So, you’re about to invest in Acme Inc., but you’re concerned about future underperformance 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 executive team achieving a predetermined level of earnings (the budget). If they underperform the budget, you’re granted free 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 EBIT must be at least $20m, otherwise your equity will increase by 1 point for every $1m of budget underperformance. 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 EBIT of $10m. That means if Acme’s EBIT is $10m or below, your firm’s ownership increases to a maximum of 85% in 2009 (gratis). If it is somewhere in between, your equity increases accordingly.
The idea behind the equity ratchet is to motivate the executive 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. This isn’t to say I’m an ardent supporter of equity ratchets; if anything, I think they can damage the alignment of interest that you get from investing with the executive team in the first place.