A ratchet mechanism varies the amount of equity held by different parties and is often used as a reward. Giving options to one party to increase their ownership stake is an example.

Another type of ratchet mechanism is where at exits, once a PE funds IRR hurdle rates has reached, the extra proceeds still to be shed outs are shared equally, i.e management receive half of the extra proceeds rather than the maybe 20% that they might technically deserve.

This is a huge incentive to management to achieve a high sale price for the company. Let's do a numbers example. Here we have a deal that has a threshold IRR of 25%. This means that the PE fund wants a minimum return of 25%, but they would love a return above this and want to incentivize management to work hard and grow the company far in excess of the IRR. For any value over the 25% IRR, there is then a ratchet mechanism that shares returns 50 50 between management and the PE fund. The current PE fund ownership is 80% and the absolute value of their investment is 80.

What happens on exit? Well, the company is sold for 350 after four years. Great. First, the PE fund gets its minimum return, which was a four year IRR of 20% on the 80, that's 195. So that 195 is immediately directed towards the PE fund. How much do management gets? Well, if the PE fund have 80% and that is worth 195, we divide it by 80 and multiply by 20 to get management 49. That is set aside for management.

So the value already set aside pre ratchet is 244, but the exit value is 350, which means there is still 106 of proceeds up for grabs for the ratchets.

That 106 is shared. 50/50 between the PE fund and the management. So the PE fund gets its 195 plus 50% of the 106, and that's 248, and management gets its 49 plus 50% of the 106, and that's 102.

Legally, the ratchet is either structured via changing the share ratio or alternatively changing the proceeds paid to different holders of shares.