Full Ratchet

Deciphering Full Ratchet: Protecting Early Investors

Understanding the intricacies of full ratchet provisions is essential for both early investors and founders in the world of startups and venture capital. These contractual arrangements are designed to safeguard the interests of initial backers by preventing dilution of their ownership in subsequent funding rounds. Let's delve deeper into what full ratchet entails, its implications, and how it compares to alternative approaches.

Unpacking Full Ratchet

A full ratchet serves as a protective measure for early investors, ensuring that their percentage ownership remains intact despite future fundraising efforts by the company. This provision stipulates that in the event of subsequent rounds of fundraising where shares are issued at a lower price than the initial offering, the conversion price or option price for existing shareholders is adjusted to match the lowest sale price.

Key Insights:

• Full ratchet provisions shield early investors from dilution of their ownership stake.
• They offer cost protection if future rounds are priced lower than the initial investment.
• However, they can deter new investment and prove costly for founders and later-stage investors.

Navigating Full Ratchet Scenarios

While full ratchet provisions offer security to early investors, they come with drawbacks. Founders may find it challenging to attract new investment rounds due to the potential dilution impact. Additionally, honoring full ratchet obligations can be financially burdensome for the company and subsequent investors. As a result, full ratchet provisions are often time-limited to mitigate their adverse effects on fundraising efforts.

Full Ratchet in Action: An Illustrative Example

Consider a hypothetical scenario where a company issues convertible preferred shares to early investors at a set price. Subsequent fundraising rounds occur at lower valuations, triggering the full ratchet provision. In this case, the company must adjust the conversion price of existing shares to match the latest round's price, ensuring that early investors are not disadvantaged.

This adjustment process can lead to a ripple effect, as the issuance of additional shares to accommodate early investors' demands for compensation may further dilute the ownership stakes of founders and subsequent investors.

Evaluating Alternatives: Weighted Average Approaches

In contrast to full ratchet provisions, weighted average approaches offer a more balanced solution. These methods, including narrow-based and broad-based weighted averages, consider the impact of all outstanding shares on the conversion or option price, rather than solely focusing on the latest round's pricing. This approach aims to protect the interests of all stakeholders while facilitating future fundraising efforts.