A worked down round, full ratchet against broad-based weighted average, and why the size of the new round does not matter to the ratchet.
Full ratchet resets the earlier investor's conversion price to the new, lower round price, whatever the size of the new round. In an illustrative company where a Series A bought 2,000,000 shares at $2.00 and a Series B comes in at $1.00, full ratchet doubles the Series A to 4,000,000 shares and cuts the founders from 50.00 to 42.86 per cent. Broad-based weighted average anti-dilution in the same round leaves them at 48.84 per cent: the ratchet issues seven times as many extra shares.
Worked in full in The Venture Capital Associate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The company is fictional. Before the down round it has 9,000,000 fully diluted shares: 6,000,000 held by the founders, a 1,000,000 share option pool and 2,000,000 Series A preferred bought at $2.00, which is $4,000,000 invested. The business has missed its plan and a new investor offers $3,000,000 of Series B at $1.00 a share, half the Series A price. The Series A terms carry anti-dilution protection, and the question on the founders' side of the table is what that protection costs them under each formula.
| Holder | Shares | Ownership |
|---|---|---|
| Founders (common) | 6,000,000 | 66.67% |
| Option pool | 1,000,000 | 11.11% |
| Series A preferred at $2.00 | 2,000,000 | 22.22% |
| Total | 9,000,000 | 100.00% |
The Series B buys 3,000,000 shares at $1.00. Ownership is shown as converted to common, which is how it is read at an exit large enough for every preferred holder to convert. Liquidation preferences matter below that level and are a separate question.
Anti-dilution does not issue new preferred shares directly. It lowers the conversion price, so each Series A preferred share converts into more common. Under full ratchet the new conversion price is simply the new round price.
New conversion price = Series B price = $1.00
Series A as-converted shares = amount invested / new conversion price = $4,000,000 / $1.00 = 4,000,000
Extra shares = 4,000,000 − 2,000,000 = 2,000,000
The fully diluted count becomes 14,000,000: 9,000,000 before, 3,000,000 for the Series B and 2,000,000 of ratchet shares. The founders' 6,000,000 shares are now 42.86 per cent.
The weighted average formula moves the conversion price only part of the way, in proportion to how much money comes in at the lower price relative to the company's size.
CP2 = CP1 × (A + B) / (A + C)
A = shares outstanding before the round, fully diluted = 9,000,000
B = shares the new money would have bought at the old price = $3,000,000 / $2.00 = 1,500,000
C = shares actually issued = 3,000,000
CP2 = $2.00 × 10,500,000 / 12,000,000 = $1.75
Excel: =CP1*(A+B)/(A+C), then =Invested/CP2 for the as-converted Series A.
The Series A now converts into $4,000,000 / $1.75 = 2,285,714 shares, an extra 285,714. The fully diluted count is 12,285,714 and the founders hold 48.84 per cent. The mechanics are set out in more detail in how broad-based weighted average anti-dilution works.
| Holder | No protection | Weighted average | Full ratchet |
|---|---|---|---|
| Series A conversion price | $2.00 | $1.75 | $1.00 |
| Extra shares to Series A | 0 | 285,714 | 2,000,000 |
| Founders | 50.00% | 48.84% | 42.86% |
| Option pool | 8.33% | 8.14% | 7.14% |
| Series A | 16.67% | 18.60% | 28.57% |
| Series B | 25.00% | 24.42% | 21.43% |
| Founders' value at $60m exit | $30,000,000 | $29,302,326 | $25,714,286 |
The down round itself costs the founders 16.67 points, from 66.67 to 50.00 per cent. That part they would suffer under any terms. Weighted average adds 1.16 points. Full ratchet adds 7.14 points, worth about $4.3 million at a $60 million exit. Note the last column of the Series B line: the ratchet shares dilute the new investor too, from 25.00 to 21.43 per cent, which is why a Series B investor facing a ratchet will usually price its round on the post-adjustment share count, or ask the Series A to waive.
| Series B | No protection | Weighted average | Full ratchet | Ratchet shares |
|---|---|---|---|---|
| $3m at $1.50 | 54.55% | 54.08% | 51.43% | 666,667 |
| $3m at $1.00 | 50.00% | 48.84% | 42.86% | 2,000,000 |
| $3m at $0.50 | 40.00% | 37.84% | 28.57% | 6,000,000 |
| $0.5m at $1.00 | 63.16% | 62.80% | 52.17% | 2,000,000 |
| $6m at $1.00 | 40.00% | 38.71% | 35.29% | 2,000,000 |
The last column is the argument against full ratchet. The number of ratchet shares depends only on the price, never on the amount raised. A $500,000 bridge at $1.00 triggers the same 2,000,000 shares as a $3,000,000 round. Under weighted average that small bridge costs the founders 0.36 of a point; under full ratchet it costs 10.98 points. A ratchet turns any small cheque at a low price, including an insider bridge priced to save the company, into a large transfer to the protected investor.
Price compounds the effect. Halving the round price again, to $0.50, triples the ratchet shares to 6,000,000, and the Series A ends up owning more of the company than when it invested, even though the business is worth far less.
Full ratchet is a price-only mechanism: it gives the protected investor the new price on all of its money, however little new money arrives. Weighted average scales the adjustment to the size of the round. When a term sheet offers full ratchet, run the bridge case, a small round at a low price, because that is where the two formulas diverge most. The share count arithmetic for each round is in the free companion workbooks for the book and in how much founders own after seed, Series A and Series B.
It is rarer than broad-based weighted average, which most venture term sheets use, and it tends to appear when a company has little bargaining power. Its cost is that the adjustment ignores round size: in the illustrative case a $500,000 bridge at $1.00 costs founders 10.98 points of ownership under full ratchet and 0.36 of a point under weighted average.
It equals the price of the dilutive round. The protected investor's as-converted shares are its amount invested divided by that price. A Series A that invested $4,000,000 at $2.00 converts into 4,000,000 shares when a Series B is priced at $1.00, double its original 2,000,000.
Yes, unless the new round is priced on the post-adjustment share count. In the worked case the Series B expects 25.00 per cent but holds 21.43 per cent once the 2,000,000 ratchet shares are issued. New investors therefore often require the earlier investors to waive the adjustment, or set their price after it.
This article is one calculation from The Venture Capital Associate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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