Anti-Dilution Provisions — Full Ratchet vs Weighted Average, Explained for AIF Investors
Anti-dilution protection exists to answer one question: if the company later raises money at a lower valuation than the fund paid, does the fund get compensated for that price drop? The mechanism that answers this question is one of the most consequential — and most frequently misunderstood — clauses in any AIF term sheet. Get the formula wrong, or agree to the wrong type without understanding the maths, and the economic consequences can be severe for whichever side didn't do the calculation properly.
Why Anti-Dilution Exists
When an AIF invests at, say, ₹100 per share, it is implicitly betting the company's value will grow. If a later round prices shares at ₹60 — a down round — the fund's earlier investment is now worth less than it paid, purely because of the price at which new shares were issued, even if the fund's percentage ownership hasn't technically changed yet through dilution. Anti-dilution protection adjusts the conversion price of the investor's preference shares to compensate for this, effectively issuing the investor additional shares on conversion to soften the blow.
It is important to be precise about what anti-dilution protection does not do: it does not guarantee the fund's investment retains its dollar value, and it does not protect against ordinary dilution from new money coming in at a higher or equal valuation. It only triggers on a genuine down round.
Full Ratchet: The Aggressive Version
Full ratchet anti-dilution adjusts the investor's conversion price down to match the new, lower issue price — regardless of how many shares were issued in the down round. Even if the company issues just one new share at a lower price, the fund's entire earlier investment gets repriced as if it had originally invested at that new, lower price.
Worked Example — Full Ratchet
- Fund invests ₹10 crore at ₹100/share in Round A → 10,00,000 preference shares, conversion price ₹100
- Company later raises a down round at ₹60/share (Round B)
- Under full ratchet, the fund's Round A conversion price is repriced to ₹60/share
- The fund's 10,00,000 preference shares now convert into 16,66,667 equity shares (₹10 crore ÷ ₹60) instead of the original 10,00,000 The founders and other common shareholders absorb this entire adjustment through dilution — the fund's economic position is almost fully protected, at the direct expense of everyone else on the cap table.
Full ratchet is founder-hostile and is used sparingly in the Indian market — typically in distressed or highly investor-favourable situations, bridge rounds ahead of a likely restructuring, or where the fund has exceptional negotiating leverage. It is rarely the market-standard ask in a normal growth-stage venture round.
Weighted Average (Broad-Based): The Market Standard
Weighted average anti-dilution adjusts the conversion price using a formula that accounts for both the size of the down round and the company's total capitalisation — so a small down round has a proportionally small effect on the conversion price, rather than the all-or-nothing repricing of full ratchet.
The standard broad-based weighted average formula is:
New Conversion Price = Old Conversion Price × (A + B) ÷ (A + C)
Where:
- A = number of shares outstanding before the new issue (on a fully diluted, as-converted basis — "broad-based" means this includes the ESOP pool and all convertible securities, not just common shares)
- B = number of shares that would have been issued at the old conversion price for the amount raised in the new round
- C = number of shares actually issued in the new (lower-priced) round
Worked Example — Weighted Average
- Fund invests ₹10 crore at ₹100/share → 10,00,000 preference shares, conversion price ₹100
- Company's fully diluted shares outstanding before the down round: 50,00,000 (A)
- Down round: company raises ₹3 crore at ₹60/share → 5,00,000 new shares issued (C)
- B = ₹3 crore ÷ ₹100 (old price) = 3,00,000 shares New Conversion Price = ₹100 × (50,00,000 + 3,00,000) ÷ (50,00,000 + 5,00,000) = ₹100 × 53,00,000 ÷ 55,00,000 = ₹96.36
Compare this to full ratchet, which would have repriced straight to ₹60. The weighted average adjustment is meaningfully softer — the fund gets some protection, proportional to how large the down round actually was relative to the company's total capitalisation, rather than a full repricing triggered by any down round regardless of size.
Broad-Based vs Narrow-Based Weighted Average
Within weighted average protection, there's a further distinction worth knowing:
- Broad-based: the "A" figure in the formula includes all fully diluted shares — common stock, preferred stock (as-converted), the full ESOP pool (including unallocated options), and other convertible securities. This produces a larger denominator and therefore a smaller adjustment — more founder-friendly.
- Narrow-based: the "A" figure includes only common stock and possibly issued preferred, excluding the unallocated ESOP pool and other convertibles. This produces a smaller denominator and a larger adjustment — more investor-friendly than broad-based, though still meaningfully softer than full ratchet. Broad-based weighted average is overwhelmingly the market standard in Indian AIF-backed venture and growth deals. Narrow-based is uncommon outside more aggressive or distressed-adjacent negotiations.
Side-by-Side Comparison
| Feature | Full Ratchet | Weighted Average (Broad-Based) |
|---|---|---|
| Adjustment basis | Repriced to new low price, regardless of round size | Proportional to round size relative to total capitalisation |
| Founder impact | Severe — full dilution absorbed by founders/common | Moderate — dilution shared more proportionately |
| Market prevalence in India | Rare, mostly distressed situations | Standard in most growth/VC-stage rounds |
| Negotiation posture | Aggressive investor ask | Balanced, expected market term |
| Complexity to calculate | Simple | Requires fully diluted cap table detail |
What This Means in Practice for AIF Term Sheets
For a fund manager drafting or reviewing a term sheet, the practical guidance is straightforward: default to broad-based weighted average unless there's a specific reason (distress, exceptional leverage, structured bridge financing) to push for full ratchet. Asking for full ratchet as a standard term in an ordinary growth round will draw immediate and justified founder pushback, and can damage the negotiating relationship for terms that matter more.
For a fund's internal cap table modelling, it's worth running the weighted average formula against realistic down-round scenarios before the term sheet is signed — the protection looks identical on paper ("weighted average anti-dilution") regardless of whether the underlying company has a small or large fully diluted share count, but the actual economic protection delivered varies significantly with that denominator.
A Note on Pay-to-Play Provisions
Anti-dilution protection is sometimes paired with a pay-to-play clause, which requires existing investors to participate in the down round pro-rata to retain their anti-dilution protection — investors who don't participate lose the benefit (often converting to common stock or losing the weighted-average adjustment entirely). This is a mechanism companies and lead investors use to ensure a down round actually gets fully subscribed, and is worth understanding as a companion concept even though it's a separate clause from anti-dilution itself.
FAQs on Anti-Dilution Protection
Does anti-dilution protection apply to every future funding round?
No — it only triggers on a genuine down round, where the new issue price is lower than the investor's original conversion price. Rounds at an equal or higher price do not trigger anti-dilution adjustment.
Can anti-dilution protection be waived for a specific round?
Yes, and it commonly is — companies often negotiate a carve-out for specific issuances (ESOP grants, strategic partner shares below a certain threshold, acquisition-related stock) that don't trigger anti-dilution adjustment even if technically priced lower, to avoid penalising the company for routine equity administration.
Is full ratchet ever justified from a fund's perspective?
In specific circumstances — genuine bridge financing ahead of a likely restructuring, situations with real going-concern risk, or where the fund is providing critical rescue capital — full ratchet can be a reasonable ask. Outside those situations, it's generally considered an aggressive term that most experienced Indian VC/PE investors avoid requesting as standard practice.
How does anti-dilution interact with liquidation preference?
The two are independent mechanisms addressing different scenarios — anti-dilution protects against a down-round price drop by adjusting conversion price, while liquidation preference determines payout priority and amount on an exit or winding-up. A term sheet will specify both separately, and a fund can have strong protection on one without the other.
This article is intended for general informational purposes and does not constitute legal, tax, or investment advice. Anti-dilution mechanics depend on the exact drafting of the specific term sheet and constitutional documents — consult your legal advisor before relying on any formula discussed here for a specific transaction.
Anuj Desai & Associates advises AIFs on term sheet structuring, cap table modelling, and investor protection provisions. Talk to an advisor to discuss your fund's next round.