Demistifying Term Sheets: Part 6 - Anti-Dilution

Negotiating a term sheet can feel like walking a tightrope, a delicate balance between ambition and protection for both entrepreneurs and investors. Every line of a term sheet carries weight, telling a story about the future of a business. Drawing from years of experience in the VC play, we are pulling back the curtain to highlight what really matters in a term sheet, how both sides should approach it, and the lessons we have learned (sometimes the hard way) to avoid common pitfalls.

In the spirit of transparency, we are sharing a copy of our full term sheet template here.

This article is meant to serve as a guide to navigating term sheet negotiations, highlighting the most critical clauses, and sharing tips for both entrepreneurs and investors. Our term sheet reflects how we do things differently. When our founders Gonzalo Martínez de Azagra and Igor de la Sota set up the fund, they did not just replicate existing VC practices, they built something that truly represents Cardumen Capital’s values.

That said, this guide is not set in stone; it is a living document that evolves as the market changes. But before diving into the details, here is an important starting point: a term sheet is not a promise to invest, in other words, it is not a legally binding document. Even when signed, it is not a guarantee of funding. Instead, it should be seen more as an agreement to keep negotiations private and, in some cases, to pause the company from exploring other offers for a certain period of time.

Now, let us get down to business. While every term sheet is unique, just like every investment offer, there are certain key terms that almost always come up in negotiations. Keep reading to learn what these are and why they matter.

In this article we will shed some light on Anti-Dilution clauses.

Anti-Dilution

The anti-dilution term is designed to protect investors if the company raises funds at a lower valuation (a "downround"). It adjusts the price at which investors’ preferred shares convert into common stock, ensuring they retain more equity than they otherwise would in such situations.

Types of Anti-Dilution Calculations

1. Weighted-Average Adjustment:

• This method softens the impact of a downround by recalculating the conversion price based on the weighted average of the old and new share prices.

There are two variants:

• Broad-based weighted average: Includes all shares outstanding, including options, making it the most founder-friendly and the standard nowadays.
• Narrow-based weighted average: Considers only a subset of shares, offering more protection to investors.

2. Full-Ratchet Adjustment:

• This method resets the conversion price to match the new lower price, maximising investor protection but heavily diluting founders.
• It is uncommon today due to its harsh impact.

Key Takeaways

Cardumen Insight

‍Broad-based weighted-average adjustments are the market norm, offering a fair compromise. Our advice, rather than dwelling on anti-dilution clauses, prioritize provisions that foster alignment and collaboration during challenging funding environments.