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Bury the Ratchets
By Colin Blaydon and Michael Horvath

01/01/2003
Venture Capital Journal
Copyright (c) 2002 Thomson Financial, Inc. All Rights Reserved.

With private equity markets grim, venture capitalists are resuscitating a financing tool from downturns past: the full ratchet.

A full ratchet enables early round investors to preserve the value of their initial investment in a down round. Essentially, the early ratchet-protected investors get additional "free" shares so that their effective share price equals the new lower price. The investors avoid a markdown in the value of their investment. Even better, they don't look like they were wrong.

But nothing comes for free. With ratchets, the price is paid by the common and non-protected shareholders, who end up diluted, and by the new investors, whose ownership percentage is limited by these new shares. Indeed, full ratchets can turn off potential investors to a deal at a time when a company needs new money the most.

Though the tough market conditions that ratchets are supposed to protect against have largely happened already, some investors are now attempting to insert "retroactive ratchets" in down rounds. At the same time, once-burned investors are insisting on favorable full ratchets in new deals, when there are probably some better ways to avoid dilution. This article takes a critical look at ratchets and offers alternative term structures that may produce more desirable outcomes.

How Ratchets Work

Ratchets are a mechanism for adding shares to an earlier investment round when a new round of financing is done at a lower share price. The most simple and aggressive form is the full ratchet, which issues sufficient supplemental shares to investors in an earlier round so that their effective share price equals the lower share price of the new round.

If, for example, the new round share price is half the price of a previous round, a full ratchet would give the previous round investors twice the number of their original shares. This form of anti-dilution protection basically re-prices the earlier financing round to make a dollar in the earlier round equivalent to a dollar in the new round in terms of the percentage of outstanding shares bought by the investments in either round.

New investment money and old money that is ratchet-protected share relative ownership in direct proportion to their investments, independent of the share price of the down round, while the common and non-protected shares suffer dilution as the round price goes down. So, continuing the example of a 50% reduction in share price, if a new round investor puts in half of the money that earlier ratchet-protected rounds had already put in, then they would own half the number of shares of the earlier investors, after their ratchet adjustment. If the new share price were set very low, approaching zero, then the new investor could own no more than one third of the shares, even as the common and other unprotected shares are effectively diluted out of the picture.

Full Ratchet Example

  • Founders/Common: 20 shares
  • Original investors: 10 shares at $10 per share, $100 investment for 1/3 ownership
  • New investors: 50 shares at $1 per share, $50 investment
  • Full ratchet effect: Original investors get 90 new shares, for a total of 100 shares (The ratchet entitles the original investors to won as many shares as their original investment would buy them at the new price. In this case that's 100 shares, and they already have 10 shares.)

Respective ownership percentages after new round:
 

With Full Ratchet

Without Full Ratchet

Founders/Common

12%

25%

Original Investors

59%

13%

New Investors

29%

63%

The appeal of the full ratchet for the original investor is obvious. The effective price per share of the original investment is knocked down to the new price of $1 per share. In this example, the original investor's stake in the company also explodes to a super-majority, which could be useful in influencing the direction of the company down the road. Without the full ratchet, the original investor would be holding only 13% of the company after having paid twice what the new investor paid to hold 63% of the company.

The tension with the full ratchet is obvious too. From the eyes of a prospective investor, putting money into a company where the original investor has a full ratchet looks like a bad deal. Instead of holding a majority interest in the company, which the changed market circumstances would dictate in the absence of ratchets, the new investor has half the ownership of the original investor. Founders and management that holds common shares may also balk at seeing their stake drop so much. Their option positions may need to be "re-loaded," that is, they may need to be given more shares, to keep them incentivized.

The Retroactive Ratchet

Though ratchet protection is generally supposed to be forward looking, ratchets are increasingly being inserted retroactively as part of new financing rounds. That's because, in cheerier times, few deals leading up to recent financings had ratchets. Retroactive ratchets, or "get well" provisions, can add insult to a new outside investor's injury. Not only do the new investor shares get diluted by the ratchet-generated shares as in the example above, but the rights to the ratchet shares were not even part of the original investor agreement.

Here's an example. In a case the authors recently saw, a company that had gotten a strong valuation on a previous round needed new financing to get to cash breakeven. This down round was to be led by one of the existing investors, who proposed a retroactive re-pricing of their earlier round by issuing additional shares to that round, effectively creating a retroactive ratchet. When the management team went out to try to raise new money, potential investors protested that they were paying a price for their shares that was twice the effective price being paid by the earlier round investors.

To make the investment sufficiently attractive to the new outside investors, the round price for these new investors had to be lowered. But that change further diluted the common shareholders and unprotected preferred shareholders. In the end, the early investors also had to give up a portion of their retroactive ratchet shares to soften this impact and further narrow the price differential between the new outside money and the new funding provided by the earlier investors.

Alternatives to Full Ratchets

Other ratchet structures are less severe than full ratchets. For most of the '90s, ratchets were typically weighted-average ratchets. This formula re-prices an earlier round by issuing enough additional shares to that round to bring the effective price down to the average price of both the new and the previous round. In other words, the average price is the total investment of both rounds divided by the number of shares of both rounds, before adjusting for the ratchet shares.

"Pay to play" provisions are a way to attempt to justify the issuance of ratchet shares. A ratchet with a "pay to play" provision requires the old investors with ratchets to participate in the new financing round in order to trigger the issuance of ratchet shares. (These provisions are also sometimes called "play or pay," meaning that if you don't play by investing in the new round, then you pay by losing your anti-dilution protection.) Typically, the requirement is for investors with ratchets to invest their pro rata share in the down round. In essence, they get new shares under the ratchet provision but they have to pay for them.

Finally, investors wanting protection of their ultimate return should consider liquidation preferences as an alternative to ratchets. Ratchets are a way of making the average price paid for a position look better in the event the company turns out to be less successful than anticipated. However, the price at some interim stage of a company's development becomes immaterial when it comes time to liquidate the company. At that point liquidation preferences are the final arbiter of who gets what. Of course, securing excessive multiples in liquidation preferences will appear no less unsavory to future investors than ratchets, unless they are also granted similar rights. However, the direct effects of liquidation preferences on percentage ownership and on share prices don't emerge until the company is sold, which means less fodder for disagreement in getting a deal done.

Using Ratchets Appropriately

In sum, ratchets can turn off potential new investors and disgruntle unprotected shareholders, most importantly management whose continued commitment is crucial for future success. Early investors still bent on using ratchets despite these pitfalls should be prepared either for pressure to waive their ratchets entirely if they are not participating in subsequent rounds, or to reduce the number of ratcheted shares they insist on receiving.

Do these ratchet woes mean VCs can't protect themselves? To the contrary, there are ways of doing so that are more "win win." In particular, "pay to play" provisions and liquidation preferences can lessen the insidious effects of ratchets while still providing dilution and valuation protection.

Colin Blaydon and Michael Horvath are professors at the Tuck School of Business at Dartmouth and direct the school's Center for Private Equity and Entrepreneurship, which focuses on the role that private equity plays in fueling growth companies around the world. They can be reached at pecenter@dartmouth.edu.

This article originally appeared in the January 2002 issue of the Venture Capital Journal.

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