Full Ratchet

Full Ratchet Anti-Dilution: Definition and Guide

What is a full ratchet?

A full ratchet is an anti-dilution provision in a financing agreement that protects early investors by resetting the conversion price (or option strike) of their convertible securities to the lowest price at which the company subsequently issues shares. In other words, if the company sells new shares at a lower price than earlier rounds, the earlier investors’ conversion price is adjusted to that lower price to preserve their ownership percentage.

How it works

• If a later financing issues shares at a price below the earlier investors’ conversion/strike price, the earlier investors’ conversion ratio is adjusted downward (or strike price lowered) to match the new, lower price.
• The adjustment typically increases the number of common shares that earlier investors can receive upon conversion, offsetting the dilutive effect of the lower-priced issuance.
• Full ratchets are usually applied only for a limited period or under specified conditions because they can significantly affect founder and future-investor equity.

Example

Assume:
– Founders own 1,000,000 common shares.
– Series A investors buy 1,000,000 preferred shares at $1.00 per share (convertible 1:1).
After the Series A:
– If the company later sells 1,000,000 new shares at $0.50 per share, a full ratchet would adjust the Series A conversion price from $1.00 to $0.50.
– The Series A preferred would then convert at 2:1 (because the conversion price halved), so the 1,000,000 preferred become 2,000,000 common.
– Resulting share count: Founders 1,000,000; Series A converted 2,000,000; New investors 1,000,000 → total 4,000,000 shares.
– Ownership percentages: Founders 25%, Series A 50%, New investors 25%. Founders’ stake dropped from 50% to 25%.

This illustrates how a full ratchet can sharply dilute founders and later investors.

Pros and cons

Pros
– Strong protection for early investors against down-round dilution.
– Simple to understand and apply: conversion price is set to the lowest subsequent price.

Cons
– Can severely dilute founders and employees (option holders).
– Makes the company less attractive to future investors, who may demand compensation or refuse to invest.
– Can complicate negotiations and future financings.
– Often considered overly founder-unfriendly and can hinder company growth.

Alternatives: Weighted average anti-dilution

A weighted average anti-dilution adjustment is the most common alternative and is typically viewed as fairer. It adjusts the conversion price based on both the price and the number of shares issued in the new round, producing a smaller adjustment than a full ratchet.

Two common variants:
– Narrow-based weighted average: uses a smaller base (usually only common shares outstanding) and results in a larger adjustment (more protection to earlier investors).
– Broad-based weighted average: uses a broader base (common shares plus options/warrants and convertible securities), resulting in a smaller adjustment (less dilution to founders).

Weighted average formulas balance the relative sizes and prices of rounds, so dilution is shared proportionally.

Practical considerations

• Full ratchets are more likely in very early or high-risk financings where investors demand maximum protection.
• They are often limited in duration or subject to carve-outs to reduce long-term harm to the company.
• Negotiations frequently trade off anti-dilution protection for other investor rights (liquidation preference, board seats, etc.).
• Founders and boards should evaluate the long-term impact on hiring and fundraising when accepting a full ratchet.

Key takeaways

• A full ratchet resets conversion prices to the lowest subsequent issue price, giving strong anti-dilution protection to early investors.
• It can cause significant dilution for founders and disincentivize future investors.
• Weighted average anti-dilution is a more balanced, commonly used alternative.
• Use of a full ratchet is typically restricted or negotiated to limit negative effects on future financing and company incentives.