Equity
Management Carve-Out Plans: Why $7.8 Million Came Off the Top and Common Stock Got Nothing
A management carve-out pays employees off the top when a sale can't clear the preference stack. Where it sits in the waterfall, and what 409A and 280G require.
By 409.AI Team - 2026-09-21
# Management Carve-Out Plans: Why $7.8 Million Came Off the Top and Common Stock Got Nothing
Trados sold to SDL for $60 million. By most startup standards that's a fine outcome. The common stockholders received zero.
Here's the arithmetic. Before a dollar reached the cap table, $7.8 million went to a management incentive plan the board had adopted to keep executives at the table through the sale. That left $52.2 million for preferred holders whose liquidation preference totaled $57.9 million. The preferred took a $5.7 million haircut. Common stock, sitting behind all of it, got nothing, and the Delaware Court of Chancery later appraised those shares at exactly that: nothing.
The instrument that did this is called a management carve-out, and it shows up at exactly the moment a sale price can't clear the preference stack. Founders tend to learn what it is in the week they're asked to approve one.
What a carve-out plan actually is
A carve-out is a contractual promise to pay cash to named employees when the company is sold. It isn't equity. Nobody gets shares, nothing vests on a four-year schedule, and it never appears on the cap table. It's a bonus obligation that springs into existence at closing and gets satisfied out of the deal proceeds.
Boards adopt them for an unglamorous reason. When the preference stack is larger than any realistic sale price, the management team's options are worthless and their incentive to run a sale process collapses. A CEO holding 400,000 underwater options has no financial reason to spend six months in a data room. Buyers notice this, and a deal that depends on a disengaged management team tends not to close.
The pool gets sized one of three ways: a flat dollar amount, a straight percentage of proceeds, or a sliding scale that pays a bigger slice on a bigger deal. Wag Labs, whose 2020 plan is [filed with the SEC](https://www.sec.gov/Archives/edgar/data/1842356/000110465922099765/pet-20211231xex10d15.htm) and worth reading if you want to see real drafting, used a single percentage: 15% of aggregate transaction proceeds. Trados effectively paid 13%.
Where the money comes from
This is the part that decides everything, and it's usually one clause.
A carve-out paid off the top comes out before the waterfall runs. Every class below it absorbs the cost. A carve-out paid after the preference comes out of whatever is left once preferred holders are made whole, which means the common stockholders and the option holders fund it alone.
Run $40 million through a company with a $50 million preference stack and a 10% carve-out. Off the top, management takes $4 million and preferred splits the remaining $36 million against a preference they were never going to clear. Common gets nothing either way, so in this deal the placement is an argument between management and the investors. Nobody else has standing to care.
Now run $70 million through the same company. Off the top, management takes $7 million, preferred takes its full $50 million, and $13 million flows down to common. Paid after the preference, management still takes $7 million but it comes entirely out of that $13 million, leaving common with $6 million. Same deal, same pool, and the common stockholders are $7 million apart based on where one sentence sits in the plan document.
That gap is why the waterfall math in your charter and the carve-out document have to be read together. If you haven't worked through how [liquidation preferences and the waterfall](https://409.ai/articles/liquidation-preferences-waterfall-common-stock-exit) distribute proceeds at your company, the carve-out question can't really be evaluated, because a carve-out is just another claim inserted into that same queue.
What the Trados court actually held
The Trados decision matters less for the outcome than for the standard it applied. A seven-member board approved the plan and the sale. Two directors were management participants in the plan. Four were affiliated with the preferred stockholders whose preference the deal was structured to satisfy. That's a majority of the board on both sides of the transaction, so the court applied entire fairness review rather than the business judgment rule, and the directors had to prove the deal was fair rather than having the court assume it.
They won. The court found that Trados had no realistic path to a valuation that would escape the gravitational pull of a $57.9 million preference and its accumulating dividend. The common stock was worth zero before the sale, so receiving zero in the sale was entirely fair. Harvard's corporate governance forum has a [readable summary of the ruling](https://corpgov.law.harvard.edu/2013/09/03/delaware-court-of-chancery-upholds-trados-transaction-as-entirely-fair/).
The useful lesson isn't "carve-outs are safe." It's that the board had to defend the plan through a full trial and a post-trial opinion to establish that the common was already worthless. Had the company been worth something to the common, that $7.8 million would have been $7.8 million taken from stockholders by directors who benefited from taking it. Boards with investor-designated directors on both sides of a carve-out should assume a plaintiff will eventually ask a court to price the common stock as of the day they approved the plan.
Section 409A: the two-and-a-half month rule
A promise today to pay cash later is deferred compensation, and deferred compensation that misses Section 409A is brutal for the employee: immediate income inclusion of the vested amount, a 20% additional tax on top of ordinary rates, and premium interest. The employee bears all of it. Most carve-out plans stay out of that territory through the short-term deferral exemption rather than by complying with 409A's distribution rules.
The exemption is mechanical. Under [Treas. Reg. 1.409A-1(b)(4)](https://www.law.cornell.edu/cfr/text/26/1.409A-1), the payment has to be actually or constructively received by the 15th day of the third month after the end of the taxable year in which the right to it stopped being subject to a substantial risk of forfeiture. For a carve-out that vests at closing, the risk of forfeiture lapses on the closing date, so a December 15 closing means the money has to be in employees' hands by March 15. The Wag plan solved this the way most well-drafted plans do, by requiring a lump sum within 30 days of closing and leaving no room for the timing to drift.
Two drafting habits break the exemption. Paying the carve-out over a retention period after closing pushes payment past the window. Letting participants elect when to receive the money converts the arrangement into an elective deferral, which is squarely inside 409A and has to satisfy its rules on its own terms. If you want a plan that pays over time, the honest answer is to design it as compliant deferred compensation from the start rather than hoping the exemption stretches. The same discipline governs any [nonqualified deferred compensation plan](https://409.ai/articles/409a-nonqualified-deferred-compensation-plans) a private company runs.
Earnouts complicate this. When part of the price arrives 18 months after closing, most plans pay the corresponding slice of the carve-out as and when stockholders receive it, which is what Wag's plan does for contingent consideration. That needs its own analysis, because the payment date is now outside the short-term window.
Section 280G is waiting on the other side
A carve-out payment contingent on a change in control is a parachute payment. For a founder, C-level executive, or 1% shareholder who counts as a disqualified individual, the carve-out stacks on top of accelerated equity and severance, and if the total crosses three times that person's average compensation, a 20% excise tax lands on the excess. Private companies can generally avoid it with a shareholder vote, which is the whole reason the [Section 280G cliff and the 75% vote](https://409.ai/articles/section-280g-golden-parachute-startup-exit-shareholder-vote) tend to appear on a deal timeline two weeks before signing.
Wag's plan handled this the aggressive way: it sought stockholder approval, and any excess amount that didn't get approved reverted to the stockholders instead of being paid. Management bore the risk of a failed vote. That's a negotiation point, not a standard, and the alternative allocations range from a gross-up to a best-net cutback.
The allocation fight nobody documents early enough
Two questions decide whether a carve-out is fair or just a transfer, and both tend to get deferred until the letter of intent is signed and everyone is tired.
The first is double-dipping. If a participant also holds stock or vested options that pay out in the deal, do they collect both? Wag's plan reduced each participant's bonus by the transaction proceeds they received on their own equity, so the carve-out functioned as a floor rather than a bonus on top. Silence on this point in a plan document is not neutral; it defaults to the participant keeping both.
The second is who allocates. A pool of "15% of proceeds" with individual percentages left to the board's later discretion is a pool that gets allocated by whoever holds the board majority at the time of sale, which is usually not the founders. Named percentages in the plan itself are worth the awkward conversation. It's the same structural issue that surfaces when [options roll over or get cashed out in an acquisition](https://409.ai/articles/stock-options-acquisition-rollover-section-424a-ratio-test): the mechanics you don't specify get specified for you by whoever has the stronger hand when the deal is live.
Tell your appraiser
A carve-out plan is a contingent claim that sits ahead of common stock in exit scenarios, which means it belongs in the conversation with whoever prepares your [409A valuation](https://409.ai/products/409a). An option pricing model allocates enterprise value across exit outcomes; if 10% of proceeds is diverted before equity holders are paid in every one of those outcomes, the value attributable to common changes. Appraisers can only reflect what they're told about, and a carve-out plan adopted by unanimous written consent rarely makes it into the standard document request.
This tends to matter most at companies that already have a problem, since carve-outs cluster around the same conditions that produce [down rounds and underwater options](https://409.ai/articles/down-round-409a-underwater-options-repricing). If you're adopting one, your next valuation is probably going to move anyway.
What to do with this
If your company's preference stack has grown past what a realistic acquirer would pay, a carve-out plan isn't a governance failure waiting to happen. It's often the only structure that gets a sale done at all, and for employees holding worthless options it's the difference between a payout and a thank-you note. [Phantom stock and SARs](https://409.ai/articles/phantom-stock-sars-private-company-409a-asc-718) solve a related problem with a different instrument, but neither works once the equity is underwater, which is exactly when carve-outs earn their place.
Adopt it early, while the board is not yet staring at a specific offer and the common stock still has a defensible value. Name the individual percentages. Put the waterfall placement in writing. Pay within 30 days of closing. Decide the double-dip question before anyone knows who benefits from the answer. Every one of those choices is cheap in the abstract and expensive once there's a live term sheet and a director on both sides of the table.
*This article is general information, not legal or tax advice. Carve-out plans are heavily fact-specific and should be drafted with counsel.*