The recent IPO of Square, Inc. has many taking a closer look at Silicon Valley and their “unicorns”. In a previous blog post I discussed how “For Unicorns, It’s a Long Road Out of Silicon Valley.” While its a difficult journey for unicorns, its a little easier on investors because of “ratchets”. If you are the CEO/CFO of a microcap public company, the ratchet concept is probably very familiar to you (although you may be familiar with terms like market conversions, downside protection, market adjustment, etc.). For those of you unfamiliar with the concept, Investopedia defines a “full ratchet” as;
“An anti-dilution provision that, for any shares of common stock sold by a company after the issuing of an option (or convertible security), applies the lowest sale price as being the adjusted option price or conversion ratio for existing shareholders.”
Simply put, ratchets allow companies to raise capital at high valuations by promising investors, that if shares are issued at a lower price, they will have their investment repriced at the new (lower) price or a discount to the new price. For public companies the ratchet is usually based on market price or some calculation thereof. For private companies the ratchet is usually based on the valuation of future private funding rounds, an IPO price, or the sale price (if the company gets acquired).
Those in the micro-cap space know that virtually every funding deal has a ratchet because of volatility in the market and substantial risk. Often, those in the micro-cap space think the ratchet is an aspect unique to small public companies. What many don’t know is that even Silicon Valley unicorns have ratchets in their funding transactions.
According to law firm Fenwick & West LLP, about 30 percent of private unicorns have/had a ratchet in place with at least some of their investors. In the case of Square, some investors were “guaranteed returns of as much as 20 percent on their investments“. Whats more, in addition to ratchets, unicorn funding transactions also include things like liquidation preferences, board seats, and controlling preferred stock (just to name a few). If you’re a micro-cap CEO, next time an investor asks for downside protection just sit back and smile because at least you’re not a unicorn!
Ben Kotch is a managing director and investment committee member at Acquis Capital, LLC, a private investment firm that specializes in acquisition funding. He has extensive experience with both private and public companies. Ben graduated with an economics degree from Bentley University where he concentrated in entrepreneurship and law.