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A “Full ratchet” anti-dilution adjustment is the most aggressive form of anti-dilution provision. It provides the greatest protection to the Investor and has the greatest negative impact on the founders, employees and ordinary shareholders. A “full ratchet” anti-dilution adjustment retroactively re-bases the Investors’ original investment price to the per share price being offered in the down-round financing, irrespective of the number of shares offered in the down-round financing.
For example, if an Investor previously subscribed for Series A Shares at £1.50 per share, and the new shares issued in the down-round are issued at £0.50 per share the effective price of the Investor’s Series A Shares would be reduced to £0.50 per share. This would either be effected by a bonus issue or by adjusting the conversion ratio into which the Series A Shares would convert into Ordinary Shares. Under the full ratchet adjustment, the same result is obtained whether the company raises £500 at a price of £0.50 per share or raises £100,000,000 at a price of £0.50 per share.
By contrast, “weighted average” anti-dilution provisions (which will be covered in the next post) are less protective to Investors, and will adjust the Investors’ entry price downward to compensate for the subsequent financing, but in a manner that takes into consideration the overall number of shares issued in the subsequent financing. Depending upon the mechanic (either a bonus issue or conversion) being used the calculations are different, but the end result is the same. The calculations are as follows:
Number of Anti-dilution Shares to be issued to the Investor = (Investor’s original investment/Down-round price per share)-number of shares held by the Investor prior to the down-round
Conversion Ratio = Investor’s original price per share/conversion price
For example (using the conversion mechanic), if a company has the following share capital structure:
- 5,500,000 Series A Shares, issued at £1 per share (this would also be the original Conversion Price)
- 6,000,000 Ordinary Shares
- 1,000,000 Options
In a down-round financing the company issues 6,666,667 Series B Shares at £0.60 per share for a total aggregate subscription of £4,000,000
The Series A Shares would be adjusted as follows:
£0.60 would become the new conversion price.
The Conversion Ratio would be 1.67 (£1/£0.60)The Series A Shares would convert into 9,166,667 (5,500,000*1.67) Ordinary Shares upon conversion of the Series A Shares (in any cap table the Investor’s shares would be represented as 9,166,667 on a fully diluted basis, notwithstanding that a conversion event has not occurred)
In the event that the bonus issue mechanic is used, the Investor would on completion of the down-round financing receive a bonus issue of 3,666,667 Series A Shares ((5,500,000/£0.60)-5,500,000), which added with his original shareholding would give the Investor a total of 9,166,667 Series A Shares.
If a company has any leverage, it should always try to avoid full-ratchet adjustments and seek to negotiate a weighted average formula (see the next post). Full-ratchet provisions are not current market practice, but if a full-ratchet is unavoidable, companies should try to minimise the impact of the full-ratchet in the following ways:
- negotiate a time limit, after which the Investor’s anti-dilution protection switches to a weighted-average;
- negotiate a share price floor, whereby below a specific price, whereby if the price per share in a down-round is below a specific threshold, the Investor would only receive weighted-average protection;
- negotiate an ownership cap, whereby any increase in ownership is capped at a particular level;
- negotiate a carve-out, or performance adjustment for the founders/employees (although the other ordinary shareholders would still be effected) to ensure that the founders/employees are still incentivised (this could also be linked to performance criteria or milestones)
- negotiate a pay-to-play
The Anatomy of a Term Sheet series can be found in full here