How do you balance anti-dilution protection with other terms and conditions in a VC term sheet?

Anti-dilution protection is crucial for investors, especially in early-stage startups where the risk of future down rounds is higher. While negotiating such clauses, it's important to strike a balance that protects investors without overly penalizing founders or discouraging future investment. Full ratchet anti-dilution can be too punitive, while weighted average is more common and founder-friendly. In the current venture climate, there's a trend towards more founder-friendly terms, reflecting the high competition for quality deals.

In my experience drafting such agreements for founders, I discovered that the effectiveness of the anti-dilution provisions depends on several factors: [1] Negotiation power between VC and founder [2] Startups' valuation should increase over time. If the valuation is stagnant or declines, these provisions become ineffective [3] Antidilution protection comes in different types - full ratchet, weighted average. I am yet to see a founder accepting a full ratchet [4] These provisions kick in at later rounds, where price/share increases at the end of every round and not in early-stage startups. [5] The complexity of capital structure with convertible preferred and liquidation preferences will affect the antidilution provisions.

Dilution is not a bad word. Paraphrasing Mark Cuban would you rather own 10% of a grape or 1% of a watermelon? Anti-dilution provisions are in place to protect against dilution caused by down rounds. In up rounds investors want to limit their dilution and may ask for non-dilutive equity but call it anti-dilution. Investors that ask for anti-dilution or non-dilutive equity, come off as inexperienced and predatory. A company that accepts such terms is either inexperienced or in distress. Better terms to offer Major or Lead Investors are pro-rata rights. Pay to play. Even if the company is in distress, you can offer your lifeline investors pro-rata rights. Non-dilutive provisions limit a company's ability to raise future capital.

Here are a few key points to keep in mind: 1. Understand the purpose: Anti-dilution protection is designed to protect investors from dilution in the event of future down-round financings. 2. Negotiate the scope: Anti-dilution protection can be either full-ratchet or weighted-average. Full-ratchet protection provides stronger downside protection for investors. Weighted-average protection is generally considered more balanced. 3. Consider the pricing mechanism: The pricing mechanism for anti-dilution protection can vary. 4. Evaluate the impact on future investors: Anti-dilution protection can affect the attractiveness of the investment for future investors.

In my experience there are some situations where asking for anti dilution is perfectly normal and acceptable. For example to avoid a founder being diluted to the point she is no longer incentivised.

When a company raises money in a down round, that issuance is viewed as diluting the value of the stock held by the earlier investors. For that reason, investors often negotiate anti-dilution protection as part of their investment in order to offset the dilutive effects of future down rounds. Actually there are more types or at least sub-types. Other anti-dilution "clauses" that are under the Weighted average mentioned is the Broad-based weighted (fully diluted) and the narrow based average anti-dilution, and last is the Contractual anti-dilution: Less commonly, some stockholders may negotiate the right to receive, for no additional payment, additional shares to protect them from dilution.

A core axiom of VC terms is that *every* term is an *economic* term, and every term balances with all the others. You should expect to negotiate all these things together. Sometimes a "headline" valuation is important to the founders, and the VC will want something in return for that which might show up in anti-dilution terms. If founders believe that the higher valuation is warranted and that there is very low likelihood of a later down round, then being asked for full-ratchet anti-dilution clause makes sense for the VC - who would be, in a sense, calling the founders' bluff on the probability of that later down round.

Redemptuon rights are a good feature. From the company's perspective, I prefer the option to repurchase, rather than a mandatory repurchase requirement. This allows the company to choose whether the best use of capital is buying out an investor or company growth.

In my experience, the level of dilution of a founder is directly proportional, and exponential, to their engagement and interest in continuing to run the business. Clauses that prevent unlimited dilution can bring risks, depending on the stage of the company and the profile of the founder.