VC Ratchets + The Square IPO
Wow - it’s been quite some time since I’ve written a blog post. I apologize for the delay. It’s been a pretty hectic month between school, soccer, and the summer internship hunt. Nevertheless, I think that I have a pretty informative post prepared, and I’m excited to share it with you all. This piece will be discussing the ratchet, a provision in venture capital that is often misunderstood given its complexity. As of late, it has become increasingly important to understand the role of ratchets in venture financing, particularly in the context of later stage investments. This is because private investors have been providing capital at valuations that are traditionally earned through the public market, so protective provisions (ratchets) have become more and more common.
A perfect example of this can be seen with Square — a mobile payments company that recently held its initial public offering (IPO). The venture community was abuzz because later stage investors had their ratchets triggered during the IPO, potentially driving down the share price. With so much confusion among public market investors about how / why ratchets affected the IPO, I thought that it would be prudent to write a post explaining ratchets in greater detail.
Essentially, a ratchet is an anti-dilution provision that protects VCs in the case of a “down-round.” A down-round is when a new investor is buying shares at a valuation that is lower than a previous investor. In the case of Square, public market investors had the opportunity to buy shares at a valuation that was lower than the valuation used for previous, private investors, so the private investors had their ratchets triggered. The ratchets reduced the share price at which the private investors converted their debt to stock, which effectively increased the number of shares that they were able to purchase.
Yes, I know, that was some pretty technical language, but I think that a few examples will make this topic much more clear. Each example that I provide for you will relate to a different type of ratchet, as there are various levels of protection and complexity.
The first type of ratchet is known as a “full ratchet,” and full ratchets provide the most protection for the VC / private investor. At the same time, it is important to note that a full ratchet will cause the most harm to the entrepreneur. When a full ratchet is in place, a VC firm will adjust its share price to whatever is the share price of the down-round. Let’s run through a quick example:
Originally, an investor offers $400K at a $600K pre-money valuation
• There are 600,000 shares outstanding, including 100,000 options, so the investor buys 400,000 new shares at $1/share to buy 40% of the company
• Pre-money = $600K; Post-money = $1M
• The investor now owns 40%, the entrepreneur owns 60%, and both parties agree to a full ratchet
In the next round, another investor offers $500K at a $500K pre-money valuation
• If the investor offers $500K, he/she is valuing the business at:
• Pre-money = $500K; Post-money = $1M
• There are 1M shares outstanding (600K entrepreneur, 400K past investor)
• So, the new investor gets 1M shares
• New investor: $500K / 1M shares = $0.50/share
• Old investor: $400K / 400K shares = $1/share
The full ratchet kicks in for the old investor…
• If the new investor is getting stock for $0.50/share, the first investor will get the same.
• $400K / ($0.50/share) = 800K shares
• The old investor now has 800K shares
BUT WAIT
• With the old investor now owning 800K shares, there are 1.4M shares outstanding…
The new investor is giving $500K
• $500K / 1.4M shares = $0.36/share
• Well, now the old investor has to recalculate his/her shares
• $400K / ($0.36/share) = 1.12M shares
• Shares outstanding = 600,000 (entrepreneur) + 1.12M = 1.72M
This process CONTINUES to iterate until…
• The share price is less than $0.17/share
• The new investor buys 3,000,012 shares
• The old investor gets 2,000,010 shares
• The entrepreneur is left with 500,000 shares and 100,000 options
As you can see, a full ratchet can be extremely harmful to the entrepreneur. After a raising a very small down-round, the entrepreneur is left with ~10% of his/her business, with the investors owning ~90%. This means that the burden of responsibility is almost entirely on the entrepreneur’s shoulders if the company is forced to raise a down-round; it is the entrepreneur that must face the financial repercussions. As a result, entrepreneurs very rarely agree to such a risky provision, so “weighted ratchets” have been developed to protect the VC / private investor but split the financial burden.
The first type of weighted ratchet that I would like to discuss is the “narrow-based” weighted ratchet. A narrow-based weighted ratchet provides some protection for the VC / private investor, and it causes some harm to the entrepreneur. When a narrow-based weighted ratchet is in place, a VC firm / private investor will take into account the dilutive impact of a down-round and only calculate additional stock based on current outstanding securities (does not include options and other convertible securities). Much like before, I think that the best way to explain a narrow-based weighted ratchet is through an example. I will also provide a formula for your reference.
Originally, an investor offers $400K at a $600K pre-money valuation
• There are 600,000 shares outstanding, including 100,000 options, so the investor buys 400,000 new shares at $1/share to buy 40% of the company
• Pre-money = $600K; Post-money = $1M
• The investor now owns 40%, the entrepreneur owns 60%, and both parties agree to a narrow-based weighted ratchet
In the next round, another investor offers $500K at a $500K pre-money valuation
• Because there is 1M shares outstanding, the investor gets 1M new shares
• Pre-money = $500K; Post-money = $1M
• New CP = $1/share * (900K + (($500K / ($1/share))) / (900K + 1M)
• New CP = $0.7368/share
• Original investor: $400K / ($0.7368/share) = 542,888
• Original investor only has 400,000 shares prior to the fundraise
• 1,142,888 new shares issued (1M new investor, 142,888 old investor)
As you can see, a “narrow-based” weighted ratchet may dilute the entrepreneur, but it does not have the iterative impact of a full ratchet. A narrow-based weighted average does not take into account outstanding options and convertible notes, so the common stock outstanding number is lower, causing the new conversion price to be slightly higher than it otherwise could be. This brings us to the final type of ratchet, the “broad-based” weighted ratchet. The only difference between a narrow-based and broad-based weighted ratchet is that the outstanding options and convertible notes are taken into account when determining the new conversion price. After taking into account these shares, the new conversion price becomes slightly higher, and the entrepreneur suffers from less of a dilutive impact. The broad-based weighted ratchet provides the least amount of protection for the investor. Here’s an example:
Originally, an investor offers $400K at a $600K pre-money valuation
• There are 600,000 shares outstanding, including 100,000 options, so the investor buys 400,000 new shares at $1/share to buy 40% of the company
• Pre-money = $600K; Post-money = $1M
• The investor now owns 40%, the entrepreneur owns 60%, and both parties agree to a narrow-based weighted ratchet
In the next round, another investor offers $500K at a $500K pre-money valuation
• Because there is 1M shares outstanding, the investor gets 1M new shares
• Pre-money = $500K; Post-money = $1M
• New CP = $1/share * (1M + (($500K / ($1/share))) / (1M + 1M)
• New CP = $0.75/share
• Original investor: $400K / ($0.75/share) = 533,333
• Original investor only has 400,000 shares prior to the fundraise
• 1,133,333 new shares issued (1M new investor, 133,333 old investor)
Altogether, ratchets can clearly impact a fundraising round. Different types of ratchets offer different levels of protection to VCs / private investors, so it is important that entrepreneurs understand this topic before agreeing to any term sheets. I would always advise both entrepreneurs and private investors to have a lawyer review outstanding term sheets before agreeing to a deal.
In the case of Square, investors were putting in such massive amounts of money that they insisted on a ratchet. Because the IPO offered shares at a lower valuation than the private investment, the old investors were issued additional shares to compensate for the down-round, and these additional shares may dilute the value of the public stock.
I hope that after learning more about ratchets, the Square situation now makes a bit more sense. If you happen to have any questions or comments, feel free to write a response to this post. I look forward to writing again soon.