What is the full ratchet?
The term “full ratchet” refers to a contractual provision designed to protect the interests of early investors. More specifically, it is an anti-dilution provision which, for any ordinary share sold by a company after the issue of an option (or a convertible security), applies the lowest selling price as being the adjusted option price or the conversion ratio for existing shareholders. .
Full ratcheting anti-dilution protects early stage investors by ensuring that their ownership percentage is not reduced by future fundraising rounds. For this reason, the full ratchet arrangement can be quite costly from the perspective of the founders or investors of the business participating in subsequent fundraising cycles.
Key points to remember
- The full ratchet is an anti-dilution provision that protects the interests of early investors.
- It requires early investors to be compensated for any dilution of their property caused by future fundraising rounds.
- Full ratchet arrangements can be costly for founders and can undermine capital raising efforts in future fundraising rounds.
- Weighted average approaches are a popular alternative to the full ratchet layout.
How full ratchet arrangements work
A full ratchet arrangement ensures that current investors are able to maintain their ownership percentage if a company issues additional share offers. A full ratchet also offers a level of cost protection if the price of future rounds is lower than that of the initial round.
The existence of a full ratchet arrangement can make it difficult for the business to attract new investment cycles. For this reason, the full ratchet provisions are generally only kept in force for a limited period.
Real example of a complete ratchet arrangement
As an illustration, consider a scenario in which a company sells 1 million convertible preferred shares at a price of $ 1.00 per share, on terms that include a full ratchet clause. Suppose that the company then undertakes a second fundraising, this time selling 1 million common shares at a price of $ 0.50 per share.
Due to the full ratchet clause, the company would then be obliged to compensate the preferred shareholders by reducing the conversion price of their shares to $ 0.50. In fact, this means that preferred shareholders should receive new shares (at no additional cost) to ensure that their overall ownership is not diminished by the sale of the new common shares.
This dynamic can lead to a series of adjustments in which new shares must be created to meet the demands of both original preferred shareholders (who benefit from the full ratchet clause) and new investors who wish to buy a percentage. fixed company. After all, investors want not only an abstract number of stocks, but a concrete percentage of ownership. In this situation, the founders of companies can quickly see their participation held by the back-and-forth adjustments from which old and new investors benefit.
For these reasons, the complete arrangement of the ratchet is considered to be very favorable to the first investors. An alternative provision, which uses a weighted average approach, is probably more fair to balance the interests of the founders, the first investors and the subsequent investors. This approach is available in two varieties: the weighted average with a narrow base and the weighted average with a wide base.