Anti-Dilution Provisions
When the valuation drops, preferred shareholders are protected. The common shareholders absorb the impact.
The Mechanism of Conversion
Anti-dilution clauses don't grant investors free shares directly. Instead, they adjust the ratio at which Preferred Stock converts into Common Stock. Originally set at 1:1, a down round triggers a formula that lowers the conversion price, effectively giving the investor more common shares per preferred share.
Broad-Based Weighted Average
This is the industry standard (present in ~95% of NVCA term sheets). It adjusts the conversion price based not just on the new lower price, but on how many shares are issued at that lower price. A small bridge note at a low cap will have a minor impact; a massive Series C down round will have a major impact.
CP2 = CP1 * (A + B) / (A + C)
CP2: New Conversion Price
CP1: Old Conversion Price
A: Common shares outstanding pre-deal (fully diluted)
B: Aggregate consideration received / CP1 (Shares that *would* have been issued at old price)
C: Actual shares issued in down round
Full Ratchet (The Punitive Model)
A Full Ratchet is draconian. It ignores how much capital is raised in the down round. If the company issues even a single share at a lower price, the conversion price for all previous preferred shares drops to match that new exact lowest price.
The Death Spiral
Full ratchets can cause a "death spiral." As the conversion price drops, the investor effectively owns a larger percentage of the company, crushing the founders' and employees' equity to near zero. This demotivates the team, destroying the company from within.