Common Stock Carveouts In Acquisitions

If you read our term sheet series, you know that we spent a fair amount of time discussing liquidation preferrences.  Jesse Fried and Brian Broughman, a professor and graduate student at Berkeley, respectively, recently published a paper about the emergence of common stock carveouts and some of the reasons why they belive venture capitals are not getting the liquidation preferences that the VCs originally bargained for.

It’s an interesting read.  I agree with most of their conclusions, but am not sure that state law plays as big of a factor as they think.  Jesse and I are shooting emails back and forth about this and I have found the discussion robust and intelligent.

The abstract of the paper:  

The literature on venture capital contracting implicitly assumes that VCs’ cash flow rights – including their liquidation preferences – are fully respected. Using a hand-collected dataset of Silicon Valley firms sold in 2003 and 2004, this paper is the first to document that common shareholders often receive payment before VCs’ liquidation preferences are satisfied. We show these carveouts are larger when governance arrangements give common shareholders more power to impede the sale. Our study shows how VCs’ control rights and cash flow rights interact to affect VCs’ cash flow outcomes, and contributes to a better understanding of VC exits.

You can find the paper here, it’s downloadable from bottom of the page.

Jesse’s bio is here.

  • Interesting research. But I think it’s important not to draw too many conclusions from a dataset that is restricted to 2003 and 2004 exits. Those were brutal years in which many, if not most, VC-backed companies were sold at prices equal to or below the total value of liquidation preferences. In those situations it is always necessary to motivate management with a carve-out in order to achieve any exit at all. These tend to be distressed situations in which many aspects of the shareholders agreement are re-opened for discussion. We would expect agreed shareholder terms to be respected at exit in most other situations.

  • Jesse Fried

    It is important to emphasize that our paper is not looking at carveouts to the management team when firms are sold, but rather at carveouts to common shareholders as a class. We start with the total proceeds of the sale, and subtract any carveout to management (there were management carveouts in many but not all of the firms in our sample). The net proceeds are what is available to be paid to common and preferred shareholders (as shareholders). We look at the division of these net proceeds as between preferred and common shareholders. We find that in most cases preferred shareholders cash-flow rights in full, and on average preferred shareholders get over 95% of their cash flow rights. But in over 25% of cases there is a deviation in favor of common shareholders, with some deviations as large as 25% of the preferred shareholders cash-flow rights. We then find that these deviations are associated with various measures of common shareholders’ ability to impede the sale (board seats, etc) and conclude that the deviations are a “payoff” for common shareholders’ acquiescence to the sale.

  • Knox Massey

    I agree with Max. Professors and grad students might be hard pressed to find agreements from the BOD on management carve-outs. I can cite a few examples locally where the liq prefs were not satisfied in order to give management(who did their best)a carve-out package that makes all parties in the deal happy. For the (smart)investors point of view, a good relationship with entrepreneurs/founders/management is as important (if not more) than absolute liq prefs. Of course, I don’t know if funds make a point to tell their LP’s that–but that’s a different story for a different topic.

    Love the site–keep it up.

  • Brian Broughman

    Thanks for both of your comments. As academics we rely on and greatly appreciate advice from the people actually doing VC deals. I agree with the concern that 2003 and 2004 may have unusual years for the sale of VC-backed firms, with many firms sold underwater as a result of depressed valuations. I don’t think, however, that the time period should change the nature of the relationship, though we may observe more carveouts as a result of the time period.
    I also wanted to point out that we distinguish between carveout payments targeted at management and carveout payments awarded to common stockholders as a class. In the study we only measure carveout payments to common stockholders, not payments used to incentivize management. Our reason for this distinction is that we wanted to study the relationship between preferred and common stockholders, and focus on common stock’s holdup power. The incentives of management and common stockholders, while overlapping in many instances, are not exactly the same. The VCs and the acquiring firm may need to award some payment to management or other key employees to keep everyone motivated and get the deal done. Common stockholders are being cashed out in the sale and there is generally less reason to keep them motivated. The other reason we focus on carveouts to common stockholders as a class is that it was much easier for us to measure than payments to management, which can be structured in numerous ways. Thanks for the comments.