What is full ratchet anti-dilution protection?
August 4, 2007
Full ratchet anti-dilution protection is conceptually much simpler than the weighted average approach, and its effect on the company is considerably more severe in the event of a dilutive financing. Under the full ratchet formula, the conversion price of the preferred stock outstanding prior to such financing is reduced to a price equal to the price per share paid in the dilutive financing.
For example, if the outstanding preferred stock was previously sold at a price of $1.00 per share, and the new preferred stock in the dilutive financing is sold at a price of $0.50 per share, the effective price of the previously outstanding preferred stock would be reduced to $0.50 per share with the result that each share of such preferred stock previously convertible into one share of common stock would now be convertible into two shares of common stock.
Under the full ratchet formula, this same result is obtained whether the company raises $100,000 at a price of $0.50 per share or raises $10,000,000 at a price of $0.50 per share. In contrast, the amount of money raised in the dilutive financing is an important factor in determining the new conversion price in the weighted average formula.
Below is an example of how full-ratchet anti-dilution protection works.
Assume that the pre-financing capitalization of the company is (same as example for weighted average anti-dilution protection):
1,500,000 Common Stock
2,500,000 Series A Preferred Stock (issued at $1/share)
2,000,000 Series B Preferred Stock (issued at $2/share)
Also assume that there is a dilutive financing with the issuance of 2,000,000 shares of Series C Preferred Stock at $0.50 per share, for total gross proceeds of $1,000,000.
Series A adjustment
The Conversion Price of Series A Preferred Stock becomes $0.50.
Thus, the number of shares of common stock issuable upon conversion of Series A Preferred Stock =
(2,500,000) * ($1.00/$0.50) = 5,000,000
This results in a Series A Conversion Rate of 2:1
Series B adjustment
The Conversion Price of the Series B becomes $0.50.
Thus, the number of shares of common stock issuable upon conversion of Series B Preferred Stock =
(2,000,000) * ($2.00/$0.50) = 8,000,000
This results in a Series B Conversion Rate of 4:1
Problems with the full ratchet
At first glance, the full ratchet formula seems very attractive for investors as it completely protects their investment from any subsequent price erosion until the occurrence of a liquidity event (at which time the preferred stock would normally be converted to common stock). The company should argue that it is unfair to have the company bear all the downside price risk where there is no limit on the upside potential for the investors.
However, a full ratchet formula can also be problematic for the investors in a syndicate. Because the prior money invested is fully protected with regard to price decreases, if the company’s prospects deteriorate and the company is forced to undertake a dilutive financing, there is no incentive for all of the investors to participate in the new dilutive round. Therefore, the lead investor(s) may have difficultly inducing the smaller investors in the syndicate to continue to participate, and the burden of continuing to fund the company can fall heavily on the lead investor(s). In addition, the application of the full ratchet will be disclosed to the incoming invstors in the new round upon review of the company’s charter documents in the due diligence process. This will make the company appear significantly less attractive to invest in and will exacerbate the problems of an otherwise already difficult financing. Because the number of pre-financing shares outstanding increases due to the anti-dilution adjustment, the price per share of the new series of preferred stock will decrease. This results in a circular formula, that requires strong spreadsheet skills to solve.
In addition, as a result of the anti-dilution protection for the preferred stock, the percentage ownership of the common stock will decrease, which decreases the incentive of management and employees.
[Note: this post and others on anti-dilution are based on (and complete sections of text copied from) an article titled "The Venture Capital Anti-Dilution Solution" written by Mike O'Donnell and Anton Commissaris.]