What Does Full Ratchet Mean?

Are you an investor worried about protecting your equity in a startup? 

A full ratchet provision might be the solution you need. In venture capital, this tool helps early investors safeguard their shares from losing value during future funding rounds, especially when new shares are issued at lower prices. It ensures you keep the value of your original investment, even as the company grows and changes. 

This article will explain how full ratchets work, why they matter, and when they should be used, giving you the clarity you need to navigate funding agreements confidently.

Exploring the Mechanics of Full Ratchet Provisions

The term full ratchet helps describe an anti-dilution protection mechanism used in venture capital as well as funding agreements that protect investors against the effects of equity dilution during subsequent funding rounds. If a company issues new capital and sells these shares (at a lower price than the investors paid when the company was started), existing investors risk having their shares outstanding diminish significantly. To prevent this, a full ratchet provision is designed to reset the price at which the existing investors’ shares were purchased to the lower price of the newly issued shares.

Full ratchet provisions play the role of protecting investors in that they do not have to lose value in their equity stake when the company raises funds at a valuation lower than that in time of their initial investment. Full ratchet provision: If an investment company adjusts the conversion price of the existing investors’ convertible securities (e.g., preferred shares or convertible notes) to match the new issue price. By changing this, they keep their ownership percentage the same they originally held, as if they were simply buying their shares at the new lower price.

For instance, if a company issues new shares at $5, the full ratchet provision would adjust the original investor’s shares to the new price of $5, thereby doubling the number of shares without requiring the investor to buy new shares. Certainly this provision provides protections to investors, but it also puts a very heavy strain on the company and founders, potentially leading to excessive dilution of their own ownership, and further complicating future fundraising efforts. 

Operational Dynamics of Full Ratchet Clauses

Investment agreements contain full ratchet provisions, which provide anti-dilution protection to early investors to be protected against dilution of equity value of their original investment so that new shares can be issued at a lower price. The basic idea behind these provisions is to roughly adjust the conversion price of convertible preferred stock (i.e., preferred shares or convertible notes) so that later issuing shares in follow-on funding rounds are priced differently.

The full ratchet provision kicks in when, in a restructuring, a company issues new shares at a lower price per share in comparison to the earlier investors. This permits an original investor to change his or her preferred shares into a bigger number of common shares, leaving their ownership share undiluted.

Let’s assume an investor bought shares at $10, but the company later issues shares at $5, the full ratchet provision operates to adjust the conversion price to $5 and ultimately double the number of shares for which the investor can convert. The effect is to protect the investor’s share from the lower share price, which is in their interest.

Though, this benefit for the early investors can severely dilute founders’ or other shareholders’ shareholding. The ratchet adjustment increases the number of shares and, therefore, reduces the ownership percentages of those with less anti-dilution protection. Furthermore, this dilution can complicate future funding as new investors might be reluctant to invest, if existing shareholders have strong anti dilution provisions (risk of which could erode their investment).

In other words, while full ratchet clauses are great for investors, full ratchet clauses can be trouble for a company’s capital structure and for future fundraising in particular by introducing greater dilution risk for founders and new investors. 

Full Ratchet vs. Weighted Average

The two major anti-dilution protection systems under an investment agreement include the full ratchet and weighted average, which have very different effects on shareholders. Both of these approaches have profound effects on equity ownership, and the investor and company are obliged to know about all these impacts.

The more aggressive of these is full ratchet. Full ratchet lowers the original investors’ original conversion price to match the new, lower one only available when a company issues new shares at a price lower than the one paid by early investors. It means they can convert more shares, maintaining their equity stake 100%. But while this method is good for protecting investors, it has serious dilution problems for founders and other shareholders, as their percentage share ownership declines, because there are more total shares outstanding.

The two major anti-dilution protection systems under an investment agreement include the full ratchet and weighted average, which have very different effects on shareholders. Both of these approaches have profound effects on equity ownership, and the investor and company are obliged to know about all these impacts. Weighted average, in particular, adjusts the conversion price based upon the total number of new shares issued and the price of the new shares, alongside the preemptive rights of existing shareholders, allowing them to maintain their ownership percentage proportionately. 

This choice between these two depends on the priorities of the investor and the company. Investors looking for maximum protection, especially in volatile markets where it appears likely that future down rounds will occur, prefer full ratchet. Nevertheless, companies often favor the weighted average method because it is a more balanced solution, balancing investor protection and abating intense dilution. It can increase the probability of future investments to the company.

So to recap, full ratchet provides stronger investor protection, but requires significant dilution. 

Full Ratchet Example

An example to consider is with the meal kit delivery service Blue Apron. Blue Apron had their IPO in 2017, when its share price was $10, yet soon faced rising competition and operational headaches and its share price began to fall. By the end of the year, the share price had dropped to around $3 as the young company struggled to maintain its market position.

Check out its movement in the months following its IPO: 

Blue Apron stock price performance after its 2017 IPO

So, let’s take an example of an early investor who bought 10,000 at IPO price of $10, holding a $100,000 stake. New investors came in at just $3 a share when Blue Apron solicited more funding to survive. Under a full ratchet provision, the conversion price would adjust from $10 down to $3, to maintain the value of their investment. That would mean their stake would increase to 33,333 shares ($100,000 ÷ $3 per share), meaning they’d have tripled their share count and would still have made their original investment.

This full ratchet provision protects the original investor’s stake and ropes in other shareholders, such as company founders and employees, but on more diluted terms. The more shares on the market, the lower percentage ownership of those who don’t have anti-dilution protection. At Blue Apron, this sort of provision would have complicated an already tough financial position, making it harder to draw in new investors or tame the capital structure.

This is an example of the benefits to early investors with a full ratchet clause, but also a way to increase dilution for others who already are having challenges regaining market confidence. 

Advantages of Full Ratchet

The biggest advantage of full ratchet provisions is that they allow investors to escape from down rounds in which a business raises money at a lower valuation than previously. This protection assures that an investor’s stake stays protected from any bad factors that might befall a company, including the possibility of a stock split that could further dilute ownership stakes. Full ratchet provisions prevent equity dilution of the investor by adjusting the conversion price to the new, lower share price. It protects the stake of the investor because the investor’s ownership percentage is the same even if new shares are issued at a lower price.

If we think from an investor perspective, full ratchet clauses are especially useful in startups with high or volatile risk where the future is very much up in the air. In such a case, these provisions act as an insurance policy, reducing the risk of investment and increasing the attractiveness of the investment. To a certain extent, they put in place an insurance mechanism: if the company must go back to the early investors at a lower valuation, early investors won’t have to give up a significant part of their equity.

Moreover, full ratchet provisions make a good negotiating tool for investors, especially in those cases when the expected high returns are balanced with high risk. However, investors are confident about working with less stable companies because they know their investment is protected from dilution. Also, these guarantees can result in more attractive overall terms for investment, because any other risks stemming from the investment are covered up by the full ratchet provision.

In general, full ratchet clauses are important to preserve equity value for investors, but particularly in markets that are challenging (making it difficult to raise capital at favorable terms) or challenging conditions for a company. A key factor in making investments in startups and high growth companies an attractive proposition for venture capitalists and other early investors is this protection. 

Disadvantages of Full Ratchet

Although full ratchet provisions are great for investors, they can also be a problem for startups and other shareholders. One of the major weaknesses is the ability of the proposed transaction to severely dilute the existing shareholders’ equity. If there is a down round with a full ratchet provision, investors with these protections have their conversion price reset to the lower valuation. Consequently, this results in the issuance of a large number of additional shares to these investors, particularly if they hold participating preferred stock, immensely diluting the stakes of founders, early investors, and employees who don’t have such protections.

This dilution can be demotivating for company morale and retention, particularly for founders and key employees whose ownership positions get drastically reduced. Their potential reward for hard work, sacrifice, and commitment diminishes, weakening the alignment of interests between management and investors. To mitigate this, some investors may use real-time trade alerts as a supplementary tool to monitor market shifts and avoid unforeseen dilution risks, but this doesn’t always address the deeper morale issues that arise.

The existence of a full ratchet provision also makes the company less desirable to new investors in future funding rounds. New investors may be deterred if they know earlier investors are fully protected from dilution, reducing their share of the company’s future success. This could hinder the company’s ability to raise capital to scale operations or navigate difficult market conditions.

Finally, negotiating full ratchet provisions can create friction between the company and its investors. Founders may be pressured to accept these terms, leading to conflicts of interest and strained relations. In extreme cases, these provisions can lead to the loss of control by the original founders and early stakeholders as their equity and influence erode over time. 

Strategic Insights: When to Choose Full Ratchet

Both investors and companies must be very careful when considering a full ratchet clause in equity agreements. For investors, full ratchet provisions provide strong protection against future rounds of dilution. Because the company can raise capital at a lower valuation, the investor’s stake remains intact in high risk markets or with new ventures. The added value of this protection is for those seeking to decrease risk in volatile industries where down rounds are more prevalent.

The less need to secure capital quickly on the company’s side, the more likely the decision to accept a full ratchet clause. If you’re a startup or early stage company with limited negotiating power, these terms may feel unavoidable to get investors onboard. But all this means companies also need to acknowledge the risk — large dilution of founders’ and employees’ equity in future rounds at lower prices — that can compromise morale and undermine more long-term incentives for key stakeholders.

If a company expects very fast growth and expects little risk for a down round, the company may choose to go for the full ratchet. In situations like this, the right tradeoff is often between immediate funding and future risk. On the other hand, those companies that are confident in their growth potential may prefer lesser aggressive anti dilution protections such as a weighted average method, which gives investor protection with minimal impact on overall equity.

Finally, all this should be done with a good understanding of the trade offs of having a full ratchet provision. The decision they make has to be something that when you consider the prospects of this company growing and financial projections and market condition that you want to take on that risk at some level, that aligns with our long term goal and our risk tolerance. 

Legal Considerations: Understanding Full Ratchet Agreements

It is vital for companies and investors to be diligent when it comes to drafting and enforcing full ratchet provisions because it is a legal minefield. Full ratchet clauses help ensure early investors, but often come with a legal cost.

The main legal issue here is to be absolutely certain that the clause is clear and precise. In order for the full ratchet to be effective, the conditions that trigger the full ratchet and a method of recalculating shareholdings must be explicitly defined. For example, business and investors may disagree about the meaning of vague or ambiguous language. Also, clauses should reflect the shareholders agreement completely to avoid any conflict with other terms.

A second problem occurs when the company seeks a future financing round. Full ratchet provisions scare new investors into thinking that their equity is diluted more dramatically than if they had alternative protections, such as weighted average clauses. Especially if the company runs out of capital, this could easily give rise to legal disputes, or go on and on in renegotiations.

Full ratchet clauses can be legally tough to enforce also. If they don’t stand by their provision, investors can sue them into costly and time consuming litigation. Also, the ratchet can dilute fully, creating tension among shareholders, and can lead to conflicts that are litigated or arbitrated by a lawyer.

Due to these risks, full ratchet provisions are negotiated and drafted with the help from experienced legal counsel for investors and companies alike. These terms are made clear, enforceable, and line with the larger goals of the agreement, which reduces the possibility of future conflict and legal complication. 

Conclusion

Full ratchet provisions also have an important role to play to protect investors from dilution in the subsequent equity rounds, as new shares issued at lower prices will do nothing to decrease an investor’s equity value. This protection is immensely beneficial to investors, but brings with them very large challenges, especially for startups or other shareholders who will see their shares severely diluted, and their incentives reduced.

However, understanding the strategic implications and legal complexities of full ratchet clauses is critical for both companies and investors. But these provisions require careful consideration and expert legal advice, with a balancing act between keeping investors protected while ensuring we keep a healthy and motivated shareholder base. Full ratchet clauses thoughtfully integrated into equity agreements helps both parties better manage their risks and more importantly, seek future growth together. 

Deciphering the Full Ratchet: FAQs

What are the Important Considerations to Make before Agreeing to a Full Ratchet?

If you’re not sure if you’ll have the opportunity to re-price on the next round, you probably shouldn’t agree to a full ratchet provision. But it’s also important to think about the company’s growth strategy and how a full ratchet would impact future investor relations and the ability to raise capital.

What Does the Inclusion of Full Ratchet Clauses Mean for Subsequent Funding Round Valuation?

If new shares are priced lower than the ratchet level, founders and other shareholders may be diluted by the more shares being issued to early investors. This dilution can lower the company’s total valuation and make it less appealing to potential new investors in the future funding rounds.

What Other Ways Are There to Acquire Full Ratchet Protection in a Less Objectionable Form?

This is in fact a very common alternative of the weighted average anti dilution provision. The result is less drastic dilution of existing shareholders, at the expense of protection from the dilution effects of new shares remaining at issue. By analyzing this, this makes it a more balanced option for companies that want to protect investors, but not dilute others heavily.

What Does Full Ratchet Say about Founders’ and Executive Company Founders’ Motivation?

To the extent that full ratchet provisions decrease equity value in future fundings to these lower valuations, they are also demotivating to founders and executives. This dilution dilutes its own potential returns, a misalignment that may disadvantage founders, executives, and investors alike and hinders future long term growth for the company.

Under What Circumstances Would We Expect a Full Ratchet?

Down rounds often trigger a full ratchet, whereby a company offers new shares at a lower price from previous rounds. Then the clause adjusts the price of convertible securities on conversion to a lower price, thereby protecting early investors from dilution.