Full ratchet anti-dilution

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A full ratchet anti-dilution formula provides that the conversion price of an investor's securities will be automatically decreased, upon the issuance of additional securities, to the same price that such additional securities are "sold" by the company. The conversion price is the price by which one share of preferred stock (using preferred as the convertible security) converts into common stock, by dividing the original issue price (the price an investor paid for a share of preferred stock) by the conversion price. The lower the conversion price, the more shares of common stock one share of preferred stock will convert into. A typical full ratchet anti-dilution provision would read as follows: "In the event this Corporation shall issue Additional Shares of Common Stock (including Additional Shares of Common Stock deemed to be issued) without consideration or for consideration per share less than the applicable Conversion Price in effect on the date of and immediately prior to such issue, then and in such event the Conversion Price of the Series A Preferred shall be reduced, concurrently with such issue, to the lowest price at which any of the Additional Shares of Common Stock are issued."

An example of the effect of a full ratchet anti-dilution formula is as follows: Investor A purchased 1,000,000 shares of Series A Preferred Stock of Company X at $1.00 per share at a pre-money valuation of $3,000,000 for a 25 percent stake, on a post-financing basis ($4,000,000), in Company X (we assume as is usually the case each share of Series A Preferred initially converts into one share of common stock). One year later, Company X sells 1,000,000 shares of Series B Preferred Stock at $0.50 per share (again convertible one-to-one into common) at a pre-money valuation of $2,000,000 for a 20 percent stake, on a post-financing basis ($2,500,000), to Investor B. With no anti-dilution protection, Investor A would own 20 percent of Company X after the sale of the Series B Preferred Stock (1,000,000 shares out of 5,000,000 shares). However, the full ratchet anti-dilution provision in Company X's charter provides that the conversion price for the Series A Preferred Stock that Investor A purchased for $1.00 per share will be reduced to $0.50 per share, such that upon conversion, Investor A would be entitled to receive 2,000,000 shares of Company X common stock upon conversion rather than 1,000,000 shares. What will really happen is that Investor B will take into account this anti-dilutive effect into its term sheet to allow it to maintain its percentage interest at 20 percent, thus further crushing Company X's founders and holders of common stock (including optionees). However, the real issue here is that full rachet adjusts the Series A Preferred Conversion price regardless of the number of shares of Series B Preferred actually sold at the dilutive price. Therefore, the issue is one share of Series B Preferred issued at $0.50 per share will have the same impact on the Company from an ant-dilution adjustment standpoint.