Ratchets — how management's share can grow (or shrink)
A ratchet is a mechanism that changes how exit proceeds are split depending on how good the exit is. Instead of management owning a fixed slice come what may, the slice steps up (or down) as the investor's return crosses agreed thresholds. Done well, it's an elegant alignment tool. Read lazily, it's a source of exit-day surprises.
The two directions
- Positive ratchets reward management for outperformance: clear a 2.5x money multiple or a 25% IRR for the investor, and management's share of the ordinary equity steps from, say, 12% to 15%. Sometimes there are several tiers.
- Negative (reverse) ratchets work the other way: undershoot the base case and management's share steps down. Less common, and worth spotting early if present, because it changes the risk shape of the whole package.
The mechanics under the hood
Ratchets are implemented in the articles of association, typically by adjusting share-class conversion ratios or the waterfall allocations at exit. Which means the details are legal drafting, and the details decide real money:
- Which metric, measured how? MoM or IRR (see our guide on both), gross or net of fees, on the whole investment or per tranche — each definition moves the thresholds in practice.
- Cliff or straight-line? Some ratchets jump at the threshold (2.49x gets nothing extra, 2.51x gets the full step); others interpolate smoothly between points. Cliff-style ratchets make small differences in the final price enormously consequential.
- What's in the return calculation? Prior refinancings, dividends already taken, and rolled-up loan-note interest all feed the investor's return number. A refinancing that returned half the fund's money early can put a ratchet threshold much closer than the headline valuation suggests.
- Leaver interaction. Ratchet upside usually attaches to shares — if leaver provisions have thinned your holding, they've thinned your ratchet too.
Reading yours
Find the ratchet schedule in the articles (or the investment agreement), then answer three questions: What are the thresholds, in whose metric? Where does the deal track against them today? And what does each tier do to your personal outcome at a plausible exit value? Ratchets convert cleanly into a table of "exit price → my proceeds" — and that table is the honest version of your package.
FAQ
Are ratchets standard in UK PE deals?
They're common but not universal — practice varies by house and deal size. Presence, direction and generosity are all negotiated, which also means they're renegotiable at new money events.
Does a ratchet cost me anything if the deal underperforms?
A positive-only ratchet doesn't — it's upside on top of your base position. A reverse ratchet does, and if one exists in your documents it deserves the same modelling attention as the upside case.
Can a ratchet have tax consequences?
The step-up mechanics can raise valuation and employment-related-securities questions, which is why ratchet design usually involves tax advisers on both sides at the outset. If your ratchet was bolted on informally, that's a flag worth professional eyes.