Ratchet

Term and Definition: Ratchet

The term “ratchet” is used in a legal context, particularly in corporate law and corporate finance. It refers to a contractually agreed adjustment mechanism which adjusts (“ratchets”) the participation or subscription rights of certain investors upwards or downwards, usually in response to future capital measures, such as later financing rounds. With a ratchet, equity positions are primarily structured so that the original investor is protected from dilution of their shareholding.

Forms of Ratchet in Law

Down-Ratchet

The most commonly used form is the down-ratchet. Specifically, this clause means that if there is a capital increase at a lower price per share than that paid by the ratchet-beneficiary, the beneficiary is retrospectively treated as if they had also invested at the lower price. As a result, they receive additional shares to compensate for their loss in value.

Application in Financing Rounds

Corporations, especially start-ups and growth-oriented companies, use down-ratchets to create incentives for early investors. Legally, an adjustment formula is usually integrated within participation agreements, shareholder agreements, or convertible loan agreements.

Up-Ratchet

An up-ratchet is the counterpart to the down-ratchet. Here, there is a reduction or even withdrawal of preferred participation rights, for example, if a higher company valuation is realized in a future financing round. This variant is used comparatively rarely, as it can disadvantage existing investors.

Full Ratchet versus Weighted Average Ratchet

In legal practice, two main types can be distinguished:

• Full Ratchet: The beneficiary is treated as if their original acquisition of shares had taken place entirely at the lowest price of the new round.
• Weighted Average Ratchet: Here, the adjustment takes place according to a mathematical average formula, taking into account the amount and conditions of the new capital measure.

Both versions are explicitly specified in the participation agreement.

Legal Structure of a Ratchet

Contractual Implementation

The ratchet provision is found in investment and participation agreements as well as in the articles of association. Its legally secure design is central to avoiding later disputes. The following core aspects are usually regulated:

• Specification of Triggering Events: e.g. further financing round below a certain company valuation (down-ratchet)
• Calculation Method for the Adjustment: precise formulas including reference values and timeframe
• Beneficiary Group: definition of which investors are covered by the clause
• Limitation of Effect: e.g. time limitation, event-related, or limited to certain amounts
• Ancillary Rights and Obligations: such as adjustments to voting rights or liquidation preferences

Corporate Law References

The implementation of a ratchet regularly requires amendments to the articles of association or corresponding agreements among the shareholders of a limited liability company (GmbH) or a stock corporation (AG). Depending on the legal form and national legislation, different majorities and formalities are required, such as resolutions of the general meeting, notarization, or entries in the commercial register.

Impact on Existing Shareholders

The effectiveness of a ratchet clause can lead to dilution of the shares of shareholders who are not beneficiaries. This can have a detrimental effect on their voting and property rights. For this reason, ratchet clauses are often thoroughly negotiated at shareholder meetings and, if necessary, equipped with approval or veto rights.

Limits and Restrictions of the Ratchet under German Law

Statutory Restrictions

In German corporate law, certain limitations arise in particular from the Limited Liability Companies Act (GmbHG) and the Stock Corporation Act (AktG). For example, a ratchet provision must not violate the prohibition on repayment of contributions (§ 30 GmbHG). Contractual requirements of equal treatment and minority shareholder rights must also be strictly observed in drafting such agreements.

Case Law and Arbitration

German courts set high standards for the transparency and fairness of ratchet clauses. Undue disadvantage to non-beneficiary shareholders can render the provision void or contestable. In particular, transparency and understandability in the articles of association, the structuring of triggering mechanisms, and clear limitations are legally recommended.

Tax Consequences

Ratchet clauses can have tax implications. For example, the allocation of additional shares to an investor may be classified as a taxable event (gift or hidden contribution). Companies and investors should therefore carefully assess the tax consequences when designing and implementing a ratchet agreement.

Ratchet in International Transactions

Application in International Comparison

While ratchet clauses under US law (e.g. Delaware Law) are almost standard in venture capital investments, the German market tends to apply stricter standards. In cross-border shareholdings, it is therefore essential to clarify exactly which legal system and jurisdiction the ratchet provision is subject to.

Conflicts with Mandatory Law

Transnational shareholdings can lead to conflicts with German, European or other national company, tax or capital market law. A carefully drafted governing law and jurisdiction clause is advisable in such cases to avoid uncertainties.

Summary: Importance and Legal Consequences of the Ratchet

“Ratchet” is an essential structuring instrument in equity financing and corporate transactions. Its legal implementation requires a high degree of precision and sensitivity to corporate, tax, and transactional legal frameworks. Balancing the interests of investors and existing shareholders, complying with legal requirements, and avoiding tax and regulatory risks are key aspects in the contractual integration of a ratchet. A properly drafted ratchet clause reflecting the intentions of all parties involved is an important building block to ensure operational and planning certainty for companies and investors alike.

Frequently Asked Questions

What legal risks exist in the use of ratchet clauses in venture capital agreements?

The use of ratchet clauses in venture capital agreements carries various legal risks that are of considerable importance to both founders and investors. Ratchet clauses mean that the equity positions of founders and early investors can change drastically if the valuation of the start-up drops in subsequent financing rounds (down round). From a legal perspective, the main risk is that existing shareholders can be disadvantaged through dilution of their shares, which may result in a significant restriction of their voting and participation rights – especially if appropriate protective mechanisms (such as anti-dilution protection or approval requirements) are not stipulated in the articles of association. Furthermore, ratchet clauses must be transparently and unambiguously regulated in the shareholder agreement; otherwise, ambiguities can create a risk of legal disputes between the parties. It must also be noted that such clauses may potentially be subject to scrutiny under the law on general terms and conditions (AGB law) in § 307 BGB, if they unilaterally disadvantage foundersand unreasonably disadvantage them.

Abuse of ratchet clauses can be limited through balanced and detailed contract structuring and by implementing control and protective mechanisms. This can be achieved, among other things, by establishing limits to the effect of the ratchet clause (e.g. a cap on the maximum number of shares granted), by clarifying exceptions (such as for down rounds due to external, uncontrollable events), and by incorporating approval requirements for relevant measures (as with anti-dilution clauses or drag-along/tag-along clauses). Sometimes, the founders’or specific minority shareholders’ veto rights are also envisaged. It is also legally significant for ratchet clauses to be drafted clearly, unequivocally, and verifiably in order to minimize potential disputes regarding their application and scope. An independent legal review of all clauses in advance is strongly recommended.

What tax consequences can arise from the application of a ratchet clause?

In addition to corporate law consequences, the effects of a ratchet clause can also have tax implications for the parties involved. If shares are shifted or value allocations are changed as a result of a ratchet clause, this may be regarded as a compensated transaction or as a hidden contribution/withdrawal. In particular, a hidden contribution may arise under § 20 para. 1 No. 1 EStG or a hidden profit distribution, if the redistribution does not satisfy the arm’s length principle. The transfer of shares may also trigger real estate transfer tax or gift tax, if the transfer is gratuitous or partially gratuitous. The tax qualification of the ratchet clause in the respective constellation is also crucial—especially regarding withholding tax and income tax. Therefore, it is strongly recommended to obtain tax advice before introducing and implementing a ratchet clause.

What formal requirements must be observed when introducing a ratchet clause into articles of association?

To validly introduce a ratchet clause within a GmbH’s articles of association, notarization is generally required (§ 53 para. 2 GmbHG), since any amendment to the articles must be notarized. If the shareholders’ agreement contains provisions on capital measures or voting rights as a result of applying a ratchet, these must also be notarized. If the ratchet clause is included in a separate participation agreement, a written form is generally sufficient from a legal perspective, provided no elements relevant to the articles are affected. Where the ratchet clause effectively results in a shift of rights in the company (e.g. issuance of new shares), a shareholders’ meeting and an appropriately qualified majority for amendment may also be required.

Is it possible to enforce a ratchet clause in court?

The enforceability of a ratchet clause in court depends largely on its substantive structuring and compliance with all legal requirements. As a rule, ratchet clauses—if regulated transparently and clearly, and if they do not violate mandatory law or public policy—are legally binding and can be enforced in court. Nevertheless, individual court decisions may render specific clauses invalid if they represent an unreasonable disadvantage to a contractual party (§ 138 BGB, immorality, or § 307 BGB, review under the law on general terms and conditions). It is also relevant that all corporate law procedures have been observed (e.g. proper notice for shareholders’ meetings, statutory majorities). Any violation of formal requirements, resolution procedures, or minority protection may impede enforcement in court. Individual legal advice on enforcement in court is recommended in order to verify and ensure the ratchet clause’s effectiveness on a case-by-case basis.