Ratchet clause
In the intricate world of venture capital (VC), term sheets often contain clauses that are not immediately intuitive but play a critical role in protecting investor interests. One such clause is the ratchet. Understanding the ratchet clause is crucial for both investors and entrepreneurs, as it can significantly influence the financial outcome of an investment, particularly during subsequent funding rounds or exit events. This article dives deep into what a ratchet clause is, how it works, its types, and its implications.
What is a Ratchet Clause?
A ratchet clause is a type of anti-dilution protection in a VC term sheet. It is designed to protect investors from dilution of their ownership percentage if the company raises additional capital at a valuation lower than the one in their initial investment round. This situation, known as a down round, can devalue earlier investments, and the ratchet clause mitigates this risk by adjusting the price at which the earlier investor’s shares are effectively issued.
At its core, the ratchet clause ensures that investors retain a favorable financial position, even if the company’s valuation declines.
How Does a Ratchet Clause Work?
When a ratchet clause is triggered by a down round, it adjusts the conversion price of the preferred shares held by investors. The adjusted price increases the number of common shares the investors can convert their preferred shares into, thus compensating for the lower valuation of the company. This adjustment is achieved without the investor having to inject additional capital.
For example:
- An investor purchases 1,000 preferred shares at $10/share in a Series A round, implying a valuation of $10 million.
- Later, the company raises a Series B round at $5/share, implying a valuation of $5 million.
- If a ratchet clause is in place, the Series A investor’s effective share price might be revised to match the Series B price, or to a calculated average, depending on the type of ratchet (discussed below).
Types of Ratchet Clauses
Ratchet clauses can be structured in various ways, but the two most common types are full ratchet and weighted average ratchet.
1. Full Ratchet
A full ratchet adjusts the investor’s conversion price to the lowest price at which new shares are issued. This approach is the most favorable for investors but can be highly dilutive to founders and employees.
Example: If shares were originally purchased at $10/share and new shares are issued at $5/share, the original investor’s effective price per share is adjusted to $5/share. Consequently, they receive twice as many common shares upon conversion of their preferred shares.
Pros for Investors:
- Maximum protection against dilution.
Cons for Entrepreneurs:
- Significantly dilutive, potentially discouraging future investors or harming morale among the founding team.
2. Weighted Average Ratchet
A weighted average ratchet considers both the price of the new shares and the number of shares issued. This method is less punitive to founders while still providing meaningful protection to investors.
The formula typically used is:
Example: If the company issues 1 million shares at $10/share and later issues 500,000 shares at $5/share, the new conversion price will be a weighted average based on these amounts.
Pros for Investors:
- Balanced protection.
Pros for Entrepreneurs:
- Less dilutive compared to full ratchet.
Why Do Ratchet Clauses Matter?
For Investors
Ratchet clauses provide a safety net, ensuring that their initial investment retains value, even in challenging circumstances. This protection can make the investment more attractive, particularly for early-stage companies with high risk.
For Entrepreneurs
While ratchet clauses are a necessary feature to attract investors, they can also pose risks. Significant dilution can reduce founder control, lower the attractiveness of employee equity incentives, and create potential conflicts in future funding rounds.
Negotiating Ratchet Clauses
Given their impact, ratchet clauses are often heavily negotiated. Entrepreneurs may seek to:
- Limit ratchet clauses to specific scenarios, such as major down rounds.
- Advocate for a weighted average ratchet instead of a full ratchet to reduce potential dilution.
- Use milestones or performance metrics to adjust the ratchet’s impact.
Investors, on the other hand, may push for ratchet clauses as a condition of investment, particularly in riskier ventures.
Real-World Implications of Ratchet Clauses
Ratchet clauses have played a pivotal role in high-profile VC-backed companies. For example:
- Snap Inc. IPO: In the lead-up to its IPO, Snap’s pre-IPO investors were protected by ratchet clauses, ensuring favorable returns even as public markets valued the company lower than initial expectations.
- WeWork: Ratchet clauses reportedly influenced investor negotiations during WeWork’s valuation downturn, demonstrating their critical role in complex funding scenarios.
Conclusion
The ratchet clause is a powerful tool in a VC term sheet, providing anti-dilution protection to investors while creating potential challenges for founders. Its inclusion and structure can influence the dynamics of a funding round and the long-term relationship between investors and entrepreneurs.
For founders, understanding the nuances of a ratchet clause and negotiating it effectively can help strike a balance between attracting investment and preserving equity. For investors, it serves as a key mechanism to safeguard investments in the high-risk, high-reward world of venture capital.
As with any term sheet provision, careful consideration and expert advice are essential to navigating the complexities of ratchet clauses.