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Ratchet

An anti-dilution mechanism that protects a series of preferred stock by automatically adjusting the conversion price to a lower price in the event that the preferred series was issued at a higher amount. If the common stock is later sold at a lower price than the investor paid per share, the investor may be entitled to additional shares equal to what he could have purchased with the same amount of money if the stocks had originally been at the lower price.

The goal of the full-ratchet is to help early investors maintain their percentage ownership. An investor might buy enough shares to have a 10 percent investment stake in the company. When prices go down, he is entitled to more shares in order to maintain that 10 percent stake. Keeping the initial percentage stake is especially important if doing so confers the stakeholder with voting rights and other mechanisms for direct involvement in company decisions.

 

A secondary goal of the full-ratchet is to encourage early investing and protect early investors. If an initial investor pays $5 per share, only to see the price drop in subsequent rounds, he would be dissuaded from early investing in the future.

 

EXAMPLE:

Ratchet – if the conversion price of Series A Preferred Stock is $1.00 – equal to the initial purchase price per share – and XYZ sells its Series B stock for $0.25 per share, then the Series A conversion price would be adjusted from $1.00 to $0.25.