Full Ratchet

Definition

Full ratchet is a contractual provision designed to protect the interests of early investors. Specifically, it is an anti-dilution clause that applies when a company sells any common stock after issuing options (or convertible securities), using the lowest sale price as the adjusted option price or conversion rate for existing shareholders.

Origin

The full ratchet clause originated in the venture capital and private equity sectors, aimed at protecting early investors' stakes from being diluted by subsequent company financings. As startup financing activities increased, this clause became a common feature in investment agreements.

Categories and Features

Full ratchet is a type of anti-dilution clause, characterized by adjusting the option price or conversion rate to protect investors' shareholding percentages. It is typically applied during new rounds of company financing to ensure early investors' shares are not diluted. The advantage is effectively safeguarding investor interests, but the downside is it may limit the company's future financing flexibility.

Case Studies

Case 1: A tech startup introduced a full ratchet clause during its Series A funding to ensure early investors were not diluted during Series B financing. Case 2: A biotechnology company included a full ratchet clause in its financing agreement, helping early investors maintain their shareholding percentage before the company went public.

Common Issues

Investors might worry that full ratchet clauses could restrict the company's future financing capabilities, as new investors may be reluctant to accept such terms. Additionally, a common misconception is that all anti-dilution clauses are full ratchet, whereas there are other types, such as weighted average.