For some time, high-tech, start-up firms have slowed in their progression to an IPO, typically going through multiple rounds of private financings (sometimes six or more). Concomitantly, mutual funds have become significant investors in these later round private placements, in the hopes of stealing a march on those rival funds who wait for the IPO before investing. Finance scholars have noted that mutual funds behave very differently than venture capital firms in this process. While the VC firms focus their negotiations on board representation and monitoring, Harvard Business Professor Josh Lerner and his co-authors in a recent study find that mutual funds largely ignore monitoring rights, but focus instead on contractual protections that protect their expected rate of return. In particular, mutual funds seek two types of provisions: (1) redemption rights that allow them to escape (possibly if the IPO is delayed), and (2) a pricing “ratchet” that entitles them to additional shares in the event that the IPO prices below the valuation reflected in the final private-equity round. See Chernenko, Lerner and Zeng, “Mutual Funds as Venture Capitalists: Evidence from Unicorns” (available on SSRN). Thus, a poor IPO outcome (a “down round” in the vocabulary) may entitle the holders of this ratchet provision to additional shares that place them in the same (or nearly the same) economic position as if the IPO had priced at a level equal to the last private-equity round valuation. Effectively, they are held harmless (or relatively so) from the risk of a “down round,” but public investors suffer twice (both when the IPO price falls and again when dilutive shares are issued under the ratchet).

Although these ratchet provisions are often described as “anti-dilutive,” the accuracy of this description depends on your perspective—because the issuance of the additional shares can be highly dilutive both to the public investors in the IPO (who may already be disappointed that the IPO fell below the anticipated pricing level) and to those who bought (without a ratchet provision) in earlier private equity rounds. In the case of WeWork’s recent spectacularly failed IPO, the principal holder of the ratchet provision was SoftBank, the Japanese investment bank whose billionaire founder, Masayoshi Son, had long been WeWork’s principal backer. According to a computation by Renaissance Capital, LLC, which specializes in analyzing IPOs, the ratchet clause held by SoftBank would have entitled it to more than $400 million in additional shares if WeWork’s IPO were to come in with less than a $14.5 billion valuation. If the IPO came in as low as $10.5 billion, the shares to which SoftBank (and certain other holders of similar ratchet clauses) would have been entitled jumped to slightly over $500 million. Today, WeWork is probably worth well less than $10 billion, and thus the share issuance would have been even higher.