Venture Capital firms (“VC’s”) often invest in early-stage start-ups with uncertain valuations. Through the process of negotiating the terms of their investment, VC’s will have often worked to protect themselves should the valuation of your start-up decrease in subsequent financings after the VC’s investment. One common method, known as a “ratchet” clause, is an anti-dilution clause that works to protect and, in some circumstances, can even increase the VC’s proportionate ownership of your start-up, should your start-up’s valuation diminish over time.

In a typical example, a ratchet clause, included in the terms of preferred shares that the VC is acquiring in connection with its investment, provides that preferred shares issued to the VC, which are convertible into common shares, have a conversion rate that is adjusted to reflect the issue price per share of subsequent financings. Types of ratchet clauses can include “weighted ratchets”, “half ratchets”, “two-thirds ratchets” and “full ratchets”. In a “full ratchet”, the conversion price of the issued and outstanding preferred shares is adjusted to be the same as the issue price of securities issued in a later financing, provided the price per share has diminished.  The other variations work to modify the conversion price in a manner that is less burdensome.

Here’s an example to illustrate how punitive a full ratchet clause can be:

On completion of a “series A financing”, VC-1 invests $10 million for 25% of your company, setting an approximate valuation of $40 million. VC-1 receives 25,000 series A preferred shares with a price per share of $400. Because this is the initial financing, each series A preferred share is convertible into one common share. The founders retain the remaining 75% equity represented through 75,000 common shares. The capital structure of your company would be as follows:

Founders VC-1
75,000 common shares 25,000 series A preferred shares

 

On completion of a subsequent “series B financing”, VC-2 invests $5 million for 20% of your company, setting an approximate valuation of $20 million. VC-2 receives 25,000 series B preferred shares with a price per share of $200. Because the company’s valuation has dropped, it looks as though VC-1 has lost half its initial $10 million investment. VC-2’s investment is called a “down-round”, because the valuation of your start-up has gone down in relation to VC-1’s prior investment. The capital structure of your company would be as follows:

  Founders VC-1 VC-2
Before Conversion 75,000 common shares 25,000 series A preferred shares 25,000 series B preferred shares
After Conversion
(fully diluted without ratchet)
75,000 common shares
(60%)
25,000 common shares
(20%)
25,000 common shares
(20%)

 

If VC-1 had negotiated the inclusion of a “full-ratchet” clause into the terms of its preferred shares, the conversion price of its series A preferred shares would be adjusted down from $400 to $200 in order to account for the $200 price per series B preferred share in the series B financing. In this case, the 25,000 series A preferred shares held by VC-1 would then be convertible into 50,000 common shares. After the application of the full ratchet clause, the capital structure of your company would be as follows:

  Founders VC-1 VC-2
Before Conversion 75,000 common shares 25,000 series A preferred shares 25,000 series B preferred shares
After Conversion

(fully diluted with ratchet)

75,000 common shares (50%) 50,000 common shares
(33.33%)
25,000 common shares
(16.66%)

 

Before the application of the full ratchet clause, the founders’ 75,000 shares represented 60% of the equity in the start-up on a fully diluted basis. After the down-round and the application of such clause, the founders’ 75,000 common shares represent 50% of the equity of the Company on a fully diluted basis. Should VC-1 convert its series A preferred shares into common shares, the founders would have lost 10% of their company for no immediate value. This situation compounds when you have multiple investors exercising ratchet clauses after a down-round, or investors modeling their investments to account for ratchet clauses in favour of other investors. It’s easy to see how you can quickly start losing control of your company.

While ratchet clauses may seem punitive to founders, it is important to remember that VC’s take significant risks when investing in speculative start-ups. An anti-dilution clause like a ratchet is simply intended to protect the VC from a significant dilution of its equity position to mitigate some of the significant risk they face. Understanding the potential effects of a ratchet clause on the ownership of your start-up will assist both the founders and VC’s in negotiating successful investments.