If You’re a Startup Founder, Beware of This ‘Hard Period’ of Investors

The game has changed for early-stage investing, and not in a good way for founders.

Mac Conwell, venture capitalist at Rarebreed Ventures took to twitter this week To warn the founders that it is adding a provision known as a “full ratchet” to early-stage agreements to allow more investors.

When a portfolio company’s valuation drops after an investment, a dilution provision, the full ratchet favors the earlier investors. As Conwell explains, “If a company raises money in the form of a lower valuation or share price in the future, earlier investors reinvest their equity to match the new low price.”

In a so-called “down round,” your earlier investors may own significantly more than the company you bought earlier, at a 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 $5m valuation, those first investors will now own half of your company, And you may no longer have complete control over decision making.

If you are an early stage company and a potential investor wants to include a full ratchet in the deal, what should you do? Conwell’s advice is clear: “As a founder at an early stage, if you see it…. run.”

However, there is one scenario where Conwell suggests you should not focus on a full ratchet. If you’re a late-stage company hoping to exit soon, using full-ratchet can be a way to meet with investors midway through 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 will be closer to $1.5 billion. A full ratchet will allow you to take the investor’s money at a relatively high valuation, while protecting the investor against a low-valuation exit.