The terms of an equity ratchet predicate its value. Often the terms don’t just state that, for example, “our equity will ratchet up 5% if your EBIT falls below $30m in 2010″. Usually, a positive linear scale is used to incrementally ratchet the equity according to a predetermined range of earnings.

This is best demonstrated with an example. So, we have a 70% stake in an investee with 2009 EBIT of $30m. We invest with the proviso that a ratchet applies to 2010 earnings, whereby, for every $100k the EBIT drops below $30m in 2010, our equity ratchets up 0.1%. There is a cap on this to prevent us taking over the entire company in a bad year. The cap is at a maximum of an extra 15% of equity, which translates to a range of $15-30m. Therefore, if EBIT in 2010 drops all the way to $15m, our equity ratchets up 15% to a total of 85%.

The first thing you’ll notice here is that in practice, a ratchet rarely achieves a perfect equilibrium around your original paid multiple. What I mean is, if you invested $105m for your 70% stake (which equals a 5x EBIT multiple), the ratchet doesn’t help you keep your original 5x multiple. If EBIT did drop to $15m and your equity ratcheted up to 85%, then you’re effectively invested at an 8.2x multiple (all else equal and no applicable debt).

You may ask… why can’t the ratchet maintain our original multiple? Put simply, other investors just wouldn’t go for it because the risk of losing their entire stock-holding is very likely. Plus, why do you deserve this protection anyway?

There are many ways you can value this ratchet, but in the example above, you can see with the ratchet your effective multiple is 8.2x if EBIT drops to $15m. Whereas, without the ratchet, the multiple would be 10x. The enterprise values in these two instances differ by about $26.5m. Of course, the ratchet isn’t worth $26.5m because one would hope the probability of EBIT dropping by 50% is less than 100%. If you want to get really technical, you could value the ratchet at each interval and apply a probability to each scenario and then sum the results. But, that’s way too much work and you can’t really use the calculation in negotiations because it draws attention to the fact that ratchets are evil.

With all of this said, I recently posted on the concept of the equity ratchet and the  pros and cons of equity ratchets.