The game has changed for early-stage investments, and not in a good way for founders.
Venture capitalist Mac Conwell of RareBreed Ventures took to Twitter this week to warn founders that he's seeing more investors adding a provision known as "full ratchets" into early-stage agreements.
An anti-dilution provision, full ratchets favor earlier investors when the valuation of a portfolio company decreases post-investment. As Conwell explains, "if a company raises money in the future as a lower valuation or share price, then the earlier investors get their equity readjusted to match the new lower price."
In a so-called down round, your earlier investors could end up owning substantially more of the company than they purchased at your earlier, higher valuation. If you sell 25 percent of your company to your first investors at a valuation of $10 million and give them a full ratchet, but then raise more money at a $5 million valuation, those first investors would now own fully half of your company, and you might no longer have full control over decision-making.
What should you do if you're an early-stage company and a potential investor seeks to include a full ratchet in the deal? Conwell's advice is plain: "As a founder in the early-stage, if you see this ... RUN."
However, there is a scenario where Conwell suggests you shouldn't mind a full ratchet. If you're a later-stage company expecting an exit soon, using a full-ratchet can be a way to meet investors in the middle when it comes to valuation. Conwell gives the example of a founder who believes his company will sell in the range of $4 billion, while an investor believes the exit would be closer to $1.5 billion. A full ratchet would allow you to take the investor's money at a relatively-high valuation while providing the investor protection against a lower-valuation exit.