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II. Protective rights and anti-dilution provisions
There are two kinds of provisions to ensure that an investor has the opportunity to retain his stake:
  1. Veto rights against issue of fresh shares
Under an SHA, investors typically have a veto right against fresh issue of shares – no fresh shares can be issued by the company to any person or entity without the consent of the investors. This enables investors to protect their stake and ensures their control over the capital structure of the investee company.
  1. Pre-emption rights
A pre-emption right grants existing shareholders the right to proportionately subscribe to a fresh issue of shares so that they are not diluted, i.e. they are able to maintain their shareholding percentage. Section 81 of the Companies Act recognizes this pre-emption right for shareholders of public companies. However, this section does not apply to private companies. Therefore, investors typically include this right in the shareholders agreement executed with the company. In case of a new issue, they have the right to proportionately subscribe to shares (at the same price as other shareholders). The investor’s quota of shares can be issued to another shareholder only if they refuse or fail to subscribe.
  1. Anti-dilution rights
Anti-dilution rights provide for an adjustment in the investor’s shareholding if new shares are issued to a third party at a lower valuation than the valuation at which the investor had invested. They are only triggered when the company’s valuation has reduced in a subsequent round of funding, called a ‘downround’.



Consider a company which has a total of 500 issued shares of face value Rs. 10. Of the 500 shares, an investor subscribed to 100 shares at Rs. 60 per share, thus valuing the company at 500 x 60 = Rs. 30,000.

In case a new investor intends to invest, the company can issue shares to him at the same or a higher valuation – subject to consents from the existing investor for issue of fresh shares, and for any necessary waivers of their pre-emption rights.

However, what will happen, if say, a new investor subscribes to 100 shares at Rs. 40? In that case, the company’s valuation would be down to 600 x 40 = Rs. 24,000. The new investor had invested at a much higher valuation and hence will remain in a position of economic. He will require (through an anti-dilution adjustment mechanism) that in such situations, fresh securities should be issued to him such that his subscription price for the company’s shares adjusts back to Rs. 40 (from the much higher price of Rs. 60 that he paid).

Thus, an anti-dilution clause typically works by adjusting the conversion price of preference shares or convertible debentures that the investor holds, so that the investor can get correspondingly higher number of shares. The objective is to treat the earlier investment as though it had been made at the lower valuation (either fully or on a proportionate basis). Note that the price is reset completely to the newer value only if the full ratchet anti-dilution protection method is used.





Assume that a Shareholder's Agreement for XYZ Ltd. contains an anti-dilution provision in favour of Midnight Capital LLC, a Californian investor. If Midnight Capital has paid USD 10 million for 10 percent of the issued shares of XYZ Ltd., (therefore valuing it at USD 100 million) and a new investor Redlight Capital investors USD 20 million for 50 percent (thus valuing the company at USD 40 million), Midnight Capital should receive such shares which equate its investment of USD 10 million to a USD 40 million valuation, that is, 25 percent.

Ideally, the price adjustment is not complete – it is dependent on the ratio of shares that the new investor has subscribed to. Hence, if we take the first example, the price will come down from Rs. 60 to somewhere around Rs. 40 (it could be Rs. 48, for example) depending on the volume of investment by the new investor as compared to the volume of investment by the previous investor – this is known as the weighted average anti-dilution protection.

The mathematical formula for calculation of weighted average anti-dilution protection can be found on the link.

Usually, anti-dilution protection works where convertible instruments are issued – which enables the price at which these instruments convert into equity to be reset in a manner that the existing investor will get more equity shares when he converts his securities. It is more difficult to apply anti-dilution protection to an equity shareholder – he will have to be issued fresh shares by the company for which he will have to pay a minimum price as under Indian law shares cannot be issued at a discount to face value without Central Government approval or for free (unless bonus shares are issued out of profits of the company). The minimum price at which shares will have to be issued will depend on a) the face value of shares and b) in case he is a foreigner, valuation considerations under foreign exchange regulations.

e. A “proportionate tag-along clause” is often found in a term sheet. An investor who puts his money into an early stage business does so because he has bought into the vision of the founders – therefore, it is extremely critical for him that the founders stay absolutely dedicated to the business, on a full-time basis.
Further, his shares are not liquid – it is not going to be easy for him to sell shares to a third party. Therefore, he is always looking for lucrative opportunities to make a killing from his investment and exit from the company.
One of the rights any investor will insist on while making the investment, to preserve his freedom to exit, is a tag-along right. A tag-along right kicks-in the moment a founder sells any portion of his shares, and allows the investor to sell his own shares as well. This right is incorporated in the shareholders agreement.
How does a tag-along work?
Investors will not permit the founders to sell any portion of their shares for a significant time (ranging from 4-5 years till the time the company goes to IPO, but the duration is negotiable) after their investment, by inserting lock-in provisions. After expiry of the lock-in, if a founder dilutes his shareholding, investors will want the right to be able sell all of their shares. So, while the founder may only sell 2 percent of his shares, an investor who holds 10 percent of the company’s shares may want the flexibility to sell all of his shareholding.
Is this in the interest of the founders?
Of course not. It becomes much more difficult for the founders to find a buyer who is rich enough to buy out the investor’s shares simultaneously. Even if the founders were lucky enough to find a rich and willing buyer, they wouldn’t want an entirely new investor in the company bearing down their nose just because they sold a measly 2 percent of their shares.
What’s the way out? While you will not see investment agreements which do not feature a tag-along right in favour of the investor, a tag-along can be made more reasonable.
Enter the proportionate tag-along.
Imagine a company where the founders hold 80% shares, and investors hold the balance 20%. Assume that the founders want to dilute (sell) a 20% (one-fifth) of their existing holding in the company. Thus, after selling, their shareholding will be down to 64% (since 20 percent of 80 is 16 percent). In this case, what happens to investor's shares?
Tag along rights allow investors to also sell out at the same price as the founders. In the above example, if the investors had a full tag - they will be free to sell their entire shareholding of 20 percent in the company when the founders dilute even a fraction of their holding (as explained before). If, however, they have a proportionate tag, investors can only sell a proportionate amount (i.e. 20% of 20), which is 4%. In a proportionate tag, the investor shareholding will reduce to 16%.
A proportionate tag is more benevolent for the founders – by limiting the ability of existing investors to dilute (to a proportionate extent), it does not impose the headache of handling an entirely new investor on the founders, and makes it comparatively easier for founders to dilute his shares.
Is dilution a bad thing necessarily? Why do founders dilute shareholding?
Each time an entrepreneur raises investment, his or her ownership in the startup is likely to get diluted. Dilution only reduces the amount of equity and control over the company, but if the company is performing well, the overall value of the remaining shares typically increases, which is the reason any entrepreneur looks for funding. If a founder is looking for exit,

Further, founders may also want to voluntarily dilute their stake under certain circumstances, despite continuing to be wedded to the business in the long-term - they may need to liquidate minute fractions of their stake from time to time for raising cash and meeting other personal requirements.
Why will an investor agree to a proportionate tag? How can founders justify a proportionate tag along to an investor?
A proportionate tag impacts both sides - the founders and the investor proportionately as per their relative shareholding percentages. This is a very logical and reasonable term to ask for, and investors often relent on terms that are downright unfair to founders (if founders are able to identify and point out the same), even though they were initially included in the drafts. However, investors often get away with founder-unfriendly terms because most founders do not understand the commercial implications of some of the terms. Understanding the impact of these terms and knowing what to suggest in a negotiation can work wonders. 

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