The most common answer is, it depends. Contracts between investors and a business are specialized to that specific business. For example, what is written in a contract for investors in a fintech company may be completely different from what is written in a contract for investors in a car wash business.

However, there are two basic frameworks: time period and return based.

Time Period

Time period is the simplest framework and within the framework it states that starting X date (say five years from signing the contract) investors have a right to their equity call option. From a management perspective, this is easy to understand and keep track of because once the contract is signed and money has been exchanged then management knows that it doesn’t have to worry about returning capital to investors until X date (at the earliest).

It is important to note that with a time period framework, the time period needs to be set a few years after projected return of capital because otherwise the investor will have essentially made a 10%-12% “loan” with no collateral. In other words, these investors are taking on a significant amount of risk and want the opportunity to gain in the “promote” years. Promote years are when the investors receive a step-up share of the business's proceeds.

Below is an example of a promote written in an offering sheet:

“Upon the completion of payments to the holders of the Class A Units of all (i) Class A Preferred Return and (ii) Class A Contribution Amounts, the Company shall make distributions in accordance with the Final Distribution Waterfall (otherwise known as the “Step-Up”) which is as follows: 30% to the Class A Members in respect to their respective Class A Units, and 70% to the Class B Members in respect to their respective Class B Units.”

In this case, the investors will want to share in the 30% of cash flow distributions for a year or two before potentially being bought out by the Class B members (i.e., management team).

Return Based

The more complex framework is return based. Complexity is increased because the equity call option is typically decided by a specific metric or metrics. These metrics in turn have to be defined so management and investor expectations are aligned. A common metric used is when an investment hits X Multiple on Invested Capital (MOIC) (e.g., an equity call option isn’t allowed until investors have a 3x MOIC). If MOIC is not used, then another metric often used is Internal Rate of Return (IRR).

A return based framework is beneficial to investors because it allows a bit more protection; however, this framework is more common in larger deals.

404

This page could not be found.