A valuation ratchet — often called a valuation-adjustment mechanism — is a contractual provision that adjusts the effective price an investor paid if the company misses agreed milestones. It is one of the most common investor-protection terms in both RMB and cross-border venture deals.
How it works
The company or its founders commit to a target — typically revenue, profit, or a qualified listing by a certain date. If the target is missed, the investor receives compensation: extra shares, a cash payment, or an adjusted conversion price. The effect is to lower the investor’s effective entry valuation after the fact.
The common variants
- Equity ratchet: the investor receives additional shares, diluting founders.
- Cash compensation: the company or founders pay the difference in cash.
- Conversion-price adjustment: preferred shares convert at a more favorable ratio.
- Buyback: in the strictest form, founders must repurchase the investor’s shares with interest if a listing deadline is missed.
Why it matters
For founders, ratchets transfer execution risk back onto them and can become punitive if targets are set aggressively. For investors, they provide downside protection but can distort incentives, especially near milestone dates. Regulators in several markets now scrutinize ratchet-heavy structures before listing.
When reading a term sheet, the key questions are which milestone triggers the adjustment, who bears it — company or founders personally — and whether there is any cap. Those three details determine whether a ratchet is mild insurance or a loaded clause.
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