A management carve out plan (MCOP) is a written obligation of the company that, in simple terms, provides that certain management members get a predetermined slice of proceeds when a company is sold. The MCOP can serve a critical role as founders and other management team members are diluted down by rounds of financing or if their equity is not in the money. Note that MCOPs are rare when the company is young and has only raised a limited amount of venture capital – no need yet for the carve out as the founders still own a large chunk of the company (thankfully).
A few key points to consider:
1. As the investors’ aggregate liquidation preference (ALP) increases typically the need for a MCOP also increases. The ALP is the total amount of $ that preferred stock holders are owed on a sale of the company under their liquidation preferences. Often times this is simply the aggregate purchase price plus any accrued dividends (not typical for dividends to accrue, but watch out if they do!). The more the company raises the higher the ALP, and thus the higher the hurdle before the common stock held by founders and stock options held by other employees are in the money. Also, if the preferred stock carries a multiple liquidation preference (like 2X), then the ALP will obviously be more than the original purchase price.
2. Is it unfair for the MCOP to provide that it only kicks in once the ALP is cleared (in other words once the sale price exceeds ALP)? I have seen this many times, and as an investor I think it is fair in some circumstances, particularly when the ALP is not too high. But, in any given situation, investors may want to motivate the management team in a sale situation. Having to clear the ALP first could get in the way of motivation. It is not uncommon for the MCOP to kick in from dollar one. It all depends on the facts and circumstances at the time the MCOP is adopted.
3. The MCOP is typically expressed as a percentage of net sale proceeds (often between 5% and 10%) and is clearly an obligation of the company. A great question to consider is how the MCOP is allocated among management members. I prefer to keep the allocations undefined and rather give the CEO the allocation power subject to Board approval at the time of the sale event. That way the CEO is empowered and can allocate based on extremely current facts (as opposed to setting allocations well in advance of a sale event). Yet sometimes it is necessary to allocate in advance to better align the interests of management team members. Remember VC = OB (see earlier post from February 18, 2011).
4. For clarity, the Board is the body that adopts the MCOP. But when should the MCOP be adopted? I prefer it to be adopted before the company is even put in play. It is not uncommon, however, for it to be adopted at the time of the sale. Consider who has the most bargaining power at the time of the sale. It might be the management team or it might be the investors. This will typically depend on how valuable the team is to the buyer and the success of the company.
5. Finally, should the MCOP proceeds be decreased by the value of equity held by the management team members that benefit from the plan? That does make sense and I have dealt with numerous VCs that insist on it. The argument is that the MCOP is a backup plan to make sure that the management team members get what they bargained for in equity value. For example, if the CEO bargained for 7% fully diluted, then the CEO should get 7% of the sales proceeds (assuming that any option exercise price is very low). The MCOP could be used to fill that gap, particularly if allocations are done at the time of the sale transaction. Anyway, good point to consider and netting out equity value from a MCOP payout accomplishes this.
The MCOP is a surprisingly complex topic. You probably noticed above many flip-flops. MCOP analysis is fact driven, and sometimes I cannot suppress the lawyer in me.
It’s also not uncommon for certain clawback provisions to be tied to a MCOP. For example, the shares from a MCOP may sit in escrow for 12-18 months and if, during that time, certain milestones are not hit, the number of shares in the MCOP can be reduced before they are distributed to the participants.
For example, percentages of the total share allotment might be tied to specific clients staying with the company post-acquisition. Or, may be tied to specific integration milestones. The idea is that, even if participants in the MCOP leave, they have some motivation to ensure that the acquisition goes smoothly post-transaction.
There are also tax implications to consider. The IRS isn’t totally clear on when a transaction like this becomes a taxable event. Is it at the price of the assets when they are made available to you, even if you can’t sell them because they are in a holding pattern? Is it when the clawback restrictions expire, thus ending a period where you have a substancial risk of forfeiture? Or, is it when both the clawback provisions and the escrow period end, meaning, when you can actually sell the assets?
I’m dealing with this now. (And, btw, my accountant is recommending that I report the value at the time that the clawback restrictions expired, even though I’m still in escrow and can’t sell the assets). It gets complicated, but do agree with you that it’s a great way to reward management (or other critical members of a transition team). Especially when an acquisition puts all of the common shareholders underwater.
Just found your blog via a Tweet from Brad Feld – had no idea that there were VCs/entrepreneurs Upstate, but very happy to see that there are. Look forward to reading more.
thanks Andrew. much appreciated.
Excellent article. Can you comment on how these carve-outs are treated for tax purposes? Capital gains or ordinary income?
Ordinary income…..sorry! Definitely compensation related ordinary income is what I have been told.
This is a great post. Thanks for the overview. 🙂