Carve outs for management is a tool that is often overlooked by boards in angel-backed companies. It is a tool that can be a critical in making an acquisition occur, but is difficult to get right. First of all, both management and the board are often too close and emotionally involved to make a clear decision.
For those that aren’t familiar with the concept of a carve out, it is a payment to management, from the proceeds of a transaction, that is paid out before investors are paid the amount they would otherwise be due from the sale of the company.
Having served on more than my share of boards, and often on the comp committee, I am often asked about the following situation, which is typical of one where a carve out occurs:
- A company has taken quite a bit of investment, usually from institutions and angels.
- The deal that was struck has a liquidation preference (if you don’t know what this means, you should educate yourself). Good terms for companies meeting their goals are 1x participating preferred (sometimes capped); bad terms are 2x to 3x and usually granted when a company is in trouble and needs to raise money.
- Acquisition seems like the best alternative, but the offers are for less than the liquidation preference (or not much more than the preference).
In this case, the common stock and options are essentially worthless. The founders, employees, and others who bet on the upside find themselves in the position of having worked for little-to-no upside (or in the case of board members or consultants who took options nothing!).
What is the board to do?
Here is my perspective from serving on dozens of boards and many comp committees:
- It was management’s sweat that got the company to exit. This needs to be rewarded.
- On the other hand, the board needs to recognize that management did not deliver the value that was promised when the money was taken. (Nor did the board.) It is not fair to give management a great return, while investors lose money.
- The board should try, as a first priority, to ensure that management gets a good deal from the acquiring company. This is good for the acquirer and allows more of the proceeds to go to investors.
- One often hears that management is unwilling to allow a deal to proceed if they don’t make enough money. And therefore they would rather the company stay in operation, even if it means a greatly reduced valuation. If the original deal terms don’t either carry enough voting shares, or the rights to force the sale, then the investors might be screwed. This is why alignment with the entrepreneur and deal terms can matter.
- Finding a fair solution is often difficult. Hiring an experienced person/consultant might be a good idea, if the board and management are willing to follow their dispassionate advice.
- If a carve out is necessary, I believe that it should be graduated (like a graduated income tax). In that way, as the investors do better, management increasingly does better. This aligns incentives. For example, if the liquidation preference is $10M and the acquisition will be in the range of $5-15M, the carve out might look like this:
- 5% of proceeds for the first $5M (which is $250k at $5M)
- Between 5-10M, $250k plus 7.5% of the amount over $5M, which is $375k at 10M
- $875k plus 10% (plus the value of their stock, which is now in the money) for any amount over $10M
- This seems to give both aligned incentives and balance the reward for management with the need to get investors their money back.
Of course, all of this looks much better when the company sells for a lot more than was invested!