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By Andrew Gordon on July 10, 2015 Dear Early Investor,
In my last article, we discussed protections against future down rounds. You learned how liquidity preferences and discounts offered in convertible notes work.
Today you'll learn another way to protect against loss. It's called the "full ratchet."
The full ratchet is not new. It's been around for a while.
But it has become much more popular recently.
Here's one way to rationalize its use: As valuations creep higher, the full ratchet is needed to offset price risk.
Here's a better way to explain it: Increasing use of these full ratchets encourages valuations to rise beyond what they would normally fetch.
How the Full Ratchet Is Done
There are basically two types of converting provisions... - Suppose the IPO is a down round - going for a lower share price than the previous round. Then this provision kicks in, giving investors more shares. Like a magic bullet, they get paid the IPO price.
- Another provision actually prevents a startup from going public under certain circumstances - if, for example, its IPO price is less than what the investor paid in the previous round.
Fenwick & West recently analyzed the terms of 37 companies with valuations of $1 billion or more (in the 12-month period ending March 31).
It found that this was done about 30% of the time.
Do No Harm?
This practice not only gives preferential treatment to deep-pocketed investors, but also could hurt early investors.
It's simple math. The issuance of more shares dilutes your stake.
Increasing the supply of shares also puts downward pressure on share price.
Nor does the second provision align with the interests of early investors.
An IPO that makes early investors a great deal of money could be blocked by later investors under the second provision mentioned above.
Here's an example...
A pre-IPO company has a post-money valuation of $10 billion. And it wants to do an IPO at an $8 billion valuation. It can't. Even though the majority of investors in the company would benefit hugely, including the founders themselves!
So why would founders agree to provisions that could bite them in the backside? |
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| Here's a wild guess...
Greed.
Mind you, we can't blame the VCs. They're not investing this late. The valuations are too high and the returns too low.
The mutual funds, hedge funds, sovereign wealth funds and corporate investors are the culprits. They comprise 75% of those who invest in the pre-IPO rounds.
Because these startups wait so long to IPO, they supposedly share the same risk profile of new public companies.
I disagree. The price risk is now much higher in many cases.
These provisions wouldn't be necessary if late-stage investors didn't feel prices were overstretched.
Founders, of course, love getting $1 billion or more valuations for their startups. They get to raise more money and cash out at bigger sums.
It's the classic "you scratch my back and I'll scratch yours" deal.
Why shouldn't they ride higher prices for all it's worth?
Sweetheart Deal
Big institutional investors would probably adopt the "no harm no foul" stance in defense of the extremely favorable terms they get.
Does the SEC agree? Seems so. In words or actions, I haven't seen the SEC object to such practices.
Well, it should be objecting. Big investors are misleading you. It absolutely can harm the everyday investor.
Legal or not, the whole thing stinks.
Big investors should NOT be allowed to invest in companies with huge growth potential at zero risk while smaller early-stage investors (like you and me) invest in these same companies without such guarantees.
I have a problem with that.
And the full ratchet is to blame.
Bad Consequences Inevitable
Founders and early investors need to be wary. You know what they say. When something is too good to be true...
These ratchet provisions allow valuations to go higher and higher while dodging adverse consequences to the investing parties negotiating and ultimately setting the valuation.
Founders think they've hit a gold mine.
But nothing good can come from a world without consequences. What they're really doing is digging a pretty deep hole for themselves.
These high valuations create higher growth expectations. And that, in turn, requires bigger fundraising amounts to fuel faster growth.
I'm noticing this dynamic more and more these days.
It can't go on forever.
At some point, the money runs out.
At some point, the company gets too big to meet growth expectations.
It's one thing to grow 100% year over year when you're small. It's much harder when you're big.
I believe a day of reckoning looms.
It reminds me of how the banks and their inscrutable financial engineering (referring particularly to Collateralized Debt Obligations) burst the housing bubble in 2008 and nearly took down the global financial system.
What we're grappling with now is a very different kind of financial engineering. It's not nearly as clever or inscrutable but it's just as dangerous.
And it's leading us to what could be a bad ending.
Invest early and well,
Andrew Gordon
Founder, Early Investing
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