The Weighted average Ratchet method adjusts the conversion price for a stock. (Conversion price is a price per share at which a convertible share, such as a preferred share can be converted into a common stock). Basically we have early investors who have an conversion price of say A, then we have a second round of investment and these new investors receive preferred share at a lower conversion price say B.
So to avoid protect the interest of first investors and avoid this price variation, the first investors always insist in having a clause in their agreement that protects their interests. The Weighted average adjusts conversion price based upon two points:
a) The amount of money raised during the first investment and price per share offered during that time.
b) The amount of money being raised during subsequent investments and the price per share at which this money is raised in the subsequent investments.
So the weighted average method results in a new conversion price which will be lower than the conversion price that was present during the first round of investment.
There are two types of ratchets, broad based and narrow based ratchets. Difference between the both would be that in broad based calculation we use all the shares ie both common stock and preferred share for calculation of weighted average price, while for narrow based ratchet we use only the common stock that is outstanding for Calculation of the weighted average price.
The Formula for broad based weighted average ratchet would be as below:
[(Price of first round)*(Shares raised in first round)] + [(Price of second round)*(Shares raised during second round)] / Total outstanding shares
Suppose we say that in first round of investment we raise 100000 at $1 price and say after few months we receive a second round of investment of 200000 at $2. Then if we calculate the weighted average price according to the above formula we get the weighted average price as $1.667.