Anti-dilution protection mechanisms: Full ratchet or weighted average ratchet, what’s the difference?

You have discerned that a ratchet protects investors when the company raises funds at a lower valuation than the valuation retained for their investment via anti-dilution subscription rights, giving them the right to subscribe – for a symbolic amount – to a certain number of shares in the event of a downround.

Ratchet mechanisms generally fall into two types:

Full ratchet anti-dilution

Full ratchet anti-dilution protection effectively fully lowers the subscription price of the original investment to the subscription price of the down round.

As a result, the investors benefiting from the ratchet receive a number of additional shares equal to the difference in shares issued based on the original subscription price and the subscription price of the down round.

As such, it is important to provide for a reasonable monetary threshold (a minimum investment amount) in order for a down round to trigger a full ratchet anti-dilution protection. Otherwise, even a very limited (bridge) down round would indirectly lead to an entirely disproportionate dilution. This is why a convertible loan is an often utilized tool by shareholders in such a context.

Weighted average ratchet anti-dilution protection

Weighted average ratchet anti-dilution protection lowers the subscription price of the original investment to the average subscription price of the original investment and the subscription price of the down round taking into account the weight of the different investment rounds.

Broad based weighted average ratchet anti-dilution protection is calculated by reference to the company’s fully diluted equity (i.e. including convertible securities such as warrants and stock-options).

Narrow based weighted average ratchet anti-dilution protection is calculated by only taking into account the company’s issued shares (i.e. only the existing and the newly issued shares, excluding convertible securities).

Which ratchet offers the most protection?

A full ratchet will always result in a better protection for its beneficiaries than a weighted average ratchet and, therefore, is more detrimental to existing shareholders than a weighted average ratchet.

Given that a broad based weighted average ratchet will take into account more securities to set the reference value of the shares, it should result in a lower protection for the beneficiaries of the ratchet compared to the narrow based weighted average ratchet.

Our experience at Beyond tells us that, when the principle of a ratchet is accepted by the existing shareholders, the narrow based weighted average ratchet is the anti-dilution protection mechanism retained by most parties.

How does this translate in terms of numbers?

Below you will find an example visualizing the consequences of a down round (€ 250.000 invested at € 0,50 / share) occurring after a seed investment round (€ 750.000 invested at € 1 per share) with/without anti-dilution protection, including the difference between a full ratchet and a weighted ratchet approach.

As the cap table is modelled after a seed investment round, the founder’s shares are not taken into account for the calculations. Moreover, for the sake of simplicity, the example does not illustrate any difference between a narrow based weighted average ratchet or a broad based weighted average ratchet (the latter being rarely used based on our practice).

Example without ratchet mechanism

Example with ratchet mechanism

Want to see the impact of a ratchet on your shareholding? Visit our page dedicated to our simulators: you can apply these mechanisms to your cap table and compare different scenarios in just a few clicks.

FAQ

What is the difference between a full ratchet and a weighted average ratchet?

A full ratchet fully adjusts the subscription price of the original investment down to the price of the down round.

A weighted average ratchet only adjusts it partially. The new subscription price is calculated using a formula that takes into account both the size and price of the original investment round and the size and price of the down round.

A full ratchet therefore provides stronger protection to the investor, but also causes more dilution for the existing shareholders.

How does a full ratchet adjust the original subscription price?

It lowers the subscription price of the original investment to the subscription price of the down round.

The investor benefiting from the ratchet can then subscribe, for a symbolic amount, to additional shares so that its position reflects the lower subscription price.

This is essentially equivalent to recalculating how many shares the investor would have received if its original investment had been made at the down round price.

What is the difference between a broad based and a narrow based weighted average ratchet?

The difference lies in the securities included in the calculation.

A broad based weighted average ratchet takes into account the company’s fully diluted capitalization, including instruments such as subscription rights and other convertible securities.

A narrow based weighted average ratchet takes into account only the company’s shares.

Because the broad based formula includes a larger number of securities in the calculation, it generally results in a smaller adjustment and therefore less protection for the investor.

Which ratchet mechanism is most often used in practice?

Based on Beyond’s experience, once shareholders accept the principle of anti-dilution protection, most parties settle on a narrow based weighted average ratchet.

A full ratchet always gives its beneficiaries better protection, but it is correspondingly more damaging to the existing shareholders.

Why should a minimum investment threshold be set before a full ratchet is triggered?

Without a threshold, even a very small down round (for example bridge financing) would trigger the full anti-dilution protection mechanism and lead to disproportionate dilution for the existing shareholders.

The agreement should therefore provide that the full ratchet only applies if the down round exceeds a minimum investment amount.

This is also one reason why parties may use a convertible loan for a limited bridge financing rather than immediately carrying out a priced equity round.