Let me take this a step further.
A ratchet is a term whereby, if another VC later pays a lower price for shares in your start-up … the VC that bought shares earlier with the ‘ratchet’ protection gets a price adjustment to that lower price.
On the surface, actually, it doesn’t seem that awful.
But its impact varies based on stage.
In early-stage investing, a ratchet is viewed as highly non-standard, at least in Silicon Valley. If a VC invests at $1 and the company is later worth $1000 a share, do the founders get a ratchet and take away the VCs’ $999 gain? No 🙂 So why should the VCs get one the other way?
So a ratchet in a typical early-stage investment in a U.S.-style internet tech co. is rare and because of that, a bit of a flag even.
[ Also, early stage VCs probably don’t like ratchets b/c it’s the later guys that benefit from them, to their detriment … if the Series A guy buys at $0.10 a share, and the B guys buy at say $1.00 a share with a ratchet, and the Series C guy buys at $0.50 … the Series B investor gets “ratcheted” down to $0.50 per share, but really it’s only the Series A guy and the founders that take the dilution from this ratchet, as the B guys are simply issued 2x the shares they had before. So it makes sense very early-stage VCs wouldn’t like ratchets for reasons that don’t have all that much to do with being founder-friendly 🙂 ]
Later stage, I’m more zen about it. If you are trying to raise a round at $3 billion before your IPO … and the valuation you are asking is kind of crazy, kind of way ahead of public comps … and the round isn’t oversubscribed … i’m not sure what the issue is.
It helps you agree to disagree. I’ll pay your (in my opinion) inflated price. But if I’m right, and you’re wrong, and the IPO is only at $2 billion … we adjust the price to $2 billion. Or 85-90% of $2 billion so at least I have some profit.
Doesn’t seem the end of the world to me. And public markets seem to agree. They don’t seem terribly bothered by ratchets in late-stage valuations.