A Hidden Pitfall of Convertible Debt: Full Ratchet Anti-Dilution Rights
- Lighter Capital
- Jul 28, 2015
- 4 min read
Updated: Oct 2
Previously, we covered one little-known problem with convertible debt—unpriced liquidation preferences. Here, we’ll look at another hidden pitfall of convertible debt: Giving investors full ratchet anti-dilution rights.
As a founder, it's easy to assume that "anti-dilution rights" protect you from excessive dilution. Nope. Exactly the opposite—they are rights that limit investors’ dilution if there is a later round of equity financing at a lower per share valuation (or a down round).
There are two main types of anti-dilution protection that may be included in the terms of your convertible debt financing: weighted average and full ratchet.
We'll help you understand a full ratchet so you can avoid inadvertently giving away too much of your company to early investors.
DEFINITIONS
Convertible debt: This is a loan that converts into equity later (usually at the next priced round).
Anti-diltuion rights: These are contractual protections for investors to prevent their ownership from being diluted too much in future financings.
What is a Full Ratchet?
Full ratchet is the least entrepreneur-friendly anti-dilution right. If your startup raises at a lower valuation in the next round, the earlier investor’s conversion price is reset entirely to match the new, lower price.
It's a safety net for investors—a complete repricing of a prior equity investment to any lower price per share that happens in a later round. For founders, full ratchet can be a landmine if not negotiated carefully. Here's why.
Full ratchet increases the risk for founders
A single down round can drastically reduce your equity stake and control if full ratchet rights are in place. Additionally, full ratchet anti-dilution rights can make follow-on fundraising much harder and weaken your negotiating power in future funding rounds.
For example, Let’s say you secure $1M in equity financing at a price of $2/share. So you issue 500,000 shares, and you give these investors full ratchet anti-dilution rights. A year later, you raise another $1M, but this time, for various reasons, the valuation per share goes down. You issue 1 million new shares at $1/ share.
Since the $1/share price the recent funding round is lower than prior round's share price, the full ratchet anti-dilution provision is triggered. Therefore, the $2/share price is “fully lowered” to $1/share, which you accomplish by issuing 500,000 additional shares to the 2015 investors.
In total, you’ve now issued 2 million shares: 1 million to the first round investors and 1 million to the next round of investors.
The net effect is that you, the entrepreneur, get significantly diluted, since all prior investments are now at the lowest per share price.
GO DEEPER
Frequently Asked Questions
Q. Why are you saying my convertible debt has a full ratchet?
Well, the convertible debt converts dollar-for-dollar into stock at a future equity round (generally at a discount or with stock warrants). That means you, the entrepreneur, are taking all downside risk of the valuation dropping below what you’d expected.
We've had this conversation with entrepreneurs far too many times:
Founder: “We raised money at a $6M pre-money valuation with convertible debt.”
LC: “You mean a $6M cap?”
Founder: “Yeah.”
LC: “Oh. That means you raised money with a capped upside for you and unlimited downside for yourself."
Founders don’t generally like hearing this, but it’s true, unfortunately.
Q. Can a full ratchet with convertible debt be even worse than a full ratchet with equity?
Well, yes, in fact it can. When a startup issues convertible debt, it is often offering to repay what was originally invested with a discount, and with interest. Between the discount and the accruing interest, the shares at the trigger point can add up very quickly.
Standard convertible debt terms allow note holders to buy equity at a 15% to 30% discount, and that discount can apply even if the investor is already getting a bargain due to a valuation cap—and implicitly, given full ratchet anti-dilution rights. So if you get slammed with this phenomenon, it will hurt even more than in a traditional priced equity round.
Q. How can I prevent the full ratchet?
First, you need to get an experienced startup lawyer. There’s really no substitute for this to make sure you don’t end up with problems in your cap structure. Second, there are a couple of basic ways to get rid of the implied full ratchet in convertible debt:
Do a priced round—a real equity round. Just set a price and simple terms and be done. One caveat: lots of angel investors don’t feel comfortable leading due diligence and negotiations. They find your company interesting, but they don’t want to lead. So you don’t have anyone to negotiate with. What do you do? You (and your lawyer) draft a term sheet you think is fair and you get investors to sign onto it, or give you “feedback about changes they’d like to see to it.”
Have a valuation floor. You give them a cap, they give you a floor. Seems fair enough.
Full Ratchet Alternatives You Can Negotiate
To be sure, investors deserve some adequate compensation for taking a risk on early-stage startups. You just want to be sure you aren’t giving away more than you intend to secure those early dollars.
Instead of full ratchet, many founders negotiate weighted-average anti-dilution, which is more balanced. It adjusts conversion price based on both the lower price and the number of new shares issued—softening the blow for everyone.
Other alternatives include narrow- and broad-based weighted average anti-dilution.
Narrow-based weighted average offers investors more protection, but it's less risky than full ratchet for founders.
Broad-based weighted average is a common middle ground for anti-dilution rights.
And finally, it may be possible to negotiate convertible debt with no anti-dilution in a hot market, but it is rare.
As a founder, your north star is balancing capital needs with cost and long-term control. Giving away full ratchet rights might solve today’s cash crunch, but it could sacrifice your future upside.
Find the right types of funding at the right times.
If you're curious about the best capital solutions for maintaining runway throughout your startup's growth journey, be sure check out Lighter Capital's Startup Funding Playbook.
