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Understanding IPO Ratchet Provisions in Equity Compensation

IPO ratchets are special provisions that protect investors' returns during an initial public offering (IPO). For employees with equity compensation, understanding these mechanisms is crucial as they can significantly impact the value of your equity.

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What Is an IPO Ratchet?

An IPO ratchet is a protective provision that guarantees certain investors (typically late-stage investors) a minimum return on their investment when a company goes public. If the IPO price falls below the guaranteed return threshold, additional shares are automatically issued to these investors to make up the difference.

How Ratchets Impact Employee Equity

Basic Example: Assume you work at a startup valued at $1 billion in its last funding round, where investors received a 1.5x ratchet protection:

  • Last round price per share: $10
  • Guaranteed return (1.5x): $15 per share
  • If IPO prices at $12 per share:
    • Investors are entitled to $15 but only getting $12
    • Additional shares worth $3 per share are issued to investors
    • This dilutes all other shareholders, including employees

Compounding Ratchet Example: A compounding ratchet is more complex and potentially more dilutive:

  • Initial Investment: $10M at $100/share
  • Ratchet: 20% annual compound return
  • Time to IPO: 2 years
  • Guaranteed Return Calculation:
    • Year 1: $100 * (1.20) = $120
    • Year 2: $120 * (1.20) = $144/share minimum guarantee

If the IPO prices at $120/share, investors receive additional shares worth $24/share ($144 - $120), significantly diluting other shareholders.

Impact on Employee Options

Value Dilution

  • Your equity ownership percentage decreases as new shares are issued
  • The dollar value of your equity drops proportionally to the dilution
  • Unvested options typically remain at the same strike price despite lower share value

Example: Consider a software engineer with 10,000 options:

Pre-ratchet:

  • Company value: $500M
  • Shares outstanding: 50M
  • Your ownership: 0.02%
  • Value of your equity: $100,000

Post-ratchet (20% dilution):

  • Company value: $500M
  • Shares outstanding: 60M
  • Your ownership: 0.017%
  • Value of your equity: $83,333
Protection Strategies

Review Grant Documents

  • Look for ratchet provisions in your equity documents
  • Understand trigger conditions and calculation methods

Consider Timing

  • Exercise decisions should account for potential ratchet impact
  • Evaluate IPO timing relative to vesting schedule

Diversification

  • Don't rely solely on equity for compensation
  • Consider negotiating higher base salary if ratchets present significant risk
Questions to Ask Your Employer
  • Do any investors have ratchet rights?
  • What are the specific return guarantees?
  • How would dilution be calculated and distributed?
  • Are there any employee protections against ratchet dilution?

IPO ratchets represent a significant risk to employee equity value. Understanding these provisions helps you make informed decisions about your equity compensation and career planning. Always consult with financial and legal advisors for personalized guidance.