A carve out is a negotiated provision that allocates a portion of exit proceeds to common shareholders—typically founders and employees—even when preferred shareholders' liquidation preferences would otherwise consume the entire sale price. This mechanism protects management equity value when exit prices fall below investor expectations. Understanding these scenarios through waterfall modeling helps stakeholders evaluate potential outcomes.
What is a Carve Out in Venture Capital
In venture capital financing, preferred shareholders typically hold liquidation preferences that entitle them to receive their capital back before common shareholders. When a company exits below total invested capital, these preferences can completely eliminate payouts to founders and employees who hold common stock or options.
A carve out changes this distribution waterfall by setting aside compensation for management before calculating liquidation preference distributions. Most carve outs are negotiated during the acquisition process, not at initial financing.
Real-World Example
A company raises $50 million but exits for $40 million. With standard participating preferred stock, investors would claim the entire $40 million, leaving common shareholders with zero.
A 15% carve out would reserve $6 million for common shareholders, with $34 million to preferred shareholders. This maintains incentive alignment in difficult exits, protecting employee stock options and equity grants.
How Carve Outs Work in Exit Scenarios
Carve outs fundamentally alter the distribution waterfall by introducing an employee compensation layer before or after liquidation preference calculations. The placement significantly impacts how proceeds flow to different stakeholders.
Pre vs. Post-Liquidation Positioning
Pre-liquidation carve outs remove the designated amount from total proceeds before calculating any liquidation preference distributions, providing the strongest protection for common shareholders.
Distribution sequence (pre-liquidation):
- Calculate carve out amount from total proceeds
- Allocate carve out to designated common shareholders
- Apply liquidation preferences to remaining proceeds
- Distribute residual according to conversion terms
Post-liquidation carve outs apply after satisfying all liquidation preferences but before common shareholders receive their pro rata distribution. This structure is less favorable to common shareholders but easier to negotiate.
Distribution sequence (post-liquidation):
- Pay liquidation preferences in full
- Calculate carve out from remaining proceeds
- Allocate carve out to management/employees
- Distribute residual pro rata to all common shareholders
If liquidation preferences consume all or most proceeds, post-liquidation carve outs provide minimal or zero benefit since little remains for the carve out pool.
| Carve Out Type | Common Protection | Investor Impact | Achievability |
|---|---|---|---|
| Pre-Liquidation (10%) | High - guaranteed 10% of total | Reduces preference pool | Very difficult |
| Post-Liquidation (10%) | Medium - only if proceeds remain | Minimal impact | Moderate |
| Tiered (5-15%) | Variable based on exit size | Scales with performance | Difficult |
Types of Carve Out Structures
Carve out provisions can be structured in multiple ways depending on the exit circumstances and negotiating positions of different stakeholders. The chosen structure significantly impacts how much compensation ultimately flows to common shareholders.
Fixed Dollar vs. Percentage-Based
A fixed dollar carve out (e.g., "$5 million") provides certainty but doesn't scale with transaction size. A percentage-based carve out reserves a fixed percentage of total exit proceeds, scaling proportionally with transaction value.
Typical percentage ranges:
| Exit Scenario | Carve Out % |
|---|---|
| Down round exit | 15-20% |
| Flat exit | 10-15% |
| Modest upside | 5-10% |
Tiered carve out plans adjust percentages based on total exit proceeds. For example: 20% for exits below $30M, 15% for $30-50M, and 10% above $50M. This balances investor returns with management motivation.
Calculation Example
Understanding waterfall mechanics is essential for evaluating carve out economic impact. Here's a practical example:
Company profile:
- Total capital raised: $20 million (Series A)
- Liquidation preference: 1x non-participating
- Exit valuation: $15 million
- Negotiated carve out: 15% pre-liquidation
Distribution WITHOUT carve out:
- Series A Preferred receives: $15 million (full proceeds, preference not satisfied)
- Common Shareholders receive: $0
Distribution WITH 15% pre-liquidation carve out:
Step 1: Calculate carve out
- 15% × $15M = $2.25 million reserved for common shareholders
Step 2: Apply preferences to remaining proceeds
- Remaining pool: $15M - $2.25M = $12.75 million
- Series A receives: $12.75 million (partial preference satisfaction)
Final distribution:
| Stakeholder | Amount | Per Share |
|---|---|---|
| Common Shareholders (carve out) | $2,250,000 | $0.28/share |
| Series A Preferred | $12,750,000 | 64% of invested capital |
Tax Implications
Carve out distributions carry significant tax consequences. The IRS determines whether distributions are capital gains (favorable, ~20% rates) or ordinary income (higher, up to 37% rates).
Compensation vs. Capital Gains Treatment
The IRS applies a facts and circumstances test. Factors supporting capital gains treatment include:
- Pro rata distribution among common shareholders
- Paid through equity ownership rights, not separate agreements
- Long-term holding periods exceeding one year
- Broadly distributed across employees, not just executives
Red flags include individual negotiations, disproportionate executive allocations, or contingency on continued employment.
409A Compliance
Most acquisition-related carve outs satisfy 409A requirements by tying distributions to change in control events, which are permitted triggers. Violations trigger 20% additional federal tax plus interest penalties.
Negotiating Carve Out Terms
Successful carve out negotiations require understanding the competing interests of preferred shareholders, common shareholders, acquirers, and the company itself.
Key Stakeholder Positions
Preferred shareholders resist carve outs as they reduce proceeds for liquidation preferences. They may support when management retention is critical, the alternative is total loss, or acquirers demand protection.
Common shareholders (founders and employees) have leverage when their continued participation is essential through specialized knowledge, customer relationships, technical expertise, or regulatory licenses.
Acquirers typically support carve outs because management cooperation reduces execution risk and simplifies transaction structure.
Critical Negotiation Points
Carve out percentage ranges by company situation:
| Situation | Starting Ask | Typical Settlement | Investor Ceiling |
|---|---|---|---|
| Distressed sale | 20-25% | 15-18% | 20% |
| Below preferences | 15-20% | 10-15% | 15% |
| Modest exit | 10-15% | 8-12% | 12% |
Pre vs. post positioning example with $50M exit, $60M preferences, 15% carve out:
| Position | Carve Out Calculation | Common Receives | Preferred Receives |
|---|---|---|---|
| Pre-liquidation | 15% × $50M = $7.5M | $7.5M | $42.5M |
| Post-liquidation | 15% × $0 = $0 | $0 | $50M |
Allocation options: Pro rata by ownership (transparent, tax-favorable), board discretion (flexible but conflicted), management-determined (performance-aligned), or predetermined formula (objective but inflexible).
Frequently Asked Questions
What is the difference between a carve out and a management bonus pool?
A carve out allocates exit proceeds to common shareholders based on equity ownership, either before or after liquidation preferences. A bonus pool is cash compensation from the acquirer, structured as ordinary income regardless of shareholdings.
Can preferred shareholders block a carve out proposal?
Yes, most carve outs require preferred shareholder consent as they modify the liquidation preference waterfall. Preferred holders with board seats or protective provisions can effectively veto proposals unless voting thresholds are met.
When should management push for pre-liquidation carve out positioning?
Always advocate for pre-liquidation positioning when exit valuations are expected below liquidation preferences. Pre-liquidation carve outs guarantee common shareholder proceeds even when preferences consume the entire sale price, while post-liquidation structures become worthless in those scenarios.
Do carve outs affect the company's 409A valuation?
Carve outs negotiated during exit don't directly affect 409A valuations, which measure pre-transaction fair market value. However, carve outs established in financing rounds may increase common stock value by providing downside protection.
Conclusion
Management carve outs represent a critical negotiation mechanism that protects founder and employee equity when exit valuations fall below liquidation preferences. The choice between fixed vs. percentage-based structures, pre vs. post-liquidation positioning, and allocation methodologies directly determines economic outcomes. Success requires understanding stakeholder leverage points and documenting carve out terms with precision to avoid future disputes and tax complications.