I had a meeting last night with an entrepreneur and old friend of mine visiting Silicon Valley from Tel Aviv in my San Francisco office and then we went 1:1 afterwards (without my Rubicon team) for a drink. I was keen to learn about the opportunity to invest in his new startup, but I also wanted to hear how my previous investment I made 7 years earlier into his last startup would work out for both him and me. His last startup (I will not name names in this post) is an Israeli company backed by Pitango, Carmel and other leading VCs from Israel.
The two co-founders left the company about 18 months ago after nearly 10 years of building up this first startup. Both now have new tech companies we’re looking at potentially investing in. The previous company continues to grow revs with solid profit margins, but has failed to scale to the level we had all initially hoped for, but is still a valuable asset. They have a meaningful liquidation stack of over $40m total that needs to be paid off to the VCs and bond holders before the founders’ common shares (founder stock) would receive any consideration from the exit. This means that it is possible that their previous company where they raised over $40m of VC funding might be sold for less than the $40m invested. They have a 1x liquidation preference they need to pay the VCs back and a few million dollars venture debt that gets paid out before the VCs. So the waterfall of liquidation preferences looks like this: 1) venture debt, 2) VCs, 3) common shareholders (founders). Based on current multiples of top line, bottom line, growth and comps it would appear the sale of the company any time soon would most likely not clear the liquidation stack for the founders. So after a decade of hard work and sacrifices the founders would come out making nothing and return pennies on the dollar to the VCs after the venture debt guys get made whole.
The good news is that a few years ago in an effort to keep the founders incentivized to keep running the company when raising yet more funding, in an agreement among the founders and VCs, they signed a “management incentive plan” more commonly known as a “carve out”.
In this case of my friends from Tel Aviv the carve out is a classic 10% of the top line of the sale consideration. (Consideration means the mix of cash, stock, earn-out or any other form of compensation in an M&A trade sale of a company). So for simple math if the liquidation stack (amount owed back to creditors and equity investors) were $100m and the company were sold for $90m, the entire $90m would normally go to the creditors and investors. With a “10% carve out” the creditors would get whole first. So let’s pretend that their loan was $10m of venture debt and $90m of equity liquidation pref, which totals $100m. In this case if the company were sold for $90m in cash, the venture debt guys would get their $10m back first and then 10% of the remaining $80m (=$8m) would be paid to the owners of the carve out, typically management, and then the remaining $72m would be paid back to the VCs. With no carve out the founders of this case would get nothing for the sale of $90m cash. With the carve out, if split two-ways by two founders they would each walk away with $4m in the pocket and just worry about their tax burden on the 4. The sad thing here I have witnessed in other cases is that that the head of sales, head of product and lots of other key management folks are often not included in the carve out and they get essentially left out in the cold. It pays to have a voice at board meetings. (WARNING: to you senior blokes that are fighting to make a startup successful and watching the amount of funding raised eclipse the amount you could ever sell the company for.)
In the case of my buddy from Tel Aviv the carve out is 10% of exit consideration and it’s a two-way split between him and his co-founder CTO, also a good friend of mine after so many years.
What I found interesting to me learning of this over last night’s drink was to see that after all these years, blood, sweat and tears they effectively each own 5% of the company despite all the messing with the cap table from so many financings and even leaving the company. Often without a carve out a founder can find herself owning less than 5% at the time of exit; so that’s really not so horrible this carve out scenario of selling the company for less than the funds invested. Absent a carve out in a profitable rosy scenario founders owning less than 5% at the time of exit can easily happen with other cofounders, employee stock option pool, and Series A to G – not uncommon. Add the reality of down rounds, I have witnessed founders getting diluted to less than zero, and even zero and then fired to stop the salary payment (mind you, this has never happened at Rubicon, but I have seen this with my own eyes.)
So the “carve out” is another tool in the toolbox of both the founder / hired CEO and VC.
See below why it makes sense for the VC.
How Liquidation Preferences and Carve Outs Play in Exit Scenarios
Antoine Papiernik, partner at Sofinnova Partners and old VC contact of mine in Paris shared this insight for my previous book: The Entrepreneurial Bible to Venture Capital (McGraw Hill). Keep in Mind that Antoine focuses on healthcare life science deals that are often backed by huge syndicates of VCs sharing the risk and upside. These companies can consume upwards of $1bn of funding before the exit and running through multiple binary clinical trials where a syndicate of 14 different VCs backing one single startup is not uncommon. I think the lessons from biotech crossover brilliantly to the internet / software world. For some reason what is abundantly clear to everyone in biotech is less clear to folks in tech, but I often see the crossover clearly in my mind and it helps shape my thinking as a former biotech investor now purely focused on tech.
Here are Antoine’s words:
“The more VCs involved with a company, the harder it becomes to bring the company to an exit. With many VCs in the cap table, you get many differing point of views and motivations around each financing, staffing, and exit decision. Some of the VCs may be limited on cash to continue to invest in that company the reserves of their fund, the timing of their fund, loss of belief in the company, and many other factors. Management needs to lead a company to an exit with the support of a subset of the board. If management does not get paid, the exit will not happen. Liquidation preferences dictate how much of the exit price goes to pay back VCs before management gets any money from the exit proceeds. The result is that companies have a specific liquidation preference hurdle to clear before management sees any cash. Often in the capital-intensive deals the liquidation preference may be $150 million to $250 million.
As a result, if an opportunity comes along to sell the company for $250 million rather than $1 billion, the VCs may not see that opportunity. Management simply would not inform the VCs of this. This is bad. So VCs need to provide management with an incentive. This is done with a management incentive plan known as a carve out. We at Sofinnova make sure our managers have carve outs so they know they will benefit from a sale. This is not the VC “being nice.” VCs will regret it if you don’t put these in place. We once had a deal where we invested in the series A alone and then carried the company through series B and C. We could have sold the company after series A and gotten our money back; but instead we replaced the CEO, recapped, and kept fighting on. We then ended up with a third CEO before getting to the exit with a 3-times liquidation pref. These nightmares and recaps could have been avoided had we exited after series A and rewarded the founding CEO. This is a mistake we would not make again. In the end, management needs to lead the company to an exit with the support of at least a subsection of the board.”
Back to me Andrew Romans writing:
Antoine Papiernik at Sofinnova is right. Put a carve out in place the moment the company’s performance and time into the deal is at risk of not clearing the liquidation stack. Do this to get the information and take the credit for being founder-friendly and the good guys that take care of their founders even when sailing through rough waters. Get the information. You can always block the sale. If your fund is already in carry (profit) selling with a carve out for pennies on the dollar can return a lot of cash to your LPs and you as the GP.
Here’s one more Antoine contributed to my previous book I think worth sharing here. It’s a bit of rough play and therefore controversial. If it’s about to happen to you, well, you may as well be able to spot it coming on the horizon before it’s already happened. This is gold for founders, hired CEOs and investors of all stages.
How to Smoke Out the Serious VCs in Your Syndicate
Laissez-moi passer les paroles à Antoine…
“Sometimes a CEO or leading VC needs to smoke out the VCs that are not serious about supporting and building the company. One option at your disposal is to put in place a bridge financing with a 20-times liquidation preference plus a new option plan for management. This is a “pay-to-play”, and you find out pretty quickly who wants to play. If investors do not invest, they get washed out. You can’t accept free riders who want to find reasons to look for the future. Only soldiers that can fight should be in the battle. If you lose belief, sell for one dollar. Toxic prefs protect against a dead syndicate.”