The shareholding percentage of a shareholder reflects the investment value of a shareholder. Commonly, a shareholder’s rights are tied to his shareholding percentage, special rights may be provided to a shareholder due to his higher shareholding percentage, and such rights fall away if such shareholder’s shareholding drops below a certain threshold.
In an event wherein a company proposes to issue shares at a valuation which is lower than the valuation at which an existing shareholder has purchased shares, such issuance would result in decline of the existing shareholder’s investment value along with diluting the shareholding of such shareholder. An anti-dilution provision protects a shareholder’s shareholding and investment value in the company from being diluted, that is, being reduced by unilateral acts of the company or other shareholders. Commonly, anti-dilution provisions are structured in two ways, being the full ratchet method and the broad based weighted average method.
How does a full ratchet anti-dilution Clause work?
A full ratchet clause ensures that the company issues requisite number of new shares to the existing shareholders to maintain their original investment value.
Illustration:
A company has a total authorised share capital of INR 1,00,000 and it has issued 1,000 shares at a price of INR 10 per share to an existing shareholder (hereinafter referred to as Mr. A).
Mr. A’s total investment will be INR 10,000 for a shareholding of 10% in the company.
In a subsequent issue, if the company issues shares at a price of INR 5 per share, then in such case the investment value of Mr. A will be 1,000 shares at a price of INR 5 per share which will amount to INR 5,000.
In order to mitigate the reduction in investment value, the company will have to issue 1,000 new shares to Mr. A to maintain his investment value of INR 10,000.
How does a broad based weighted average anti-dilution clause work?
This method takes into account the existing shareholding, proposed number of new shares to be issued and price of such new shares. The formula to determine the revised price of Mr. A’s shares post the new issuance will be as follows:
Adjusted Price= CP x (A+B) ÷ (A+C)
CP – Existing price.
A – Total number of equity shares prior to the proposed issue of shares.
B – Consideration to be realised by the proposed issue divided by per share price of the existing shares.
C – Proposed number of shares to be issued.
Illustration:
A company has a total authorised share capital of INR 1,00,000 and it has issued 1,000 shares at a price of INR 10 per share to an existing shareholder (hereinafter referred to as Mr. A).
Mr. A’s total investment value will be INR 10,000 for a shareholding of 10% in the company.
In a subsequent issue, the company issues 1,000 shares at a price of INR 5 per share. In this case the adjusted price per share held by Mr. A post the new issuance will be as follows:
Adjusted price= 10 x (1,000+500) ÷ (1,000+1,000) = 7.5
CP= 10
A= 1,000
B= 1,000 x 5 ÷ 10
C= 1,000
Accordingly, post the new issuance, Mr. A’s investment value will be INR 7,500.
In order to restore the investment value of Mr. A to INR 10,000, the company will have to issue 333 new shares at the price of INR 7.5 per share.
Both the full ratchet and broad-based weighted average methods have their advantages and disadvantages. The full ratchet method provides stronger protection for existing shareholders as it ensures their investment value is fully maintained. However, it can be financially burdensome for the company because it requires issuing a large number of new shares.
On the other hand, the broad-based weighted average method strikes a balance by considering the overall impact of the new share issuance on existing shareholders. It may result in a more moderate adjustment and require issuing fewer new shares, which can be more favorable for the company. However, it’s important to note that this method may not completely restore the investment value of existing shareholders.
Ultimately, the choice between these methods depends on the specific circumstances and negotiations between the parties involved. Companies need to consider the financial implications and the level of protection they want to provide to existing shareholders, while shareholders should carefully assess the potential impact on their investment value.
You can read Part 1 of this Knowledge Series – Right of first offer (ROFO) and Right of first refusal (ROFR) here.
You can read Part 2 of this Knowledge Series – Drag Along and Tag Along Right here.
For more information about Shareholders Agreements you may write to us at: solutions@bridgeheadlaw.com.
Karan Narvekar | Partner
Sunny Nirmal | Associate
Views expressed are personal to the authors and do not constitute as legal advice.
