The Case of the Carveout Conundrum

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HEIDI: Welcome to The Startup Solution and “The Case of the Carveout Conundrum.” I’m Heidi Roizen from Threshold Ventures.

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About four years ago, an entrepreneur I’ll call “Anya” was developing a software product in the agricultural supply chain space. My firm, Threshold Ventures, liked what we saw, so we invested six million dollars in her A round. In the two years that followed, things got a bit rocky, and she started missing some important milestones. By then, Anya was also running low on capital. Luckily, she found some new investors who were willing to extend her runway with a senior A-1 round of $4 million. So, we agreed to let her go forward with that financing to see if she could get back on track. Unfortunately, about a year later, a new competitor emerged, kind of blowing Anya’s product out of the water.   

Anya was finding it impossible to raise any more money, and she didn’t have enough traction to get to breakeven. So, with about nine months of runway left, she turned her attention to finding an acquirer. And shortly after pivoting to this path, Anya left me this message.

ANYA:  Hey Heidi, it’s Anya. My lead developer quit today. I’ve been open with everyone about our round falling through and that I’m talking to some companies about M&A…so I get that people are worried, but now I’m worried that the team’s going to fall apart before I can get anything done. Anyway, one of my friends went through something similar, and he said that they used a carve-out agreement to motivate people to stay through a deal. Can you walk me through how to do that? Thanks.

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HEIDI: Look, this is not surprising – once people know that their startup will either be sold or shut down, it’s only natural for them to worry that their jobs will go away and their equity will be worthless. Some of them might vote with their feet.

As those of you who are regular listeners already know, companies in this situation usually sell for pretty low prices – usually for less than the total money they’ve raised. And since virtually all tech startups raise money by selling preferred shares, those preferred shareholders have a contractual right to receive their money back first in any sale event. This means if there’s not even enough proceeds to pay those preferred shareholders back, there’s not going to be any money left for the common shareholders in line after them, like Anya and her team.

What Anya was asking me about, a management carve-out agreement, is a way to incentivize a team to stay through a situation like this even when their common stock is likely to be worthless. You can think of it as a sort of sales commission paid to team members who stay with the company until an acquisition can be consummated. If the company is sold, they get a payout and maybe also continuity for their job. And for a lot of people, that’s enough to make it worthwhile to stick around. 

Unfortunately, carveouts are much more complicated than simple commission plans – which is why I’m devoting a whole episode to them. I’m going to expose you to some of the twists and turns by walking you through Anya’s situation. But even after you’ve listened, please know that carveouts are not a DIY project – so you’ll need a good lawyer and a good tax advisor if you’re gonna go down this path.

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For Anya, the first conversation we needed to have was about who to include. She had pared the company down to the 20 people she felt would be essential to any acquirer and wanted to include all of them in the carveout – which seemed perfectly reasonable to me. Anya also felt bad for her co-founder, who left two years earlier and still owned a fair bit of common stock. So, she wanted to include him, too.

I hate to say no to entrepreneurs, but this is a no for me. Remember that with a carveout, you’re diverting money from someone who has the contractual right to get it (usually the preferred shareholders) and giving it to someone else. And almost always, the person you are diverting it from will have some sort of vote as to whether you can even do this. Feeling bad about worthless common stock is probably not gonna be a compelling justification to those voters. From my experience, the only justification for a carveout is to increase the likelihood and potential value of a company sale. So, if someone is no longer involved with the company, there’s no justification to include them, sad as that may be.

Anya was bummed, but she got it. She created a spreadsheet with every employee on it and assigned each person a percent of the total carveout based on how critical she thought they were to a potential transaction. Each person who stayed through the close of the transaction would receive their share, even if they were terminated at the close because the buyer didn’t want to keep them. But if they chose to leave before the close, they’d forgo their payout, and it would go back into the carve-out pool. 

And speaking of those payouts, there’s one thing Anya hadn’t thought of that we also needed to account for. Sometimes, the buyer pays with stock, not cash. But you can’t take in private company stock and magically pay out cash. So, we had to add the stipulation that whatever we got as proceeds would also be used to pay the carveout. This sounds fine in theory, but it turns out to be problematic in practice. Let’s park that thought for now, but we’ll come back to it when it screws up Anya’s deal later on.

Next, we had to decide what to do if the common shares actually ended up in the money. While this is rare, it does happen, and then it seems kinda unfair for employees to get both the carveout, which was intended in part to make up for their worthless common shares and then also get additional value from those common shares. So, we agreed to a very typical term, that if the common shares and exercisable stock options become in the money, the amount that each person gets from those shares would be netted from their carve-out payment.

The final thing we needed to agree on was how much the carveout was actually going to be in terms of a percentage of the sale price. Because I’ve only done a couple carveouts in the last few years, I asked one of my favorite lawyers, Alex Kassai of the law firm Cooley – about what he’s seeing in the current market. He said that roughly half of carveouts today are in the 6-10% range, with the bulk of the rest being in the 11-15% range.

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With Anya, we settled on 12.5%, feeling that this created a decent incentive for her team to stay while still being reasonable with respect to the preferred shareholders, who, again, are paying for the carveout with money they would otherwise be entitled to.

Now, there are all sorts of bells and whistles people sometimes add to carveouts. I’ve heard people lobby for increasing the percentage as the sales price gets bigger. I’ve heard others argue for decreasing the percentage as the sales price gets bigger. To me, it’s best to keep it simple. After all, a carveout is there to incentivize employees to stick around. So those employees should be able to clearly calculate what they would actually get. To me, straight percentages seem fair, are easy to calculate, and they seem to work fine.  

Now that we had a deal that we both felt was fair, Anya had company counsel draft a carve-out agreement to capture all this for board approval. While every company is different, the vast majority require board approval to put a carveout in place. And depending on the rights of your shareholders, you may also want or need shareholder approval, which Anya needed from a majority of each class of the preferred shares. Even if not necessary, getting shareholder consent, including from common shareholders, can be a wise way to avoid a lawsuit in the future.

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The board quickly approved the carveout, but when we got to shareholder approval, we hit a snag.

In the agreement, we explained that the carveout would be calculated as 12.5% of the net sales price – that is, the sales price of the company minus transaction fees and debt. In Anya’s case, she estimated a million dollars would go to the lawyers and the banker for their professional fees, and another million would go to pay back a credit line she had drawn. Then, the carveout would be calculated on that net amount and come right after those payments, that is, 'at the top of the stack,’ before any preferred shareholder would get paid. Sounds fair, right?

Well, no, not in this case. We neglected to think about the implications of taking the carveout off the top, which, counterintuitively, actually impacts the people at the bottom of the stack the most!

Let me explain. Anya had a million of debt, a million in lawyer and banker fees, and then the carveout to pay. But then her A-1 investors held a senior preference, meaning they would get their four million dollars back before we A-round investors would be due anything.

But this order creates a problem when it comes to who actually ends up footing the bill for that carveout. To see this, imagine first that her company sold for $10 million but don’t include the carveout yet. In this case, the first two million would pay the debt and the fees, the next four million would go to the senior A-1 investors, and the last four million would then go to us A-round investors – and then we’d be out of proceeds.  

But now let’s add the carveout, which comes ‘off the top,’ so to speak. Start with the same 10 million, with the first two again going to the debt and the fees, which leaves an eight million dollar net sale price and eight million dollars to distribute. But now, pay the carveout, which is 12.5% of that eight million, or one million dollars. Now we’re down to only seven million left. Four million of that goes first to the A-1 investors, leaving three million to go to us A investors.  

So now, do you see the problem? In the first example with no carveout, we A investors at the bottom of the stack would have gotten four million dollars, but when you add in the carveout, we A investors would only get three million dollars – that is, we alone would have paid for the entire carveout!  

Does that seem fair to you? No? Well, it didn’t seem fair to me either! And we had sufficient voting rights to block the deal, not only the carveout but also the entire acquisition. Of course, we wanted both these things to happen, but not if the carveout came at our sole expense. So, we used that leverage to negotiate that the carveout be taken equally, percentage-wise, from all the preferred shareholder proceeds.  

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By the way, I hope you hear that clock ticking because all this back and forth takes time. It may take 30-60 days – or longer to get a carve-out plan formally approved. It took us more than a month with Anya’s, but we got it in place and approved by both the board and the shareholders. And it seemed to work because only one of the employees decided to leave after it was announced.

Anya then worked with a boutique investment banker and spent five months on outreach to find an acquirer. They contacted over 40 companies, had interest from about a dozen, and ended up having serious discussions with four of those. One dropped out, and two made all-stock offers in the two-million-dollar range. But one company got excited about the opportunity and bid 10 million dollars in an all-stock deal. Plus, they committed to making market-rate job offers to all 20 employees. It wasn’t enough to get everyone their money back, but we felt good about the extensive process, and everyone agreed that this was by far the best offer, so we should take it.

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And that’s when we hit our next problem. Remember when I said we can only pay out the same currency we get in? Well, getting private company stock creates a big problem for the carveout. 

For tax purposes, carve-out payments are not considered long-term capital gains. They’re ordinary income – because they’re not stock that has appreciated, but in essence are bonus payments. So, if an employee is paid, say a hundred thousand dollars worth of stock in the acquirer’s company, they’ll immediately owe ordinary income taxes on that. But what money do they use to pay those taxes? They usually can’t sell that private company stock in order to get liquidity, and most early-stage startup employees don’t have fifty grand lying around to pay those taxes.  

To make this deal work, Anya needed to find a way to get some of the proceeds in cash and then had to get that cash to go to the entities who actually needed to receive cash – that is, the debt, the banker, and lawyer fees, and the carveout recipients.

Anya needed three million dollars in cash – a million for the debt, a million for the fees, and a million for the carveout. So, she went back to the acquirer and asked them to revise their offer. Instead of 10 million in stock, she asked for 3 million to be paid in cash, with the remaining seven million to be paid in stock. Luckily, when she explained why she needed this to happen, the buyer agreed to do it.

Then, she went to her investors and explained the problem, as well as her proposed solution. Unlike the employees, the investors were all booking losses, so they wouldn’t be facing any tax liabilities. If all the investors agreed to take the stock and let the cash be used for the debt, the fees, and the carveout, then Anya’s solution could work.  

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Luckily, all the investors had faced this situation before, so we were amenable to doing it, so long as the shares were being fairly valued. What do I mean by that?

Well, those of us taking stock had to believe that it was being fairly valued relative to the sticker price of the deal. Many deals fall apart when the acquirer wants to, for example, give the target company’s investors common shares but value those shares at the acquirer’s last-round preferred price. Those two classes of stock are not worth the same, and that’s not a fair trade! But luckily, the buyer was very excited about the deal and had recently raised a large round of funding. So, they offered us senior preferred stock, the same class as their last round, which meant we had a very recent market validation of the price.

So, we closed the deal and got our 10 million in stock and cash – except actually, we only got nine million at the time. Why? Well, there’s often something called a holdback, which just means a portion of the proceeds are held in escrow for some period of time, usually six months or so. This is so that the acquirer has a pool of resources to claim against if they find some sort of problem that doesn’t match what they agreed to.  

For example, if they were told the company would have 500 thousand in its bank account at close, but the account ended up empty, they might claim that against the holdback. This is a typical term. The amount is usually held back proportionally from everyone getting proceeds, except from fixed fees like the lawyers would get.

Luckily, nothing came up. So, once we cleared the holdback period, here’s how the payouts ultimately played out. The first three million, which was all cash, had gone to the lawyers, the bankers, and to the carveout – that is, to the employees who stayed til the close of the deal. That left seven million in stock for the investors. The first four million of that would have flowed to the senior A-1 investors, leaving three million for us A-round investors. But since we had both agreed to pay for the carveout, the A-1 investors instead got three and a half million, and then we A-round investors also got three and a half million.

Today, Anya and her team are still working for the acquirer and about to release a new version of her product I’m hearing good things about. I’m hoping for a good outcome not only for Anya and her team but also for us since we’re still shareholders in the company that acquired hers.

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So, what can you take away from the case of the carveout conundrum?

First, carveouts are useful constructs for motivating a team to remain through a transaction. However, carveouts should not be used to make other shareholders or former employees better off for reasons unrelated to helping a transaction to occur. 

Second, carveouts tend to fall into a typical range of 6-15%, and I believe the best ones have simple terms.

Third, carveouts are complicated! They take time to negotiate and then put through your company’s approval process, so plan on at least 30-60 days and a good attorney to get this done.

And finally, especially if the acquirer is buying your company for stock, you may need to renegotiate some of the terms of your sale agreement and your carveout to make all the pieces fit together. But it’s worth the work to get to that happy outcome!

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HEIDI: And that concludes “The Case of the Carveout Conundrum.” For the record, this situation is real, but Anya is a composite. And many thanks to Alex Kassai and the team at Cooley for making sure I got the legal parts right. 

Thanks for listening to “The Startup Solution.” We hope you have enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures.

Further Reading

Here is a great legal review of carve-out agreements:  Carving Up the Pie

I didn’t cover this in the podcast, but a somewhat simpler version of a carve-out agreement, and one with additional usage for non-change-of-control events, is the Retention Bonus.  More here

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