Full Ratchet

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Full Ratchet
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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[1].

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[2].

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[3].

Footnotes

  1. P.K. Cornelius 2003, p.419
  2. J.W. Bartlett, R. Barrett, M. Butler 2010, p.203
  3. J.C.Leach, R.W. Melicher 2011, p.463

References

Author: Małgorzata Oleksińska