Full Ratchet

Full ratchet is a form of anti-dilution protection used in venture capital financing. This clause protects investors from dilution of their shares if the company issues shares in a later financing round at a lower price than in the previous round.

Definition and concept:

With a full ratchet clause, the conversion price of an investor’s preference shares is automatically adjusted to the lowest price at which new shares are issued in a subsequent financing round. This results in the investor receiving more shares for their original investment in order to maintain or even increase their percentage stake in the company.

How it works:

Assume that in round 1, investor A buys preference shares for EUR 1 million at EUR 10 per share (100,000 shares). In round 2, the company issues new shares at EUR 5 per share. With a full ratchet clause, the conversion price for investor A would be adjusted to EUR 5 per share, whereby he would now be entitled to 200,000 shares without contributing additional capital.

Importance for startups and investors:

For investors: – Maximum protection against dilution in down rounds – Maintaining or even increasing the percentage share in the company – Strong negotiating position in future financing rounds For start-ups:
– Potentially high dilution for founders and early employees
– Complex capital structure makes future financing rounds more difficult
– Possible demotivation of the team due to excessive investor preference

Variants and related concepts:

1. partial ratchet: limited adjustment of the conversion price 2. weighted average ratchet: milder form of adjustment that takes into account the size of the new financing round 3. pay-to-play: obligation of investors to participate in future rounds in order to retain anti-dilution protection

Negotiating points:

1. trigger events for the ratchet adjustment 2. time limitation of the full ratchet clause 3. exceptions for certain types of share issues (e.g. employee stock options) 4. limitation of the adjustment to a certain percentage or amount 5. linkage with other investor protection clauses

Advantages and disadvantages:

Advantages for investors: – Maximum protection against loss of investment value – Strong leverage effect in future negotiations – Potential excess return on successful exits Disadvantages for start-ups:
– Extreme dilution of founders and early employees possible
– Deterrent effect on new investors
– Complicates the capital structure and makes future financing more difficult

Market trends and developments:

1. declining popularity: full ratchet is increasingly viewed critically in many startup ecosystems 2. preference for more balanced solutions: Tendency towards weighted average or other milder forms of anti-dilution protection 3. Sector-specific differences: Full ratchet remains more relevant in high-risk or capital-intensive sectors 4. Regional variations: Different levels of acceptance in different global startup hubs

Legal and financial aspects:

– Careful drafting of investment agreements and articles of association required – Complex calculations when adjusting conversion prices – Possible tax implications when issuing additional shares – Consideration of disclosure obligations towards other investors and stakeholders

Strategic considerations for start-ups:

1. long-term effects: Analysis of potential scenarios and their impact on capital structure 2. Negotiation tactics: balancing acceptance of full ratchet against other concessions 3. Alternative protections: Exploration of options such as liquidation preferences or dividend rights 4. Transparency: Open communication with all stakeholders about the implications of full ratchet

Best practices for investors:

1. balanced approach: consideration of the long-term relationship with the startup and other investors 2. risk assessment: balancing protection against potential excess return 3. flexibility: willingness to renegotiate in later rounds to support business growth 4. due diligence: thorough assessment of whether full ratchet is appropriate for the specific investment

Conclusion:

Full ratchet offers investors the strongest anti-dilution protection, but at the same time can have a significant negative impact on a startup’s capital structure and momentum. While it may be justified in certain high-risk scenarios, it is increasingly viewed critically in the industry. It is crucial for startups to carefully consider the potential long-term consequences of a full ratchet clause. The extreme dilution and complexity it introduces into the capital structure can make future funding difficult and affect the motivation of the team. Investors should consider that the short-term protection offered by full ratchet may come at the expense of the long-term success of the company and therefore their own returns. A more balanced approach that takes into account the interests of all stakeholders can often lead to more sustainable and successful investments. In an evolving startup ecosystem that increasingly emphasizes fair and sustainable practices, alternative forms of investor protection that offer a better balance between risk protection and growth promotion are preferred. The use of full ratchet should therefore be considered very carefully and only in exceptional cases.