TLDR:
A ratchet is an anti-dilution protection mechanism that adjusts the conversion price of preferred shares downward if new shares are issued at a lower price, protecting early investors from dilution in a down round.
Ratchet Mechanics in Different Structures
Ratchet provisions appear in several financial instruments with similar but distinct mechanics. In convertible debt and preferred stock, anti-dilution ratchets adjust conversion prices downward when new shares are issued at lower prices. In warrants and options, ratchets (often called ‘anti-dilution adjustments’) modify the exercise price and/or the number of shares covered. In earnout agreements, performance ratchets create contingent additional payments if target metrics are exceeded. Understanding which type of ratchet applies in a given instrument is crucial to modeling the financial impact correctly.
How Ratchet Provisions Function
Ratchet anti-dilution provisions reset the conversion price of preferred shares to the lowest price at which any new dilutive issuance occurs. A “full ratchet” applies this reset regardless of the size of the new issuance — even a tiny down-round issuance can dramatically reprice large preferred positions. A “broad-based weighted average ratchet” considers the size of the new issuance relative to total shares, producing a more moderate adjustment. Most venture deals use the weighted-average variant, with full ratchet reserved for distressed or punitive scenarios.
Practical Impact at Exit
Aggressive ratchet provisions can dramatically reshape exit waterfalls in down-round scenarios. A full-ratchet Series A facing a sharp Series B down-round can see its conversion price drop by 50% or more, doubling its effective ownership and pushing common stockholders (founders and employees) deeper into the waterfall. Founders should model multiple exit scenarios — base case, conservative case, and stress case — when accepting ratchet provisions during financing negotiations.