What Does Ratchet Mean?
A ratchet is an anti-dilution protection mechanism whereby management's equity stake may be altered on the happening of various future events. Ratchet is provided as an incentive to management, as they are given the opportunity to achieve additional economic compensation. It is provided in the form of additional economic rights attached to the managers' preferred shares.
Divestopedia Explains Ratchet
When a firm raises new equity capital, the existing managers/investors have the option of retaining the original proportionate ownership in the firm. This is achieved by means of an anti-dilution clause, which protects the investor from a reduction in percentage ownership in a firm due to future issuance of additional stock to other entities by the firm. A ratchet requires clear determination of the triggering event and the date and form of payment. When a ratchet is created, it is essential to limit the maximum entitlement of the managers by linking the amount payable to a maximum participation percentage. Usually, as a result of the implementation of a ratchet, those who own a fixed number of common shares suffer significant dilution.
For example, if a manager/investor had previously paid $10 per share for a 20% stake in the firm, he would then get more shares to maintain his percentage ownership in the firm if it were to issue new shares at the rate of $8 per share. He would have the right to convert his existing shares to $8 per share, thereby increasing his number of shares by 25% and maintaining 20% ownership.