Q: We are in the midst of negotiating a carve out with an investor on the East Coast. Two stumbling blocks have occurred. The first issue is what is an appropriate option pool size and does it vary from East to West coasts? The investor tends to believe that there are a significant differences in sizes of pools for Boston based companies vs. Bay Area-based companies.
Secondly, we are debating whether or not it’s appropriate/acceptable for management to have a carve out and maintain participation in the ESOP should an exit be large enough to be in the money?
A: (Jason). Most of the compensation reports that we’ve seen, as well as evidence from our own portfolio would indicate that there are not significant differences in option pool sizes between coasts. That being said, the range of option pools can be anywhere from 10-30%, so the there is a wide variance, but our opinion is that this is fact specific, not location biased. It really depends on how many rounds of financing the company has consummated and, to some extent, company performance. Recaps tend to decrease the size of the pool to the minimum amount to keep current employees properly incentivized and not much extra.
With respect to your question regarding the carve out and employee participation in the ESOP (Employee Stock Option Plan), we assume the following:
1. The company has enacted a carve out plan for employees on the assumption that a liquidation event will not properly compensate employees due to the potential size of the liquidation event and the liquidation preferences ahead of the common stock underlying the employee options. For background on management carve out plans, see our prior post here; and
2. The employees have options / stock issued from the ESOP, which depending upon the size of the liquidation event may or may not yield any return.
The way we’ve seen management carve out plans and options mix at the time of liquidation events are fairly standard. In short, we’ve seen a reduction in the aggregate carve out once the employee options are in the money. Let’s create an easy mathematical example and look at two potential outcomes.
- Carve Out Plan: 10% of aggregate liquidation proceeds.
- Range of liquidation events that would return nothing to employee options / stock: $0 to $50M dollars. (In other words, any event that would return $0 to $50M to the company would offer no return to employees due to liquidation preferences).
- Employees would receive 20% of any amounts of consideration above $50M.
From $0 to $50M, the carve out provides 10% of proceeds to the recipients of the carve out plan. At $50M, $5M would be the carve out. With a $60M dollar deal, the employees would receive $2M on their options. So what happens to the carve out?
The carve out is normally reduced – how much is a negotiation. In some cases, it’s a dollar-for-dollar reduction. In our case that would mean that at $50M, employees get $5M and at $60M employees would get $5M, but at $60M, the carve out piece would only be $3M, while the option payout of $2M would pick up the rest. In this case, you’ll note there is a “flat spot” for employee return until the deal size is above $75M.
One could argue that in order to incentivize management to maximize the value of the deal above $50M, there should be a “sharing” of the proceeds. Instead of a dollar-for-dollar reduction, maybe it’s a 75 cents reduction for every dollar. Again, it’s a negotiation.