Mechanics of Searcher equity vesting/priority on exit

searcher profile

March 01, 2023

by a searcher from Harvard University - Harvard Business School in Atlanta, GA, USA

In a conversation with another searcher recently int became clear that we had different assumptions about the mechanics of equity payout on exit in a typical deal.

I understood that the return of principal and 20% hurdle to investors were senior to all of the operator’s equity, even if vested… such that in a return scenario where investor IRR<20%, equity payout to the operator was 0. His understanding was that the initial and time based portions of operator equity were in the same tranche as the preferred, so even if investors got a small or negative return, the operator still made some money on their equity.

Can anyone enlighten me?

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commentor profile
Reply by a professional
from Dartmouth College in Los Angeles, CA, USA
On exit the preferred will receive their capital and preferred return first. So if the return doesn't satisfy the hurdle there is no return on the common. It's possible to pay distributions on the common prior to an exit so there is some payout on the equity, but upon exit the preferred has to get paid first. If the return is higher than the hurdle then there can be a catch up where the common gets paid to give them their pro rata share of all returns, including the amounts below the hurdle, but this only happens after the preferred get paid. NOT LEGAL ADVICE.
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Reply by a professional
from Villanova University in West Chester, PA, USA
You would need to have an attorney review the organizational documents to provide a legal opinion on distribution. If you mean just generally, you can structure a deal however it makes the most sense for the parties. All of it will be set forth in a well drafted operating agreement or bylaws. I'd be happy to discuss this further.
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