Full Ratchet

What is a full ratchet?

Full ratchet (complete price adjustment) refers to the form of anti-dilution protection in which the entry price of a protected investor is reduced entirely to the lower price per share of a later round. The entry price is the price per share the investor itself paid; a round at a lower price is called a down round. How many shares are issued at the new price is irrelevant. The terms full ratchet clause and full ratchet anti-dilution are also in common use.

The full ratchet is one of two basic forms of anti-dilution protection; the other is the weighted average. It is agreed in the term sheet and regulated in the participation agreement and in the shareholders' agreement. In a GmbH (German limited liability company), it is implemented through additional shares (compensation shares, Ausgleichsanteile) which the investor takes up in a capital increase at their nominal value, usually EUR 1 per share. The name goes back to the ratchet, which can be turned in one direction only: the price is adjusted downwards, never upwards. In German funding rounds, this form is the exception.

Full ratchet: mechanics and formula

The calculation needs only two figures: the amount the protected investor has invested, and the lowest price at which the company subsequently issues shares. This new price becomes the adjusted entry price.

Formula: Compensation shares = investment amount / new price per share minus shares previously held

The calculation previous shares × (old price / new price minus 1) is equivalent. With 25,000 shares and a price fall from EUR 120 to EUR 60, this gives 25,000 × (2 minus 1) = 25,000 compensation shares.

If the price halves, the number of shares of the protected investor doubles. The size of the new round does not enter the calculation. Even a small issue at a low price, for example to a single investor in a bridge round, triggers the full adjustment. This is the difference from the weighted average, which takes the scope of the new issue into account. If a later round follows at an even lower price, the adjustment is made again, unless the contract provides a limit.

Effect on shareholders and future rounds

The compensation shares come at the expense of all shareholders without equivalent protection. Because the entry price is adjusted in full, the protected investor, valued at the new price, is in the position of having invested at that price from the outset. The risk of the lower valuation is thus essentially borne by the other shareholders.

The clause has an effect beyond the round in which it applies. For new investors, a full ratchet is an obstacle, because every lower price in their own round triggers additional compensation shares and thereby makes their price more expensive or reduces their stake. They therefore often make their entry conditional on the protected investors waiving the clause or switching to a weighted average. If the founders' stake falls sharply, their commitment to the company can also suffer, which new investors factor into their valuation.

When a full ratchet is agreed

It is more likely to be demanded in special situations. These include valuations well above what comparable rounds support, and financing situations in which one investor is the only one ready to invest. A further occasion is bridge financing ahead of an expected larger round. The investor thereby secures a valuation that it considers uncertain itself.

Limits on the full ratchet in contract practice

• Time limit: The full ratchet applies only to rounds within a certain period after the protected round. After that, a weighted average applies or no protection at all.
• Floor price: The adjustment ends at an agreed price below which the entry price is not reduced.
• Partial amount: Only part of the investment is adjusted in full, the rest on a weighted-average basis or not at all.
• Participation obligation: Only an investor that participates pro rata in the down round keeps the protection (pay-to-play).
• Exceptions: Allocations from the employee programme, conversions on terms fixed in advance and issues approved by the protected investors do not trigger an adjustment.

Worked example: calculating a full ratchet in a down round

The share capital of a GmbH of EUR 90,000 is divided into shares of EUR 1 each. The founders hold 55,000 of them, a business angel without protection 10,000 and the Series A investor 25,000, who invested EUR 3 million for them. In addition there are 10,000 virtual shares. A full ratchet is agreed. The follow-on round brings EUR 3 million from a new investor, who pays EUR 60 per share. The starting position corresponds to the weighted average example, so that the two forms can be compared.

• Entry price: EUR 3 million / 25,000 = EUR 120; adjusted price under the full ratchet: EUR 60
• Shares after adjustment: EUR 3 million / EUR 60 = 50,000; compensation shares 50,000 minus 25,000 = 25,000, taken up at the nominal amount of EUR 25,000 in total
• New shares of the round: EUR 3 million / EUR 60 = 50,000; share capital afterwards 90,000 + 50,000 + 25,000 = EUR 165,000, shares on a fully diluted basis including the virtual shares 175,000
• Fully diluted stakes: founders 55,000 / 175,000 = about 31.43%, business angel about 5.71%, Series A investor 50,000 / 175,000 = about 28.57%, new investor about 28.57%, virtual shares about 5.71%
• Without protection, the founders would stand at 55,000 / 150,000 = about 36.67% and the Series A investor at about 16.67%; under the broad-based weighted average, the latter would receive 5,000 instead of 25,000 compensation shares
• Value of the Series A shares at the new price: 50,000 × EUR 60 = EUR 3 million, exactly the original investment
• Small round: if the new investor invests only EUR 600,000 at EUR 60, that is, for 10,000 shares, the full ratchet still produces 25,000 compensation shares, two and a half times the new issue
• Consequence of the small round for the founders: without protection 55,000 / 110,000 = 50%, with a full ratchet 55,000 / 135,000 = about 40.74%
• By comparison: the broad-based weighted average would yield only 1,190 compensation shares (rounded down) and a founder stake of 55,000 / 111,190 = about 49.46%

The Series A investor is made completely whole at the new price; the founders lose a good five percentage points of their stake compared with the position without protection. The small round shows the main criticism: an issue of EUR 600,000 triggers the same adjustment as one of EUR 3 million. It costs the founders a good nine percentage points of their stake.

Distinctions: full ratchet, weighted average and management ratchet

• Weighted average: reduces the entry price only as far as the ratio of existing to newly issued shares yields. Small issues therefore lead only to small adjustments.
• Anti-dilution protection: the umbrella term for all forms of price-based anti-dilution protection, including its implementation in the GmbH.
• Management ratchet: an arrangement from private equity under which the management's stake increases if the financial investor achieves certain return targets. It shares only the name with anti-dilution protection.
• Milestone-based adjustment: changes the stake if agreed plan targets are missed. It is tied to the development of the company, not to the price of a later round.

Common mistakes

• Looking only at the valuation. A full ratchet is often accepted in exchange for a high valuation without calculating the consequences of a round at a lower price.
• No time limit agreed. Without a time limit, the clause also applies in rounds that take place years later under entirely different market conditions.
• Small issues not excluded. Without an exception, a single issue at a low price is enough to trigger the full adjustment.
• No floor price. If there is no lower limit, the entry price can fall to a fraction in a very low follow-on round.
• Consequences for the next round underestimated. New investors factor the compensation shares into their price or demand a waiver. Both delay the round.

Frequently asked questions

Is a full ratchet permissible under German law?

Yes, as a contractual arrangement between the shareholders. It is implemented through a capital increase in which the other shareholders participate on the basis of their contractual obligations and waive their subscription right.

How common is a full ratchet in German funding rounds?

It is rare. The broad-based weighted average is customary; a full ratchet is more likely to be found in bridge financings or with valuations that the investor considers uncertain, and then usually time-limited.

Does a full ratchet also apply if only a few shares are issued at a lower price?

Yes, unless an exception applies. The adjustment depends solely on the lower price, not on the number of shares issued at that price.

What is the difference between a full ratchet and a weighted average?

The full ratchet always reduces the entry price entirely to the new price, the weighted average only as far as the scope of the new issue justifies. In the worked example, the large round yields 25,000 instead of 5,000 compensation shares, the small round 25,000 instead of 1,190.

Can a full ratchet be changed afterwards?

Yes, with the consent of the protected investors. This often happens in the course of a new round, when the new investor makes a switch to a weighted average or a waiver a condition.

The Roemer Capital view

If a term sheet contains a full ratchet, Roemer Capital calculates it for several prices of a follow-on round. The result is set against a variant with a weighted average and a lower valuation. This comparison shows whether the higher stated valuation outweighs what the protection costs the founders in the unfavourable case.

If the full ratchet cannot be avoided, Roemer Capital negotiates a short time limit, a floor price and exceptions for small issues and the employee programme. The decision rests with the shareholders, the contractual implementation with their law firm.