English law

Russian law

Share ratchets are a contractual mechanism contained in a shareholders' agreement or articles of association. Under the ratchet, the number of a shareholder's shares and/or the amount of consideration sale proceeds that they receive on an exit (sale or IPO) is increased or decreased (ratcheted up or down) according to an agreed performance formula.

The formula is agreed by negotiation between the parties and can be linked to the personal performance of the shareholder (if they are an individual). Alternatively, they can be based either on the:

A typical share ratchet would give senior management shareholders an additional share or consideration entitlement if the investor's IRR on its investment from dividends, interest, management charges and consideration sale proceeds exceeds an agreed target amount. Sometimes ratchets are calculated pro rata to actual performance against targets. In other cases there can be stepped increases, with gateways between steps. Ceilings or caps on the ratchet amount are usual. For more information on ratchets, see Practice note, Ratchets: non-leveraged investments.

Ratchets are less popular than they used to be and there are a number of tax issues to consider, depending on the jurisdictions involved (see Practice note, Private equity and tax: management buyouts: tax issues for management: Performance ratchets). However, they are still sometimes used on private equity investments and management buy-outs.

In theory, contracts could be structured to replicate these mechanisms (in particular through the execution of a conditional preliminary sale and purchase agreement). However, the concept has not yet been properly tested in the courts.