How Does A Ratchet Clause Affect Startup Investment?

Maya runs a SaaS startup in Melbourne. She has just received a term sheet from an investor offering $300,000, which feels like the next big step for the business. Then she spots a clause saying the investor gets anti-dilution protection if the next round is at a lower valuation.

That one clause can change who owns what later. It may not matter if your valuation keeps climbing, but if you raise a down round, a ratchet clause can shift more ownership to the investor and dilute you and your co-founders.

This is one of those funding terms that sounds technical, but the founder decision is practical: how much future dilution are you willing to accept, and what can you negotiate before you sign?

What Is A Ratchet Clause In A Startup Investment?

A ratchet clause in a startup investment is a contractual anti-dilution protection that adjusts an investor's position if your company later issues shares at a lower price.

In simple terms, the investor is saying: if I invest now at one price and the company later raises money at a cheaper price, I want some protection so I don't wear the full impact of that lower valuation.

You'll usually see this in a term sheet, subscription agreement, convertible note or SAFE-style document, and then carried through into your shareholders agreement or constitution. It often sits alongside other investor rights, such as:

• pre-emptive rights to participate in future capital raises
• information rights, such as regular management reports
• reserved matters that need investor consent
• liquidation preferences on an exit or winding up
• rights attached to preference shares

In Australia, ratchet clauses are usually a matter of contract rather than a special statutory right. The Corporations Act 2001, your company constitution and your shareholders agreement still matter because they control how shares are issued, what approvals are needed and what rights attach to each class of shares.

The key point is this: a ratchet clause isn't just legal wording. It can affect your cap table, your voting dynamics and how attractive the company looks to future investors.

How Can A Ratchet Clause Affect Your Future Ownership?

A ratchet clause can reduce your future ownership because it may give the protected investor more shares, or a better conversion ratio, if you raise money at a lower share price later.

Let's use a simple example.

Say you and your co-founder own 1,000,000 ordinary shares. An investor puts in $250,000 at $1 per share, so they receive 250,000 preference shares. After that round, the investor owns 20% on an as-converted basis.

A year later, growth is slower than expected and you need to raise again. The new investor is only willing to invest at $0.50 per share. They invest $250,000 and receive 500,000 shares.

Without Any Ratchet

If the first investor has no ratchet protection, the cap table after the new round looks roughly like this:

• Founders: 1,000,000 shares, about 57.1%
• First investor: 250,000 shares, about 14.3%
• New investor: 500,000 shares, about 28.6%

With A Full Ratchet

If the first investor has a full ratchet, their $1 conversion price may reset to $0.50. Their 250,000 preference shares may then convert as if they had invested at $0.50, giving them 500,000 shares on conversion.

After the new round, the cap table could look roughly like this:

• Founders: 1,000,000 shares, about 50%
• First investor: 500,000 shares, about 25%
• New investor: 500,000 shares, about 25%

That difference is significant. Your founders' stake has dropped from about 57.1% to 50% before you even consider option pools, adviser shares or later capital raises.

The exact outcome depends on the clause wording, share classes, option pool and how the formula works. That's why you want the numbers modelled before you agree.

What Is The Difference Between A Full Ratchet And Weighted Average Anti-Dilution?

A full ratchet is usually more investor-friendly, while weighted average anti-dilution is usually a more balanced approach for founders and investors.

Both are designed to protect an investor from a down round, but they do it differently.

Full Ratchet Clause

A full ratchet usually resets the earlier investor's conversion price to the price paid in the later down round, regardless of how many shares are issued in that later round.

This can be harsh for founders because even a small down round can trigger a large adjustment.

For example, if an investor came in at $1 per share and you later issue a small number of shares at $0.50, a full ratchet may still treat the earlier investor as if they invested at $0.50. The size of the later issue may not soften the impact.

Weighted Average Anti-Dilution

Weighted average anti-dilution adjusts the conversion price using a formula that takes into account both:

• the lower price of the new shares
• the number of new shares issued

Using the example above, a broad-based weighted average formula might adjust the first investor's conversion price from $1 to about $0.857, rather than all the way down to $0.50. Their as-converted shares might increase from 250,000 to about 291,667, instead of 500,000.

This still protects the investor, but it doesn't transfer as much dilution to the founders.

You may also see narrow-based and broad-based weighted average formulas. A broad-based formula usually counts more shares and options in the calculation, which often produces a less severe adjustment for founders. The wording matters a lot.

Should A Ratchet Clause Be In Your Shareholders Agreement?

It depends, but if the investor has negotiated anti-dilution rights, the shareholders agreement and constitution need to deal with them clearly.

A term sheet is usually not enough on its own. It sets out the commercial deal, but the binding mechanics often sit in the final transaction documents. If the documents don't line up, you can end up with confusion later when you try to raise another round.

For an Australian proprietary company, you should check how the ratchet interacts with:

• your constitution and any rights attached to preference shares
• your shareholders agreement and issue of shares provisions
• director powers to issue shares under the Corporations Act 2001 and your company documents
• shareholder approval thresholds for new issues or variation of rights
• pre-emptive rights held by existing shareholders
• employee share schemes or option plans
• the company's share register and ASIC lodgements

If a ratchet is triggered, the company may need to update its register of members and lodge share changes with ASIC, often through the usual company change process. Many share issue changes must be lodged within 28 days.

You should also think about future fundraising rules. Chapter 6D of the Corporations Act 2001 regulates fundraising disclosure. Many startup raises rely on exemptions, such as offers to sophisticated or professional investors, but the right pathway depends on who you're offering shares to and how the raise is structured.

The practical goal is simple: future investors should be able to read your documents and understand exactly what happens if you issue shares at a lower price.

What Negotiation Points Should You Raise Before Signing?

You can often negotiate a ratchet clause, especially at term sheet stage before the commercial position becomes locked in.

The best approach is to turn the clause into specific questions. Don't just ask whether it's fair. Ask what it does to your ownership under likely scenarios.

Here are practical points to raise with the investor and your lawyer:

• Full ratchet or weighted average: Can the clause be changed from full ratchet to broad-based weighted average?
• Trigger events: Does it only apply to a genuine priced equity round, or could it be triggered by convertible notes, SAFEs, options or small strategic issues?
• Excluded issues: Are employee options, adviser shares, founder shares, pro-rata issues and shares issued for acquisitions excluded from the calculation?
• Minimum raise threshold: Does the down round need to be above a minimum amount before the ratchet applies?
• Time limit: Does the protection end after the next qualifying financing or after a fixed period?
• Pay-to-play: Does the investor need to participate in the down round to receive anti-dilution protection?
• Founder dilution cap: Is there a cap on how much extra dilution the ratchet can cause?
• Board and shareholder approvals: Who needs to approve the share issue that triggers the ratchet?

A pay-to-play clause can be particularly useful. It means an investor may only receive the benefit of the ratchet if they keep supporting the company by investing their pro-rata share in the new round.

Your negotiating position will depend on demand for the round, your runway, your valuation and the investor's leverage. Even if the investor won't remove the ratchet, you may be able to narrow when it applies.

What Should Your Lawyer Review In The Investment Documents?

Your lawyer should review the ratchet clause together with the full funding package, because anti-dilution rights rarely operate in isolation.

A clause may look acceptable in the term sheet but become more founder-unfriendly once it interacts with preference share rights, option pool expansion, future issue approvals and reserved matters.

A useful review should cover these documents:

• term sheet
• subscription agreement, investor rights agreement or share purchase agreement
• shareholders agreement
• company constitution
• preference share terms
• option plan, employee share scheme documents or share vesting arrangements
• cap table and fully diluted ownership model
• company records, including your share register, and ASIC records, including current officeholders and lodged share/member details

If you're preparing your own issue notes before speaking to a lawyer, use this outline. It's not a finished legal document, and it should be tailored before you rely on it.

1. Current Cap Table: List each shareholder, share class, options and fully diluted percentages.
2. Proposed Investment Terms: Record the investment amount, valuation, share price and share class.
3. Ratchet Type: State whether the clause is full ratchet, narrow-based weighted average or broad-based weighted average.
4. Trigger Events: Describe exactly which future share issues will activate the clause.
5. Excluded Issues: List employee options, founder shares or other issues that shouldn't trigger the adjustment.
6. Worked Scenarios: Model at least two future rounds, including a down round and an option pool increase.
7. Approvals Needed: Note board, investor and shareholder approvals under the constitution and shareholders agreement.
8. Records And Lodgements: Identify share register updates and ASIC forms that may be needed after a share issue.

Good legal review should leave you with a clear founder decision: accept the clause, negotiate it, or change the economics of the round to reflect the extra dilution risk.

Key Takeaways

• A ratchet clause in a startup investment can change your ownership if you later raise money at a lower share price.
• A full ratchet usually favours the investor more strongly than a weighted average anti-dilution clause.
• The real impact only becomes clear when you model the numbers on your cap table.
• Your shareholders agreement, constitution and preference share terms should all line up before you sign.
• You can often negotiate trigger events, exclusions, time limits, pay-to-play rules and dilution caps.
• Australian companies also need to manage Corporations Act, ASIC and fundraising requirements when issuing shares.

If you'd like help with reviewing your investment term sheet, negotiating your shareholders agreement, or modelling how investor rights affect your cap table, you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.