What Is a Full Ratchet?
Let me explain what a full ratchet is—it's a contractual provision I see often in investment deals, designed to protect early investors like you might be. Specifically, it's an anti-dilution tool that kicks in for any common stock sold by a company after issuing an option or convertible security, setting the lowest sale price as the adjusted option price or conversion ratio for existing shareholders.
Key Takeaways
- A full ratchet is an anti-dilution provision that applies the lowest sale price as the adjusted option price or conversion ratio for existing shareholders.
- It protects early investors by ensuring they are compensated for any dilution in their ownership caused by future rounds of fundraising.
- Full ratchet provisions can be costly for founders and can undermine efforts to raise capital in future rounds of fundraising.
- Weighted average approaches are a popular alternative to the full ratchet provision.
Understanding Full Ratchets
You need to understand that a full ratchet protects early-stage investors by making sure their percentage ownership isn't reduced by future fundraising rounds. This provision also gives them some cost protection if future rounds price shares lower than the initial one.
But there are caveats you should know. Offering these protections to early investors can get expensive from the founders' or later investors' viewpoint.
In essence, having a full ratchet can make it tough for the company to bring in new investments. That's why these provisions are typically only active for a limited time.
Full Ratchet Example
Let me walk you through an example to make this clear. Imagine a company sells 1 million convertible preferred shares at $1.00 each, with a full ratchet provision in the terms. Then, in a second round, they sell 1 million common shares at $0.50 each.
Because of the full ratchet, the company has to compensate those preferred shareholders by dropping their conversion price to $0.50. This effectively means issuing them new shares for free to keep their ownership percentage the same after the new shares are sold.
This can create a chain of adjustments where new shares are issued to satisfy both the original preferred shareholders under the ratchet and new investors who want a specific ownership percentage, not just a number of shares.
In this setup, company founders often see their own stakes shrink rapidly due to these adjustments favoring old and new investors.
The Full Ratchet vs. Weighted Average Approaches
You might consider an alternative like the weighted average approach, which I find fairer in balancing interests among founders, early investors, and later ones. It comes in two forms: narrow-based weighted average and broad-based weighted average.
