Ratchet

The term ratchet is used in transaction agreements for two different mechanisms that should be kept separate.

(a) Management ratchet (sweet equity): a contractual adjustment of management’s shareholding quota in the target depending on performance thresholds at exit — typically tiered MOIC or IRR hurdles at the level of the shareholding in the target. On reaching the thresholds, management receives a disproportionately large share of the increase in value; correspondingly, a shortfall means a reduction of the sweet-equity tranche.

(b) Anti-dilution full ratchet: an adjustment of an investor’s conversion price to the lowest subsequent price if the company is refinanced in a down round. This variant is investor protection, not an incentive instrument; in DACH VC practice, broad-based weighted average is the dominant market standard (see Anti-Dilution).

Return thresholds at fund level between the fund manager and the capital providers (hurdle, catch-up) are to be distinguished from this (see Carried Interest). Both ratchet variants are explanation-intensive in their design and must be carefully structured for tax and legal purposes.