A Startup’s Guide to Ratchets & Other Anti-Dilution Provisions

Callum Ritchie February 11, 2025

For startups, raising capital is a significant milestone, but it also comes with risks, particularly in the form of equity dilution. For founders, protecting their ownership stakes is crucial, and understanding anti-dilution provisions, particularly ratchets, is key to safeguarding their interests during venture capital negotiations.

This guide breaks down ratchets and other anti-dilution provisions to help you navigate the complexities of venture capital funding rounds.

What is Equity Dilution?

Equity dilution occurs when a company issues new shares, reducing the ownership percentage of existing shareholders. This often happens during additional funding rounds or when share options are exercised. While dilution is common in startups, anti-dilution provisions can protect investors from losing equity when new shares are issued.

What Are Anti-Dilution Provisions?

Anti-dilution provisions are crucial contractual mechanisms used in venture capital financing to protect investors from a reduction in the value of their equity holdings when a company issues new shares at a lower valuation than previous funding rounds. These provisions adjust the conversion price of the investor’s preference shares or result in the issue of additional shares to the investors, ensuring that investors maintain a more favourable economic position despite a “down round.”

A “down round” occurs when a company raises capital at a lower valuation than its previous round. This often results in dilution, meaning that existing shareholders’ ownership percentage decreases. Anti-dilution provisions are designed to mitigate the impact of such dilution for investors, often at the expense of founders and early-stage common shareholders.

Methods of Anti-Dilution Protection

Anti-dilution provisions work through two primary methods:

Adjusting the Conversion Rate – Preference shares can convert into a higher number of ordinary shares by lowering the conversion price.
Issuing Additional Shares – Investors may receive additional shares to compensate for the loss in value, maintaining their ownership percentage.

Types of Anti-Dilution Provisions

There are two primary types of anti-dilution provisions: full ratchet and weighted average. Each has a different impact on equity distribution and company control.

Full Ratchet Anti-Dilution

Mechanism: Full ratchet anti-dilution is the most investor-friendly provision. It adjusts the conversion price of the investor’s preference shares to the lowest price at which new shares are issued. Alternatively, it may involve issuing additional shares to investors to compensate for the dilution.

For example, if an investor initially purchased preference shares at £1.00 per share, but the company subsequently issues new shares at £0.50 per share, the conversion price of the existing preference shares is adjusted to £0.50 per share, or additional shares are issued to maintain the investor’s ownership percentage.

Impact:

Significantly protects investors from dilution.
Greatly reduces the percentage ownership of founders and early investors.
Can create an overly punitive dilution effect, making it harder for the company to attract future investors.
May discourage management and early employees due to their reduced ownership stake.

Example Calculation:

An investor initially holds 1,000,000 shares purchased at £1.00 per share.
The company later issues 2,000,000 new shares at £0.50 per share.
Under full ratchet, the investor’s price is lowered to £0.50, effectively doubling their shares they would receive upon conversion or, if additional shares are issued instead, the investor will receive an amount of new shares to maintain their original ownership percentage.

Weighted Average Anti-Dilution

Mechanism: Weighted average anti-dilution takes a more balanced approach by adjusting the conversion price based on the number of new shares issued and the price at which they are sold. This method provides a fairer adjustment compared to full ratchet, as it considers the broader equity structure and averages the price across different fundraising rounds taking into account the issued share capital of the company. Similar to full ratchet, this method can also involve issuing additional shares instead of adjusting the conversion rate.

Types of Weighted Average Anti-Dilution:

Broad-Based Weighted Average: Takes into account all shares, including share options and warrants, leading to a more moderate dilution impact.
Narrow-Based Weighted Average: Considers only the new shares issued in the down round, leading to a slightly more significant dilution effect on existing shareholders compared to the broad-based method.

Example Calculation (Broad-Based Weighted Average):

The company originally had 5,000,000 shares outstanding.
An investor held 1,000,000 preferred shares purchased at £1.00 per share.
The company issues 2,000,000 new shares at £0.50 per share.
Applying the weighted average formula, the adjusted conversion price would be £0.77 per share, rather than £0.50 (as would be the case in full ratchet).

Impact:

More equitable for both investors and founders.
Less punitive compared to full ratchet, making future fundraising more feasible.
Founders retain a larger portion of equity compared to full ratchet.
Still offers reasonable protection to investors in the event of a down round.

Key Considerations for Founders and Investors

For Founders:

Negotiation Strategy: Founders should aim for broad-based weighted average anti-dilution rather than full ratchet, as it is less dilutive and allows for greater flexibility in future fundraising.
Long-Term Equity Impact: Overly protective investor provisions can make it harder to attract new investors or incentivize employees through stock options.
Convertible Notes and ASAs: Some early-stage financing instruments include automatic conversion terms, which can be influenced by anti-dilution clauses.
Trigger Events: Define when anti-dilution provisions are triggered, limiting them to specific scenarios such as a down round.
Cap on Dilution: Negotiate a cap on how much dilution can occur.

For Investors:

Protection Against Devaluation: Ensuring an anti-dilution provision is in place safeguards against loss of value if a down round occurs.
Balancing Protection and Growth: While full ratchet provides strong protection, it may discourage future investment rounds. Weighted average provisions often strike a better balance.
Voting Rights and Board Influence: Investors should consider whether an anti-dilution provision aligns with their overall influence in company decision-making.

‘Pay to Play’ Provisions

The “pay to play” provision is designed to encourage investor participation in future funding rounds while ensuring that only active investors retain the benefits of anti-dilution protection. This mechanism prevents passive investors from benefitting from protective provisions without contributing additional capital.

How Pay to Play Works

If an investor with anti-dilution protection chooses not to participate in a new funding round by purchasing their pro-rata share of newly issued securities, they risk losing some or all of their protection. This is typically enforced by converting their preference shares into a separate class (often referred to as the “pay to play class”) which maintains preferential rights but no longer includes anti-dilution adjustments.

This approach ensures that investors are incentivised to support the company’s growth rather than merely benefitting from protective provisions without financial commitment. It also prevents inactive investors from obstructing future fundraising efforts, as they cannot use their class rights to veto critical funding decisions.

For startups and founders, incorporating a pay to play clause can help maintain a stable investment base and attract committed long-term investors. For investors, it serves as a safeguard against dilution but comes with the responsibility of continued financial support.

FAQ’s

1. How can founders negotiate fair anti-dilution provisions?

To ensure fairness in equity financing, founders should:

Advocate for broad-based weighted average anti-dilution instead of full ratchet.
Set up pay to play provisions to ensure only committed investors benefit from protections.
Work with legal and financial advisors to ensure that anti-dilution clauses do not hinder future fundraising efforts.

2. Can anti-dilution provisions be waived or modified?

Yes, anti-dilution provisions can be waived or modified if the company’s investors and board agree to do so. This may happen in cases where strict anti-dilution terms make it difficult to attract new investors or if all parties recognise the need for more balanced financing terms.

Summary

Anti-dilution provisions, play a vital role in venture capital and startup financing. While these provisions protect investors, they can also significantly impact the equity structure and future fundraising potential of a company. Founders should carefully negotiate these terms to balance investor protection with long-term company growth, while investors must ensure they receive adequate downside protection without hindering the company’s ability to scale.

How we can help

If your company is preparing for a fundraising round or considering agreeing to anti-dilution provisions with investors, we offer a 20-minute discovery call to discuss your situation in further detail. Our team at The Jonathan Lea Network can provide expert advice on structuring your investment agreements.

Please email wewillhelp@jonathanlea.net providing us with any relevant information ensuring that any call we have is as productive as possible or call us on 01444 708640. After this call, we can then email you a scope of work, fee estimate (or fixed fee quote if possible), and confirmation of any other points or information mentioned on the call.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.