Comments on: Private equity ratchets in practice II

By: The Private Equiteer

The Private Equiteer — Mon, 26 Oct 2009 23:55:22 +0000

Thanks for the note Dirk. Sure, they’re usually only one-way, like you suggest, but imagine it working both ways.

So, say the normal ratchet is that the investor gets 5% extra equity if returns are below 20% IRR. This is designed to motivate management by punishing them on the downside. This is how a typical ratchet works.

But, also image not only motivating them on the downside, but motivating them on the upside by reversing the ratchet to give them 5% extra equity if returns are above say 30% IRR.

This is what I mean by a two-way ratchet. Think of it as a one-way ratchet, plus a stock option plan for management.

By: Dirk

Dirk — Mon, 26 Oct 2009 12:54:30 +0000

I don’t really understand the term two way ratchet. There is just one ratchet, with (in general) the purpose of sharing incremental returns above a certain threshold in a different way from the common equity.

By: The Private Equiteer

The Private Equiteer — Tue, 20 Oct 2009 21:08:07 +0000

Thanks for the kind words vlade… and for the comments on this post and elsewhere. Comments keep me honest and teach me a thing or two in the process.

By: vlade

vlade — Tue, 20 Oct 2009 14:13:02 +0000

Yep, I really liked your point b) (target the returns), as it makes it clear what you’re trying to achieve – so from that point, you don’t really have to divide alignement, in fact you can create interest in being ratcheded out (but still achieving or even over-achieving your results).
In fact, in a perfect-day scenario it could make your exit strategy extremely easy too, as the other shareholder(s) would ratchet you to the point where it would be trivial to buy you out. That sounds bad – until the point where you take into account that in real money terms you’d at that time over-achieved your goals probably. Yes, you might have had more – but would have?

Me like . Thanks for the good job showing PE to outsiders like me.

By: The Private Equiteer

The Private Equiteer — Tue, 20 Oct 2009 12:17:14 +0000

It’s similar to having a one-way ratchet and an executive option agreement. While the mechanics are a little different, you save on having to draft a completely separate option agreement as a two-way ratchet is generally just a few extra sentences in the stockholders’ agreement.

You could argue that a two-way ratchet divides interests because it creates different outcomes for different investors. But if it is structured properly, all investors benefit more as returns increase. So in effect, interests are still aligned adequately.

We’ve put a two-way ratchet in a term sheet a few times, but never invested on one. I’m a fan if they’re tied to returns (after exit), but not otherwise.

By: vlade

vlade — Tue, 20 Oct 2009 07:32:23 +0000

Thanks – I thought about two-way ratchets, but didn’t have time to ask whether they are actually used..