Ratchet Clause — When founders lose their startup to venture capital firms
Have you ever heard stories of founders losing their startup to venture capital firms? Although not often, it does happen. Ratchet Clause is one of those terms that might kill startups.
What is Ratchet Clause?
Ratchet Clause is a provision that protects an option holder, or convertible holder, from any dilution of their investment in subsequent rounds of funding. The provision guarantees that if an equity investment sold in a subsequent funding round decreases the original investor’s equity ownership percentage, then they will be compensated by receiving additional shares sufficient to maintain their percentage of ownership at its original level.
In short, Ratchet Clause helps investors agree to contribute capital to ensure their stakes in the startup does not decrease in value in the following rounds of valuation in which the value of the company falls.
Example:
When startup’s value drops to $750,000 in series B funding round, according to Ratchet Clause, Series A investors are issued additional shares with new value to ensure the investment capital at the time of Series A funding is guaranteed.
At a valuation of $750,000, the $500,000-initial capital of Series A investor is equivalent to 67% of the company’s value. The founder instead of selling only 10% of the shares to Series B investors, startup founder has to issue an additional 17% of total shares to Series A investors because the value of the company has decreased and this complies to the Ratchet Clause in the previous round of funding.
Case: The collapse of Vietnam’s million-dollar startup The KAfe in 2017.
The KAfe was the first chain of coffee shops serving fusion cuisine (Eurasian style) in Vietnam. This was once the most famous cafe chain to Hanoi’s youth.
According to The KAfe Group’s Series B fundraising document, The KAfe invited investors to buy Series B shares, they included an anti-dilution clause on investors’ share ownership.
The KAfe’s fundraising process:
Angel Round: Dennis Nguyen and New Asia Partners
Series A: Cassia Investments with a capital of $5.5 million, equivalent to 50% of The KAfe’s valuation.
Series B: $20 million for 18% of The KAfe (unsuccessful).
The big capital of $5.5 million that Cassia Investment poured into The KAfe along with the Ratchet Clause puts Dao Chi Anh — the founder of the kafe under a terrible pressure.
When the capital in series A was almost exhausted, The KAfe still had to continue to open more restaurants in order to bring positive signals to investors in series B at the request of early stage investors. Conflicts in the views of founders and investors occurred. Investors wanted to raise more capital in series B for the purpose of rapid growth and profit, while the founder wanted a long-term development. In addtion, the pressure from the investment terms made Dao Chi Anh leave the CEO position of her own company.
What should we pay attention to?
Choose the right investor
There are investors called shark investors, who only have the goal of earning money, not a companion goal. Their priorities are to usurp power with the goal of making short-term profits from controlling the company and selling it, not with a long-term goal
Many financial investors aim to this goal. Therefore, the order of priority for investor consideration should be: Partners in the same industry => Investment funds in the same industry => Financial investment funds.
Be careful in negotiating terms of investment
Investors will impose targets on growth and profit, and if the founders are unable to meet the targets, they will increase the percentage of ownership and acquire the company. Startups are not likely to build their own proactive financial strategy from the beginning. Subsequently, when they are in need of money, they will blindly accept all investors’ requests.
In addition, they often forget negotiating an Incentive package (income, including salary and bonus) for founders. The Incentive package is normally placed in every deal, but investors often ignore it, and startups don’t know how to negotiate.
Conclusion
Fundraising isn’t fun. But it’s an important process. It’s truly a marketplace where the validity of your idea is challenged and where your progress since your last time in the market is measured.
