The ratchet protects investors against dilution in future rounds of financing if the company raises funds at a lower valuation than the previous round, which is called a "down round".
Investors sometimes ask to have a Ratchet warrant attached to each of their shares.
This mechanism thus allows investors to adjust their level of participation in the company by subscribing to new shares in next round(s) at their nominal value to ensure the correction of the valuation of their participation, in case of a subsequent dilutive transaction at a price lower than the initial round price.
There are three formulas, more or less dilutive:
- the full-ratchet allows the average subscription price of the ratchet beneficiaries' shares to be reduced to the price of the new round;
- the narrow-based weighted average ratchet reduces the average subscription price of the ratchet beneficiaries' shares to a weighted average of the first round price and the new round price (calculated without taking into account shares issued prior to the first round);
- the broad-based weighted average ratchet reduces the average subscription price of the ratchet beneficiaries' shares to a weighted average of the first round price and the new round price (calculated, unlike the narrow-based weighted average ratchet, taking into account shares issued prior to the first round).
The full-ratchet is the most dilutive formula while the broad-based weighted average rachet is the least dilutive formula.
Please note that up to 10 shares can be issued following the exercise of one ratchet warrant (ratio 1 to 10).