A provision that protects existing preferred stockholders from the future dilution of their investments
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Full ratchet is a provision that protects an 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 original investor’s equity ownership percentage, then they will be compensated by receiving additional shares sufficient to maintain their percentage of ownership at its original level.
After the adjustment, fresh shares should be issued to the investor, without requiring him or her to make any additional payments. The investor retains their original percentage of ownership – what changes is the number of shares they hold.
Full Ratchet – Anti-dilution Provision
This 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 with companies that have capitalization tables that include a large number of options and convertible securities. The main aim of the provision is to protect existing shareholders from a dilution of the investor’s equity investment. It adjusts the conversion price of the preferred stock to common stock and reflects the new round price.
The main types of anti-dilution provision are full ratchet and weighted average.
Assume that Company ABC has 1,000,000 outstanding shares, out of which 100,000 shares are owned by Investor X. With a current market price per share of $10, the company is valued at $10,000,000. 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 to the public. This brings the total Company ABC shares to 1,500,000 and the total valuation to $15,000,000. The new stock issue dilutes Investor X’s stake in the company – 100,000 shares – from 10% to 6.67%.
If Investor X wishes to maintain their original percentage of ownership, then having a full ratchet provision attached to their original equity investment in Company ABC.
How Does a 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 costs.
This is achieved by reducing the conversion price to allow investors to 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 feel the full effects of the dilution since the value of their shareholding becomes lower than that of the current shareholders.
One possible negative effect of anti-dilution provisions is that they may make it less likely that original investors will contribute in later funding rounds. As long as the investors are satisfied with the percentage amount of their original equity investment, then they can rest assured that their equity position will not be diluted. They are not incentivized to purchase additional shares.
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) at $0.5 per share, with a plan to raise $1,000,000. This means that they will be issuing 2,000,000 additional shares of stock. Without the full ratchet anti-dilution clause, Investor X would see their equity investment in the company considerably diluted, as the total amount of the company’s common stock has increased from one million shares to three million shares.
Company ABC must adjust the shares held by preferred stockholders in round 1 and round 2 to prevent dilution of their stake. This 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 stock issued in the third round of financing. In short, Investor X can convert their preferred shares to the number of common stock shares that will equal their original equity stake in terms of percentage of ownership.
In this case, Investor X receives adjustments, according to the anti-dilution provision, as follows:
Preferred stock round 1 adjustment:
The $1/share is reduced to $0.50/share when converting the preferred stocks to shares of common stock. This yields a conversion ratio of 2:1. Therefore, the 100,000 preferred shares that Investor X holds from round one are converted to 200,000 shares of common stock, at no additional cost.
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. The conversion ratio here is 4:1.
Disadvantages of Full Ratchet
Including a full ratchet provision in the company’s charter documents may deter some potential new investors from investing in the company. The company will appear less attractive to invest in since the anti-dilution provision only protects the current shareholders and puts any burden of dilution on the new shareholders.
However, this risk is considered minimal, as the new investors are not suffering any actual loss – they are merely not receiving the additional benefits that original Investor X enjoys.
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