Broad-Based Weighted Average Ratchet

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DEFINITION of 'Broad-Based Weighted Average Ratchet'

A mechanism seen in early-stage, pre-public companies in response to a subsequent round of financing that involves issuing shares at a lower price than first-stage investors received. A broad-based weighted average ratchet almost always involves preferred stock, in which early investors have a conversion price ("price X"), while a later round of investors receive preferred shares with a lower conversion price ("price Y"). A weighted average price is calculated that will effectively reprice the shares issued at price X and price Y to the value of:

[(Price X) * (shares issued at Price X)] + [(Price Y) * (shares issued at Price Y)] / Total Outstanding Shares on a Fully Diluted Basis

INVESTOPEDIA EXPLAINS 'Broad-Based Weighted Average Ratchet'

The company issuing the shares would prefer to not make any adjustments to preferred shares with higher conversion prices, but most venture-capital groups and investors will insist on a clause that protects their interests in the event that a lower round of financing (also called a "down round") occurs in the future.

In a broad-based ratchet, all rights of ownership (real or potential) are counted in the denominator of "total shares", whether they are preferred or convertible shares, warrants, or options. In a narrow-based ratchet, only common stock outstanding is used to compute the weighted-average price of shares to all investors.

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