Full Ratchet Anti-Dilution Protection
Full-ratchet, anti-dilution protection prevents an investor from being diluted at all from subsequent investment. Basically, the conversion price of the preferred stock (the price at which the preferred stock is converted to common stock) is reduced to allow the investor to convert the preferred shares into a given percentage of the outstanding common stock. Specifically, the conversion price changes to match the conversion price of shares issued in future rounds (if it is a “down round” where the conversion price is lower than in prior rounds). This allows the preferred shareholder to take advantage of an “up round” along with the common shareholders, and avoid any of the loss of value associated with a down round. In this case, the other equity holders (such as the entrepreneurs) bear the full weight of the dilution and the protected investor does not share the dilution. It can, however, negatively affect the ability to obtain later funding, due to the limiting effect on future issuances of stock. Basically, the preferred shareholder is less likely to participate in the next round as they are getting a conversion adjustment and receiving more shares without putting in additional value. Further, the follow-on investors will be paying less for the shares due to the earlier preferred shareholder’s conversion rights.
- Example: ABC, Inc., issues series A preferred shares at $1.00 conversion price (meaning the common shares were valued at $1). If the value of the stock drops to $.90 at the time of a series B issuance, then the series A shareholder will be able to convert her shares at $.90. This means the conversion ratio is 10/9. The series A shareholder will now receive an increased number of shares at conversion without putting in any additional capital.
- Note: If the series A investor does not participate in the series B financing, then the total percentage ownership in the startup will go down with the addition of total outstanding shares on an “as converted” basis.