I’ve harped on a little (or maybe a lot) about how iniquitous and unscrupulous earn out ratchets are. I’ve said they misalign interests from the outset and lead to adversarial relationships when triggered. So, are there any equitable ways to structure earnout ratchets? And, if not, why do we still use them?
Like most things, there are shades of grey. At one end, we have short-term one-way earnings-based ratchets that go against the mantra of private equity and pin executives to short-term performance. At the other end, we have long-term two-way returns-based ratchets that create much better alignment across the entire stock register.
So, let’s check out these characteristics:
There’s one more consideration for two-way ratchets… the ratchet rate. Should the rate be equal for the downside and upside? Well, it depends. In all fairness it should, but sometimes the ratchet rate is adjusted to bridge valuation gaps. Managers may opt for a higher ratchet rate in exchange for a lower initial valuation, or vice versa. Also, the private equiteer must ensure the upside ratchet rate isn’t so aggressive as to eat into their target return (I’ve seen this happen).
So, it’s best to plot out a range of scenarios before agreeing to a ratchet to make sure that, a) everyone is sufficiently incentivised, b) your target returns are possible in most scenarios, and c) misalignment and adversarial terms are minimised. Good luck.