What Does the Anti-Dilution Clause in My Term Sheet Actually Do to Me?
You just got a term sheet. The valuation looks right. Then you notice the words “anti-dilution protection” in the preferred stock terms. You move past it.
That is something you should take a closer look at. That clause determines how much of your company you keep if a future round prices below today’s valuation.
How Anti-Dilution Actually Works
What It Protects (and Who It Protects)
Anti-dilution protects investors, not founders. If you raise a future round at a lower per-share price than the current round, the clause adjusts how many common shares the investor’s preferred stock converts into. The investor’s effective ownership can increase, while the founder’s ownership may decrease.
That adjustment typically happens automatically at closing, based on the agreed terms, without requiring a new negotiation.
Full Ratchet vs. Weighted Average
These are the two types of anti-dilution. The difference matters significantly:
- Full ratchet: The investor’s conversion price resets to match the new, lower price. Even one share sold at the lower price triggers the full adjustment. This is generally considered the most aggressive form.
- Weighted average: The adjustment uses a formula that blends the old and new price based on how many shares were sold at the lower price. A small down round causes a smaller adjustment.
Weighted average is widely considered the market standard, while full ratchet is less common. If you see full ratchet language, it is worth pushing back.
Broad-Based vs. Narrow-Based Weighted Average
Within weighted average, the formula can be calculated two ways:
- Broad-based: Counts all shares outstanding, including common, preferred, options, and warrants. Produces a smaller adjustment. More founder-friendly.
- Narrow-based: Counts a smaller subset of shares. Produces a larger adjustment. More investor-favorable.
Broad-based weighted average is commonly used. Narrow-based is worth flagging and negotiating.
When It Gets Triggered
Anti-dilution activates when a future financing round prices shares below the conversion price established in the current round. Common triggers include:
- a priced round at a lower per-share price than the current round
- a bridge note that converts at a discount large enough to constitute a down round
- any qualifying issuance as defined in the anti-dilution provision of the term sheet or related documents
The definition of what qualifies as a triggering event varies by document. Read the actual language.
3 Mistakes Founders Make With Anti-Dilution
Mistake #1: Assuming Full Ratchet Is Standard
First-time founders often accept full ratchet without question because it looks like boilerplate. It is not standard. Weighted average is the norm. Full ratchet is aggressive and almost always negotiable. A single down round under full ratchet can significantly impact founder equity.
Mistake #2: Not Modeling a Down Round Before Signing
Most founders sign without running the numbers. Before accepting any anti-dilution formula, model a scenario where your next round prices 20%, 30%, and 50% below today’s valuation. The resulting dilution to your stake is the real cost of what you are agreeing to. Do this before the term sheet is signed, not after.
Mistake #3: Treating Anti-Dilution and Pro-Rata Rights as the Same Thing
These are separate provisions. Pro-rata rights let investors participate in future rounds to maintain their percentage. Anti-dilution adjusts the conversion price when a round closes below the prior price. Both can affect your cap table in different ways. In a down round, both can apply at once and compound the dilution to founders.
Before You Sign, Work Through This
☐ Does my term sheet use full ratchet or weighted average anti-dilution?
☐ If weighted average, is it broad-based or narrow-based?
☐ Have I modeled a down round at 20%, 30%, and 50% below my current valuation?
☐ Do I understand what qualifies as a triggering issuance under the specific document language?
☐ Have I confirmed how anti-dilution interacts with pro-rata rights in a down round scenario?
☐ Has my counsel reviewed the full conversion mechanics, not just the headline terms?
If you cannot answer all six, you may want to review the preferred stock terms more carefully before signing.
Bottom Line
Anti-dilution is not a formality. It is a mechanism that can shift equity from founders to investors when a down round closes. The formula in the term sheet determines the size of that transfer. Understanding it before you sign is critical.
Want to Understand What You Are Signing Before the Round Closes?
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Sources Used
- Cooley GO, “Anti-Dilution Provisions” — Cooley GO, https://www.cooleygo.com/glossary/anti-dilution-provisions/
- Carta, “Anti-Dilution Provisions Explained” — Carta, https://carta.com/learn/startups/fundraising/anti-dilution/
- NVCA, “Model Legal Documents — Term Sheet” — NVCA, https://nvca.org/model-legal-documents/