Beware The Death Spiral Of 'Full Ratchet' Anti-Dilution

Today's uncertain economic environment, coupled with the

tightening of available capital from venture capital funds, has

marked the return of a dangerous price protection device:

"full ratchet" anti-dilution. This device, generally

included in the terms of preferred stock issued to new investors,

seeks to protect those investors from being diluted by a subsequent

financing at a lower valuation — the so-called "down

round" — by causing an adjustment to the applicable

conversion rate for the preferred stock.1

To understand how this works, here is an example that assumes a

company issued its Series A Preferred Stock at $5.00 per share.

These shares would ordinarily be convertible into common stock

upon an initial public offering (IPO) and certain other events on a

one-for-one basis — that is, upon conversion, the holder

would receive one share of common stock for each share of Series A

Preferred.

The full ratchet conversion formula, however, would provide that

if in the future, any additional shares of preferred stock or

common stock are issued at a lower price than the per-share price

paid for the Series A Preferred, then the conversion rate for the

Series A Preferred shares will be adjusted so that upon conversion,

the holders of Series A Preferred will receive as many shares of

common stock as if they had originally purchased Series A Preferred

shares at the same lower price paid for the subsequent

round, regardless of the size of the round relative to prior

financings.

For example, if in the next round the Series B Preferred was

issued at $2.50 per share, the full ratchet would cause the

conversion rate for the Series A Preferred shares to be adjusted

downward from the original $5.00 to $2.50 and the holders of Series

A Preferred would be entitled to convert each share of Series A

Preferred into two shares of common stock, whereas the

Series B Preferred holders would receive only one share of

common stock for each share of Series B Preferred. This provision

"protects" the Series A Preferred investors by making

sure that they will always get the benefit of the lower-priced

shares issued in later financing rounds.

What is the problem with this provision? The answer is simple.

From a practical standpoint, as seen in the example below, the

anti-dilution protection will result in additional shares being

issuable to the holders of Series A Preferred, which means that the

company will have to issue more shares to the new investors to get

them to the desired ownership percentage of the company. The

dilutive effect on the ownership percentages of the founders and

management can be severe and destabilizing for the company. As a

result, most investors would not want to come in as new investors

and put money in...