Anti-dilution of shares in Dutch Company Law

Anti-dilution provisions protect investors in a down round. When a private company conducts a “down round,” it sells new shares at a lower price than it did during the previous fundraising round. In other words, the company discovers that it needs additional money and that its valuation has dropped since the previous round of funding. Anti-dilution provisions are created to attract powerful first-round investors. The possibility of a down round considerably increases the venture’s initial flexibility and, thus, its investment value; yet initial investors may want to safeguard their interests against dilution.

Pre-emptive rights under Dutch law

According to Article 206a of Book 2 of the Dutch Civil Code, unless the articles of association state otherwise, each shareholder has a pre-emptive right upon the issuance of new shares pro-rata to the total amount of its shares held by that shareholder. Holders of preferred shares (a common occurrence in venture capital firms) have no pre-emptive rights in principle. Furthermore, any minority short of a controlling interest can overturn any such statutory anti-dilution protection, and no room for pricing arrangements is provided.

Contractual anti-dilution provisions

Anti-dilution provisions kick in during a down round by adjusting the share price at issuance. The initial venture capital investors gain more shares by contractually creating the situation in which the initial investors are deemed to have invested in the first round at a lower price. Venture capital transactions may include one or more of the following anti-dilution mechanisms:

1. Broad-Based Weighted Average anti-dilution 
2. Narrow Based Weighted Average anti-dilution 
3. Full Ratchet anti-dilution 

Weighted Average anti-dilution provisions provide milder anti-dilution protection, whereas Full Ratchet anti-dilution provisions provide more aggressive protection.

The Broad-Based Weighted Average formula considers all issued shares, whereas the Narrow-Based Weighted Average formula only considers the protected investor’s shareholding. There are numerous calculation methods.

The outcome of the various anti-dilution provisions can be demonstrated as follows: Investor A initially purchased 1 million shares (A Shares) at a price of EUR 1 (Old Price), and in a down round, Investor B purchases 1 million shares (New Shares) at a price of EUR 0.50. (New Price).

• Broad-Based Weighted Average anti-dilution with the following Broad-Based Weighted Average formula, the effect for Investor A would be that he is entitled to 111,111 new shares:
  • Average Price = (Old Price*Total Shares + New Price*New Shares) / (Total Shares + New Shares) 
    • Average Price = (1*4,000,000 + 0.50*1,000,000) / (4,000,000 + 1,000,000) = EUR 0.90 
  • New Shares = A Shares*Old Price/Average Price – A Shares 
    • New Shares = 1,000,000*1/0.9 – 1,000,000 = 111,111 

• Narrow Based Weighted Average anti-dilution with a Narrow Based Weighted Average formula, the effect for Investor A would be that he is entitled to 333,333 new shares:
  • Average Price = (Old Price*A Shares + New Price*New Shares) / (A Shares + New Shares) 
    • Average Price = (1*1,000,000 + 0.50*1,000,000) / (1,000,000 + 1,000,000) = EUR 0.75 
  • New Shares = A Shares*Old Price/Average Price – A Shares 
    • New Shares = 1,000,000*1/0.75 – 1,000,000 = 333,333 

• Full Ratchet anti-dilution Full Ratchet anti-dilution provisions entitle the investor confronted with a down round to several shares calculated based on a price equal to the price per share paid by new investors. The following Full Ratchet formula would result in Investor A being entitled to 1,000,000 new shares:
  • New Shares = A Shares*Old Price/New Price – A Shares New Shares = 1,000,000*1/0.50 – 1,000,000 = 1,000,000 

Dutch law observations

Anti-dilution provisions are heavily influenced by Anglo-Saxon law. The contractual mechanisms are governed by Dutch law, but the provisions of Dutch law governing the issuance of shares must be considered. Shares in a Dutch limited liability company cannot be issued “at no cost” or in any other way. Article 191 of Book 2 of the Dutch Civil Code states that the nominal value of the shares must be paid up at the time of issue. Furthermore, a resolution of the general meeting is required to implement any anti-dilution provisions, according to paragraph 2 of Article 2:206 of the Dutch Civil Code.

Venture capital investors, on the other hand, would prefer an issuance of shares ‘at no cost’ in accordance with anti-dilution provisions. One option for approaching the ‘at no cost’ scenario would be to include an obligation to create and maintain a reserve for dilution scenarios. This reserve ensures that the additional shares can be issued to the protected investor ‘at no cost’ at that time. Another option is to agree that the protected investor will only pay up the nominal value of newly issued shares under the anti-dilution provision.

Conclusion

Anti-dilution provisions can be an effective tool under Dutch law. This does not necessarily imply that such provisions are appealing to later-round investors in a Dutch law environment. Initial investors should keep in mind that requiring these types of provisions may have a commercial impact.

Please contact us if you would like specific examples of how share dilution can work and be avoided.

This guide is part of Legal Assistance Netherlands in our Launch Guide.