First see dilution. Recap: dilution is bad. If you have a nice glass of lemonade and put a bunch of ice in it, eventually the lemonade will start to get watery...a.k.a. diluted. (Science!) If you own 50% of the shares of a company with 1 million shares outstanding and the company issues 1 million more shares, you'll own only 25% of the company. (Finance!)
Consider dilution from the eyes of an entrepreneur: the eventual goal in any company is to create wealth for shareholders. In the beginning, the founder owns all of the "wealth" or at least the shares in the company. Over time, that founder gives away pieces of the company in the form of shares to investors (in exchange for money). The problem is that the more shares the founder hands over, the less of her own company she owns.
An anti-dilutive act is anything the founder does to stop this problem. For example, she might buy back some of her own shares. Example: Some companies are anti-dilutive from the start, especially if they don't need a ton of money to get started. Yahoo! required only a little over $1 million of total capital until it reached break even. It chose to take on more capital because it believed that the dilution was worth the incremental capital raised so that it could take advantage of market opportunities. eBay was about the same.
The great fortunes of the Internet era were made in part because the founders suffered so little dilution that, at the end, they had tens of billions of dollars of wealth via their large percentage ownership stakes in the companies they founded.
Related or Semi-related Video
Finance: What are anti-dilution provisio...4 Views
finance a la shmoop what are anti-dilution provisions okay people we [Man talking inside a beaded wall]
are inside of the beaded walls of start-upville.com and there's a
disagreement revolving around the vision that two parties see in their crystal [Person waves at crystal ball]
balls the founder this gal rose-colored glasses the visionary behind brain
planes her telepathically controlled flying car company her vision of the
future flying cars everywhere in just two years well she thinks that her first
round of investment capital is a bargain at $1 a share and she is certain that
the next round of investing which she expects to happen in two years will be [Investment round 2 brain planes stock at 10 dollars a share]
at $10 a share so that's the vision of rose-colored glasses very fast uptake in
demand for telepathically controlled flying cars no big regulatory hurdles no
major accidents and no headaches but the vision of Manny milesonhistires is
very different he thinks that the dollar a share he's investing at is a gift a [Manny thinking of a gift]
gift to the company way too rich, way too expensive, a very high price to pay for a
stock with zero proven track record Manny believes the long term vision that
telepathically controlled flying cars are in fact the future Manny just
believes that it'll take longer for the masses to adopt this new way of doing
things and you know iron out the bugs ouch Manny thinks that rose will miss [Iron squishes a bug]
all of the financial projections she has made on her projected income statement
you know as part of her business plan and normally he'd just wait around until
the next round to then invest likely at a cheaper price he thinks but he knows
that if he doesn't invest now well he'll be iced out of the next round which he
thinks will be at 50 cents a share meaning half of the dollar he's putting
in so to protect his shareholders the people who gave Manny the money to invest
on their behalf in the first place his limited partners Manny gets an anti [Shareholders give Manny money]
dilution provision in his contract that is he invests at a dollar a share to buy a
third of the company a million shares got it a buck each
million shares...then time passes sure enough cars
do crash into trees, cars crash into each other, cars crash into buildings cars [Car crashes into building]
just crash okay and while texting and driving you have a very bad idea
and of course Rose is forced to do the next round of funding sheepishly at
fifty cents a share well if there were originally two million shares of common
stock that belonged to Rose as the founder and Manny bought a million of
them for a dollar with the company now raising 1.5 million dollars at 50 cents
a share while the company would have a total of 6 million shares outstanding
the original 3 million shares in the first round plus 3 million shares now at
50 cents each see we're doing the math of the dilution here for you it's scary
but Manny originally bought a third of the company for his million bucks for a
million shares, Manny still owns that million shares he bought at a buck each
only now his ownership stake has been massively diluted he owns a million out [Manny's shares highlighted]
of a total of six million shares outstanding or 1/6 of the company way
down from the one third he originally bought well his current stake is roughly
just 17 percent of the company so his anti-dilution provision kicks in and his
original million bucks gets essentially repriced to the 50 cents that the new
round was set for...so what actually happens here well basically he is issued
more shares to "true him up" unquote to owning a third of the company again [1/3 ownership circled]
why a third, because that's what his anti-dilution provision stipulated in
the contract he had bought a million shares owned one out of six million and
to be undiluted he needs to own 2 out of 6 million or said another way Rose is
forced to print more shares to give to him so that he now owns one-third of the
company which is what he originally signed out to own when he put in the
million bucks with this second round the company has 6 million shares out and if
another million is printed and given to him well then he'd own 2 million shares
but there would be 7 million shares now outstanding so depending on how brutally
the anti-dilution contractual language was written Rose might have to print [Paper printing]
even more shares to cover his anti-dilution clause
at the cost of her dilution and yeah note in all of this just how much Rose
has now been diluted from owning a hundred percent of the company the day
she started it while she now after just two rounds still owns her two million
shares that comprise all of the company at the beginning only now there are some
seven million shares outstanding and likely many many more to come as she
raises more and more capital so at this point she only owns two sevenths of the
company and of course none of this will matter if the flying car biz doesn't [Rose driving a flying car]
take off or maybe takes off a little too quickly if you know if you catch our
drift [Car floating into space]
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