Full Ratchet Anti-dilution: Everything You Need to Know
Full-ratchet anti-dilution refers to a provision in which the lowest sale price is applied to common stock shares a company sells after issuing a convertible security or option as the conversion ration or adjusted option price for current shareholders.3 min read
2. How Full-Ratchet Anti-Dilution Works
3. Disadvantages of Full Ratchet Anti-Dilution
4. Weighted Average Anti-Dilution
Full-ratchet anti-dilution refers to a provision in which the lowest sale price is applied to common stock shares a company sells after issuing a convertible security or option as the conversion ration or adjusted option price for current shareholders. This lets shareholders maintain the same ownership percentage as they had with the initial investment.
Reasons for Full-Ratchet Anti-Dilution
If an investor originally paid $5 per share for a 20 percent stake in the company and new financing is released at $2.50 a share, he or she would have to purchase additional shares to maintain the current ownership stake. With full-ratchet anti-dilution, this individual can convert existing shares to the $2.50 price, thus doubling the number of shares held and preserving his or her ownership stake from dilution by the new stock offering.
The full-ratchet strategy also provides cost protection if a new round of financing is offered at a higher price than the initial round of financing. This also allows an original investor to maintain the current ownership stake without investing additional funds in the company.
Some companies require investors to hold a certain percentage of existing shares to maintain preferred rights. This is important if an investor will lose voting rights with a new stock offering because he or she will fall below this percentage.
Many investors also want to maintain their current percentage as the company grows, which can increase their eventual return on investment when share values rise.
How Full-Ratchet Anti-Dilution Works
Full-ratchet anti-dilution is often included in preferred stock terms for new investors. Here's how this price protection strategy works:
- A company offers an initial round of preferred stock, Series A, at $10 per share.
- If the company later makes an initial public offering (IPO), the shareholders who purchased Series A stock shares could convert preferred stock to common stock on a one-to-one basis.
- Provisions in the original stock terms indicate that if more shares of common or preferred stock are offered at a cost of less than $10 per share, the Series A investors can convert preferred stock shares to common stock shares at the lower price, thus increasing their percentage of holdings.
- For example, if the company subsequently offers Series B preferred stock at a cost of $5 per share, stockholders who purchased 100 shares of Series A stock could convert it to 200 shares of Series B stock. This allows early investors to get the first benefit of later stock offerings.
Disadvantages of Full Ratchet Anti-Dilution
This strategy requires the company to issue more shares to new investors so they can also reach their desired ownership percentage, meaning the percentage of the company the founders and managers own can still be severely diluted.
In addition, many new investors would be hesitant to put money into a company with anti-dilution protections on outstanding preferred stock shares, as this may ultimately devalue the company.
The full ratchet works best in cases in which investors disagree on a company's value during the initial round, as it can be used to automatically adjust the cap table if the business fails to perform to expectations. In other scenarios, however, a full-ratchet strategy adds complexity without adding benefit. For this reason, most companies and investors prefer the weighted average method of anti-dilution.
Weighted Average Anti-Dilution
The weighted average method also issues additional shares of common stock to preferred stockholders during a down round and adjusts the conversion rate, but the impact is easier to control and integrate into the pricing of the new stock shares. Also called broad-based anti-dilution, it strives to balance money previously raised with the amount of money raised in a down round and the share prices of each. The conversion rate is typically lower than that of a full-ratchet strategy.
In cases where full-ratchet provisions must be used, their effective period should be limited to one year, after which weighted average provisions would be used. Otherwise, investors must take an active role in the governance of the organization and the decision to welcome additional investors. To maintain their ownership stake without anti-dilution provisions, they will have to invest in future rounds of financing.
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