What is 'Full Ratchet'
Full ratchet is an anti-dilution provision that, for any shares of common stock sold by a company after the issuing of an option (or convertible security), applies the lowest sale price as being the adjusted option price or conversion ratio for existing shareholders.
Full-ratchet anti-dilution protection allows an investor to have his percentage ownership remain the same as the initial investment.
BREAKING DOWN 'Full Ratchet'For example, an investor who paid $2 per share for a 10% stake would get more shares in order to maintain that stake if a subsequent round of financing were to come through at $1 per share. The early round investor would have the right to convert his shares at the $1 price, thereby doubling his number of shares.
A full ratchet anti-dilution provision ensures that current investors, or shareholders, are able to maintain their same percentage of ownership should a company create additional offerings. It is considered an anti-dilution provision since the intent is to prevent an original shareholder’s stake from being diluted by the creation of new securities.
Aside from preventing the dilution of a shareholder’s stake, a full ratchet also offers a level of cost protection should the pricing of the initial round be higher than those sold later within the round, or in subsequent rounds. This may allow a shareholder to maintain their percentage stake within a company without requiring any additional funds. This is done by converting the price paid on currently held shares to the corresponding number of shares that could have been purchased with the same funds at the lower price.
Purpose for Maintaining the Percentage of a Shareholder’s Stake
Within certain companies, a shareholder must hold a minimum percentage of the available shares to maintain certain rights. Most notably, this may be valuable to investors if falling below a certain percentage would mean a loss of voting rights that were held prior to the creation of additional shares.
Additionally, investors may be interested in maintaining the same percentage if the company is expected to gain positive momentum. This can lead to larger returns if share values rise especially in the short term. It can also help protect from the perceived short-term losses that can appear to occur as soon as the new offerings are made publicly available. Since these new shares may be acquired at discounted prices, or without the additional of any funds, the current shares may lose some value as the company’s assets are divided among a growing number of shares.