Full Ratchet Definition
Full ratchet is a special type of provision that safeguards the interests of investors from dilution which is a result of new stocks issued at a price less than the actual amount invested by investors or shareholders. Hence, such protection lets the investor to retain his portion of ownership that is similar to the initial investment value.
A Little More on What is Full Ratchet
For example, if an investor holds a 10% stake in a company by paying $2 for each share, he or she would receive more number of shares for keeping the stake as 10% in case the company goes for the second round of financing. So, if the company issued its shares at $1 per share, the first round investor can do the conversion of his or her shares at $1 per share, and ultimately, hold the double quantum of shares.
The main goal of full ratchet is to make sure that the existing shareholders of the company don’t have to compromise on their ownership stake when the company devises another round of financing. It is referred to as anti-dilution as the objective is to protect the dilution of shareholder’s initial stake when new securities are issued.
Besides protecting the stake of shareholders from dilution, a full ratchet provides cost benefits, provided the price made in the first round is more than the price quoted in the subsequent rounds of financing.
This permits a shareholder to sustain his or her percentage stake without needing any excessive funds for investment. This is calculated by making the conversion of price offered for existing shares to the given number of shares that the investor could have bought given the same amount of funds at a lesser price.
Full Ratchet in Practice
There are many companies that ask shareholders to have a certain percentage of shares to enjoy such privileges. Also, investors can find it beneficial because having less than standard percentage of shares would result in restricted voting rights that they had before the next rounds of financing.
If the organization hopes to have a favorable momentum, then investors might look forward to retaining the similar percentage. This would ultimately translate into better returns if the value of shares increases, particularly in the short run. It can also save them from short-term risks arising due to exclusive public offerings. As such exclusive shares are available at discounts, or can be possessed without incurring any additional costs, it may result in lowering the value of existing shares as the assets of the company are allocated among an increasing quantum of shares.