[Legal Q&A] What’s the worst clause in a termsheet?

Question: What is the one term/clause/function you hate seeing in Capital Raising documents for your founders and wish was abolished forever?

Answer: I truly despair about “full ratchet” down provisions in the anti-dilution sections of angel/venture capital amended charter documents. Full ratchet provisions grant investors immunity from down rounds by adjusting the conversion to common equity price of the preferred they acquire to equal the same lower price per share at which the company may subsequently issue common equity after their initial investment.

I believe this provision grants investors a status in the company that is unwarranted–providing almost a guaranty against any dilution of their position in the company, unlike any other company participant, and without further investment on their part.  Once an investment is made, I believe it is warranted that the angel/venture capital investor  share the risk of a down round with all other participants in the company, or at least be protected from that risk with a more even-handed “weighted average” formula (allowing the conversion price to float down based on the magnitude of the sale price reduction balanced against the size of the new investment and the percentage ownership of the prior investor in the company) that includes specific carve-outs from the application of the formula to a price reduction on subsequent issuances (e.g., issuances pursuant to stockholder approved employee plans or issuances in other than capital raising transactions, such as mergers and acquisitions).

The absolute guaranty against dilution provided by full ratchet terms distorts the relationships between Company participants, stretching the separation that already exists between the common and preferred equity holders. I much prefer the better alignment between the investment classes that comes with the weighted average–combined with sensible  carveouts to applicability– formula. This allows company management to run the Company and recommend the issuances of equity even at reduced prices when it makes sense, without risking a total realignment of investment interest in Company equity as a result of that decision.

Answer provided by – Peter Rothberg, Partner at Duane Morris, Ultra Light Startups sponsor and counsel.