What it means
When a company raises money at a lower valuation than its previous round, earlier investors see the value of their stake fall. Anti-dilution clauses in the share terms compensate them, and a full ratchet is the harshest form because it ignores how many cheap shares were actually issued.
The mechanism works through the conversion price. Preferred shares convert into ordinary shares at a stated price, and a full ratchet simply replaces that price with the new, lower issue price, so the same original investment now converts into far more shares.
The alternative that most negotiated term sheets end up with is a weighted average ratchet. That version adjusts the conversion price only partly, in proportion to how many shares were sold at the lower price, which is far less punishing when a company raises a small bridge round on tough terms.
Founders should care because the dilution lands on them and on the employee option pool. A full ratchet can turn a modest down round into a large ownership shift, and it can make the company harder to finance later because incoming investors dislike inheriting a heavily ratcheted capital structure.
Investors argue the clause is protection against being sold an inflated valuation. In practice it is most often seen in distressed rounds, in late-stage private financings and occasionally in convertible instruments, and it is frequently traded away for a higher liquidation preference or a board seat.
In practice
Real-world examples.
Example
A consumer app raises a bridge round at half its previous share price to reach its next milestone. Its lead investor's full ratchet doubles that investor's share count, and the founders discover they have given away more ownership in the bridge than in the original round.
Example
A hardware start-up negotiating a Series B refuses a full ratchet and offers a broad-based weighted average clause instead, paired with a higher liquidation preference. The investor accepts, because the weighted average still protects against a genuine collapse in valuation.
Example
An incoming Series C lead reviews a company's cap table, finds a full ratchet held by an early investor, and makes the deal conditional on that investor waiving the clause. The waiver is agreed in exchange for a small allocation in the new round.
Formula
Calculation
Adjusted Conversion Price = Lowest Price per Share in the New Issue
Shares on Conversion = Original Investment / Adjusted Conversion Price
A Series A investor puts in $4,000,000 at $2.00 per share, receiving $4,000,000 / $2.00 = 2,000,000 preferred shares. The company's total share count after that round is 10,000,000, of which founders and employees hold 8,000,000, so the investor owns 2,000,000 / 10,000,000 = 20%.
Eighteen months later the company raises a down round at $1.00 per share. Under a full ratchet the investor's conversion price resets to $1.00.
Shares on conversion = $4,000,000 / $1.00 = 4,000,000 shares, an increase of 2,000,000 shares issued at no extra cost.
Total shares rise to 12,000,000, so the investor now holds 4,000,000 / 12,000,000 = 33.3% while the founders and employees fall from 80% to 8,000,000 / 12,000,000 = 66.7%. A weighted average clause would have produced only a fraction of those extra shares, because it accounts for the size of the new issue rather than just its price.Case study
Seen in the real world.
This is an illustrative, fictional story. Kestrel Analytics, an invented software company, raised $4,000,000 at $2.00 per share, giving its lead investor 2,000,000 of the 10,000,000 shares then outstanding, or 20% of the company.
Growth stalled and eighteen months later the only offer on the table was a round priced at $1.00 per share. The full ratchet in the original documents reset the lead's conversion price to $1.00, turning its 2,000,000 shares into 4,000,000 and taking its stake to 33.3% of the enlarged 12,000,000 shares, while the founding team and option holders dropped from 80% to 66.7%.
The illustrative lesson is not that the investor behaved badly, since the clause was agreed and disclosed. It is that Kestrel's founders had never modelled a down round, and a clause they read as a formality cost them a third of their remaining ownership at the worst possible moment.
Watch out
Common mistakes.
- Treating anti-dilution clauses as boilerplate, when the difference between a full ratchet and a weighted average version can be worth a double-digit percentage of the company.
- Assuming the protection only bites in a catastrophic down round, when a single share issued below the old price is enough to trigger a full reset.
- Forgetting the employee option pool, which is diluted alongside the founders and can leave a company unable to hire without another top-up round.
Questions
People also ask.
How is a full ratchet different from a weighted average?
A full ratchet resets the conversion price all the way to the new lower price, while a weighted average moves it only partly, in proportion to how many shares were issued cheaply.
Does the protected investor pay anything for the extra shares?
No, the additional shares arise from the conversion adjustment, which is exactly why the dilution falls entirely on the unprotected shareholders.
Can a full ratchet be removed later?
It can, usually by negotiation when a new round arrives, since incoming investors often make a waiver or conversion to weighted average a condition of funding.
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