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Full Ratchet Anti-Dilution Definition Example and Alternative

Full Ratchet Anti-Dilution Definition Example and Alternative

Full Ratchet Anti-Dilution: Definition, Example, and Alternative

What Is a Full Ratchet?

A full ratchet is a contractual provision that protects the interests of early investors. It is an anti-dilution provision that applies 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 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

A full ratchet protects early-stage investors by ensuring that their percentage ownership is not diminished by future rounds of fundraising. This provision also offers cost protection if the pricing of future rounds is lower than that of the initial round.

There are some caveats, though. Offering these assurances to early-stage investors can be expensive for company founders or investors participating in later rounds of fundraising.

The existence of a full ratchet provision can make it difficult for the company to attract new rounds of investment. For this reason, full ratchet provisions are usually only kept in force for a limited period of time.

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Full Ratchet Example

To illustrate, consider a scenario where a company sells 1 million convertible preferred shares at $1.00 per share, under terms including a full ratchet provision. Suppose the company then undertakes a second fundraising round, selling 1 million common shares at $0.50 per share.

Due to the full ratchet provision, the company would then compensate the preferred shareholders by reducing the conversion price of their shares to $0.50. This means that the preferred shareholders would receive new shares (at no additional cost) to ensure their overall ownership is not diminished by the sale of new common shares.

This dynamic can lead to a series of adjustments in which new shares need to be created to satisfy the demands of both the original preferred shareholders (benefiting from the full ratchet provision) and new investors who wish to purchase a fixed percentage of the company. After all, investors desire not just an abstract number of shares, but a concrete percentage of ownership.

In this situation, company founders can find their ownership stakes quickly diminished by the back-and-forth adjustments benefiting old and new investors.

The Full Ratchet vs. Weighted Average Approaches

An alternative provision using a weighted average approach is arguably fairer in balancing the interests of founders, early investors, and later investors. This approach comes in two varieties: the narrow-based weighted average and the broad-based weighted average.

An alternative provision using a weighted average approach is arguably fairer in balancing the interests of founders, early investors, and later investors. This approach comes in two varieties: the narrow-based weighted average and the broad-based weighted average.

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