A ratchet is an anti-dilution provision that automatically adjusts the conversion price of preferred shares downward when a company raises capital at a lower valuation than previous rounds, effectively granting existing investors additional shares to compensate for the dilution. This protective mechanism ensures that early investors maintain their proportional ownership and economic value when a "down round" occurs.
Why It Matters
Ratchets represent one of the most investor-friendly protective provisions in venture capital, directly impacting both founders and future investors. A full ratchet—the most aggressive form—can dramatically increase dilution to founders and common shareholders, sometimes transferring 20-30% additional ownership to protected investors after a significant down round. Understanding ratchet provisions helps investors negotiate fair terms while maintaining founder incentives, and alerts entrepreneurs to potentially punitive clauses that could devastate their equity stake if business conditions deteriorate.
Example
Imagine an investor purchases 1 million Series A preferred shares at $5.00 per share with full ratchet protection. Two years later, the company struggles and raises Series B at $2.50 per share—a 50% down round. Without the ratchet, the Series A investor's shares would convert to common stock at the original $5.00 price, yielding 1 million common shares. With the full ratchet activated, their conversion price adjusts to $2.50, meaning their preferred shares now convert to 2 million common shares ($5 million invested ÷ $2.50 new price). The founders and employees who hold common stock suddenly see their ownership percentages cut nearly in half, even though the company raised the same amount of capital. A weighted-average ratchet—a more moderate alternative—would adjust the conversion price based on the amount raised in the down round, resulting in less severe dilution to common shareholders.