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”.
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 overlapping liquidation preferences, 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.
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 your 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. Check back tomorrow for some more complications.