What Is A Full Ratchet?
Full ratchet is a protective measure for early investors in a startup. It is an anti-dilution provision used in investment agreements, especially in the context of convertible preferred stock.
It ensures that if the startup issues new shares in a downround, then the earlier investors’ buying price gets adjusted to match the new, lower price. This protects their investment value from decreasing due to the issue of new, cheaper shares.
What Is A Ratchet In IPO?
In the context of an Initial Public Offering (IPO), a ratchet is a mechanism that can protect the interests of investors who hold convertible securities, such as convertible preferred stock, if the IPO price is lower than the price at which the securities were originally issued. This protection is often in the form of an IPO ratchet provision.
When an IPO occurs, and the offering price is lower than the conversion price of the convertible securities (due to market conditions or other factors), the ratchet mechanism adjusts the conversion price downwards to match the IPO price.
What Is The Difference Between Full Ratchet And Weighted Average?
Full ratchet and weighted average are two common forms of anti-dilution provisions in investment agreements. The key difference between them lies in how they adjust the conversion price of convertible securities.
Full Ratchet
- With a full ratchet, the conversion price is adjusted on a one-to-one basis, meaning that if new shares are issued at a lower price than the original conversion price, then the conversion price of the original securities is adjusted down to match the lower price.
- This mechanism is more favourable to investors as it provides them with full protection against dilution but can be more punitive to the company and other shareholders.
Weighted Average
- Weighted average anti-dilution provisions take into account the number of new shares issued and the price at which they are issued when determining the adjusted conversion price.
- This mechanism is generally considered more balanced because it mitigates the extreme dilution experienced by the company and existing shareholders, while still protecting the investors from significant dilution.
In summary, the main distinction between the two lies in the method of adjustment. While full ratchet is more favourable to investors and potentially harsher on the company, weighted average seeks to strike a balance between the interests of both parties.
What Are Full Ratchet Terms?
Full ratchet terms are specific clauses in investment agreements that detail how the full ratchet anti-dilution provision will be applied. These terms specify the conditions under which the conversion price of the original securities will be adjusted and the calculations involved.
Key components of its terms may include:
- The trigger for applying it is usually a new issuance of shares at a lower price.
- The formula used to calculate the adjusted conversion price.
- Any limitations or exceptions to the full ratchet provision, such as excluding certain types of issuances or share sales below a certain threshold.
The purpose of full ratchet terms is to provide clarity and transparency regarding how the anti-dilution protection will be implemented in the event of share issuances at lower prices.
What Are The Disadvantages Of Full Ratchet?
While full ratchet anti-dilution provisions offer strong protection to investors, they also have some disadvantages and potential downsides:
- Company Dilution: Full ratchet can be highly dilutive to the company and its existing shareholders, as it can lead to a significant reduction in the conversion price of previously issued securities, resulting in a larger number of shares being issued to the investor.
- Deterrent To New Investors: Knowing that a full ratchet provision could significantly dilute their ownership, potential new investors may be hesitant to invest in the company. This can make it more challenging for the company to secure additional funding.
- Complexity And Disputes: Its calculations can be complex, leading to potential disagreements and disputes between investors and the company over the adjustment process and its fairness.
- Negative Impact on Valuation: The use of a full ratchet can negatively affect the company’s valuation, as it may be perceived as an unfavourable term by potential investors or acquirers.
