Venture Capital firms (or VC’s) often invest in early-stage start-ups with uncertain valuations. The terms of a VC’s investment will often be heavily weighted in favour of the VC and may include downside protection. This means that the VC’s investment will be protected in the event that the valuation of your start-up decreases in subsequent financings. One common method used by VC’s for downside protection is known as a “ratchet” clause. 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, if the value of your start-up diminishes over time.
A ratchet clause is often included in the terms of the convertible securities (such as preferred shares or convertible debt) that the VC is acquiring in connection with its investment. The clause operates by adjusting the conversion rate of the securities that the VC receives to reflect the issue price per share of subsequent financings.
There are a number of different types of ratchet clauses, including “weighted ratchets”, “half ratchets”, “two-thirds ratchets” and “full ratchets”. A “full ratchet” clause operates by ensuring that the conversion price of the convertible securities held by the VC is adjusted to be the same as the issue price of securities issued in a later financing if the price per share has decreased. A “full ratchet” offers the most downside protection for the VC and is the most dilutive for the start-up. The other types of ratchet clauses provided lesser degrees of downside protection and dilution.
So, how much can this actually affect your ownership in your start-up? Let’s look at an example:
You have a great new technology and things are moving quickly. You fly down to California and meet with a number of VCs who love you and your start-up! Life is good. You settle on your first venture capital investor (we’ll call it VC-1) and complete your “series A financing”. Under your series A financing, VC-1 invests $10 million for 25,000 series A preferred shares at a price per share of $400, which represent 25% of your company. The terms of the series A preferred shares provide that each series A preferred share is convertible into one common share.
So, VC-1 valued your start-up at $40 million. You and your other founders retain the remaining 75% equity represented through 75,000 common shares. At this point, the capital structure of your company is as follows:
You continue to build your start-up and find that you could use another cash injection to take your start-up to the next level. For any number of reasons, VC-1 says it will need to skip this round of financing, so you meet up with another venture capital firm (we’ll call it VC-2) who decides to invest $5 million into your start-up. On completion of this “series B financing”, VC-2 invests $5 million for 25,000 series B preferred shares with a price per share of $200. The terms of the series B preferred shares provide that each series B preferred share is convertible into one common share.
So, VC-2 just acquired 20% of your company and by doing so valued your company at $20 million post-investment. VC-1’s $10 million investment is only worth $5 million based on this valuation. Since your start-up’s value dropped, VC-2’s investment is called a “down-round”. The capital structure of your company would be as follows:
Now let’s assume VC-1 negotiated the inclusion of a “full-ratchet” clause into the terms of the series A preferred shares. As a result, the conversion price of its series A preferred shares is adjusted down from $400 (the price per series A preferred share) to $200 (the price per series B preferred share). This changes your capital structure significantly. Now the 25,000 series A preferred shares held by VC-1 are convertible into 50,000 common shares:
If there were no full ratchet clause, the founders’ 75,000 shares represented 60% of the equity in the start-up on a fully diluted basis after the series B financing. The full ratchet clause caused a transfer of 10% of the company from the founders to VC-1 (assuming VC-1 converts their preferred shares at that point) for no additional value. The net effect is that the founders gave up 25% equity for the $5 million investment by VC-2.
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. This illustrates the importance of understanding not only the terms of each series of financing, but also how those financings interact as a whole. If you don’t, you might find an unwelcome surprise if you give up more of your company that you ever wanted or intended.
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.