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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)

What is Full Ratchet?

Full Ratchet is a type of anti-dilution provision used in venture capital contracts. In a situation where a company issues new shares at a price lower than what earlier investors paid, the full ratchet clause adjusts the price at which the earlier investors purchased their shares, essentially allowing them to own a larger percentage of the company.

How does Full Ratchet work in practice?

Let’s say an investor originally paid $2 per share. If the company later issues new shares at $1 per share, the full ratchet clause will adjust the original investor’s share purchase price from $2 to $1 per share. By adjusting the initial price, the investor now owns a larger number of shares, hence his ownership percentage doesn’t get diluted.

What is the purpose of the Full Ratchet provision?

The purpose of the full ratchet provision is to protect the interests of the early-stage investors. It ensures that their share of ownership is not heavily diluted when the company issues additional shares at a lower price than what they initially paid.

Are there any disadvantages to the Full Ratchet provision?

The Full Ratchet provision can be disadvantageous for the company and potentially for later investors. The company might find it more challenging to attract new investors due to the fear of heavy dilution, and existing shareholders may also be dissuaded from buying more shares.

What is the difference between Full Ratchet and Weighted Average Anti-Dilution?

While full ratchet adjusts the share purchase price of all convertible securities to the price at which new shares are issued, the weighted average anti-dilution provision adjusts the conversion rate based on the amount of money previously raised and the reduction in the new issue price. Overall, the weighted average is considered less severe and more fair than the full ratchet.

What is the impact of Full Ratchet on Founders?

Full ratchet can often lead to significant dilution of the founders’ share in the company. This can reduce their control over the business and lower their potential earnings if the company is sold.

Related Finance Terms

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