By Russ Wilcox, Partner at Pillar. As seen in Hackernoon.
We all understand that innovation is hard, and not all start-ups succeed. If you build a career as a serial entrepreneur, the odds are that sooner or later you are likely to find yourself leading a business that has run out of cash. Whether the business has run its course, you weren’t able to find product-market fit, or the market conditions have unexpectedly changed, the inevitable next step is to sell your business for whatever you can. This allows everyone to move on.
Before you start calling possible suitors, consider taking one important step just for you and the rest of your team. Ask your Board for a carve-out in writing.
What’s a Carve-Out?
If you will be selling a company that has built up a significant amount of liquidation preferences, there may be uncertainty as to whether the exit price will be enough to repay them all. Typically the liquidation preferences are equal to all your past investment dollars raised, and sometimes there is 5-8% compound interest as well. If you sell for less than the preferences, all of the proceeds go to the investors, and the Common Stock (what you own as a founder) gets zero.
In that case, what typically happens is that the Board creates a “carve-out” so that 5-10% of the exit price, no matter how low, will go into a pool.
If the pool is expected to be small, the distribution may be limited to the senior team, e.g. half for the CEO and half for the VPs. If somewhat bigger, it may be distributed pro rata across Common shareholders. Rank-and-file employees don’t usually participate, however, the acquirer often chooses to offer raises, fresh options, or stay bonuses to key personnel as part of the acquisition.
The carve-out is a motivational sales commission for the managers who have to stick with the company and make sure it gets sold, even though they know their own jobs may be ending.
What’s a Stay Bonus?
If the company looks like it has a decent chance of being sold as a going concern, then the Board may put in place stay bonuses for the senior team, so that the business can be shopped as a functioning company all the way to the last moment of cash remaining. This is pretty rare and would usually only happen if the team is really talented and likely to be recruited away during the period of financial distress.
If you get a bonus like this, don’t spend it. Set it aside for the next few months, because if you fail to sell the company and go bankrupt, creditors will surface. Once they discover management was given a recent bonus, they will sue the team to get back the money. Depending on how this negotiation proceeds, management may have to return 25-50% of the stay bonus.
Insist on a Written Carve-Out
Let’s say you are asked to start shopping the company and you ask politely for a carve-out. What often happens in these situations is that the Board expresses verbal support for the idea… but does nothing.
One reason might be that they want the CEO to stay motivated to reach an exit price above the preference limit.
Another may stem from a quiet difference of opinion. Board directors who are supportive may sincerely mean it when they say “if the values look too low, don’t worry I am sure we will put in place a stay bonus.” Other Board members may be feeling less charitable but staying silent.
Once you actually get the final offer, it is too late. The company is poised to dissolve and your Board may forget all about its past verbal assurances to you. Even if some of the Board remains supportive to award the carve-out, other investors who feel upset at their losses may refuse to go along no matter what verbal assurances they gave previously. Those investors can justify their refusal by saying that they have a fiduciary obligation to do the best for their firms, so they can no longer vote in favor of a carve-out.
Therefore, it is important that you insist on getting your carve-out in writing and passed by the Board and made official BEFORE you lift a finger to shop the company, even if that irritates some people. (They are likely the ones who did not intend to treat you well anyway.)
In summary, protect yourself and your team upfront. Then you can do your best to maximize the exit value with confidence.