Ratchet
A Ratchet is a protective provision in investment agreements that shields investors from potential losses in subsequent funding rounds or an Initial Public Offering (IPO). It ensures down-round protection by allowing investors to receive additional shares if a future financing round or IPO occurs at a lower valuation than the initial investment.
What it Means:
For investors in Indian startups, a Ratchet acts as a financial safety net. If the company faces a subsequent funding round or IPO at a reduced valuation, the Ratchet provision activates, mitigating the impact on investor returns by issuing additional shares at the predetermined level.
How to Calculate:
Calculating the impact of a Ratchet involves determining the number of additional shares issued to investors to maintain the agreed-upon valuation or return rate. This is often calculated based on the percentage difference between the IPO or subsequent round price and the initial investment price.
Why Measure:
Measuring the effectiveness of a Ratchet is crucial for both investors and founders. It ensures that the agreed-upon valuation and return expectations are maintained even in challenging market conditions, fostering investor confidence and protecting their financial interests.
Examples:
Imagine an Indian startup that secured an initial investment at a valuation of INR 100 crore. The investor includes a Ratchet provision stipulating a 20% annual return. If the IPO occurs at a valuation below the predetermined level, the Ratchet adjusts the conversion, issuing additional shares to investors to meet the agreed-upon return, safeguarding their investment.
Understanding Ratchets is essential for Indian founders navigating funding rounds and IPOs, providing a mechanism to balance investor protection with the startup's valuation growth.