Canada: Funding Your Start-Up: One Clause That Could Cost You Your Start-Up

Venture Capital firms (or VC's) often invest in early-stage start-ups with uncertain valuations. The terms of a VC's investment will often be heavily weighted in favour of the VC and may include downside protection. This means that the VC's investment will be protected in the event that the valuation of your start-up decreases in subsequent financings. One common method used by VC's for downside protection is known as a "ratchet" clause. A "ratchet" clause is an anti-dilution clause that works to protect, and in some circumstances can even increase, the VC's proportionate ownership of your start-up, if the value of your start-up diminishes over time.

A ratchet clause is often included in the terms of the convertible securities (such as preferred shares or convertible debt) that the VC is acquiring in connection with its investment. The clause operates by adjusting the conversion rate of the securities that the VC receives to reflect the issue price per share of subsequent financings.

There are a number of different types of ratchet clauses, including "weighted ratchets", "half ratchets", "two-thirds ratchets" and "full ratchets". A "full ratchet" clause operates by ensuring that the conversion price of the convertible securities held by the VC is adjusted to be the same as the issue price of securities issued in a later financing if the price per share has decreased. A "full ratchet" offers the most downside protection for the VC and is the most dilutive for the start-up. The other types of ratchet clauses provided lesser degrees of downside protection and dilution.

So, how much can this actually affect your ownership in your start-up? Let's look at an example:

You have a great new technology and things are moving quickly. You fly down to California and meet with a number of VCs who love you and your start-up! Life is good. You settle on your first venture capital investor (we'll call it VC-1) and complete your "series A financing". Under your series A financing, VC-1 invests $10 million for 25,000 series A preferred shares at a price per share of $400, which represent 25% of your company. The terms of the series A preferred shares provide that each series A preferred share is convertible into one common share.

So, VC-1 valued your start-up at $40 million. You and your other founders retain the remaining 75% equity represented through 75,000 common shares. At this point, the capital structure of your company is as follows:

  Securities (before conversion) Securities (after conversion) Ownership (on a fully diluted basis)
Founders 75,000 common shares 75,000 common shares 75%
VC-1 25,000 series A preferred shares 25,000 common shares 25%

You continue to build your start-up and find that you could use another cash injection to take your start-up to the next level. For any number of reasons, VC-1 says it will need to skip this round of financing, so you meet up with another venture capital firm (we'll call it VC-2) who decides to invest $5 million into your start-up. On completion of this "series B financing", VC-2 invests $5 million for 25,000 series B preferred shares with a price per share of $200. The terms of the series B preferred shares provide that each series B preferred share is convertible into one common share.

So, VC-2 just acquired 20% of your company and by doing so valued your company at $20 million post-investment. VC-1's $10 million investment is only worth $5 million based on this valuation. Since your start-up's value dropped, VC-2's investment is called a "down-round". The capital structure of your company would be as follows:

  Securities (before conversion) Securities (after conversion) Ownership (on a fully diluted basis)
Founders 75,000 common shares 75,000 common shares 60%
VC-1 25,000 series A preferred shares 25,000 common shares 20%
VC-2 25,000 series B preferred shares 25,000 common shares 20%

 

Now let's assume VC-1 negotiated the inclusion of a "full-ratchet" clause into the terms of the series A preferred shares. As a result, the conversion price of its series A preferred shares is adjusted down from $400 (the price per series A preferred share) to $200 (the price per series B preferred share). This changes your capital structure significantly. Now the 25,000 series A preferred shares held by VC-1 are convertible into 50,000 common shares:

  Securities (before conversion) Securities (after conversion) Ownership (on a fully diluted basis)
Founders 75,000 common shares 75,000 common shares 50%
VC-1 25,000 series A preferred shares 50,000 common shares 33.33%
VC-2 25,000 series B preferred shares 25,000 common shares 16.67%

 

If there were no full ratchet clause, the founders' 75,000 shares represented 60% of the equity in the start-up on a fully diluted basis after the series B financing. The full ratchet clause caused a transfer of 10% of the company from the founders to VC-1 (assuming VC-1 converts their preferred shares at that point) for no additional value. The net effect is that the founders gave up 25% equity for the $5 million investment by VC-2.

This situation compounds when you have multiple investors exercising ratchet clauses after a down-round, or investors modeling their investments to account for ratchet clauses in favour of other investors. This illustrates the importance of understanding not only the terms of each series of financing, but also how those financings interact as a whole. If you don't, you might find an unwelcome surprise if you give up more of your company that you ever wanted or intended.

While ratchet clauses may seem punitive to founders, it is important to remember that VC's take significant risks when investing in speculative start-ups. An anti-dilution clause like a ratchet is simply intended to protect the VC from a significant dilution of its equity position to mitigate some of the significant risk they face. Understanding the potential effects of a ratchet clause on the ownership of your start-up will assist both the founders and VC's in negotiating successful investments.

To view the original article click here

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.