Anti-dilution protection mechanisms: The what and the why of a ratchet?

When startups and scaleups are in the process of raising funds with professional investors, the topic of anti-dilution protection mechanisms will unquestionably be put on the table at some point.

Why provide for anti-dilution protection?

The basic principle of such anti-dilution protection mechanisms is simple : protect investors if the company raises funds at a lower price per share than the prie per share retained for their investment, i.e. a future down round.

Because raising funds usually results in the issuance of new shares, this process dilutes the existing shareholders’ equity, especially early investors and founders. To protect their investment, investors frequently request that the company implements anti-dilution mechanisms. Such clauses safeguard the value of its beneficiaries’ holdings during subsequent funding rounds, preventing or limiting the effects of dilution when shares are issued in the framework of a future down round.

What is a ratchet?

A ratchet is the most common type of anti-dilution protection, either in the form of a full ratchet or weighted average ratchet. This mechanism mitigates the impact of a down round by retroactively adjusting the subscription price (the price paid to subscribe to a share of the company) paid by the concerned investors at the time of their original investment. Hence ensuring that the early investors’ equity participation remains stable or is less affected by the down round.

Even though there are different methods of implementing a ratchet, it is usually triggered by a down round. It however remains of the upmost importance to properly define the conditions for its activation, in order to exclude unwarranted triggering events related to other convertible securities or employee incentive plans.

Investors should keep in mind that an anti-dilution protection that is overly strong risks it quite difficult for a company to find new investors in a context where the company is in distress. As an investment in such circumstances would most likely constitute a down round, thus triggering the anti-dilution protection and therefore lead to the issuance of new shares, diluting everyone (including the new investor) but the beneficiaries of the anti-dilution protection. As this will likely not be an option for the new investor, the sole option is often convincing the anti-dilution protection beneficiary of waiving its application.

Anti-dilution protection mechanisms are always limited in time, with their duration being dependent on the business plan of the company and the investors involvement. After a certain period of time the investors should take responsibility for a company’s failure to raise money at a better valuation as they have either been actively involved themselves – and thus influenced the direction of the company – or this failure stems from external circumstances, whose consequences should not be borne by the other shareholders alone.