Ratchet Clauses in Contracts: A Plain-English Guide
What Is a Ratchet Clause?
A ratchet clause is a price-adjustment mechanism that only moves in one direction. In the investment context, a "full ratchet" lowers an investor's conversion price to match any future, lower-priced share issuance — regardless of how many new shares are issued.
Ratchet clauses also appear in other contexts, such as pricing agreements where rates can increase but never decrease, or performance contracts with escalating minimums.
How a Full Ratchet Works
Imagine an investor buys preferred shares at $10 per share. If the company later issues shares at $5 per share in a down round:
- The investor's conversion price drops from $10 to $5
- Their preferred shares now convert into twice as many common shares
- This effectively doubles their ownership percentage at the expense of founders and other shareholders
Where Ratchet Clauses Appear
- Venture capital agreements — As anti-dilution protection for preferred shareholders
- Supply contracts — Price ratchets that adjust costs upward based on inflation indexes but never downward
- Real estate leases — Rent ratchets that ensure rent only increases over the lease term
- Executive compensation — Salary ratchets preventing pay from dropping below a previous level
Key Concerns
- One-sided risk — By definition, ratchet clauses only adjust in the direction that favors the protected party
- Disproportionate impact — In down rounds, full ratchet anti-dilution can devastate founder ownership
- Chilling effect — Companies may avoid necessary fundraising to prevent triggering the ratchet
When to Consult a Lawyer
If you encounter a ratchet clause in any agreement, consider having an attorney evaluate the potential financial impact under various scenarios. For founders, negotiating for a weighted average approach instead of a full ratchet can be critical.
This article is for informational purposes only and does not constitute legal advice. Consult a licensed attorney for guidance specific to your situation.