Full Ratchet

Full Ratchet provision based on the understanding that if the company issues shares to a subsequent investor, the price per share of that later issuance shall be the price at which the earlier investor should have been entitled to invest in the first place.

The full ratchet method can be backed up by the notion that later valuation of the company is considered more accurate than the initial valuation, and that the initial investors should be treated as if they had invested at the latest, more accurate, valuation. Technically, the protected investor is granted the right to acquire as many additional shares at no cost as are necessary to make his average price per share equal to the price paid in the subsequent financing round. Full ratchet adjustments have frequently been used in the United Kingdom, especially in early-stage financing where valuations are difficult to support objectively.

Full-Ratchet Weighted Average

The full-ratchet is the most investor - favorable of anti-dilution protections available to the investor. With good reason, it makes the hair of the entrepreneur stand on end and sends a shiver up the spine. In the case of a full-ratchet, the conversion price is adjusted to ensure that the new price factors in the total amount of capital invested and preserves the full percentage ownership of the preferred.

The simple table below, which captures the complete economic effect and result to the cap table of the company:

	Series A Price & Series A Conversion Price	Common Equiv. Shares Outstanding	Ownership %	Series B Price & Series A&B Conversion Price	Common Equiv. Shares Outstanding	Ownership
Options		1000	33%		1000	20%
Common		1000	33%		1000	20%
Series A	2	1000	33%	1	2000	40%
Series B				1	1000	20%

Clearly, the repercussions of a full - ratchet are most serious for common stockholders and options recipients. These are the two sets of stakeholders who typically will get diluted, along with any class of preferred stock that may not have such protections. Hence, the conundrum for companies that are able to receive high pre-money valuations early in their lives. The entrepreneur may think this is a risk worth taking; however, valuations that are prematurely high in early rounds can adversely affect the marketability of a company in a later round. Investors who come to the table may sense that the management and its previous investors had lofty and inappropriate expectations and that, as a result, management may be difficult to work with or rely on when it comes to future performance. The economic consequences of a down round, and a full-ratchet in particular, can also be devastating for existing shareholders whose impatience and soured demeanor can create a less than welcoming environment for new investors.

Conversion Protection Clauses

The easiest and harshest adjustment is known as a full ratchet clause. For the full ratchet in our example, a new issue at $1.25 would change the conversion price for the existing preferred to $1.25 (from $2.50). That is, an existing share of convertible preferred would convert to four shares of common (twice as many as before the dilutive round). While a full ratchet involves simple calculations, the shadow such a clause casts on future investment rounds can be considerable. How this shadow affects investors may not be clear. Subsequent investors can bargain knowing that the convertibles are being made more attractive in the process. As a consequence, they will demand more shares than they otherwise would. Full ratchet-protected investors will receive enough post-conversion shares to protect their preissue conversion value. They certainly are not paying the cost of their own price protection.

That leaves:

• the entrepreneur
• founders, and
• non-price-protected investors

to pick up the tab.

Examples of Full Ratchet

• A company issues a series of convertible notes to an investor at a certain price per share. If a subsequent investor purchases shares at a lower price, the original investor's convertible notes are automatically converted into shares at the lower price.
• A company issues a series of preferred stock to an investor at a certain price per share. If a subsequent investor purchases shares at a lower price, the original investor's preferred stock is automatically converted into shares at the lower price.
• A company issues a series of warrants to an investor at a certain price per share. If a subsequent investor purchases shares at a lower price, the original investor's warrants are automatically exercised and the investor receives the lower-priced shares.

Advantages of Full Ratchet

The Full Ratchet provision is a way for a company to ensure fairness for its investors when issuing shares to subsequent investors. It is based on the understanding that, if the company issues shares to a later investor, the price per share of that issuance should be no less than the price at which the earlier investor should have been able to invest in the first place. The following are some of the advantages of adopting this provision:

• It ensures that earlier investors are not left out of the opportunity to benefit from a future increase in the company’s share price.
• It incentivizes investors to remain loyal and provide continued capital to the company, as they know they will always receive the best price per share.
• It helps to prevent dilution of the earlier investors’ holdings, as the full ratchet provision ensures that they will be issued additional shares at the same price as later investors.
• It provides a more predictable capital structure for the company, as investors will be more confident in their investments.

Limitations of Full Ratchet

The Full Ratchet provision is a powerful tool to protect investors in a company, but it also has some limitations that should be considered. These limitations include:

• The provision only applies to subsequent investors and not to the original investors. This means that the original investors are not guaranteed the same rights and protection as subsequent investors.
• The provision does not guarantee that the subsequent investor will get a lower price than the original investor. As the provision is based on the understanding that the subsequent investor will pay the same price as the original investor should have, the subsequent investor may still end up paying more than the original investor.
• The provision does not necessarily guarantee that the subsequent investor will get the same terms as the original investor. As the provision is based on the understanding that the subsequent investor will pay the same price as the original investor should have, the subsequent investor may not get the same terms as the original investor.
• The provision does not guarantee that the subsequent investor will be able to exit at the same time as the original investor. As the provision is based on the understanding that the subsequent investor will pay the same price as the original investor should have, the subsequent investor may not be able to exit at the same time as the original investor.
• The provision only applies to the issuance of new shares and not to any other form of investment. As such, the provision does not apply to investments such as convertible notes or other forms of debt financing.

Other approaches related to Full Ratchet

The Full Ratchet provision is one of several approaches used to ensure that early investors are fairly compensated. Other approaches include:

• Pre-emptive Rights: Pre-emptive rights allow existing shareholders to maintain their proportional ownership of the company by allowing them to purchase additional shares before the company issues additional shares to subsequent investors.
• Co-Sale Rights: Co-sale rights allow existing shareholders to sell their shares to subsequent investors in a proportionate amount to the investor's purchase.
• Anti-Dilution: Anti-dilution allows existing shareholders to maintain their ownership of the company by allowing them to purchase additional shares or convert their existing shares into a larger number of shares at a lower price if the company issues additional shares at a lower price than the existing shareholders paid.
• Drag-Along Rights: Drag-along rights allow existing shareholders to force other shareholders to sell their shares to a subsequent investor, allowing the investor to acquire a majority ownership of the company.

In summary, Full Ratchet is one of several approaches used to ensure that existing shareholders are fairly compensated when the company issues additional shares to subsequent investors. Pre-emptive rights, co-sale rights, anti-dilution, and drag-along rights are other approaches used to protect the interests of existing shareholders.

Footnotes

Full Ratchet — recommended articles

Treasury Stock Method — Dissenters right — Equity Participation — Fully Diluted Shares — Forced sale value — Authorized Stock — Performance shares — Issued share capital — Golden parachute

References

• Bartlett J.W., Barrett R., Butler M., (2010), Advanced Private Equity Term Sheets and Series A Documents, Law Journal Press, New York.
• Cornelius P.K., (2003), Corporate Governance and Capital Flows in a Global Economy, Oxford University Press, New York.
• Leach J.C., Melicher R.W., (2011), Entrepreneurial Finance, Cengage Learning, Australia.

Author: Małgorzata Oleksińska