Ratchet

A ratchet is a clause that adjusts a party's ownership or return depending on later events. Depending on how, for example, the company value develops, the allocation of shares may shift. This creates incentives or balances risks between the parties. In buyout structures a ratchet forms part of the management incentive plan: once the investor clears defined return thresholds at exit, expressed as a money multiple or an internal rate of return, management's share of the remaining proceeds increases in steps.

The thresholds, the size of each step and whether the adjustment is stepped or sliding are all negotiated, because a hard step just below a threshold can create perverse incentives around the timing of an exit. In venture capital the term carries a different meaning and refers to the adjustment mechanism of anti-dilution protection, particularly in its full ratchet form. What the two usages share is the underlying idea of adjusting ownership retrospectively depending on a measurable event. In both cases a model across several scenarios is needed for assessment, because the effect only emerges in combination with the full distribution waterfall and cannot be read from the clause alone.

A simple example shows the effect: if the fund achieves two and a half times the capital invested on exit, management's stake may rise from 5 to 8 percent, and to 10 percent at a multiple of three. These steps are fixed in the investment agreement and usually refer both to the capital multiple and to the annual return, because the two measures react differently to a long holding period. Reverse variants that increase an investor's stake if targets are missed are also common in venture rounds.