Unfortunately, many start-up founders do not clearly understand how much money they will receive on an exit transaction. In a world where equity is crucial to incentivizing team members, it is imperative that those team members actually understand their economic interest on a liquidity event. The most basic math (which unfortunately is the math often relied upon) is that owners will receive an amount equal to the exit-transaction purchase price, multiplied by their percent of ownership. So, for example, if the company sells for $100 million, an individual who owns 25% of the company will receive $25 million. In reality, it is highly unlikely this is the case. Before you calculate the magical exit check or wire, you need to take several things into consideration that will impact the amount you will receive. Most critical are special economic rights of investors, the company’s existing payables and debt, taxes (city, state and federal), transaction costs and ongoing obligations.
Senior Economic Rights:
When thinking about a potential exit payment, a founder should remember that typically start-up investors purchase stock (or another security such as convertible debt or a SAFE) that entitles them to special economic rights. Usually, this stock is different than the stock owned by the founders and other team members. Generally, investors purchase preferred stock (often labeled something like “Series A Preferred Stock” or “Series B Preferred Stock”), whereas founders and other team members typically hold common stock.
A key economic term to understand in any equity investment term sheet — second in importance only to valuation — is liquidation preference. The amount paid to founders on an exit can differ dramatically depending on the investors’ liquidation preference. There are two principal things to be aware of when dealing with liquidation preferences: 1) the liquidation preference amount itself (usually 1x, 2x or 3x but sometimes shown in percentages as 100%, 200% or 300%); and 2) whether the preferred stock is participating or non-participating.
Let’s tackle the liquidation preference itself first. A liquidation preference means that before holders of common stock receive any payments from an exit the holders of preferred stock will be entitled to some multiple of their money back. Most commonly these days, the liquidation preference is described as a multiple of one. So, to take a simple example, if a VC firm invests $1 million into a start-up and receives preferred stock with a 1x liquidation preference, in the case of a $10 million exit transaction the VC firm will be entitled to its $1 million back before the non-investors receive anything. As you can see, the multiple really matters here. If the preferred stock instead has a liquidation preference of 2x, the VC will be entitled to a $2 million preferential return, and if it is 3x, a $3 million preferential return. These returns must be paid before the founders ever see a dime. Particularly in the case of a small exit, the liquidation preference can be quite painful for a start-up founder.
With a larger exit, the liquidation preference may not even come into play, depending on whether the investors participate or not (i.e., non-participating) after taking their liquidation preference. This is the second key aspect to consider. Sticking with our example, you may assume that if the start-up exits for $10 million, the VC firm would first receive its $1 million back (due to the 1x liquidation preference), leaving $9 million for distribution to everyone else. But here is where the participating versus non-participating piece comes in. If the preferred stock bought by the VC firm is participating, then in addition to the 1x liquidation preference, the VC firm will receive its percentage of the $9 million remainder. If the VC firm owns 8% of the company, for example, the firm would then also take another $720,000, for a total of $1,720,000. This leaves $8,280,000 to be split by everyone else. If instead the preferred stock is non-participating, the VC firm will only take the first $1 million and will not also receive a percentage of the remaining $9 million. These days, participating preferred stock is far more common than non-participating preferred stock.
Complicating the scenario further is the fact that the VC firm in our example will most likely also have another option available at an exit, which is to convert its preferred stock into common stock. Preferred stock is often convertible into common stock at a 1:1 ratio (although the ratio varies and could even change during the life cycle of the company). To think about the conversion option, assume that instead of 8% of the company the VC firm owns 25% of the company in preferred stock with a 1x liquidation preference. If the preferred stock is participating, the analysis for the VC firm is easy — it gets its $1 million preference and then 25% of the remaining $9 million, for a total exit payout of $3,250,000. But, what if the preferred stock is non-participating? If the preferred stock is non-participating, the VC firm has to choose one or the other (i.e., its liquidation preference or the conversion option) but can’t have both. In this particular example, the VC firm will benefit more from its 25% ownership than from its 1x preference. The 1x preference gives the VC firm a $1 million payout. But, if the preferred stock is instead converted to common stock, then the entire $10 million will be allocated by percentage interest and the VC firm will receive $2.5 million (assuming a 1:1 conversion ratio). Thus, in some instances, this conversion option may be more economically advantageous to a VC firm holding non-participating preferred stock as opposed to electing not to convert and only benefiting from the liquidation preference.
Many times outstanding preferred stock will accrue dividends, which are a bit like interest, giving investors another economic advantage. Dividends can be structured in different ways, but a common structure for start-ups is that, as time passes, more money accrues in a “cloud” account for the holders of the preferred stock. Before a holder of common stock will receive any money in the waterfall, accrued dividends will be paid out to the holders of the preferred stock.
Other Factors Impacting the Waterfall:
While factors such as liquidation preferences and dividends dictate how much the holders of common stock and preferred stock will receive in relation to each other on an exit, there are also other factors that impact the amount of the payout overall.
This category may be the most obvious. At the closing of an exit transaction, the company is often expected to pay some of its existing payables or debt. For example, if a company has extensive debt outstanding either in the form of payables (such as accrued legal bills) or true debt (such as promissory notes), these amounts will often be offset against the purchase price.
Many start-ups issue convertible debt, which, for this purpose, can be thought of as a hybrid of typical outstanding debt and preferred equity. Convertible debt holders may be entitled to interest payments, exit premiums and conversion rights upon an exit. If a company has convertible debt outstanding, a start-up team member needs to understand the economic rights associated with that debt in order to have an accurate picture of where he or she stands in the waterfall.
Transaction and Ongoing Costs
Transaction costs are important to keep in mind, as they will affect the money available for distribution to stockholders. Usually, at the closing of the exit transaction the attorneys and bankers are paid via wire transfer. So, before a founder sees the 000,000s hit the company account or their personal account, funds are allocated for those transaction expenses. Other “transaction costs” can include representations and warranties insurance, filing fees and financing charges.
Further, in most deals, the transaction is not over at closing, but rather there is a holdback or escrow of some percentage of the purchase price that can be recovered by the buyer in certain instances, such as if the seller’s representations and warranties are inaccurate. Depending on the initial terms negotiated for the preferred stock, an investor may receive its maximum payout at closing irrespective of the holdback or escrow amount, whereas the holders of common stock may have to wait until the holdback or escrow release and hope that none of the money has been distributed to the buyer due to adjustments or disputes. The escrow itself will often have additional costs tied to it, such as maintenance of the escrow account with an escrow agent and taxes and fees relating to a holding entity that may exist until the escrow breaks.
A portion of the purchase price could be non-cash if, for example, it is paid in stock or equity of the acquirer, which will then impact a stockholder’s immediate payout. Also, a portion of the purchase price may be subject to an earn-out. In such a case, payment of a portion of the purchase price is contingent on certain milestones being met by the ongoing business (as owned by the acquirer after closing). As with a holdback, it can make a substantial difference to the holders of common stock whether or not an investor’s payout is also proportionally contingent on the earn-out.
After closing there may be other costs as well that will need to be covered by the ongoing entity or paid out of funds held back from the purchase price. Until all post-closing payments and post-closing obligations are complete, there will likely be some ongoing accounting, tax and legal expenses. Additionally, any post-closing disputes that occur between the parties (such as whether the seller provided the buyer with accurate disclosures or whether a milestone event was reached) can decrease the purchase price available for payment to the stockholders.
A critical set of payments due in connection with an exit transaction are tax payments. Unfortunately, there are various taxes that can impact an exit at all different levels (i.e., federal, state or local). The taxes owed will vary based on a number of factors, such as how the transaction was structured, where the company is located, the basis of the company or the stockholder in its assets or shares, as appropriate, and how, when and for how much a stockholder received his or her stock. In addition to evaluating the amount of taxes resulting from the transaction, it is important to evaluate whether the purchase price will be taxed as ordinary income or at a lower capital gains tax rate. The desire of the selling parties to pay one level of tax, and for that tax to be at capital gains rates, may be at odds with the desire of the buyer to have the ability to “step up” the basis of the company’s assets at closing and depreciate those assets over time. It is important to work with competent tax attorneys or accountants in structuring an exit from a tax perspective to create a tax-efficient exit for the selling parties.
NET NET – there are a lot of things a founder and other start-up team members receiving equity need to think about when considering what their take home amount will be upon an exit. It is not a two variable calculation. This is important not only when considering a potential exit scenario, but also when considering investment terms. When raising capital, a start-up founder should not only review the cap table but should review the cap table with a general understanding of the waterfall. And, when contemplating an exit, working through the waterfall economics is of upmost importance — the worst case scenario would be to miss the mark on what you believe your take home amount will be and then desire to unwind a transaction.