What is a Ratchet? Example of a Ratchet and the difference with the Bonus

Too often, the abuse of Anglo-Saxon legal concepts constitutes a barrier to their understanding.

Therefore, what is being sought here is to break down this barrier in the concept of the Ratchet. The vocation of every financial investor when taking part in a project by its own nature, is to divest. And even more, divest in the shortest time possible in order to obtain the maximum return.

To achieve such objectives, it is necessary that the key staff of the investee company be aligned, and motivated in their work to maximize the value of society.

For this purpose, it is common for these investors to offer extraordinary compensation (the so-called “Ratchet”) to the management team, associated with the sale of their stake in the invested entity.

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Example of a ratchet

First of all, there are as many ways to build a Ratchet as there are people involved in the agreement. But let’s propose a couple of very simple examples which aim to shed some light on the subject:

Example 1.- If I sell for an amount equal to or greater than X, you will receive X% of the net price obtained in the sale.

Example 2.- If, in my sale, I obtain an internal rate of return (IRR) equal to or greater than X%, you will receive an X% of the excess over said profitability.

Now, the question is usually not so simple. Therefore, when regulating this type of incentives, it will be necessary to resolve the following issues (without prejudice to others):

When is a Ratchet earned?

It seems clear that it accrues with a divestment or sale. However, it may happen that the parties agree that it should be accrued only when a disinvestment or sale is total. Or, that partial accruals may occur in the event of a partial divestment or sale. Or even that executives only have the right to the Ratchet from the transmission of a minimum percentage in the social capital of the society.

Special assumptions of the Ratchet’s accrual

Is there no more requirement to be entitled to the Ratchet than the sale by the investor from a certain level of profitability? And what happens if the manager has left the company? What if he or she has been fired?

Given that the purpose of the Ratchet is to encourage the management team to improve the value of the company through its work, it seems clear that the investor will always profit whatever the condition of the operation at the time of the Ratchet’s accrual.

It also seems logical that if the manager is not employed anymore for certain reasons (think that he or she has been unfairly dismissed or has obtained a disability, for example) and/ or the Ratchet has accrued in a period of time not much later than their departure (three months after voluntary retirement, for example), the party does not lose their right to this compensation or, at least, does not lose it completely.

And what if, instead of a pure and simple sale with full payment of the price in money at the close, there are deferred payments or retentions of the price in guarantee or payments in kind, or what has taken place is a merger operation?

Typically, in the case of transmission with full payment in cash, as a Ratchet is accrued the investor receives payments that may arise. And that they are perceived proportionally to such payments. That is, the manager charges to the extent that the investor receives his or her price.

In the event of transfer of title other than purchase or sale, when the price is not entirely in cash, the effective payment of the Ratchet is usually conditioned to the total or partial monetization of the consideration obtained (the manager charges as and to the extent at which the investor converts the investment into money).

Conclusion: the difference with the Bonus

Finally, considering that the bonus is also an incentive, its main difference with the Ratchet is that the bonus is usually a salary supplement (and as such, is satisfied by the employer and not by certain partners of the employer), associated with the achievement of objectives that can be very diverse (obtaining a certain sales volume, maintenance of certain relevant customers, etc.).

Although such objectives can ultimately result in a higher value of the company, the actual obtaining of the bonus does not depend on the materialization of that higher value by its partners.

Considering the above, this is the situation, without entering into discussions of labor or fiscal nature which, perhaps, may be the subject of another article.