Ratchet (Venture Capital)
A ratchet in venture capital is a provision that automatically adjusts the ownership percentage or conversion price of an investor's preferred shares based on performance outcomes — either a valuation ratchet (tied to company performance at a future date) or a price ratchet (tied to the price of a subsequent financing round).
Ratchets in venture capital appear in two distinct forms, though the term is most commonly associated with anti-dilution price ratchets in the context of down rounds (see Anti-Dilution Protection). The second form — the performance or valuation ratchet — is a separate mechanism used in growth equity and later-stage venture deals to align investor returns with exit outcomes.
A valuation ratchet (sometimes called a performance ratchet) is an agreement that adjusts the investor's effective ownership percentage based on the company's actual performance at exit or a defined measurement date. If the company achieves or exceeds a target valuation or earnings metric, no adjustment occurs. If it falls short, the investor receives additional shares (or an increased conversion ratio) to compensate for the underperformance, effectively ratcheting up their ownership at the expense of the common shareholders or founders.
Ratchets are particularly common in management buyouts and growth equity deals where the valuation is predicated on a forward earnings projection. If management misses the projection, the ratchet transfers equity from management's pool back to the institutional investor, aligning management incentives with achieving the growth targets that justified the entry valuation.
In the venture context, full ratchet anti-dilution is the most aggressive form of price ratchet: a single share issued at a lower price than the original investment resets the entire conversion price to that lower price, regardless of the scale of the down round. This form is typically only negotiated in distressed or highly uncertain financing situations.
Broad-based weighted average anti-dilution is the more common standard, as it balances investor protection with preserving founder and employee equity incentives. Understanding ratchet mechanics is essential for founders evaluating term sheets and for investors modeling outcome scenarios across different exit values.