Key takeaways
– A full ratchet is an anti‑dilution clause that protects early investors by resetting the conversion price of their convertible securities to the lowest price at which the company subsequently issues shares. (Investopedia)
– Full ratchets can fully protect early investors’ ownership percentages after a down round, but they can cause severe dilution for founders and make future fundraising harder. (Investopedia)
– A common compromise is a weighted‑average anti‑dilution adjustment (narrow or broad based), which softens the effect and better balances interests. (Investopedia)
– When negotiating or drafting terms, clarity about triggering events, the base share count, exceptions, and time limits is essential.
Understanding full ratchets — mechanics and purpose
– Purpose: Full ratchets exist to protect early investors from “down rounds” (later financings at a lower per‑share price). They ensure the investor’s conversion price is adjusted to the new lower issuance price so the investor receives as many common shares on conversion as if the investor had originally paid that lower price. (Investopedia)
– Mechanic in plain terms: If Investor A bought convertible preferred at $1.00 per share and a later round sells shares at $0.50, a full ratchet reduces Investor A’s conversion price from $1.00 to $0.50. Investor A therefore converts into twice as many common shares as before — preserving their economic share relative to the new low price. (Investopedia)
Worked example (numeric)
Assumptions:
– Founders’ common shares: 9,000,000
– Investor A: 1,000,000 convertible preferred at $1.00 (conversion price = $1.00)
– Later round: Investor B buys 1,000,000 common shares at $0.50
Full‑ratchet outcome:
– Investor A’s conversion price resets to $0.50 → each preferred now converts into 2 common shares instead of 1 → Investor A’s converted shares = 2,000,000.
– Total common after conversion and new issuance = Founders 9,000,000 + Investor A 2,000,000 + Investor B 1,000,000 = 12,000,000.
– Ownership: Founders 75% (9/12), Investor A 16.67% (2/12), Investor B 8.33% (1/12).
Founders’ ownership dropped from 90% to 75% — a strong dilution effect attributable to the full ratchet. (Investopedia)
Weighted‑average alternative (comparison)
– In a weighted‑average adjustment the conversion price is reduced by a formula that takes into account the number of shares outstanding and the number and price of newly issued shares. Two common variants:
– Narrow‑based weighted average: often uses only a small subset of outstanding shares (e.g., only common shares), which produces a larger adjustment than the broad version.
– Broad‑based weighted average: uses a larger base (fully diluted shares including options, convertibles), which produces a milder adjustment and is more founder‑friendly.
– Using the same numbers and a broad‑based weighted average formula, the adjusted conversion price falls modestly (≈$0.9545), so Investor A converts to ≈1.048M common (instead of 2M). Total common ≈ 11.048M and founders’ ownership ≈ 81.5% — less dilution than with a full ratchet. (Investopedia)
Pros and cons of a full ratchet
Pros (typically for early investors)
– Strong protection from down‑round price risk.
– Simple to apply: an explicit price floor for conversion calculations.
– Attractive to high‑risk, early‑stage backers who need strong downside protection.
Cons (for founders and future investors)
– Can cause dramatic founder dilution in a down round.
– Discourages follow‑on investment: later investors may seek larger stakes or demand higher protections themselves.
– Complicates cap table management; may trigger share issuance cascades to preserve percentage ownerships.
– Often limited in scope/time (if accepted at all) because of the above downsides. (Investopedia)
Practical steps: what each party should do
For founders (before and during fundraising)
1. Avoid full ratchets if possible. Propose broad‑based weighted average anti‑dilution instead — it’s the market standard in many VC deals and less punitive. (Negotiation tip)
2. Ask for limits and exceptions:
– Time limits (e.g., anti‑dilution protection expires after next priced round or X years).
– Carve‑outs for certain issuances (employee option pools, acquisitions, IPOs, strategic financings).
– Apply protection only to issuances that represent more than a threshold percentage of the company.
3. Model scenarios. Build post‑money cap‑table models for different down‑round prices to show the concrete effects of full ratchet vs. weighted average.
4. Use “pay‑to‑play” provisions (require existing preferreds to participate pro rata in new rounds to keep full rights) — this discourages free riders and can limit the effect of protection.
5. Get specialist counsel. Anti‑dilution language can be written many ways; a securities/VC lawyer should verify definitions and triggers.
For early investors
1. Ask for protection proportional to your bargaining power and risk. A full ratchet is reasonable only when you’re taking very early, significant risk and the company has weak bargaining leverage.
2. Consider accepting weighted average or stepping down to ratchet protection tied to a limited time window — this helps preserve future financing prospects for the company.
3. Negotiate clear definitions: what constitutes an “issue price,” “new issuance,” and which securities are included in the base share count.
For later investors and acquirers
1. Watch for legacy anti‑dilution provisions in prior rounds — they affect cap table and ownership percentages post‑closing.
2. Require representations and warranties about outstanding anti‑dilution provisions and whether they have been triggered.
For lawyers and drafters (specific drafting checks)
1. Define the trigger events precisely:
– Which issuances count (equity, convertible debt, options, warrants)?
– Is issuance at a lower “effective price” than the protected price required? How to compute effective price (net of fees, with related‑party issues)?
2. Define the base share count used in any weighted‑average calculation (narrow vs broad).
3. State the method of adjustment and the timing (when adjusted shares are issued; whether cash settlement allowed).
4. Specify exceptions (e.g., shares issued for acquisitions, employee option grants, IPOs, or shares issued in a financing by majority of directors).
5. Consider anti‑abuse rules (e.g., exclude issuances to “friendly” parties made solely to trigger a favorable adjustment).
Negotiation tips and common compromises
– If the investor insists on a full ratchet:
– Limit the scope: apply only to a single subsequent financing, or only to financings within X months.
– Cap the number of shares that can be issued to satisfy the ratchet.
– Convert full ratchet to a hybrid: full ratchet only if the down round is deeper than a pre‑agreed threshold (for example, > 50% price decline).
– Offer a broad‑based weighted average as a first counter‑proposal — it protects investors but keeps future fundraising viable.
– Use valuation‑based protections (e.g., dilution protection tied to valuation declines rather than raw price per share) to align incentives.
Checklist before signing a term sheet that includes anti‑dilution protection
– Is the clause full ratchet, narrow‑based weighted average, or broad‑based weighted average?
– Exactly which securities are counted in the “base” share pool?
– What triggers an adjustment and how is “price” calculated?
– Are there time limits, carve‑outs, and caps?
– How and when are adjusted shares issued and recorded on the cap table?
– Do you have models showing the cap table under plausible down‑round scenarios?
– Have both sides obtained experienced counsel?
Conclusion
A full ratchet is one of the most investor‑friendly anti‑dilution mechanisms: it gives strong downside protection but can impose harsh dilution on founders and complicate future financings. In practice, market participants often prefer weighted‑average adjustments (especially broad‑based) as a compromise that balances investor protection with the company’s ability to attract additional capital. Wherever anti‑dilution protection appears in a term sheet, clarity in language, careful cap‑table modeling, and experienced legal advice are essential.
Sources and further reading
– “Full Ratchet” entry, Investopedia. https://www.investopedia.com/terms/f/fullratchet.asp (accessed Oct 4, 2025).
,
What is a Full Ratchet? A practical guide for founders, investors, and lawyers
Key takeaways
– A full ratchet is an anti‑dilution clause that protects early investors by resetting the conversion price of their convertible securities to the lowest price at which the company subsequently issues shares. (Investopedia)
– Full ratchets can fully protect early investors’ ownership percentages after a down round, but they can cause severe dilution for founders and make future fundraising harder. (Investopedia)
– A common compromise is a weighted‑average anti‑dilution adjustment (narrow or broad based), which softens the effect and better balances interests. (Investopedia)
– When negotiating or drafting terms, clarity about triggering events, the base share count, exceptions, and time limits is essential.
Understanding full ratchets — mechanics and purpose
– Purpose: Full ratchets exist to protect early investors from “down rounds” (later financings at a lower per‑share price). They ensure the investor’s conversion price is adjusted to the new lower issuance price so the investor receives as many common shares on conversion as if the investor had originally paid that lower price. (Investopedia)
– Mechanic in plain terms: If Investor A bought convertible preferred at $1.00 per share and a later round sells shares at $0.50, a full ratchet reduces Investor A’s conversion price from $1.00 to $0.50. Investor A therefore converts into twice as many common shares as before — preserving their economic share relative to the new low price. (Investopedia)
Worked example (numeric)
Assumptions:
– Founders’ common shares: 9,000,000
– Investor A: 1,000,000 convertible preferred at $1.00 (conversion price = $1.00)
– Later round: Investor B buys 1,000,000 common shares at $0.50
Full‑ratchet outcome:
– Investor A’s conversion price resets to $0.50 → each preferred now converts into 2 common shares instead of 1 → Investor A’s converted shares = 2,000,000.
– Total common after conversion and new issuance = Founders 9,000,000 + Investor A 2,000,000 + Investor B 1,000,000 = 12,000,000.
– Ownership: Founders 75% (9/12), Investor A 16.67% (2/12), Investor B 8.33% (1/12).
Founders’ ownership dropped from 90% to 75% — a strong dilution effect attributable to the full ratchet. (Investopedia)
Weighted‑average alternative (comparison)
– In a weighted‑average adjustment the conversion price is reduced by a formula that takes into account the number of shares outstanding and the number and price of newly issued shares. Two common variants:
– Narrow‑based weighted average: often uses only a small subset of outstanding shares (e.g., only common shares), which produces a larger adjustment than the broad version.
– Broad‑based weighted average: uses a larger base (fully diluted shares including options, convertibles), which produces a milder adjustment and is more founder‑friendly.
– Using the same numbers and a broad‑based weighted average formula, the adjusted conversion price falls modestly (≈$0.9545), so Investor A converts to ≈1.048M common (instead of 2M). Total common ≈ 11.048M and founders’ ownership ≈ 81.5% — less dilution than with a full ratchet. (Investopedia)
Pros and cons of a full ratchet
Pros (typically for early investors)
– Strong protection from down‑round price risk.
– Simple to apply: an explicit price floor for conversion calculations.
– Attractive to high‑risk, early‑stage backers who need strong downside protection.
Cons (for founders and future investors)
– Can cause dramatic founder dilution in a down round.
– Discourages follow‑on investment: later investors may seek larger stakes or demand higher protections themselves.
– Complicates cap table management; may trigger share issuance cascades to preserve percentage ownerships.
– Often limited in scope/time (if accepted at all) because of the above downsides. (Investopedia)
Practical steps: what each party should do
For founders (before and during fundraising)
1. Avoid full ratchets if possible. Propose broad‑based weighted average anti‑dilution instead — it’s the market standard in many VC deals and less punitive. (Negotiation tip)
2. Ask for limits and exceptions:
– Time limits (e.g., anti‑dilution protection expires after next priced round or X years).
– Carve‑outs for certain issuances (employee option pools, acquisitions, IPOs, strategic financings).
– Apply protection only to issuances that represent more than a threshold percentage of the company.
3. Model scenarios. Build post‑money cap‑table models for different down‑round prices to show the concrete effects of full ratchet vs. weighted average.
4. Use “pay‑to‑play” provisions (require existing preferreds to participate pro rata in new rounds to keep full rights) — this discourages free riders and can limit the effect of protection.
5. Get specialist counsel. Anti‑dilution language can be written many ways; a securities/VC lawyer should verify definitions and triggers.
For early investors
1. Ask for protection proportional to your bargaining power and risk. A full ratchet is reasonable only when you’re taking very early, significant risk and the company has weak bargaining leverage.
2. Consider accepting weighted average or stepping down to ratchet protection tied to a limited time window — this helps preserve future financing prospects for the company.
3. Negotiate clear definitions: what constitutes an “issue price,” “new issuance,” and which securities are included in the base share count.
For later investors and acquirers
1. Watch for legacy anti‑dilution provisions in prior rounds — they affect cap table and ownership percentages post‑closing.
2. Require representations and warranties about outstanding anti‑dilution provisions and whether they have been triggered.
For lawyers and drafters (specific drafting checks)
1. Define the trigger events precisely:
– Which issuances count (equity, convertible debt, options, warrants)?
– Is issuance at a lower “effective price” than the protected price required? How to compute effective price (net of fees, with related‑party issues)?
2. Define the base share count used in any weighted‑average calculation (narrow vs broad).
3. State the method of adjustment and the timing (when adjusted shares are issued; whether cash settlement allowed).
4. Specify exceptions (e.g., shares issued for acquisitions, employee option grants, IPOs, or shares issued in a financing by majority of directors).
5. Consider anti‑abuse rules (e.g., exclude issuances to “friendly” parties made solely to trigger a favorable adjustment).
Negotiation tips and common compromises
– If the investor insists on a full ratchet:
– Limit the scope: apply only to a single subsequent financing, or only to financings within X months.
– Cap the number of shares that can be issued to satisfy the ratchet.
– Convert full ratchet to a hybrid: full ratchet only if the down round is deeper than a pre‑agreed threshold (for example, > 50% price decline).
– Offer a broad‑based weighted average as a first counter‑proposal — it protects investors but keeps future fundraising viable.
– Use valuation‑based protections (e.g., dilution protection tied to valuation declines rather than raw price per share) to align incentives.
Checklist before signing a term sheet that includes anti‑dilution protection
– Is the clause full ratchet, narrow‑based weighted average, or broad‑based weighted average?
– Exactly which securities are counted in the “base” share pool?
– What triggers an adjustment and how is “price” calculated?
– Are there time limits, carve‑outs, and caps?
– How and when are adjusted shares issued and recorded on the cap table?
– Do you have models showing the cap table under plausible down‑round scenarios?
– Have both sides obtained experienced counsel?
Conclusion
A full ratchet is one of the most investor‑friendly anti‑dilution mechanisms: it gives strong downside protection but can impose harsh dilution on founders and complicate future financings. In practice, market participants often prefer weighted‑average adjustments (especially broad‑based) as a compromise that balances investor protection with the company’s ability to attract additional capital. Wherever anti‑dilution protection appears in a term sheet, clarity in language, careful cap‑table modeling, and experienced legal advice are essential.
Sources and further reading
– “Full Ratchet” entry, Investopedia. https://www.investopedia.com/terms/f/fullratchet.asp (accessed Oct 4, 2025).