Question & Answer
What Is a Ratchet Clause?
When investors inject capital into a company, they want downside protection. Market conditions shift, valuations fluctuate, and not every investment plays out as expected. That’s where the ratchet clause comes in – a mechanism designed to adjust an investor’s equity position if future funding rounds occur at a lower valuation.
For founders, it’s a double-edged sword. While it helps secure investment, a poorly structured ratchet can lead to significant dilution, sometimes even stripping founders of meaningful control. Understanding how ratchet clauses work, and negotiating them properly, is crucial when structuring a deal.
How a Ratchet Clause Works
A ratchet clause is a form of anti-dilution protection. It ensures that if a company raises capital at a lower valuation in the future, early investors get additional shares to compensate for the drop in valuation. The goal? To prevent their stake from being diluted when the company is worth less than when they initially invested.
Ratchets are most common in venture capital and private equity deals, particularly in high-growth but high-risk startups where valuations can fluctuate significantly between funding rounds.
Types of Ratchet Clauses
Not all ratchets are the same. The structure of the ratchet determines how much dilution occurs and how aggressively investor interests are protected.
- Full Ratchet – If a future round is raised at a lower price per share, early investors’ shares are adjusted to match the new price, without considering the number of new shares issued. This means they receive additional shares to maintain their economic position, heavily diluting founders and other shareholders.
- Weighted Average Ratchet – A more balanced approach, this method adjusts an investor’s share price based on the size of the new issuance relative to the existing shares. This approach protects investors while reducing the extreme dilution that comes with a full ratchet.
Full ratchet clauses are highly investor-friendly but can be damaging to founders. Weighted average ratchets provide a middle ground, ensuring some level of protection without completely eroding founder equity.
The Impact on Founders and Existing Shareholders
Ratchet clauses shift risk from investors to founders and other shareholders. If the company performs well and valuations rise, the ratchet clause never comes into play. But if a down round happens, founders can suddenly find their ownership percentage significantly reduced.
The impact can be severe:
- Founders lose a larger percentage of ownership than they anticipated.
- Existing shareholders, including employees with stock options, face dilution.
- Future fundraising rounds become more complicated as potential new investors consider existing ratchet obligations.
In extreme cases, a poorly structured ratchet can leave a founder with minimal ownership after just one down round.
How to Negotiate a Fair Ratchet Clause
Investors will push for ratchets to protect their downside, but founders need to ensure that these clauses don’t cripple long-term equity value. A few key strategies can help maintain balance:
- Favor Weighted Average Ratchets – Instead of accepting a full ratchet, negotiate for a weighted average approach to reduce dilution.
- Limit the Duration – Ensure the ratchet expires after a certain period or only applies to the next round.
- Set Floor Valuations – Establish a minimum valuation threshold below which the ratchet doesn’t apply, preventing extreme dilution scenarios.
- Negotiate Caps – Restrict the maximum number of shares an investor can receive through a ratchet adjustment.
By structuring the ratchet properly, founders can secure investment without setting themselves up for excessive dilution in a worst-case scenario.
Ratchet clauses serve a clear purpose – protecting investors from downside risk. But they also introduce risk for founders, potentially eroding ownership and control if the company faces a down round.
In Deal Structuring, I outline real-world cases where ratchet clauses have worked both for and against founders, and how negotiating the right balance can mean the difference between maintaining control and losing ownership. The key takeaway? Always structure a ratchet with the long-term implications in mind – because what looks like a minor concession today can become a major problem tomorrow.
Deal Structuring
Buy the book today and dive into practical techniques that empower you to get started immediately, navigating transactions efficiently and maximizing your success in minimizing cash requirements.
In this book, you will:
- Be introduced to the fundamentals of deal structuring
- Learn 19 proven deal models for structuring deals
- Discover 39 key elements of deal nuances
- Access 32 actionable clauses for your term sheets
- Explore 9 specific deal structures
- Receive 257 pages of invaluable insights
- Gain the distilled expertise of 20 years