of share is adjusted in order to reduce an investor’s loss due to an increase in the number of shares in a company. Anti-dilution clauses, offer effective strategies to mitigate dilution risk and preserve investor value in private equity investments.