Waterfalls, holdbacks, escrows, earnouts, and carry — some of the complexities of “an exit”

“Make Money. Have Fun. Do Good.” is VentureSouth’s motto.

This first part, Make Money, is (we believe) the key point of angel investing — and something our members have been able to do. You do it through “exits” — getting your investment back plus, hopefully, a gain when the company you invested in gets acquired.

To celebrate the last successful exit from the VentureSouth portfolio in 2020, we thought it topical and helpful to examine some of the concepts and complications around “exits”… and hence this post.

A lot of work goes into reaching an exit: finding, structuring, negotiating, and executing investments; active work from board members, portfolio connectors, and advisors; exit strategizing, planning, preparation, and execution; and much more — not to mention the never-ending labor of the founders, management team, and employees to build a business by creating value for customers.

After all that effort, the happy day comes when the founder reports to investors that we’ve been acquired for $100 million!

After the initial congratulations, but before the celebrations get too carried away and the proceeds get spent, we need to understand what this actually means: what the proceeds are, who gets how much of them, and when the money begins to flow.

Exits and Waterfalls

Nothing happens in angel investing without flowery metaphors. When we discuss “exits” we are talking about getting our money back out of an investment. This can happen in several different ways.

Typically, we are talking about a company being acquired, either by another one (a strategic exit) or by a professional investor of some kind (a financial exit); this is what the rest of this series focuses on. (There are other ways — IPOs, secondary transactions, and more — but we’ll ignore those for now.)

Now we know we are making an exit, we mix metaphors and start looking at waterfalls. The “waterfall” describes how the proceeds from an acquisition “flow down” to the various stakeholders.

At the very top of the waterfall, we have the initial problem: how much water (cash) is there going over this cliff?

The “headline” acquisition price, “purchase price,” or other similar terms is the starting point, the amount that the acquirer is promising in “consideration.” $100 million in this example.

The optimistic investor then multiplies $100 million by their share ownership according to the cap table to calculate their proceeds. Reality is going to hit (like standing under a NC waterfall) over the next few posts: a lot of water is going to evaporate before it reaches the equity holders in the plunge pool at the bottom. (Here is one example of reality hitting a badly informed investor when selling a gin company!)

The First Evaporations

There are a few immediate claims on the water heading into the waterfall; some of these are fairly obvious, others are more complicated or controversial.

Transaction fees

Investment bankers, attorneys, accountants, advisors, and other service providers that have helped to make the exit happen get paid first for their services. These “transaction fees” can be substantial, with often several percent of the consideration going to pay those who have contributed to the transaction.

We generally recommend using an investment banker to drive a competitive exit process, as these generally lead to a higher acquisition price and a lower burden on management’s time and impact on the business. These benefits, though, come at a price. Though it varies, you could budget 5% of the transaction value, which can be several hundred thousand, potentially millions, of dollars, to these fees.

(Incidentally, if you need connections to good southeastern investment bankers, let us know — we work with our favorites frequently.)

Debt repayment

Next comes debt.

First come all those payables a company builds up over its history. Loans from founders or employees; employer taxes payables; kind payable terms your in-house counsel has given you over the years. All these liabilities come due, and all this informal credit gets called, because the company can at last pay it off!

At the same time comes formal secured or unsecured debt, like bank or SBA loans, funding from the NC Biotech center, or other investment loan programs. More recently, programs like PPP funding or EIDL loans have added to this list.

Then comes outstanding convertible note debt. While the goal of convertible notes is to convert into equity, if simply getting repaid gives the noteholders more proceeds then that’s what they can do. (Our convertible note guide explains how notes are essentially a senior liquidation preference in many scenarios.) If paid out, noteholders get principal and interest, plus any other bonuses (like a 2x change of control premium) to which they are entitled. (This probably doesn’t apply to the $100 million exit, but for <$20 million exits it could definitely soak up a lot of the proceeds.)

All these get repaid from the water flowing down the waterfall first, because debt is “more senior” than equity in waterfalls.

Working capital adjustment

Transactions almost always need to adjust for a “normal” level of working capital in a business, and this adjustment typically reduces the headline price.

Countless hours are spent trying to figure out what a “normal” level of working capital is. The precise complications and calculations are too arcane even for a VentureSouth Medium post, so let’s just say for now that, as an investor in the selling company, you will probably find that these adjustments end up making money disappear from your proceeds! Here’s a quick guide if you want one. Regardless of the details, the Golden Rule applies: when you invested, you had the gold and made the rules; now the acquirer has the gold, they make the rules.

Dividing the Pie

As we’re close to the bottom of the waterfall, we are now including a third metaphor as we figure out how to “divide the pie”.

Management Bonuses

An acquiring company is typically buying a company and, at least for a while, its management team. The buyer therefore wants the management team to be well motivated; it doesn’t care if exiting shareholders are well rewarded. So, the transaction terms often include a “management bonus” that diverts some proceeds from shareholders to management.

Sometimes this bonus is merited; sometimes only the management team thinks this is merited. Sometimes it is structured in a reasonable way, like a bonus for hitting targets after acquisition; sometimes it is structured in a less palatable way, like simply taking some of the transaction consideration and giving it to the management team despite having no contractual right to it. As you can tell, this management bonus issue can be a source of discontent and disappointment.

In particular, if the management bonus is getting paid before the investors receive their 1x liquidation preference, there is a good chance that the management team and investors are not going to agree that this is merited. From the investor’s perspective, in an unsuccessful exit, giving management a bonus for failing to meet their promises and execute their plan, and locking in our loss (sometimes without our consent) seems a bit rich. The whole point of a liquidation preference is so that investors get their money back first before the entrepreneurs prosper.

But protests aside, the reality is that, if the board approves and other shareholders agree that there’s no better alternative, there goes another few gallons of water before it reaches the bottom of the fall.

Liquidation Preferences

We have (finally) reached far enough down the waterfall to reach the equity holders — the most junior securities holders, but the ones who get the “upside” if there is some.

If you’ve been to any of our workshops in the past, you’ll know that “dividing the pie” is often not a trivial calculation. Even taking all you’ve learned from our cap table courses, figuring out who gets what between overlapping liquidation preferences, (capped) participation, convertible note acquisition change of control, forgotten warrants, vesting options, and other complications is no easy task.

For now let’s assume this calculation is done correctly, and as a Series Seed investor you are (despite all the lost water) pretty happy with your gain and distribution. If you entry valuation was low enough, you should be!

However, we’re sad to tell you that your watery slice of pie is not coming to you quite yet. Here are some more complications.

The Last Complications

The pie is so close you can almost taste it. But wait a second!

Escrow accounts

In most transactions, the buyer will insist that some of the proceeds are set aside into an escrow account. Why?

Despite all the diligence an acquirer might do on a company, they cannot know everything they might want to — in part because the selling company might not know everything. An acquirer has to rely on certain “representations and warranties” from the selling company’s management team about what kind of pie this company is and what condition it is in. Those “reps” might be made in good faith and to the best knowledge of everyone involved, but still be wrong.

For example, as an under-the-radar startup, you are hopefully not in the cross-hairs of many lawsuits. Once the $100 million transaction announcement goes out, though, lots of people now have an incentive to make a claim: no point suing a cashless startup; but lots of point suing a company being acquired for $100 million.

So instead of letting the selling shareholders have all their pie and eat it, some of the filling gets left behind to potentially pay for dealing with these surprises. In our experience, a “holdback” of 5–10% of the proceeds, set aside into an escrow account for generally 12–18 months, is fairly typical. These holdbacks can also be subdivided into a number of different buckets — indemnity escrows, tax escrows, PPP escrows, and others, depending on how everyone negotiates.

As a seller, therefore, you should not expect a complete piece of pie. The 5–10% is sitting on the shelf, and though you might hope to eat it all next year, you shouldn’t expect to; these unexpected challenges (and the fees those create) mean others will be nibbling away at your slice.

Oh, also, the sellers have to pay an escrow agent some fees for the privilege of looking after this money. Another few mouthfuls or watery gallons gone.

Earnouts

Wait! In many transactions, the buyer will insist that some of the proceeds are only payable if the acquired company hits some particular targets. Revenue goals for the next couple of years, for example. What happens now?

Well, obviously the selling shareholders shouldn’t pocket that money now — getting it back if the targets aren’t hit would be impossible. So that consideration is simply not included yet. If the headline price of $100 million consisted of 50% at the closing date of the transaction and 50% if the company hit its targets, you have to go back to the top of the waterfall and re-calculate based on $50 million.

Some of that recalculation will be easy; some not, or a bit more arguable. For example, does the investment banking fee get paid on the whole $100 million now, or not? Does the liquidation preference get calculated assuming there’s no earnout, or not? Most of these things are covered in the contracts, but it all requires thorough review to get right.

Aside from more math, what should a selling shareholder assume about getting this money? Sadly, it is a pretty safe working assumption that you will not get paid any consideration promised through an earnout. I’m sure there are good statistics out there to improve our anecdotes, but in general acquired companies (just like early stage startups) do not hit budgets, and earnouts generally disappoint.

There are many good reasons (just as there are many good reasons that startups don’t hit their projection models!); but in the same way a sensible investor will “haircut” a projection hockey-stick, a prudent buyer will not assume the acquired company will perform as advertised, and so will set earnouts to protect against it. A prudent seller should be skeptical of the chances of seeing any of that earnout.

Carried Interest

Wait! Now VentureSouth gets a cut! Or Angelist, or the venture capital fund, or whoever else manages the fund or investment vehicle through which you invested.

In general, as we’ve covered before, you expect to see somewhere around 20% of the net gain going out in carried interest. This can vary — a bargain at 10% at VentureSouth; 20–25% at VC funds; potentially even more at Angelist or other platforms — but it’s only ever zero if you invested directly in the company without these other groups involved. If you have the time, dealflow, administrative staff, and everything else to do that, great — but you have a whole different set of costs to consider to do that.

Still, a small sliver of your pie slice is feeding fund managers’ bellies through carried interest.

Are we done losing pie yet? Not quite. Here is one last complication.

Taxes

So, finally!, our preferred shareholder has a distribution. Less than expected by the naïve optimists hearing the headline price, but still it’s nice to see money flowing back from an exit. Now what?

’Tis impossible to be sure of any thing but Death and Taxes.

Indeed. However, at last we have some good news: taxes are often not a big deal in angel investing.

If you had your series seed shares for five years, you should be exempt from any federal capital gain taxes (with some caveats) — see our post on Section 1202.

If you had them for more than six months but less than five years, you can probably roll over these gains into new investments and defer (and likely eliminate) these taxes too — see our post on Section 1045 rollovers.

If neither of those apply, you still pay capital gain tax rates, which are lower than your other tax rates. (Unless you held your shares for less than a year, in which case they are the same.) See our post of capital gains taxes. (If you invested in a convertible note, of course, you are paying ordinary income on the interest and any change of control premium. Another reason to dislike convertible notes.)

So it’s possible that this mouthful of pie stays entirely on your plate and not the Treasury’s, and your post-tax net distributions likely aren’t too much different from your net distributions.

Sum up

So, we’ve now exited, reached the bottom of the waterfall, and cleaned our pie of plate!

Many minutes ago, the $100 million exit at the top of this post was a cause for celebration. Despite the evaporation of some of the delicious watery proceeds along the way, the optimistic investor is still delighted with the result. Hopefully this exercise has helped you prepare mentally for the ups and downs of exit calculations, given you a few things to consider when exiting your own company, and as an investor allowed you to enjoy your pie without worrying too much about the lost slivers!