So, you’re about to invest in Acme Inc., but you’re concerned about future under performance and you’re looking for ways to protect your investment. In the VC world, you may rely on the ability to dilute the founders in subsequent rounds at a lower valuation, but in private equity, you have much more in your toolbox. (This is more the result of convention than anything else.)
An equity ratchet works around the management team achieving a predetermined level of earnings (the budget). If they under perform the budget, you’re granted more stock and a higher ownership percentage of the business. If they perform according to budget, then the equity ratchet expires and everyone remains happy.
So, let’s say you own 75% of Acme Inc. and the executive team owns 25%. Your original investment terms state by year-end EBITDA must be at least $20m, otherwise your equity will increase by 1 point for every $1m of budget under performance. Usually, there’s a cap to prevent the private equiteer from taking complete control in a bad year. So, let’s say the cap is at EBITDA of $10m. That means if Acme’s EBITDA is $10m or below, your firm’s ownership increases to a maximum of 85%. If it is somewhere in between, your equity increases accordingly.
This is just one example. In practice, ratchets can become quite complex, incorporating other measures of performance, multi-year targets, adjustments on binary one-off events etc. However, the idea behind the equity ratchet is simple: to motivate the management team on the downside (opposed to motivating on the upside, as option schemes are designed to do). This is controversial because it goes against the concept of positive reinforcement. But as parents, we all know how well talking nicely works.
And, why is it called an equity ratchet? Because it only goes one way; in favor of you.