Full Ratchet

Core Description

• Full Ratchet is a robust anti-dilution protection mechanism used in venture and private investing to protect early investors during down rounds.
• It automatically resets the conversion price of preferred shares or convertibles to the lowest price at which new shares are later issued, regardless of round size.
• While it offers strong protection for some, Full Ratchet can heavily dilute founders and non-protected holders, impacting incentives and future financing potential.

Definition and Background

A Full Ratchet is an anti-dilution provision most frequently found in venture capital, private equity, and convertible securities. This clause ensures that if a company later issues new shares at a price below that paid by earlier investors, the conversion or exercise price for those earlier securities is reset to the new, lower price. The term typically applies to preferred stock, convertible notes, and certain options.

History and Evolution
Full Ratchet clauses became well known between the 1960s and 1980s as venture investing expanded and capital providers sought more substantial downside protection. Their use increased during market stress periods, such as the 2001 dot-com crash and 2008 financial crisis, when the likelihood of companies raising funds on unfavorable terms increased. While this mechanism was once regularly included in United States venture term sheets, it gradually made way for more balanced weighted-average anti-dilution formulas, as both funds and companies recognized its potential negative impact on future fundraising and employee incentives.

Today, Full Ratchet rarely appears in standard investment rounds unless the company is experiencing a down round (selling shares at a lower valuation) or is undergoing restructuring. Even in these scenarios, its use is often subject to modifications including caps, carve-outs (exclusions for certain issuances), or sunset provisions that limit the clause’s duration or application.

Calculation Methods and Applications

How Full Ratchet Works

In practical terms, Full Ratchet resets the conversion (or exercise) price of a preferred stock or convertible security to the lowest price per share at which new stock is subsequently issued, regardless of the size of the new issuance.

Calculation Steps:

1. Identify the Triggering Event:
   The triggering event is typically a new share issuance (for example, a financing round) at a price below the current conversion or exercise price for the protected securities.

2. Set New Conversion Price:
   The conversion price is reduced to match the lowest per-share price of the new issuance.

3. Adjust Conversion Ratio:
   With a lower conversion price, each protected preferred share converts into more common shares.

Basic Formula:
If the original conversion price (OCP) is USD 1.00, and the new, lower issue price (Pn) is USD 0.40, then:

• New conversion price = USD 0.40
• Each preferred share now converts into OCP / Pn = 1.00 / 0.40 = 2.5 common shares

Example Application (Fictional Case Example)

Consider an example where a United States-based SaaS startup issued its Series A preferred stock at USD 1.00 per share with Full Ratchet protection. A year later, due to market downturns, the company raises capital at USD 0.40 per share. The Full Ratchet clause instantly resets the Series A investor’s conversion price from USD 1.00 to USD 0.40, allowing each preferred share to convert into 2.5 times as many common shares as originally agreed. The size of the new round does not impact the adjustment; the clause focuses exclusively on the lowest price.

Practical Impact:
This adjustment can substantially increase the as-converted ownership percentage for protected investors, while equally diluting founders, employees, and anyone not protected by the clause.

Exclusions and Carve-Outs

Contracts often exclude certain triggers, such as:

• Employee option grants (ESOP refreshes)
• Warrants issued to strategic or financing partners
• Small or de minimis issuances (for operations or vendor equity) These carve-outs are essential for operational flexibility and team retention.

Comparison, Advantages, and Common Misconceptions

Key Comparisons

Full Ratchet vs. Broad-Based Weighted Average

• Full Ratchet: Conversion price drops to the lowest new issuance price, regardless of new shares issued.
• Broad-Based Weighted Average: Considers the total outstanding and issued shares to moderate the price adjustment, distributing dilution more evenly among stakeholders.

Full Ratchet vs. Narrow-Based Weighted Average

• Narrow-based weighted average: Utilizes a narrower denominator (such as only preferred shares), resulting in a more aggressive adjustment than broad-based but less severe than Full Ratchet.

Full Ratchet vs. Pay-to-Play

• Pay-to-Play: Existing investors must participate in down rounds to retain certain rights.
• Full Ratchet: Protection is automatic, regardless of participation in future rounds.

Full Ratchet vs. No Anti-Dilution Protection

• No Protection: All parties are diluted equally in a down round, and there is no conversion price adjustment for earlier investors.

Full Ratchet vs. Capped/Floored Ratchets

• Capped: The reset is limited by a maximum adjustment.
• Floored: Sets a minimum possible conversion price. Both methods reduce the severity of the Full Ratchet’s impact.

Full Ratchet vs. Pro Rata Rights

• Pro Rata: Grants holders the right (not the obligation) to maintain their ownership percentage by participating in follow-on rounds, offering behavioral—not automatic—protection.

Advantages

• Significant Downside Protection: Investors have assurance that subsequent discounted rounds will not undercut their initial investment.
• Simple and Transparent: The mechanism is contractual and formula-based, making its terms clear to all parties.
• Appealing in High-Risk Transactions: Attracts investors during uncertain market conditions.

Disadvantages

• Substantial Dilution to Founders and Employees: Can significantly change the cap table after only one down round.
• Can Deter Future Investment: Follow-on investors may be discouraged by disproportionate dilution risk.
• Potential Indicator of Financial Distress: Its inclusion can signal instability to the market or partners.
• Adds Complexity to Future Financing: May necessitate renegotiation or inventive structuring in future deals.

Common Misconceptions

• It “freezes” ownership percentages: In reality, it increases the conversion rate, not the overall percentage directly.
• It is discretionary: Full Ratchet adjustments are contractual and not subject to discretionary approval.
• Any discounted share issuance triggers it: Typically applies only to primary cash financings, not to ESOP or vendor grants.
• All investors benefit: Only the holders of Full Ratchet protected securities receive this protection; others may be adversely impacted.

Practical Guide

When Should Full Ratchet Be Used?

• Extreme Downside Scenarios: Consider this mechanism in situations of significant uncertainty or when bridge financing is required by investors seeking substantial protection.
• Distressed or Restructuring Situations: Appropriate for recapitalizations, rescue financings, or if investor leverage is strong during negotiations.
• Short-Term Bridge Financing: Can serve as a temporary protection method when company valuation is highly volatile.

Case Study: The "Bridge Round Dilemma" (Fictional Example)

Acme Ventures, a U.S.-based deep-tech startup, issued Series A shares at USD 1.50 per share in 2021. By 2023, soft market conditions and underperformance led the company to seek a USD 2,000,000 bridge round at USD 0.60 per share. The new bridge investor demanded Full Ratchet protection on conversion.

Outcome:

• The Series A conversion price reset from USD 1.50 to USD 0.60.
• The Series A investor’s as-converted stake increased (from 100,000 to 250,000 common shares).
• The founder’s and employee equity percentages dropped considerably.
• After safeguarding the new investor, the company encountered difficulties attracting further funding due to the burdensome cap table adjustments.

Practical Tips

• Model the Cap Table: Conduct scenario modeling to quantify the potential effects of a Full Ratchet in a down round.
• Negotiate Carve-Outs: Ensure that equity grants for employees or strategic partners do not trigger the clause.
• Limit Scope: Apply the Full Ratchet only to the first down round, or set caps or sunset clauses as needed.
• Communicate Clearly: Be transparent with future investors about the terms and consequences.
• Consider Alternatives: Weighted-average anti-dilution or milestone-based adjustments may better balance the competing interests of investors and team members.

Resources for Learning and Improvement

• “Venture Deals” by Brad Feld & Jason Mendelson: A comprehensive textbook about venture capital terms and term sheets.
• NVCA Model Legal Documents: Standardized templates and explanatory materials (nvca.org/resources/model-legal-documents/).
• Wilmerding, “Term Sheets & Valuations”: Practical case studies and frameworks for structuring venture financing.
• Law Firm Guides:
  • Wilson Sonsini’s Term Sheet Navigator
  • Fenwick & West’s Venture Capital Terms Survey
• Academic Reference:
  • Kaplan & Strömberg (2003), “Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts.”
• Relevant Legal Cases:
  • In re Trados Incorporated Shareholder Litigation
  • In re Nine Systems Corporation Shareholders Litigation
• Online Cap Table Calculators: Available from many major law firms and venture capital advisory platforms.
• Public Data and Market Analysis Tools: Crunchbase, PitchBook, CB Insights, and industry summary reports on venture trends.

FAQs

What is a Full Ratchet in venture finance?

A Full Ratchet is an anti-dilution mechanism that resets the conversion or exercise price of preferred shares or convertibles to the lowest price at which new shares are subsequently issued, maximizing price protection for protected investors.

How is Full Ratchet different from weighted-average anti-dilution?

Full Ratchet does not consider the quantity of shares issued—the conversion price always matches the lowest subsequent price. Weighted-average blends the old and new prices, mitigating dilution by including the number of shares in the adjustment calculation.

When is Full Ratchet typically triggered?

The mechanism triggers when a company issues equity or convertible securities at a price below the current conversion price, except for certain defined carve-outs like option grants or minor operational issuances.

Who benefits, and who loses, from Full Ratchet protection?

Early investors with Full Ratchet clauses are protected in down rounds. Founders, employees, and non-protected holders may experience increased dilution.

Can Full Ratchet terms be negotiated or limited?

Yes. Parties may negotiate caps, carve-outs, sunset provisions, or limit the clause to specific rounds. Less aggressive approaches such as broad-based weighted average formulas are also an option.

What is the effect of Full Ratchet on the cap table?

When triggered, a Full Ratchet can considerably increase the as-converted shares for protected holders, reducing the ownership percentages of founders and employees and complicating later fundraising.

Does Full Ratchet affect legal or accounting treatment?

Yes. Anti-dilution provisions must be included in the company’s charter and may impact equity accounting, disclosures, and the categorization of such securities (such as classification as liabilities or mezzanine equity).

Are all discounted new share issuances included as triggers?

Not always. Most agreements exclude grants like employee options, small vendor or operational equity issuances, or strategic partnerships from triggering the adjustment.

Conclusion

Full Ratchet anti-dilution protection is a mechanism designed to safeguard early investors from the effects of down rounds and unexpected price drops in subsequent fundraising. Its straightforward structure offers clear protection to some investors but can result in significant dilution for founders, employees, and other non-protected holders, as well as create challenges for future financing.

In practice, Full Ratchet should be considered for circumstances where substantial downside protection is required, such as in distressed financings, bridge rounds, or periods of high market volatility. Modern agreements generally combine Full Ratchet clauses with caps, carve-outs, or alternative mechanisms to create a more balanced relationship between investor protection and long-term company value.

All parties involved in venture transactions benefit from a thorough understanding of Full Ratchet provisions, scenario modeling, and careful negotiation. Leveraging industry resources and clear communication with stakeholders can help navigate the complexities of Full Ratchet anti-dilution adjustments.