There are two principal ways to formulate antidilution provisions, capitalizing the terms to make it clear we are talking about the ones which have substantive bite- the "Full Ratchet" and the "Weighted Average." Full Ratchet provisions are the real killers, at least from the founder's point of view. They provide that, if one share of stock is issued at a lower price, or one right to purchase stock is issued at a lower aggregate price (exercise price plus what is paid, if anything, for the right), then the conversion price of the existing preferred shares is automatically decreased, that is, it "ratchets down," to the lower price. Depending on how many shares (or rights) are included in the subsequent issue, this can be strong medicine. A brief example will illustrate. Assume Newco, Inc. has one million common shares and one million convertible preferred shares outstanding; the founder owns all the common, and the investors own all the preferred, convertible into common at $1 per share. Newco then issues 50,000 shares of common at .50¢ per share because it desperately needs $25,000 in cash. To make the example as severe as possible, let us say the investors control the board and they make the decision to price the new round of financing at .50¢. Suddenly the preferred's conversion price is .50¢, the founder goes from 50 percent of the equity to under 33.3 percent, and all the company has gained in the bargain is $25,000. Indeed, a Full Ratchet would drop the founder from 50 percent of the equity to 33.3 percent if the company issued only one share at .50¢. This is a harsh result, indeed. When a really dilutive financing occurs, say shares have to be sold at .10¢ per share, the founder drops essentially out of sight. The company takes in $5,000 and the founder goes down under 10 percent, never to recover because he does not have the cash to protect himself in subsequent rounds. In the jargon of venture capital, he has been "burned out" of the opportunity. There is no other provision so capable of changing the initial bargain between the parties with the dramatic effect of Full Ratchet anti-dilution. When venture capitalists are referred to as "vulture capitalists," it is likely the wounded founders are talking about dilutive financings and a Full Ratchet provision.
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