Are ratchet clause valuations worth considering?

We have an interested investor at the table but we cannot agree on valuation…is a “ratchet clause” worth considering?

Valuation is always an emotionally charged topic. 

The truth is that it doesn’t matter all that much where you start…it’s where you finish that counts.

Most investors recognise the value of key people within a business and if those founders/entrepreneurs/executives are washed out of deals through multiple funding rounds, an executive share option plan (ESOP) is typically introduced to maintain equity incentive for the most important people in the business.

Bottom line…the best deals are done at an agreed valuation that recognises the potential of the business but does not price in yet-to-be-delivered upside. If both parties to the transaction are experienced, this happy medium is not too hard to determine.

Often entrepreneurs have an over-inflated opinion of the value of their business and insist on holding out for a higher valuation. Usually investors will walk away from such situations as they are a sign that the entrepreneur will be difficult to work with on the other side of the transaction.

Sometimes, there is genuine grey area around an appropriate valuation and a ratchet clause can be a useful mechanism to diffuse the issue.

In principle the ratchet works as follows:

• Entrepreneur believes the valuation should be $X.
• Investor believes the value should be $Y where Y is less than X.
• It is agreed that the valuation will be set at $X but that it will be subject to a ratchet provision.
• The ratchet specifies performance measurements over an agreed period (typically in the range three to five years) against which the valuation may be recalibrated.
• If performance fails to achieve the benchmark by, say, 15% or more, then further shares are issued to investors to effectively adjust the pre-money valuation down in proportion to the level of underachievement (subject to an agreed minimum price). This is also known as a negative ratchet.
• If the starting valuation is set at $Y, then if performance exceeds an agreed benchmark by say 15% or more, then further shares are issued to the entrepreneur to effectively adjust the pre-money valuation up in proportion to the level of over-achievement (subject to an agreed maximum). This is also known as a positive ratchet.

The problem with a ratchet is that it can motivate undesirable behaviours if results look like falling in the range of adverse or beneficial recalibrations (depending on your perspective). It’s also a sign that good alignment wasn’t reached by negotiation – often an omen of things to come!

On the positive side, a ratchet acts as both a form of risk mitigation for the investor and further incentive for the entrepreneur. If all else fails, it’s worth considering rather than killing the deal.

Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology based businesses.

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