Key Takeaways
- Resets conversion price to lowest new round price.
- Protects early investors from ownership dilution.
- Ignores number of new shares issued.
- Harsh on founders and new investors.
What is Full Ratchet?
Full ratchet is an anti-dilution provision commonly used in venture capital agreements to protect early investors by resetting the conversion price of their preferred shares to the lowest price paid in a subsequent funding round. This mechanism ensures that your ownership percentage remains intact even if new shares are issued at a lower price.
This provision is especially relevant during a C-Corporation financing round where valuation uncertainty is high, offering strong downside protection for investors.
Key Characteristics
Full ratchet anti-dilution protection offers maximum investor safeguards with several distinct features:
- Price Reset: Adjusts the conversion price of preferred shares to the lowest price in any new funding round, regardless of the number of shares issued.
- Investor Protection: Maintains your ownership percentage by granting additional shares upon conversion.
- Down Round Trigger: Activates only if new shares are sold at a price below the previous round.
- Harsh on Founders: Can cause significant dilution for founders and employees, making it less common in later-stage investments.
- Simplicity: Easier to calculate compared to weighted average anti-dilution but more punitive.
How It Works
When a company issues new shares at a price lower than your original investment price, full ratchet protection kicks in by retroactively lowering your conversion price to that new price. This adjustment increases the number of common shares you receive when converting your preferred stock, effectively neutralizing dilution.
Unlike weighted average methods, full ratchet ignores the volume of new shares issued, focusing solely on the lowest price. This feature ensures you retain your original equity stake, even in a down round, making it a powerful tool during volatile funding conditions.
Examples and Use Cases
Full ratchet anti-dilution provisions are most common in early-stage financings where valuation risks are significant. Here are some illustrative scenarios:
- Early-Stage Tech: A startup raises Series A funding at $10 per share but later issues Series B shares at $5. Full ratchet adjusts Series A investors' conversion price to $5, doubling their shares.
- High-Volatility Markets: In sectors relying on data analytics, fluctuating valuations make full ratchet protections attractive for investors seeking firm safeguards.
- Growth-Focused Investments: Investors targeting best growth stocks may negotiate full ratchet clauses to mitigate risks associated with down rounds.
Important Considerations
While full ratchet offers strong protection for investors, it can deter future funding rounds by increasing dilution for founders and employees. You should weigh the benefits against potential challenges in attracting new investors.
Negotiating less severe anti-dilution clauses, such as weighted average provisions, may be preferable unless you are an early adopter willing to accept higher risk for stronger protection. Understanding the fair value impact on your shares is essential before agreeing to full ratchet terms.
Final Words
Full ratchet anti-dilution offers strong protection for early investors by resetting their conversion price to the lowest new round price, preserving ownership percentage during down rounds. Evaluate your term sheets carefully to understand if this provision aligns with your investment goals and risk tolerance.
Frequently Asked Questions
Full ratchet anti-dilution is a provision in venture capital agreements that protects early investors from ownership dilution by resetting their preferred shares' conversion price to the lowest price paid in a later funding round, granting them additional shares to maintain their original ownership percentage.
Full ratchet activates during a down round, which is when new shares are issued at a price lower than the previous funding round, causing the conversion price for earlier investors to be adjusted downward to that new lowest price.
Unlike weighted average methods that adjust conversion price based on both the price and number of new shares issued, full ratchet ignores share volume and resets the conversion price fully to the lowest new price, offering maximum protection to early investors.
Full ratchet can cause significant dilution for founders, employees, and new investors because it grants early investors additional shares as if they had bought at the lower price, regardless of how many new shares are issued, which can greatly reduce others' ownership percentages.
Full ratchet is mainly used in early-stage financing rounds where valuation uncertainty is high, helping to protect investors against risks from volatile markets or unclear funding prospects.
If Series A investors buy shares at $10 each and a later round issues shares at $5, full ratchet resets their conversion price to $5, effectively doubling the number of common shares they can convert to, preserving their ownership percentage.
No, full ratchet ignores the quantity of new shares issued and applies the lowest sale price retroactively to all prior shares, unlike weighted average methods that factor in the volume of new shares.
