Meaning
Price protection mechanisms adjust the conversion rate of preferred shares to the lowest price offered in any subsequent financing round. A full ratchet ensures that early investors maintain their economic position regardless of how few shares are sold at the lower price. It governs the relationship between early capital and later down rounds.
The adjustment stops once the conversion to common stock occurs or the specific protection period expires.
Downward Adjustment
Shareholders without this protection face a much larger reduction in ownership percentage during a down round. The full ratchet represents the most aggressive form of anti dilution protection available in a term sheet. It places the entire cost of a valuation drop on the shoulders of the founders and employees.
Investor Protection
New participants seek this provision when they perceive a high risk of a valuation decline. Because a full ratchet can be extremely punitive to common holders, its presence makes future fundraising more difficult. New investors might demand that existing holders waive these rights before they commit capital.
This creates a point of friction during the recapitalization of a struggling company. The capacity of the company to attract new talent is diminished when the common pool is heavily diluted.
Mathematical Consequence
The adjustment ignores the volume of the new shares issued at the lower price. Under a full ratchet, a single share sold at a low price triggers the conversion price drop for the entire protected class. This mechanism produces a sharp increase in the number of shares held by the protected investor.
It significantly alters the cap table with minimal external investment.
