Ratchets: meaning, how they work in India and examples

The word comes from a tool that turns one way and not the other. In funding, a ratchet adjusts an investor's stake in one direction only: up, in the investor's favour. If a later round is priced below what the investor paid, the investor gets extra shares or a better conversion rate. If the later round is priced higher, the investor does not give anything back.

Ratchets are a form of anti-dilution protection. There are three versions that Indian term sheets mention: the full ratchet, the broad-based weighted-average ratchet and the IPO ratchet. They differ in how strong they are, and so in how much cost they put on the founders.

Ratchets matter most when valuations fall. In a rising market they sit unused in the agreement, which is why founders sometimes agree to them without much debate and discover the cost only after a down round, when the extra shares are issued.

A full ratchet resets the investor's price to the price of the new, lower round, whatever the size of that round. If the investor paid ₹100 a share and a new round is priced at ₹60, the investor is treated as if it had paid ₹60. A small, cheap round can therefore have a large effect.

Practitioner commentary describes full ratchets as rare in institutional Indian venture deals and more likely in distressed situations. They are tough on founders and other shareholders, because the extra shares come out of their stake. The sources reviewed do not settle how full ratchets work for foreign investors in every case, so a lawyer should confirm that.

This is the more common form. It also lowers the investor's effective price after a down round, but it takes into account how much money was raised and how many shares exist. A small down round moves the price a little, and a large one moves it more. The formula usually used is: new price equals old price times (A plus B) divided by (A plus C).

• A is the number of shares outstanding before the new round, counting all options and convertibles (this is why it is called broad-based).
• B is the number of shares the new money would have bought at the old price.
• C is the number of shares actually issued in the new round.
• The investor's conversion ratio then rises to old price divided by new price.

Agreements normally list exempt issues. These often cover shares given under the ESOP, shares issued on conversion of other instruments, shares issued in a bonus or split, and shares issued in a strategic deal approved by the investors. Without those carve-outs, even routine hiring grants could trigger an adjustment.

A founder reviewing a term sheet should ask for the list of exempt issues early, since a vague carve-out can turn a mild clause into an expensive one.

An IPO ratchet protects an investor against a listing at a low price. It promises a minimum return, or a minimum price, at the IPO. If the IPO prices below that level, the company or the promoters make up the gap, often by issuing extra shares to the investor before listing.

IPO ratchets are less common than anti-dilution clauses. According to law-firm summaries, special rights of this type generally have to end before shares are listed on an Indian exchange, so the investor's protection normally falls away at listing. A DRHP therefore often describes such rights as terminating. Check the current SEBI rules and the offer document for the specifics.

Most venture investors in India hold compulsorily convertible preference shares (CCPS), which must convert into equity shares within a set time. The agreement says how many equity shares each CCPS becomes. A ratchet changes that conversion ratio: from 1 for 1 to, say, 1 for 1.25.

The change is made in the ratio rather than in the price of the CCPS, because the price of the original issue is already fixed. Secondary commentary also reports that, under the foreign exchange rules, the conversion price for foreign-held instruments cannot fall below the fair value at the time of issue, which is another reason lawyers use the ratio. The Companies Act, 2013 section 55 and the Non-Debt Instruments Rules, 2019 apply, and the exact structure needs legal advice.

An investor who pays a high price for shares in a young company faces the risk that the value was too optimistic. A ratchet limits that risk by letting the investor's stake rise if a later round is cheaper. A founder who agreed to a high valuation may see the ratchet as a hidden discount: the headline price is high, but the real price falls if things go wrong.

Both sides can reach a middle path. Common compromises are the broad-based weighted-average formula instead of a full ratchet, a cap on the extra shares, an exclusion for options and small issues, and a time limit after which the protection falls away.

An extra share for the investor means a smaller share for everyone else. If the investor's conversion ratio rises from 1.00 to 1.25, it gets 25% more shares from the same CCPS. Those shares are issued at conversion, so the dilution falls on founders, employees and other holders, and the new round's investors dilute those holders too.

A founder looking at a term sheet should model the cap table in a down round, not only in the success case. Ratchets are often cheap to give when the company is doing well and costly when it is not.

A story about a down round may mention anti-dilution adjustments or the conversion of preference shares at a revised ratio. Those are the visible signs of a ratchet. The reverse also holds: if a startup raises at a higher price, no ratchet is triggered.

A ratchet is not the same as liquidation preference, which decides who is paid first in a sale. This guide is general information and not legal, tax or investment advice, so seek professional help for real deal terms.