The following Corporate practice note provides comprehensive and up to date legal information covering:
A ratchet in private equity is a mechanism to vary the amount of equity held by founders, managers and employees post-investment.
In a venture capital context, ratchets operate as anti-dilution provisions. They protect early-stage investors from dilution by subsequent fundraisings at lower entry prices.
In a buyout context, they are generally used to reward management, whose proportion of overall equity ownership may change as a consequence of the performance of the business in line with forecasts and projections and the investor’s target return. In this context, ratchets usually have the effect of increasing management’s shareholding when the business has performed well.
Ratchets will vary significantly from investment to investment. They often involve complex financial and mathematical concepts and need to account for a variety of circumstances, including differing exit scenarios and forms of consideration.
Managers who have the benefit of ratchet provisions will be keen to ensure that they are as tax efficient as possible.
The issue with ratchets is that the proportion of exit proceeds received by managers on an exit can be significantly higher than the percentage of their shareholding, which can result in income treatment for part of the amount received. This is because part of the value is treated as arising from the manager’s employment rather than being a genuine commercial return on shares and special rules apply to shares (and other
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