Full Ratchet
A full ratchet is a contractual provision designed to protect the interests of early investors. Specifically, it is an anti-dilution provision that applies, for any shares of common stock sold by a company after the issuing of an option (or convertible security), the lowest sale price as the adjusted option price or conversion ratio for existing shareholders.
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 to protect early investors from dilution during subsequent financing rounds. As startup financing activities increased, this clause became a common feature in investment agreements.
Categories and Characteristics: Full ratchet clauses mainly come in two forms: full dilution and partial dilution. Full dilution clauses adjust the price or rate of all existing options and convertible securities based on the lowest price of newly issued stock, while partial dilution clauses only adjust a portion of the options or convertible securities. The main characteristic of full ratchet clauses is to protect early investors' interests and prevent their shareholding from being diluted.
Specific Cases: Case 1: Suppose Company A issued options at $10 per share during early financing. Later, Company A conducts a new financing round at $5 per share. According to the full ratchet clause, the early investors' option price will be adjusted to $5 to protect their investment value. Case 2: Company B issued convertible bonds at a conversion price of $15 per share during its startup phase. Later, Company B conducts a new financing round at $8 per share. According to the full ratchet clause, the early investors' conversion price will be adjusted to $8.
Common Questions: 1. Will the full ratchet clause affect subsequent financing? Yes, the full ratchet clause may put more pressure on the company during subsequent financing rounds, as new investors may demand higher returns to compensate for potential dilution risks. 2. How does this clause affect company founders? The full ratchet clause may dilute the founders' shareholding, especially if the company undergoes multiple financing rounds.
