Full Ratchet

A venture investor's first worry is not upside, it is over-valuation. In early-stage deals the valuation model is mostly contingent on future growth, so the investor looks for downside protection first and returns later.

An anti-dilution clause grants the investor the right to convert its preference shares into equity at a revised price and conversion ratio. Two methods compute the revision: full ratchet and weighted average.

The basic principle on which the ratchet operates: if there is a down round after the investor's investment, the investor is compensated by converting the preference shares into equity at the lowest issue price by the company.

Anti-dilution rights are a family, and the ratchet is only one member.

The most common is the pre-emptive right, which lets a shareholder maintain its percentage by participating pro-rata in future issues and on option exercises. It is typically associated with convertible preference shares, and it is a right and not an obligation — the investor may decline to fund the next round and simply be diluted.

The ratchet is different in kind: it issues more shares to the existing investor for no additional money, by resetting the price at which its preference shares convert.

The weighted average method is the gentler alternative. The new conversion price is computed as the ratio of the total consideration received from all issues to the total number of shares issued to date, and that new price gives the revised conversion ratio.

The comparison is settled by the workbook: the full ratchet method will always be more beneficial to owners of preferred shares, as it grants them conversion at the lowest available price, while the weighted average method will help protect some of the value of their preferred shares.

Two cautions travel with it. Full ratchets can be complicated in operation and need careful thought for tax and regulatory reasons and to avoid later conflicts between founders, the company and other shareholders. And the same protection can be achieved obliquely: a veto right over further share issuances lets an investor block a down round altogether, which the workbook offers as an alternative route to the same end.

Full ratchet
  New conversion price = lowest issue price of the subsequent round
  New shares on conversion = amount invested / new conversion price

Weighted average (as computed in the workbook)
  New conversion price = total consideration received from all issues
                         / total number of shares issued till date
  New conversion ratio = old conversion price / new conversion price

Aarna Ventures, a Rs 450 crore Category I AIF, invests Rs 24 crore in a health-tech company for compulsorily convertible preference shares at a conversion price of Rs 400 a share.

Shares on conversion   Rs 24 crore / Rs 400   =  6,00,000 equity shares

Eighteen months later the company raises a down round at Rs 250 a share.

Full ratchet: conversion price resets to        Rs 250
Shares on conversion   Rs 24 crore / Rs 250  =  9,60,000 equity shares
Additional shares issued, for no new money   =  3,60,000
Effective price paid by Aarna, recomputed    =  Rs 250 a share

Aarna ends up where it would have been had it invested at the down-round price. Every existing shareholder who does not have a ratchet — the founders above all — absorbs that 3,60,000 shares of dilution.

The workbook's own weighted-average comparison, worth reproducing because the figures are examinable. A start-up has 1,00,000 equity shares at Rs 10; angels take 30,000 preference shares at Rs 10 with a conversion ratio of 1:2 at a conversion price of Rs 20; a Pre-Series A round then issues 25,000 shares at Rs 10.

Full ratchet       conversion price falls to Rs 10
                   angels hold 30,000 shares instead of 15,000
                   additional shares issued: 15,000

Weighted average   new conversion price
                   = Rs 14.50 lakh / 1.30 lakh shares  =  Rs 11.15
                   revised ratio  20 / 11.15  =  1.79 shares
                   1.79 equity shares instead of 1, on conversion

Same down round, two formulas: 15,000 extra shares under the ratchet against a ratio moving from 1 to 1.79 under weighted average. That gap is the whole negotiation.

Chapter 11 (Investment Strategies, Investment Process and Governance of Funds), section 11.6.3, sets out anti-dilution rights with both methods worked through, and section 11.6.4 notes that a veto on further issuances reaches the same result. Chapter 11's own sample questions include 'a ratchet protects the AIF from a future down round — true or false'. Expect the workbook's numbers back, and a which-method-is-more-favourable question.

• The full ratchet always favours the preferred holder; weighted average protects only some of the value. The workbook uses both words deliberately.
• A pre-emptive right is not a ratchet. It is a right to participate pro-rata in the next round, and it is a right, not an obligation.
• The ratchet issues shares, it does not refund money. The investor's cheque is unchanged; its share count rises.
• It is triggered by a down round — a financing at a valuation lower than the previous round, whether from poor performance or from external factors reducing investor confidence.
• The workbook's weighted-average denominator counts 1.30 lakh shares — the original 1,00,000 equity plus the 30,000 preference — while its numerator includes the money from the new round. Reproduce its Rs 11.15 and 1.79 in the exam; recognise that a standard weighted-average calculation elsewhere may include the new shares in the denominator too.
• A veto right over further issuances achieves the same protection without any conversion arithmetic at all.