Anti-Dilution Ratchets in VC Term Sheets: Should Venture Capitalists Enforce Them?
A recent post by a former entrepreneur-turned-VC reminded me of a basic VC term sheet truth: Everything is negotiable. In particular, clauses that don’t work as intended because they target scenarios that don’t exist. After leading dozens of term sheet negotiations over the years, I came to the conclusion that those who write them don’t live with their consequences. Founders should know about these clauses to negotiate them out of VC term sheets. On the VC side, Investors’ interests would be better served by focusing on more critical points. In this first part in a series of articles dedicated to VC term sheets, I address ratchets, anti-dilution mechanisms meant to protect VCs from down rounds. After explaining how ratchets work and showing detailed calculations, I’ll explain how to negotiate them off term sheets.
In This Article
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VC Term Sheet: “Everything Is Negotiable”
In a compelling narrative shared through a recent X post, Xavier Helgesen, a seasoned entrepreneur and Investor through Enduring Ventures, drove home a fundamental principle of VC term sheets: “Everything is negotiable.”
Helgesen highlighted a critical oversight in how Founders, often naively, view Venture Capital documents. He pointed out that many entrepreneurs enter into agreements focusing solely on the best-case scenario—where every stakeholder profits as planned.
However, reality tends to unfold differently. Startups navigate situations where cash flow doesn’t align with optimistic projections, leading to unplanned bridge funding and valuations falling short.
Most naive businesspeople, myself included (previously), take these documents as gospel. When things go down or sideways, the most important thing that should happen is a negotiation.
Xavier Helgesen – Enduring Ventures (Source: X)
Helgesen argues that in such moments, the imperative action is negotiation, aimed at realigning all parties’ expectations with the prevailing business conditions rather than the theoretical scenarios envisaged at the deal’s inception. Unfortunately, Founders rarely initiate such renegotiations.
A practical example from Enduring Ventures’ experience illustrates this point. The firm led a turnaround acquisition worth $2 million, primarily through a seller note. According to the original terms, the Founders would have ended up with nothing due to existing liquidation preferences favoring the Investors.
Recognizing the need for the Founders’ cooperation in the turnaround and leveraging the Investors’ preference for a partial recovery over a total loss, Helgesen proposed a renegotiation. This led to the Investors converting their holdings to common stock and accepting dilution, which allowed the Founders to retain 50% of the proceeds. The result was beneficial for all parties: Investors could exit the investment satisfactorily, and the motivated Founders actively contributed to revitalizing the business.
In his negotiation, Helgesen solved a common conflict arising from liquidation preference in Venture Capital, described in the article below.
My own experience echoes Helgesen’s. A few years ago, I had to unravel terms I had negotiated as an Investor a few years before.
We had structured our investment in a digital media agency in two parts: €3 million to buy shares from a departed Founder and €4 million in convertible bonds, a debt instrument that would eventually convert into equity. The bonds bore a 15% PIK (for “payment-in-kind”) interest rate, which means that it compounded yearly until it was repaid in cash or in shares.
Founders often underestimate the compounding effect. A €4 million bond would balloon to €12.2 million by its maturity date eight years later. In our case, the interest had risen to about €7 million—the facility had been drawn in two installments a year apart.
The problem was that the company had not delivered on its original plan, which was to massively invest in resources to go from €1 million EBITDA to a multiple of that in a few years. (The perils of investing in “people businesses” will be the topic of another article.) As a consequence, the €7 million bond represented 100% of the company’s market value.
In essence, our convertible bond functioned like a non-participating liquidation preference with a 15% cumulative dividend. If we were to sell the business, the Founders would not receive anything. It was the same situation described by Helgesen in his X post.
Why Anti-Dilution Clauses Exist
The main message I want to convey in this series of articles is that VC term sheet negotiations must rely on a deep understanding of what they mean to do. Too often, practitioners serve the “That’s how we do it” argument. They end up negotiating clauses that don’t work because the scenario they target doesn’t exist.
The digital media agency situation is a case in point. If we had insisted, as Investors, on upholding our preference, we would never have exited this investment. Any acquirer would indeed require having part of the proceeds go to the Founders, who would be instrumental in the company’s next growth phase. They would have added an earn-out element based on performance. By contrast, financial shareholders such as ourselves would have received all our proceeds at the sale’s closing.
Given the company’s limited growth rate, the negotiating power would most certainly have tilted in the acquirer’s favor. Few firms would agree to disburse €7 million to make the Investors whole. Funnily enough, it’s a point I made to my ex-colleagues as an advisor to the company. I had left my PE firm to work solo and had been retained to help negotiate this point. Since I was the one originally structuring the deal, it made things easier for everyone.
Many entrepreneurs fail to consider the combined effect that preferences and ratchets can have when estimating the payment they will receive even from a successful exit.
Keith Brown & Kenneth Wiles (Source: Journal of Applied Corporate Finance, 2016)
Applying this logic, it is crucial to understand why anti-dilution clauses exist to be better positioned to negotiate ratchets. Anti-dilution clauses protect Investors from the dilution of their equity stake in subsequent financing rounds, especially when those rounds are at a lower valuation than when they initially invested.
The simplest anti-dilution clause is denominated “Right to Participate Pro Rata in Future Rounds” in the US NVCA Term Sheet template. It stipulates that Investors have pro rata rights granting them the right, but not the obligation, to participate in future funding rounds to preserve their ownership percentage. These rights are valuable for Investors who are bullish on a company’s prospects and wish to “double down” on their investment as it grows.
As I’ll mention below in more detail, ratchets operate under a different logic. They’re not about opportunity but the (misguided) belief that it is desirable to own more of an underperforming company.
How Ratchets Work
Ratchets are contractual provisions in VC term sheets designed to protect the investment value of early Investors in the event of a down round. A down round occurs when a company raises capital at a valuation lower than the valuation during the previous fundraising round. Down rounds are up in troubled economic times and VC market resets periods.
Ratchets adjust the ownership percentage of early Investors to compensate for the reduced valuation, ensuring they maintain the value of their initial investment relative to the company’s current valuation. There are mainly two types of ratchets:
- Full Ratchet: This is the more aggressive form of ratchet. If a full ratchet is in place, and a down round occurs, the conversion price of the earlier preferred stock is reduced to the price at which new shares are issued in the down round. This means that the early Investor’s earlier shares are now converted into a greater number of shares, effectively diluting the Founders and other shareholders but not the early Investors. This recalibration is based on the lowest price at which new shares are issued, regardless of the amount being raised or the size of the dilution.
- Weighted Average Ratchet: This is a less severe form of adjustment than the full ratchet. It modifies the conversion price of the preferred stock previously issued, but the new price is a weighted average of the old price and the new price at which shares are issued during the down round. This method considers both the new share price and the number of new shares being issued, leading to less severe dilution for the Founders and other shareholders compared to a full ratchet.
Full ratchets are by far more punitive for Founders. I’ll get back to it after explaining how the weighted average ratchets, which are more common, work.
Weighted Average Ratchets: Definition & Calculation
The US NVCA Term Sheet template labels the ratchet clause Anti-Dilution Provision, reproduced below. By default, it shows the formula for weighted average ratchets.
The conversion price (CP) refers to the price at which preferred stock can be converted into common stock. This price is critical because it determines how many shares of common stock the preferred stock can be converted into.
The footnote to this clause notes that “the most broad-based formula would include shares reserved in the option pool; a narrower base would exclude options or other convertibles. The formula above is the most typical.”
To illustrate how weighted average ratchets work, let’s walk through a numerical example.
Let’s assume that a company raised a seed round with Angels and a $5 million Series A round with VCs at a $15 million pre-money valuation, corresponding to a $15.00 price per share. The cap table post-Series A is:
- Founders: 67.5%
- Angels: 7.5%
- Series A Investors: 25%
Unfortunately, the startup fails to deliver on its initial plan and needs more funding to get to the next stage.
A new $5 million round is led by New Investors at a $10 million pre-money valuation—half of the previous round’s post-money valuation of $20 million or $7.50 per share.
To know how many shares the Series A holders get from the ratchet, we must calculate the new Series A conversion price using the formula above. Our assumptions are:
- CP1 (Series A Conversion Price before new issue): $15.00
- A (Total number of shares of Common Stock deemed to be outstanding immediately prior to new issue): 1,333,333 shares
- B (Aggregate consideration received by the Company for the new issue divided by CP1): $5,000,000/15 = 333,333.33
- = C (Number of shares of stock issued in the new round): 666,667 shares
We calculate the new conversion price, CP2, plugging in the values in the formula:
CP2 = $15.00 * (1,333,333 + $5,000,000/$15.00) / (1,333,333 + 666,667) = $12.50
The new Series A conversion price after the new issue (CP2) would be $12.50, 17% lower than the initial price due to the down round. This reflects the weighted average adjustment of the conversion price due to the new issue of shares at a different valuation.
After ratchet shares are issued, the cap table becomes:
| Shareholders | No Ratchets | Weighted Avg Ratchets |
|---|---|---|
| Founders | 45.0% | 42.6% |
| Angels | 5.0% | 4.7% |
| Series A Investors | 16.6% | 19.3% |
| Series B Investors | 33.4% | 33.4% |
| TOTAL | 100.0% | 100.0% |
The ratchet diluted existing shareholders (mostly Founders) by an extra 270 basis points and boosted Series A Investors’ ownership by 16%. While it may not seem much, dilution may be steeper with different assumptions. I also mention below why even a few percentage points may draw Founders’ ire.
Refer to the webinar for detailed calculations, which are easier to demonstrate visually than explain in writing. Note: The calculation necessitates an iteration function as the Series B Investors get diluted by the ratchet.
Full Ratchets: Definition & Calculation
In contrast to a weighted average ratchet, a full ratchet applies the reduced price per share of the new round to all the shares owned by previous Investors.
In our previous example, the conversion price of the Series A preferred shares is adjusted to match the new round’s price per share. So, if Series A Investors originally bought shares at $15.00, and the new Series B price is $7.50, the full ratchet adjusts the Series A price to $7.50 as well.
In this case, the cap table becomes:
| Shareholders | No Ratchets | Full Ratchets |
|---|---|---|
| Founders | 45.0% | 29.9% |
| Angels | 5.0% | 3.3% |
| Series A Investors | 16.6% | 33.4% |
| Series B Investors | 33.4% | 33.4% |
| TOTAL | 100.0% | 100.0% |
With a full ratchet, Founder dilution is much more significant. The Series A Investors may end up with a higher ownership than after the previous round.
Again, watch the webinar for detailed calculations.
Why VCs Should Not Enforce Anti-Dilution Ratchets
In many cases, ratchets don’t make sense and can even prove counter-intuitive. There are three reasons and scenarios why VCs should not enforce them, and Founders may be better off negotiating removing them from term sheets altogether.
Ratchets Demotivate Founders At The Worst Time
Entrepreneurs often place immense personal and emotional investment into their ventures, viewing the company’s valuation as a reflection of their success and worth. Fundraising Founders, in particular, view each valuation milestone as a testament to their vision and hard work.
Down rounds are disheartening to Founders on several levels. First, they stain their successful trajectory. Until then, the company grew admirably, raising funds at high valuations. A down round may translate into a more challenging exit and an entirely different wealth outcome. Second, down rounds signal that the market may not value their efforts as highly as before, which can be psychologically demoralizing.
Adding extra dilution from ratchets may further impact Founders at a critical time when they are not only the most fragile but also need to be highly motivated to navigate the company through the challenging periods materialized by the down round.
They need to innovate and drive the business forward, but a drastic increase in dilution due to the enforcement of a ratchet can deepen the blow, potentially leading to reduced motivation and commitment.
Ratchets Lead To Incentive Asymmetries & Moral Hazard
From the VC’s perspective, enforcing the ratchet clause might mean more protection, but it may backfire.
Excessive dilution of Founders can lead to incentive asymmetries, disaligning the interests of Founders from those of the Investors. This misalignment means that what motivates one party might not necessarily align with the interests of the other party. For instance, the VC firm might push for a quick exit at mid-range valuations to focus on other portfolio companies, whereas Founders might be more interested in long-term growth in the hope of creating some wealth for them.
In extreme cases, this situation might lead to moral hazard. Founders, feeling significantly less invested in the company’s financial success due to diminished ownership stakes, might not exert the same level of effort or might make riskier decisions that do not align with Investors’ preferences.
VCs who joined the industry in the last upcycle may not be aware of such dangers, and enforce highly dilutive ratchets at their perils.
Ratchets Don’t Make VC-Level Returns
Venture Capital fundamentally thrives on high-risk, high-reward investments, and its success metrics are often governed by the power law: a small number of investments need to yield exceedingly high returns to compensate for the majority that does not perform as expected.
Despite its lure, compensating a lower potential outcome by significantly increasing ownership through mechanisms like ratchets does not always align with the fundamental VC strategy.
Rather than focusing on gaining a larger share of a potentially less valuable company, it may be more prudent for VCs to acknowledge the hit from a down round and focus on supporting the company towards achieving the kind of breakout success that can deliver returns of 10x to 100x.
Such support not only boosts Founder morale but also aligns long-term goals, fostering a more collaborative effort toward achieving exponential growth.
Another option is to recognize that this ship has sailed and move on.
Conclusion: tl;dr
VC term sheets are crafted with provisions intended to protect investors’ interests. However, experience has demonstrated that some of these clauses may not function as intended. Often, the scenarios they anticipate do not exist, or the consequences of enforcing these provisions can prove counterproductive to the relationship between Founders and Investors and the VCs’ outcome.
Provisions like anti-dilution ratchets are designed to protect Investors from the financial implications of a down round but fail to consider the broader impact on Founder motivation.
I believe Investors and Founders should view term sheets as frameworks that cannot accommodate the often unpredictable nature of startup growth. A crucial skill is to project potential scenarios and support the alignment of incentives, while also considering the psychological dimensions at play.
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