Ratchets in M&A: Navigating the tax and regulatory field in India

In today’s deals, investors are taking bolder bets on niche, unproven businesses where future performance is highly uncertain. This makes it even harder — for both founders and investors — to answer a basic question: what is this company worth right now?

While earn-outs are a well-known tool for bridging that gap by tying part of the purchase price to future results, there is a parallel mechanism, far less discussed yet equally powerful, that directly shapes who ends up owning what: the ratchet.

What is a ratchet?

A ratchet is a contractual mechanism that adjusts equity ownership after an acquisition based on how the target company actually performs. Rather than tweaking the headline price, ratchets reshape the cap table — redistributing shares between buyer (Investors) and seller (Founders) depending on whether the business beats, meets, or misses its targets.

[su_pullquote align=”right”]“Ratchets act as a contractual engine for redistributing shares between investors and founders when targets are met or missed”[/su_pullquote]

At their heart, ratchets are simple in concept, even if the legal drafting can be intricate. The deal documents set agreed performance targets — usually revenue, EBITDA, or growth milestones — to be measured over a defined window post-close (commonly 1 to 3 years). Based on the outcome, the cap table is restructured.

A common misconception is that ratchets are relevant only in distressed scenarios or “down rounds” (i.e., when the target company raises new capital at a valuation lower than the previous round). That is not the case. Properly structured, ratchets are a flexible, performance-linked tool that can be used in a range of situations, including healthy or even bullish deals. Broadly, they take several forms –

1.    Upside ratchet (Founder earn-ups) – Used frequently in PE buyouts to reward outperformance. Founders start with a smaller stake at closing and earn additional equity if they meet predefined financial targets (e.g., EBITDA, ARR in SaaS deals etc.). Ratchets can also be tied to founder retention (continued employment or involvement).

Illustration: Imagine X Pvt Ltd. acquired by a PE fund, whereby founders retain 15% and PE fund acquires 85%. The deal includes an upside ratchet:

If X hits ₹120 crore ARR within 24 months, founders get an additional 5% equity.

• Outcome A: X reaches ₹140 crore ARR.
  • → Founders’ stake increases from 15% to 20%.
  • → Their upside reflects the value they created, after the deal.

• Outcome B: Company Misses Targets – ARR hits ₹110 crore.
  • → No adjustment and Founders remain at 15%

Essentially, this structure is the mirror image of the buyer‑protection ratchet (Downside ratchets), which reallocates equity away from founders when performance falls short.

2.    Anti-dilution floors for founders – Founders negotiate a minimum ownership “floor” — a level below which their stake cannot fall, even after investor anti‑dilution adjustments. Though rare, this is seen where founders have strong leverage (e.g., valuable IP, strong metrics, or competing term sheets). Functionally, this operates like a ratchet preserving a minimum founder stake through future down rounds or recapitalisations.

3.       Symmetric Ratchets – These allow equity to move in either direction — from founders to investors or vice versa, depending on performance against agreed metrics. They create a balanced, performance‑driven risk–reward sharing.

Illustration: Consider G Pvt Ltd. acquired by a strategic investor. The deal includes a symmetric ratchet linked to EBITDA performance over three years:

• If EBITDA exceeds ₹100 crore → 3% equity shifts from investor to founders
• If EBITDA falls below ₹80 crore → 3% equity shifts from founders to investor
• If EBITDA falls in the middle → no shift

When a Ratchet Fires: Translating Economics into Equity

When a ratchet triggers, the agreed performance outcome must translate into an actual change in the cap table and that can happen in any of the ways given below:

1. Issuance of new shares
2. Transfer of existing shares or
3. Alteration of conversion terms of convertible instruments

Each path may appear mechanically simple on paper, but understanding its feasibility is crucial. The elegance of a ratchet in theory often collides with the practical realities of the Companies Act, FEMA, and Income Tax rules.

In the following sections, we’ll break down how each mechanism functions in practice and evaluate their feasibility within the Indian tax and regulatory framework.

1. Issuance of shares

(a) Issue of shares for nil consideration

At first glance, granting additional shares for no consideration appears to be the cleanest way to reflect the economics of downside protection. Conceptually, it resembles a selective bonus issue in favour of the beneficiary of the ratchet.

Companies Act:

Section 63 of the Companies Act, 2013 governs bonus issues and provides that a company may issue fully paid‑up bonus shares to its members. The moot question here is – whether a selective bonus issue i.e., in this case, issuing bonus shares only to founders and not all (or only to investors excluding others) – is permissible?

Section 63(1) states that “a company may issue fully paid‑up bonus shares to its members, in any manner whatsoever…”. A literal reading of the phrase “in any manner whatsoever” creates room to argue that differential or selective bonus allotments among members are not per se prohibited, so long as they are within the broader confines of the Act and general principles of fairness. It is interesting to note that under the Companies Act, 1956, there was no specific statutory provision on bonus issues. However, in 2008, Reliance Power announced a bonus issue in which the promoters effectively waived their entitlement, resulting in a de facto selective outcome that favoured public/retail shareholders.

In the case of HIMCON, a selective bonus was issued only to the State Government, public sector banks and financial institutions. The NCLT (Kolkata) did not ban selective bonus issues outright but stressed that such structures must satisfy tests of fairness, non‑oppression and transparency; where a selective bonus prejudices a class of shareholders, it risks challenge.

In principle, a selective bonus issue may be evaluated, if it demonstrably favours minorities, based on distinct share classes, backed by overwhelming fairness and transparency. That said, there is limited jurisprudence specifically blessing selective bonus issues for private commercial arrangements such as ratchets. Implementing a selective bonus purely to satisfy ratchet mechanics — especially where it disfavors a significant shareholder class — remains legally risky.

FEMA:

Under the FEM (Non‑Debt Instruments) Rules, 2019, shares issued to a non‑resident cannot be at a price below the fair market value (FMV) determined in accordance with the prescribed valuation method.

A nil‑consideration allotment pursuant to a ratchet poses two distinct regulatory concerns:

(a)   Nil‑consideration issue to a non‑resident investor (can be observed in the case of a downside ratchet)

A selective, bonus‑style nil‑consideration issuance in favour of a non‑resident, to the exclusion or detriment of resident shareholders, may be perceived as a disguised under‑pricing of equity or a backdoor transfer of value from residents to non‑residents without compliance with the FMV rules.

(b) Nil consideration issue to residents that dilutes a non‑resident

Conversely, if additional shares are issued for free to resident promoters (or other residents), thereby diluting a foreign investor, regulators may ask whether there has been an indirect, non‑arm’s‑length transfer of value from the non‑resident to residents without any corresponding consideration.

To date, these precise ratchet‑specific fact patterns have not been definitively tested before Indian courts or the RBI, but the risk cannot be overlooked.

Income Tax:

From a tax perspective, Indian courts have generally viewed pro‑rata bonus issues to be tax neutral:

• In Pr. CIT v. Dr. Ranjan Pai [2021] 124 taxmann.com 241 (Karnataka HC), the Court observed that Section 56(2)(x) of the Income-tax Act, 1961 (now reflected in Section 92(2)(m) of the Income Tax Act, 2025) does not apply to a bonus issue. The reasoning was that any gain to the shareholder from receiving bonus shares is offset by a corresponding reduction in the value of their existing shares; the company’s funds remain within the company, and there is no transfer of property to the shareholder.
• Similarly, the ITAT Mumbai in Sudhir Memon HUF v. Asstt. CIT [2014] 45 taxmann.com 176 held that where bonus shares are issued pro‑rata, there is no property “received” in the sense contemplated by Section 56 because the shareholder’s proportionate interest in the company remains unchanged.
• In ITO v. Rajeev Ratanlal Tulshyan [2022] 136 taxmann.com 42 (Mum. ITAT), the Tribunal noted that where there is no allegation of tax evasion or abuse, Section 56(2)(x) should not be invoked mechanically.
• In Pr. CIT v. Jigar Jaswantlal Shah (R) [2023] 154 taxmann.com 568 (Gujarat HC), the Court indicated that fresh allotment of shares, per se, should not attract Section 56(2)(x) in the absence of clear evidence of tax avoidance or unjust enrichment.

These authorities collectively support the view that a pro‑rata bonus issue or a bona fide fresh allotment generally does not trigger Section 56(2)(x), provided there is no taxable “property” being received at an undervalue and no abuse.

However, a selective bonus issue in the ratchet context is more nuanced. Where shares are not allotted pro‑rata and certain shareholders obtain a disproportionate benefit, tax authorities may scrutinize whether the selective allotment results in real, quantifiable enrichment of the favoured shareholder and whether there is a tax avoidance motive or abuse of form.

Therefore, while one can argue based on the above jurisprudence that Section 56(2)(x) of the IT Act, 1961 (section 92(2)(m) of the IT Act, 2025) should not apply mechanically to bonus or fresh issues, the commercial rationale and fairness of a selective ratchet‑driven issue must be convincingly documented.

In summary, while this option is theoretically possible and most intuitive, it looks most legally precarious once you actually try to implement it.

(b) Issue of shares for consideration

Companies Act:

Section 62(1)(a) deals with rights issues, i.e., offers made to existing equity shareholders in proportion to their existing shareholding. The section does not explicitly authorise a selective rights issue in favour of only one shareholder. In practice, promoters or other shareholders can renounce their rights in favour of a particular shareholder, effectively allowing that shareholder to increase its stake. However, this is more of a practical workaround than a clean, express statutory route to targeted issuance.

For a clearly selective issuance (e.g., ratchet‑driven top‑up shares to the investor alone), Section 62(1)(c) – preferential allotment may be the more appropriate and robust route. Preferential allotments require a special resolution of shareholders; adherence to prescribed disclosures, pricing, and procedural rules under the Companies (Share Capital and Debentures) Rules, 2014.

FEMA:

If additional shares are issued to a non‑resident, the issue price must not be below FMV as per FEMA valuation norms. A ratchet that conceptually gives “extra” shares to compensate for under‑performance cannot simply use a nominal or arbitrary price lower than FMV on the trigger date. Structuring a ratchet purely through differential pricing (e.g., giving the investor additional shares at a deep discount to FMV when the ratchet triggers) could attract scrutiny as an indirect value transfer from residents to the non‑resident.

If the additional shares are issued to a resident while the non‑resident is diluted, FEMA is less directly engaged on pricing, but one still needs to be cautious about how this might be perceived.

Income Tax:

On the same reasoning as in the selective bonus context, Section 56(2)(x) / Section 92(2)(m) should not automatically apply to fresh allotments, provided there is a coherent commercial rationale and no abusive undervaluation. But where residents receive shares at a substantial discount to FMV with no clear justification, tax scrutiny is likely.

(c) Pre‑issuing ratchet shares into escrow/trust

A frequently discussed variant is to issue the “ratchet” shares upfront, either:

• into an escrow account, or
• to a trustee holding the shares on behalf of the ultimate beneficiary,

With a vesting or release condition linked to the ratchet trigger. If the performance condition is met (or not met, depending on the design), the escrowed or trust‑held shares are released to the intended beneficiary (e.g., the investor or the promoter).

This approach offers some advantages:

• The Companies Act issuance event happens once, at the outset, following normal rules (rights/preferential as applicable).
• At the time of trigger, only a transfer from escrow/trust to the ultimate holder takes place, which can sometimes be easier to manage contractually and procedurally.
• From a FEMA perspective, if the shares are issued at compliant FMV and the escrow/trust arrangement is properly disclosed and documented, the subsequent transfer may be viewed as implementing a pre‑agreed commercial arrangement rather than a new, under‑priced issue.

However, this structure is not free of risk:

• The tax authorities may argue that the economic benefit accrued over time and that the timing of taxation should coincide with vesting/release rather than initial issuance.
• Depending on who is resident/non‑resident at each step, the eventual transfer (from escrow/trust to beneficiary) may need to satisfy FEMA pricing norms, particularly if it involves a transfer from resident to non‑resident or vice versa.
• GAAR‑type arguments could be raised if the escrow/trust is used primarily to sidestep pricing or tax consequences that would have arisen had the ratchet been executed through a direct issue or transfer at the time of trigger.

Overall, while escrow/trust structures can help operationalize complex ratchets, they require careful drafting and valuation support.

2. Transfer of shares

In practice, such transfers almost always happen at nominal or nil consideration, regardless of FMV, because parties view them as fulfilment of an earlier bargain rather than as fresh sales.

The Companies Act, 2013 does not prescribe minimum pricing for private share transfers. As long as the transfer complies with the articles, shareholder agreements and requisite corporate approvals, the Act does not, by itself, dictate price.

Income Tax:

Given that these shares would mostly be unquoted, the consideration is at a minimum required to be benchmarked to the Rule 11UA value. Otherwise, this may trigger capital gains implications u/s 50CA of the IT Act, 1961 (section 79 of the IT Act, 2025) in the hands of the transferor and deemed income implications u/s 56(2)(x) of the IT Act, 1961 (section 92(2)(m) of the IT Act, 2025) in the hands of the transferee. Importantly, the relaxations for start-ups mitigating “angel tax” provisions (super‑premium issues under Section 56(2)(viib) of the IT Act, 1961) do not extend to undervalued secondary transfers triggered by performance ratchets.

[su_pullquote align=”right”]“Ratchets are flexible enough for healthy or bullish deals, not just distressed scenarios or recapitalizations”[/su_pullquote]

This creates a significant asymmetry: a ratchet designed to rebalance economics may, in tax terms, be treated as if one party made a taxable transfer at FMV and the other received a taxable “benefit” equal to the discount from FMV—despite the fact that both see it merely as fulfilment of an ex‑ante contractual bargain.

FEMA:

From a FEMA standpoint, the pricing rules differ based on the direction of cross‑border transfer:

• Resident to non‑resident (R → NR): Transfer price generally must not be less than FMV. A ratchet requiring resident promoters to transfer shares at a steep discount or nil consideration to a foreign investor directly conflicts with this minimum pricing rule.
• Non‑resident to resident (NR → R): There is usually no mandatory minimum price floor; in some cases a maximum cap may apply. Discounted or nil‑price transfers from foreign investors to residents are therefore more feasible from a FEMA pricing standpoint, though still subject to tax and anti‑avoidance scrutiny.

Overall, share transfer–based ratchets are usually the least tax‑efficient and often the most constrained under FEMA when the beneficiary is a non‑resident.

3. Alteration of conversion terms

Of the three mechanisms, altering the conversion terms of existing convertible instruments (e.g., CCDs, CCPS, optionally convertible instruments, or structured convertibles) is often viewed as the most structurally elegant way to implement a ratchet.

Instead of issuing or transferring fresh equity, the ratchet is embedded in the conversion formula of a convertible instrument issued at the time of the original investment. For example:

• At the time of investment, the terms may provide that each CCPS or CCD will convert into 1 equity share (1:1) at a specified time or upon a liquidity event, provided certain performance metrics are met.
• If the company under‑performs or the valuation falls below a threshold (down‑round scenario), the conversion ratio automatically steps up—say from 1:1 to 1:1.5 or 1:2—in favour of the investor.

In effect, the ratchet operates as a built‑in anti‑dilution or price protection mechanism. The investor pays the original subscription price for the convertibles, but the number of equity shares obtained on conversion adjusts based on the agreed formula.

From a Companies Act viewpoint, altering the conversion terms that were already baked into the instrument at issuance, and duly approved at that time (by board and shareholders as required), is relatively straightforward, provided the formula and its triggers are clearly stated upfront. If a post‑facto amendment to terms is required (e.g., to change the conversion ratio after issuance), it may require further board/shareholder approvals.

From a FEMA perspective, the key question is whether the pricing (on conversion) can be said to comply with the minimum pricing norms at the time of issuance. For compulsorily convertible instruments (like CCDs/CCPS) issued to non‑residents:

• The issue terms must be finalised upfront, and
• The resultant equity price on conversion should not be less than the FMV determined at the time of issuance

Properly drafted formula‑based conversion mechanics that are compliant with FEMA at the time of issue have generally been accepted in practice, as long as the floor price at the time of issue adheres to FMV and the formula is not structured to fall below that floor in a manner contrary to FEMA guidelines.

When the conversion ratio improves, say from 1:1 to 1:1.5 – for 1 share, the shareholder receives 50% more than what he originally invested – typically, seen in down rounds. But, a curious question is what is the consideration for those ‘extra’ shares? Typically, conversion is tax neutral u/s 47(x) of the IT Act, 1961 (Section 70 of the IT Act, 2025). The cost of acquisition of the resultant equity shares is usually taken as the cost of the original convertible instrument, apportioned appropriately. Thus, the “extra” shares under the ratchet would not, at the time of conversion, trigger a separate tax event; they simply reduce the effective per‑share cost when computing capital gains on eventual sale.

This route is often favoured by sophisticated investors and counsel for implementing downside protection in India, especially in cross‑border deals.

Summary:

In conclusion, while all three mechanical paths—issuance, transfer, and conversion adjustment—can, in theory, be used to implement ratchets in India, conversion‑based ratchets embedded in existing instruments generally offer the most legally and fiscally defensible route. Fresh issuance and secondary transfers can still be used, but only with carefully calibrated structures and a clear understanding of the attendant regulatory and tax risks.

Done thoughtfully, ratchets can be a sophisticated way to share risk and reward in emerging, high‑uncertainty sectors — but they must be engineered with regulatory realities firmly in view, not just term‑sheet elegance.

This article is written by CA Abhinaya M A, currently working with Price Warehouse & Co LLP, under the Tax and Regulatory practice, specialising in M&A.

You can reach him at – LinkedIn

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