Weighted Average Ratchet

Weighted average ratchet is a more moderate form of anti-dilution protection in venture capital financing. In contrast to the full ratchet, this method takes into account both the price and the size of a new financing round when adjusting the conversion price for existing investors.

Definition and concept:

In a weighted average ratchet, the conversion price of an investor’s preference shares is adjusted based on a weighted average calculation. This calculation takes into account the price and the number of newly issued shares as well as the original conversion price and the number of outstanding shares before the new financing round.

How it works:

The formula for calculating the new conversion price is typically as follows: New conversion price = (A + B) / (A + C), where:
A = Old conversion price x number of shares outstanding before the new round
B = Total amount of new investment
C = Number of new shares issued at the lower price Example:
Suppose a company has 1,000,000 shares outstanding and the old conversion price is 1 euro. A new round issues 500,000 shares at 0.50 euros. New conversion price = (1,000,000 x 1 + 500,000 x 0.50) / (1,000,000 + 500,000) = EUR 0.83

Importance for startups and investors:

For investors: – Moderate protection against dilution in down rounds – More balanced adjustment that takes into account the size of the new round – Preservation of a fair share in the company For startups:
– Lower dilution for founders and early employees compared to full ratchet
– More attractive for future investors due to the more balanced structure
– Better balance between investor protection and company interests

Variants and related concepts:

1. broad-based weighted average: takes into account all outstanding shares and options 2. narrow-based weighted average: takes into account only certain share categories 3. pay-to-play commissions: Can be combined with weighted average ratchet

Negotiating points:

1. definition of shares to be taken into account (broad-based vs. narrow-based) 2. exceptions for certain share issues (e.g. employee stock options) 3. time limit or staggering of ratchet protection 4. linkage with other investor protection clauses 5. treatment of convertible bonds or other financing instruments

Advantages and disadvantages:

Advantages:
– More balanced protection for investors – Less dilution for founders and other stakeholders – More flexible and fairer structure for future financing rounds – Better acceptance in the startup community Disadvantages:
– More complex calculations and implementation
– Potentially insufficient protection in extreme down-round scenarios
– Potential inconsistencies in the interpretation of the calculation bases

Market trends and developments:

1. increasing preference: weighted average ratchet is becoming the standard in many startup ecosystems 2. adaptation to new forms of financing: Integration with SAFE notes and other innovative tools 3. Global harmonization: aligning practices in different startup hubs around the world 4. Transparency initiatives: Efforts towards standardized and easily understandable wording

Legal and financial aspects:

– Precise definition of the calculation method in investment agreements – Consideration of disclosure obligations to all investors – Possible effects on the company’s accounting and valuation – Compliance with local company law and stock exchange regulations

Strategic considerations for start-ups:

1. long-term planning: analysis of the impact on future financing rounds and exit scenarios 2. capital structure management: balancing different investor interests 3. negotiation strategy: use of weighted average as a compromise in investor discussions 4. transparency: clear communication of the mechanics and implications to all stakeholders

Best practices for investors:

1. risk-return assessment: Evaluation of whether weighted average offers sufficient protection 2. Flexibility: Willingness to adjust in later financing rounds 3. Holistic approach: Consideration of the weighted average ratchet in the context of other protective clauses 4. Due diligence: Careful examination of the specific formulation and calculation method

Conclusion:

Weighted average ratchet represents a balanced approach to anti-dilution protection that attempts to reconcile the interests of investors, founders and the company itself. This method provides investors with adequate protection against dilution without unduly burdening the capital structure of the startup or making future financing more difficult. For startups, weighted average ratchet offers the advantage of a more flexible and fairer capital structure, which makes it possible to attract new investors even in challenging times without putting existing investors at too great a disadvantage. The lower dilution for founders and early employees compared to more aggressive protection clauses can also keep the team motivated and engaged. In an evolving startup ecosystem that increasingly emphasizes sustainability and fair practices, weighted average ratchet is establishing itself as a standard tool that balances investor protection and company growth. Careful structuring and negotiation of this clause remains an important aspect of structuring successful and sustainable startup financings.