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.