Ratchets . . .

are powerful forms of antidilution provisions which investors sometimes request in connection with fundings. In a ratchet, the investor is given additional shares of stock for free if the company later sells shares at a lower price. The number of free shares the investor receives is enough to make the investor’s average cost per share (counting all of his purchased and free shares) equal to the lower price per share given to the later investor. What makes the ratchet so powerful is that the first investor is given these extra shares regardless of the number of shares purchased by the later investor.

For example, if an investor who has a ratchet purchases 100,000 shares of company stock for $200,000, or $2 a share, and the company later sells another investor 100,000 shares for $1 each, the first investor would receive another 100,000 shares for free. The result would be the same if the second investor bought only one share for $1.

Ratchets can also be tied to options or warrants. When they are, the investor receives extra shares when he exercises his option. When ratchets are tied to conversion prices, as in convertible preferred stock, the extra shares are received at conversion. Other types of antidilution provisions employ weighted average or other fairness mechanisms that give the investor fewer shares when the second investor purchases fewer shares. See: Antidilution Provisions, Dilution (Percentage), Weighted Average Antidilution.