In fundraising activities, anti-dilution clauses play an important role in protecting investors’ interests against the risk of ownership dilution when a company issues additional shares. The following article shall provide Clients legal regulations and matters relating to anti-dilution clauses in capital raising.
I. Current issues related to anti-dilution clauses in capital raising
In the context of fundraising activities, especially in venture capital and startup transactions, anti-dilution clauses have increasingly become an important negotiation issue, reflecting conflicts of interest between investors and founders.
- Firstly, in practice, anti-dilution clauses are commonly designed to protect investors from the risk that a company may issue additional shares in subsequent funding rounds at a lower valuation (down round). Without a protection mechanism, the investor’s ownership ratio and share value may be significantly diluted. As a result, investors often demand strong anti-dilution protections, sometimes even imposing highly investor-favorable terms.
- Secondly, practice shows that many businesses, particularly early-stage startups, lack sufficient legal understanding when entering into investment agreements. Accepting unfavorable anti-dilution provisions (such as full ratchet clauses) may lead to severe consequences, including substantial dilution of the founders’ ownership interests or even loss of corporate control. It is one of the most common causes of disputes between founders and investors after fundraising rounds.
- Thirdly, the Vietnamese legal system currently does not contain specific provisions directly regulating anti-dilution clauses. Such provisions are mainly established through contractual agreements (such as investment agreements and shareholders’ agreements). While it provides a high degree of flexibility, also creating potential legal risks, especially when disputes arise.
- Fourthly, current trends indicate that anti-dilution clauses are gradually being “standardized” according to international practices, with weighted average mechanisms becoming more common than full ratchet provisions in order to balance the interests of the parties. However, the extent of application still largely depends on the bargaining power of each party in the transaction.
II. Concept of anti-dilution clauses in capital raising
1. What is an anti-dilution clause in capital raising?
An anti-dilution clause is a provision in an investment agreement or shareholders’ agreement intended to protect investors from a reduction in ownership percentage or share value when the company issues additional shares, particularly at a lower price than previous funding rounds.
In essence, such a mechanism adjusts the investor’s rights and interests (typically through adjustments to the conversion price or the number of shares) in order to preserve the value of the initial investment.
2. In which fundraising rounds are anti-dilution clauses commonly applied?
Anti-dilution clauses are commonly found in:
- Early fundraising rounds: Protecting early investors.
- Subsequent fundraising rounds: Particularly important in the event of a down round.
- Transactions involving convertible instruments such as preferred shares and convertible bonds.
In practice, these clauses become most significant when the company raises capital in later rounds at a lower valuation, thereby reducing the value of prior investors’ shares.
3. What are the common types of anti-dilution clauses?
Common anti-dilution provisions include:
- Full Ratchet: It adjusts the investor’s share price to match the lowest price in the subsequent funding round, providing maximum protection to investors but being disadvantageous to the company.
- Weighted Average: It adjusts according to a weighted average formula between the old price and the new price, balancing the parties’ interests and commonly used in practice.
- Broad-based and Narrow-based: Variations of the weighted average method, differing in the scope of shares included in the calculation (broad-based is generally more favorable to the company, while narrow-based is more favorable to investors).
- Pay-to-Play: Investors are entitled to anti-dilution protection only if they continue participating in subsequent funding rounds.
- Pre-emptive Rights: It allows shareholders to purchase additional shares to maintain their ownership ratio, indirectly limiting dilution.
III. Legal regulations related to anti-dilution clauses in capital raising
1. When should investors request the inclusion of anti-dilution clauses?
Investors should request anti-dilution protection in the following situations:
- When investing in early-stage companies (startups) with high valuation risks;
- When the possibility of a future down round is significant;
- When investing through convertible instruments (preferred shares or convertible bonds);
- When investors do not possess control rights within the company.
The inclusion of such clauses is consistent with the principle of freedom of contract under Article 3 of the Civil Code 2015, provided that it does not violate the law or social ethics.
2. Contents of anti-dilution clauses in capital raising
An anti-dilution clause typically includes the following basic contents:
- Conditions for application: When the company issues shares at a lower price (down round);
- Adjustment method: Full ratchet or weighted average;
- Scope of application: Classes of shares and eligible investors;
- Implementation mechanism: Adjustment of conversion price or share quantity;
- Exceptions: Cases where the clause does not apply (ESOP, internal issuances, etc.).
These contents must comply with the provisions of the Law on Enterprise 2020 regarding share issuance and shareholders’ rights.
3. In which cases may an anti-dilution clause be declared invalid?
Pursuant to Articles 117 and 123 of the Civil Code 2015, an anti-dilution clause may be declared invalid if it:
- Violates prohibitive provisions of law (for example, unlawfully restricting the rights of other shareholders);
- Contravenes social ethics;
- Is fictitious or intended to conceal another transaction;
- Is entered into by parties lacking the required legal or civil act capacity.
In addition, if the clause alters the company’s share structure in violation of mandatory provisions of the Law on Enterprise 2020 (for example, unlawful share issuance procedures), it may also be at risk of being declared invalid.
4. Can anti-dilution clauses be considered restrictions on a company’s freedom of business?
Under Article 33 of the Constitution 2013 and Article 7 of the Law on Enterprise 2020, businesses enjoy freedom of and autonomy in their operations.
Anti-dilution clauses represent voluntary commitments made by the company to investors and thus are generally not regarded as restrictions on such rights.
However, in certain circumstances, these clauses may be considered as restricting business freedom if they:
- Excessively restrict the company’s authority to issue shares;
- Deprive the General Meeting of Shareholders or the Board of Directors of their decision-making powers;
- Cause serious imbalance among shareholders’ interests.
In such cases, the clause may be partially or wholly invalidated under civil law principles.
IV. Questions regarding anti-dilution clauses in capital raising
1. Is an anti-dilution clause mandatory in every investment agreement?
An anti-dilution clause is an optional provision established based on the parties’ agreement under the principle of freedom of contract. However, in practice, investors often require such clauses in order to protect their interests.
2. Can the duration of an anti-dilution clause be limited?
The parties may fully agree to limit the duration of the anti-dilution mechanism (for example, applying it only for 2–3 years or until a specific funding round) in order to avoid imposing excessively long-term restrictions on the company.
3. Can anti-dilution clauses affect the interests of other existing shareholders?
Adjustments to the share price or increases in the number of shares allocated to investors may reduce the ownership ratio of other shareholders. Thus, such clauses should be carefully considered and, in many cases, approved by the General Meeting of Shareholders.
4. Can anti-dilution clauses be amended after the investment agreement has been signed?
In principle, an anti-dilution clause forms part of the investment agreement and is thus subject to the general provisions of contract law. Pursuant to Article 421 of the Civil Code 2015, a contract may be amended or supplemented upon mutual agreement of the parties.
In investment practice, anti-dilution clauses are often drafted based on assumptions regarding fundraising plans, company valuation, and future growth prospects. However, these factors may significantly change after the agreement has been executed, for example, where the company grows faster than expected, changes its business strategy, or attracts new investors under different conditions. In such cases, maintaining the original anti-dilution provision may no longer be appropriate and may even create an imbalance of interests among the parties.
5. If the company issues shares at a higher price than in the previous funding round, will the anti-dilution clause still apply?
Such a situation is commonly referred to as an “up round”. The fundamental purpose of an anti-dilution clause is to protect investors against a decrease in the value of their investment when the company issues new shares at a price lower than the price paid by earlier investors (a “down round”).
Where the company issues shares at a higher price than in the previous round, the company’s valuation increases, thereby increasing the value of the existing investors’ holdings as well. In such circumstances, there is no “adverse dilution” requiring protection, and therefore the anti-dilution clause will not be triggered.
V. Why should you seek legal advice from NPLaw regarding anti-dilution clauses in capital raising?
Consulting legal counsel is essential because anti-dilution clauses are highly complex and are not specifically regulated under Vietnamese law. Lawyers at NPLaw assist clients in assessing legal risks, drafting and negotiating reasonable anti-dilution provisions, while ensuring compliance with applicable laws and maintaining a balance of interests among the parties. As a result, businesses and investors can minimize risks and better protect their rights throughout the fundraising process.
The above information is provided for reference purposes only. Should clients require detailed advice regarding a specific case, please contact NPLaw Firm for immediate consultation.
