A ratchet provision is a protective mechanism in a funding agreement that automatically adjusts an investor's ownership percentage if the company later raises money at a lower valuation than they originally paid.
When your company raises funding at a lower share price than a previous round (called a "down round"), ratchet provisions kick in to compensate earlier investors.
The provision recalculates their original investment as if they'd paid the new, lower price, effectively giving them more shares for free.
This protects their investment but significantly dilutes founders and other shareholders.
Full ratchet provisions are the harshest-they reset the investor's price per share to match the lowest price in any future round, regardless of how much money is raised.
Weighted average ratchet provisions are more founder-friendly, as they calculate a blended price that considers both the new lower price and the amount of money raised, resulting in less dilution for existing shareholders.
Investors use ratchet provisions as insurance against their investment losing value if your company struggles and needs to raise money at a reduced valuation.
They're essentially protecting themselves from the risk that they've overvalued your company.
These provisions are particularly common in uncertain market conditions or for riskier ventures.
You should pay close attention to ratchet provisions during any funding negotiation, but especially in your first institutional rounds.
Full ratchet provisions can be devastating to founder ownership in a down round-potentially reducing your stake by 20-40% or more.
They can also make future fundraising harder, as new investors will be wary of existing ratchet provisions.
Absolutely-ratchet provisions are negotiable terms, not standard requirements.
Many founders successfully negotiate them out entirely or convert full ratchet provisions into the more reasonable weighted average version.
Your negotiating power depends on how competitive your fundraising process is and how badly investors want into your deal.
