TLDR:
A ratchet is an anti-dilution protection mechanism that adjusts the conversion price of preferred shares downward if new shares are issued at a lower price, protecting early investors from dilution in a down round.
Ratchet Mechanics in Different Structures
Ratchet provisions appear in several financial instruments with similar but distinct mechanics. In convertible debt and preferred stock, anti-dilution ratchets adjust conversion prices downward when new shares are issued at lower prices. In warrants and options, ratchets (often called ‘anti-dilution adjustments’) modify the exercise price and/or the number of shares covered. In earnout agreements, performance ratchets create contingent additional payments if target metrics are exceeded. Understanding which type of ratchet applies in a given instrument is crucial to modeling the financial impact correctly.