Suppose XYZ Company decides to go public and issue common shares at a value of $US 10 per share. This clearly devalues the incentive to convert your preferred share into common shares, as you would be trading your $15$US investment for a common share worth just $10 $US. An anti-dilution provision could protect you from this if it states that if XYZ issues shares at a lower price than previous funding rounds, the preferred shareholder receives more common shares when he or she changes. When setting up a company in the United States, some partners may request the introduction of an anti-dilution clause in the shareholders` agreement. This clause can sometimes be detrimental to existing shareholders when raising capital. This is why it is important to understand the mechanism of the anti-dilution clause in the shareholders` agreement. Large-scale weighted average safeguards are typical of preferred share financing and founders should expect them to be proposed and demanded by many investors. To the extent that the company can avoid the issuance of cheaper shares in non-exempt transactions, these special provisions should not harm the founders. However, other, less common types of dilution protection may be more harmful to founders. These must be carefully considered before they are approved. However, in another sense, where bonds or SAFEs have a valuation cap, it effectively offers investors dilutive protection with respect to the number of shares they will issue upon conversion.
With a valuation cap, the issuance of additional shares by the entity prior to conversion will reduce investors` conversion price and assure investors that they will receive a minimum percentage of the company just before the price cycle, compared to the valuation cap. For more information on evaluation caps (or conversion), see our article. There are several other clauses that may be better than the anti-dilution clause. For example, a pay-to-play provision may be healthier for the company than an anti-dilution clause. A pay-to-play disposition only protects investors from dilution if they participate in capital raising rounds. It protects both the shareholders, their initial participation and the company`s right of ownership in the search for additional capital. On the contrary, Feld and others suggest adjusting only the price at which preferred shares can be converted into common shares. In most startup shareholder agreements, preferred shares have the option, but not the obligation, to convert into common shares.
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