Last week, we covered one little-known problem with convertible debt—unpriced multiple liquidation preferences. Here we’ll look at another hidden pitfall of convertible debt—the fact you’re giving investors full ratchet anti-dilution rights, which burns founders in a down round.
Here are some key things to understand a full ratchet and inadvertently giving away too much of your company to early investors.
What are anti-dilution rights?
Things that keep founders from being too diluted? 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. There are various types of anti-dilution protection, but weighted average is typical today. Full ratchet is the least entrepreneur-friendly anti-dilution right.
What is a full ratchet?
It is a complete repricing of a prior equity investment to any lower price per share that happens in a later round.
For example, Let’s say in 2015 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. Then in 2016 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 in 2016 is lower than the 2015 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 2015 investors and 1 million to the 2016 investors.
The net effect is that you, the entrepreneur, get significantly diluted, since all prior investment is now at the lowest per share price.
A full ratchet is the most investor-friendly anti-dilution provision. Today many VCs ask for either broad based or narrow based anti-dilution provisions, not full ratchet.
Why are you saying 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.
Too many times we talk with entrepreneurs who say, “We raised money at a $6M pre-money valuation with convertible debt.”
“You mean a $6M cap?”
“Oh, so you raised money with a capped upside for you and unlimited downside for you?”
They don’t generally like hearing that, but it’s true.
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 can add up very quickly.
Standard convertible debt terms allow noteholders to buy equity at a 15% to 30% discount, and that discount typically applies 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 an equity deal.
How can you prevent the full ratchet?
First, you need to get an experienced startup financing lawyer. There’s really no substitute for this to make sure you don’t build problems into 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.” (Done this many times myself!)
Have a valuation floor. You give them a cap, they give you a floor. Seems fair enough.
To be sure, investors deserve some adequate compensation for taking a risk on early-stage startups. Just be sure you aren’t giving away more than you intend to secure those early dollars.
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