Planning for management carveouts in your exit

In certain exit scenarios – particularly distressed sales or situations where liquidation preferences significantly exceed the sale price – climate founders and their teams end up with little or nothing at all. A management carveout can protect you and your team against this outcome. While this isn’t something every company will need, if you find yourself facing one of these situations, it’s worth knowing how they work well ahead of time. 

Tanatswa Mapondera is Senior Associate at Aligned Climate Capital. We sat down with him to discuss when a carveout comes into play, how to negotiate for yourself and your team, and why getting ahead of the worst-case scenario gives you the best chance of a decent payout.

What is a management carveout?

A carveout occurs when a portion of transaction proceeds that would otherwise go to investors or other counterparties are diverted to the management team instead. There's flexibility in what a carveout can look like: it can be cash or stock in the acquiring entity, and doesn't necessarily have to mirror the overall deal structure. In transactions with preferred shares, the carveout comes off the top, effectively reducing the purchase price for everyone.

When do you need one?

Negotiating a carveout only becomes necessary if – due to liquidation preferences or debt obligations – there simply either isn’t anything left over for founders or the wider team. Or, there might be something, but not enough for you to feel good about the deal considering the work you’ve put in to build the business. A carveout lets you close that gap.

Staying one step ahead

While a carveout tends to be negotiated as part of an acquisition, you can start preparing for it much earlier by being thoughtful about governance when you raise outside money and change the dynamics of control within your business. Founders should ensure their board composition and voting rights don’t leave them without any leverage if a difficult exit scenario occurs down the road.

Whether a carveout is even possible comes down to thoughtfully structured governance: who has the right of refusal on a sale, what the voting composition of your board looks like, and how aligned people are with you. If your board is made up of two investor directors plus you, with no independent to provide balance, you'll be in a much weaker position should a carveout become necessary. 

If it’s crunch time…

Without having laid this groundwork, the topic of a carveout usually surfaces when you get an acquisition LOI and the price is too low to negotiate higher. You’ll need to start by bringing your lead investor onboard. They’ll then need to convince everyone else, as you'll need both board approval and stockholder approval. Bringing everyone around can be a drawn out and tense process – unless they need your cooperation for the deal to go through, there’s no reason for them to agree to a carveout. Depending on how much runway you have left, it can be a take-it-or-leave-it situation – and unfortunately, founders often end up with nothing.

How to structure a carveout that realigns incentives

Because it pushes the liquidation preference further out, the conventional approach to a carveout puts you and investors at odds with each other. A better way is to structure it like a progressive tax. The team earns into the carveout as a percentage of proceeds, with bands that increase as the sale price rises toward the liquidation preference amount, capping out at a certain point. 

For instance, say the liquidation preference is 1X with $50M raised. First, set a floor so there's no scenario where the team walks away with nothing. Then build out the tiers: between $5M and $15M, the team earns a 2% bonus; between $15M and $30M, it's 5%, and anything over $30M gets 8%. With this model, the earn out increases reasonably as sale price goes up, capping out when the team has earned their full amount and investors have cleared their 1x. The new effective bogey shifts up accordingly, and incentives are aligned because getting there benefits everyone.

Every cap table is different – this is one illustrative approach, not a template. The specific tiers, percentages, and caps will depend heavily on a company’s capital structure, the terms of the existing preferences, and the dynamics between founders and their investors. The modeling itself can be a lengthy negotiation.

If you’re going to set this up, you’ll need to do so before an acquisition is even on the table, because at that point a price is set. Take the proposal to your board and do the modeling with them. Once it's approved at board level, go to the other shareholders. If it gets at least 50% approval from shareholders you can then go through the full process: i.e. a formal board consent, then a stockholder consent, after which the carveout will be written into the amended and restated certificate of incorporation.

What else to consider around a carveout

1. Make it company-wide
If every single employee at the company is participating in the plan, it can be huge for retention and morale. Otherwise, you can create perverse incentives across your team and leadership. That said, expanding the pool can increase the total carveout size and further dilute investor proceeds – the scope should be proportionate to the deal and realistic given the numbers.

2. Negotiate when things are going well
In theory, figuring out a carveout ahead of time gives you an insurance policy for a worst-case exit scenario. And it might be easiest to negotiate with the board when things are going smoothly – with no looming outcome on the horizon, investors won’t be resentfully wondering if they could have made more, and it’ll be a much easier ‘yes’. That said, raising the topic proactively is atypical and can be a delicate conversation – founders should be prepared for investors to question why they’re focused on downside protection rather than growth. It’s not something to bring up lightly.

3. Remember investors are fighting their own battles
These negotiations can be very tense. And, when you look at the size of their fund, you might be tempted to think investors are just being greedy capitalists by refusing to budge on a few hundred thousand dollars. But they’re answering to their LPs, and ultimately, what they’re looking for is at least a 1X: a return of principal on money that’s likely been outstanding for years. The situation has to be approached collaboratively rather than combatively, with the goal of landing on a number that both works for your team and is fair for investors.

4. Use the carveout as a negotiating tool
If founders find themselves making significant personal sacrifices to get a deal over the finish line – such as pay cuts during the transition period – it’s reasonable to ask that a carveout reflect that commitment. A carveout works best when it’s positioned as a way to keep everyone at the table and aligned, not as an ultimatum. 

Tanatswa Mapondera is a Senior Associate at Aligned Climate Capital on the Venture Team. Aligned’s Venture team invests in North American Seed to Series B companies decarbonizing infrastructure through clean energy, efficient buildings, electric transport, and sustainable land use. Prior to joining Aligned, Tanatswa was an Associate at Climate Finance Advisors, a consulting and advisory firm in international development, finance, and climate policy.