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Full Ratchet

A provision that protects existing preferred stockholders from the future dilution of their investments

What is Full Ratchet?

Full ratchet is a provision that protects the option holder, or convertible holder, from any dilution of their investment in subsequent rounds of funding. The provision guarantees that if an equity investment sold in a subsequent funding round decreases the price to a price that is lower than what the investor paid for, the investor’s investment should be adjusted to tally the new price.

 

Full Ratchet Image

 

After the adjustment, fresh shares should be issued to the investor for the surplus of the consideration, without requiring additional payments. However, the investor retains the original percentage of ownership as the initial investment, and what changes is the number of shares.

 

Full Ratchet – Anti-dilution Provision

The anti-dilution provision protects investors from dilution caused by new stock issues at a price that is lower than the investor’s original investment. Such dilutions are common for companies with capitalization tables that have a large number of options and convertible securities. The main aim of the provision is to protect existing shareholders from a downward valuation of the investor’s equity investment. It adjusts the conversion price of the preferred stock to common stockand reflects the new round price. The main types of anti-dilution provision are full ratchet and weighted average.

For example: Assume that Company ABC owns 1,000,000 outstanding shares, out of which 100,000 shares are owned by Investor X. If the price/share is $10, the company is valued at $10,000,000 while Investor X’s stake in the company is valued at $1,000,000, which translates to an ownership stake of 10% in Company ABC.

In a new issue of shares, the company offers 500,000 new shares for subscription by investors. It brings the total Company ABC shares to 1,500,000  and the total valuation to $15,000,000. The new valuation dilutes Investor X’s stake in the company from 10% to 6.67%. It means that the price of conversion of the original shares needs to be adjusted to the new price which the new shares have been issued in order to retain Investor X’s 10% ownership stake.

 

How Does Full Ratchet Work

The goal of the full ratchet is to ensure current investors maintain the same ownership percentage should a company create new rounds of financing. It prevents the original shareholders’ stake from being diluted by the issue of new shares for new shareholders to subscribe. The shareholders maintain their stake without incurring additional funds. It is achieved by reducing the conversion price to allow investors convert their preferred stocks into a given percentage of the common stock. The conversion price is adjusted to reflect the conversion price of the shares issued in subsequent rounds.

The current shareholders benefit from the non-dilution provision since they are protected from any losses associated with the new rounds of financing. On the other hand, the new shareholders get to share the full effects of the dilution since the value of the shareholding becomes lower than that of the current shareholders. Also, due to the protection offered by the anti-dilution clause, the preferred shareholders are unlikely to participate in subsequent rounds of financing since they benefit from conversion price adjustment and more shares without putting in additional funds.

 

Practical Example

Company ABC is planning to start another round of financing to support its expansion plans. The current financial structure is as follows:

Common stock: 1,000,000

Preferred stock Round 1 ($1/share): 500,000

Preferred stock Round 2 ($2/share): 1,000,000

ABC projects to issue another round of financing (round 3) of $2,000,000 at $0.5 per share, with a plan to raise $1,000,000.

Company ABC must adjust the shares held by preferred stockholders in round 1 and round 2 to prevent excessive dilution of their stake. It means that the preferred stock in round 1 issued at a price of $1/share and the preferred stock in round 2 issued at a price of $2 each will be adjusted to the price of $0.50/share of the new preferred stock in the third round of financing, and their ownership will not be as diluted due to the new lower priced round.

 

Preferred stock round 1 adjustment:

The $1/share is reduced to $0.50/share when converting the preferred stocks to shares of common stock. It yields a conversion ratio of 2:1. Therefore, the 500,000 preferred stockholders in round 1 convert to 1,000,000 common stocks.

 

Preferred stock Round 2 adjustment:

The $2/share price for preferred stocks in round 2 is adjusted to the $0.5/share price of the new preferred stock in round 3. It brings the conversion ratio to 4:1 and the total common stock for round 3 stockholders to 4,000,000.

 

Disadvantages of Full Ratchet

Including a full ratchet provision in the company’s charter documents will deter new investors from investing in the company. The company will appear less attractive to invest in since the anti-dilution only protects the current shareholders and puts the burden of dilution on the new shareholders.

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Capital Raising Process
  • IPO Process
  • Recapitalization
  • Shareholder Primacy

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