Full Ratchet

Definition

Full Ratchet is a type of anti-dilution provision used in venture capitalism which ensures that the percentage ownership of an investor does not decrease with future financing rounds. This is achieved by reducing the price per share of the earlier investors to the price at which new shares are issued in later rounds. This mechanism favors early-stage investors at the expense of later investors and company founders.

Phonetic

The phonetic pronunciation of ‘Full Ratchet’ is: /fʊl ‘rætʃɪt/

Key Takeaways

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1. A Full Ratchet is an anti-dilution provision that protects an investor’s stake in a company by offering the option to buy more shares at a reduced price if the company issues additional shares at a lower valuation. This prevents the investor’s share in the company from being diluted.
2. While Full Ratchet can be beneficial to investors who want to maintain their stake in a company, it can be detrimental to founders and other shareholders. When enacted, Full Ratchet can disproportionately increase the stake of protected investors at the expense of others.
3. Full Ratchet can influence a company’s financial decisions. Knowing that issuing additional shares at a lower valuation could potentially dilute other shareholders’ stakes, a company might put off additional fundraising, potentially impacting its liquidity or growth prospects.

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Importance

Full Ratchet is a significant term in business finance, particularly in venture capital financing. It refers to an anti-dilution provision that protects investors in the event of a company issuing more shares at a lower price than what they initially paid. The full ratchet provision enables these investors to hold a constant percentage of a company’s equity by adjusting their share prices to the lowest price at which the new shares are issued. This protects their investment from dilution. Full Ratchet provisions are important to investors because they provide a safety net, ensuring their proportional ownership is not diminished if the company sells its shares at a lower price in the future. It helps in maintaining the investor’s influence and control over the company.

Explanation

Full Ratchet is a vital clause often used in the financial world, specifically in the venture capital industry. The primary purpose of this clause is to protect investors, particularly in situations where subsequent financing occurs at a lower valuation than the initial investment. So, if a company’s value decreases in subsequent funding rounds, the full ratchet provision ensures that the investor’s equity is not diluted too much. It is essentially an anti-dilution provision involving the adjustment of the conversion price to prevent dilution.Implementing a full ratchet clause can have profound implications for entrepreneurs and investors. For investors, it plays a crucial role in their risk mitigation strategy, ensuring their stake remains valuable even in challenging circumstances. Meanwhile, for entrepreneurs, it may introduce additional difficulty in attracting future investments, since potential investors could be deterred by the prospect of their shares being heavily diluted. This is particularly true if the company does not perform well financially.

Examples

1. Startup Investments: A common example of full ratchet clause usage is in startup investments, especially in venture capitalist and angel investor contracts. Let’s say an investor invested $1 million at a post-money valuation of $10 million for a 10% ownership stake. Subsequently, the startup under-performs and a new round of finance is opened up where the startup is valued at $5 million. With a full ratchet provision, the original investor’s ownership will not dilute and instead be readjusted, making their shares equivalent to 20% of the company.2. Tech Giants Spin-Off: When PayPal separated from eBay in November 2015, an example of a full ratchet scenario played out. Some of eBay’s investors were provided with price protection during the spin-off to ensure they retained their investment value. Even though PayPal’s shares had fallen in that period, eBay’s shareholders did not experience any dilution owing to the full ratchet clause. 3. Social Media Investments: In a hypothetical scenario, if a private equity firm invested in a social media company during its early stages, they might include a full ratchet provision. If later on, another round of funding took place at a lower valuation, the private equity firm’s ownership stake would not be diluted thanks to the full ratchet clause. Even though the firm invested when the price per share was higher, their ownership would be adjusted to match the lower share price of the subsequent financing round.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Anti-Dilution Provision
• Broad-Based Weighted Average
• Equity
• Convertible Securities
• Preferred Stock

Sources for More Information

• Investopedia
• Entrepreneur
• FinanceWalk
• Corporate Finance Institute