What It Is:
An anti-dilution provision is a clause in an option, security, or merger agreement that gives the investor the right to maintain his or her percentage ownership of a company by buying a proportionate number of shares of any future issue of the security.
How It Works/Example:
Anti-dilution provisions are sometimes called "subscription rights," "preemptive rights," or "subscription privileges." Anti-dilution provisions are particularly relevant for convertible preferred stock. Let's look at an example.
Assume you purchase Private Company XYZ preferred stock for $15 per share. The preferred stock is convertible, which means that you have the right to trade one share of preferred stock for one share of common stock.
Now let's assume Company XYZ decides to go public and issue common shares at $10 per share. This clearly devalues the incentive to convert your preferred share into common shares, because you'd be trading your $15 investment for a common share worth only $10. An anti-dilution provision could protect you against this if it states that if Company XYZ issues shares at a price lower than in previous financing rounds, the preferred shareholder gets more shares of common stock when he or she converts.
There are two kinds of anti-dilution provisions: the "weighted-average" provision and the "ratchet-based" provision. The ratchet provision offers existing shareholders the right to buy shares at the new lower price. The weighted-average provision gives shareholders the right to purchase shares at a price that accounts for the change in the old and new offering prices.
Why It Matters:
Anti-dilution provisions protect investors from the risk of seeing new shares issued at a lower price than the investors previously received. They also motivate companies to perform well so they can issue stock at higher valuations when need be.