What is the meaning of a full ratchet?

To guard the interests of early investors, contractual provision is designed, which is known as a full ratchet. It provides a provision from the dilution of their investment in an event when equity investment is sold by the company in a subsequent funding round. In simpler words, as more people are sharing a pie (here meaning, company), the share of slice for each person goes down.

Similarly, in cases where original investors’ equity investment percentage declines, then they will receive additional shares as compensation to maintain the original ownership level. They are also known as anti-dilution protections.

Frequently Asked Questions:

When is a full ratchet provided?

A full ratchet provision is generally given at an early stage to protect the interests of the initial investors by ensuring that their original stake or ownership does not dwindle in future fundraising rounds.

However, providing these commitments can be quite costly for the owners of the company or the investors who come in the later stage of fundings.

It is for this reason that provisions related to full ratchet are enforced only for a limited period.

What is the example of a full-ratchet provision?

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Understanding full-ratchet provision is quite simple. Let us take an example to understand Full Ratchet.

Suppose XYZ Ltd. has 10,000 shares of $10 each, the total valuation of the company comes to be $100,000. Out of these, 2,000 shares are owned by Mr A. His total stake in the company is 20% and is valued at $20,000.

In the event of an equity raising, XYZ Ltd. issued 1,000 new shares to the general public. Now the total number of the company's shares stand at 11,000, with the new valuation being $110,000. However, Mr A's stake has now diluted to 18.2%.

So, in order to maintain the original ownership level, Mr A must have a full-ratchet provision attached to his initial investment in the said company.

Why do companies offer full-ratchet provision?

Companies offer full-ratchet provision to the original investors so as not to weaken their ownership stakes. It is these investors who have faith in the companies' business and parted from their money to invest in the business operations of the company.

Who benefits from a full ratchet?

Generally, existing and the initial shareholders and the investors benefit from this provision related to full ratchet. Since they are protected from any loss or weakening of their ownership in the subsequent rounds of financing, they consider the provision as an incentive given to them. On the contrary, new shareholders are not given any such rights or benefits.

What do you mean by an anti-dilution provision?

Generally speaking, an anti-dilution provision acts as a cushion to shield the investors' interest or ownership from becoming less valuable or getting diluted. This is usually given when the investor's stake at the company weakens due to an increase in the number of outstanding shares, which is a result of a new issue of shares based on subsequent equity funding rounds.

Are there any disadvantages of full ratchet?

Inclusion of the provision of full ratchet often dissuades new and prospective investors from investing in the company. They feel that because of full ratchet, the interests of the current or the initial shareholders are protected with an anti-dilution provision while the burden of dilution is transferred to the new investors. Hence, investing in such companies are often seen as less appealing to potential and new investors.

Another disadvantage of full ratchet is that original investors may not contribute to later financing rounds for the fear of dilution of their interests.

However, as perceived, new shareholders do not suffer any loss; it is only that they do not enjoy the additional benefit presented to the original investors.

What are the types of anti-dilution protections?

Broadly speaking, anti-dilution protections can be classified into:

• Price-based anti-dilution

In cases when a company goes in for raising funds, it may dilute the value of the stocks held by the initial investors. Hence, at times, investors and founders of the company work out anti-dilution protection to negate the dilutive effects of future funding rounds.

Price-based anti-dilution can further be classified as full-rachet and weighted average anti-dilution protection.

• Contractual anti-dilution

Sometimes, early investors negotiate the right to receive new shares to protect themselves from a diluted or decreased ownership stake in the company for no additional payment, irrespective of the price at which the new shares are being sold.

What is the meaning of Weighted Average Anti-Dilution?

This method is also undertaken to issue additional equity shares to the preferred stockholders during a down round, thereby adjusting the conversion rate. Nonetheless, it strives to balance the share price and the amount raised during a down round. Here, the conversion rate is usually lower than that of the full-ratchet provision.

Is the weighted average anti-dilution approach better than full ratchet?

Usually, the weighted average approach, a substitute provision for full ratchet, is assumed to be more unbiased in balancing the interest of the owners of the company, original investors, as well as the later or subsequent investors or shareholders.

What is a ratchet warrant?

In basic terms, a ratchet warrant is nothing but a protection mechanism to defend the equity stake of the management in events of future equity raising. These ratchet warrants are offered as an incentive or a stimulus to the owners and the management. They provide additional economic rights tied up to the owner’s preferred shares.