Friday, May 04, 2007

Beef of the Week: the Term Sheet Ratchet

As term sheet season winds down to summer, just a reminder to founders: not all terms commonly used in a VC term sheet are terms of art. If a term has a range of meanings, make sure it is defined precisely in a term sheet, particularly if it affects share price.

In particular, make sure you are clear about what is meant by a term sheet reference to anti-dilution mechanisms.These are the provisions which adjust the original subscription price paid by a VC if a future investment is made at a lower price. The investors' rationale for these provisions is twofold:(a) as a new investor, they do not wish to assume the risk that the valuation they agree to is too high; and (b) they need to preserve as much economic value as possible.

Many term sheets still refer to "customary anti dilution mechanisms." Some try to be clearer by referring to "weighted average" and "full" ratchets. These are not the real terms of art, and there is some difference in what most think they are. Make sure you get clarity.

A full ratchet is a compete repricing of the shares originally issued - a capital mulligan. A weighted average mechanism generally takes into account the number of shares actually sold in the down round. Two types of weighted average adjustments are often used: broad based (usually, refers to calculating the average of all convertible securities plus options) or narrow-based (adjustment calculated based on issued shares only). Broad based is more favourable to you as it shares the pain of a lower share price.

Now go forth and issue shares.

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