In my day to day business of doing deals, I’ve noticed that an ugly term keeps coming up and people seem to wonder what it means. I keep hearing the question, ”what is a clawback provision?” It is an older term used in the financial world which basically means if certain pre-determined performance parameters are not met then the “investors” would have the ability take or “clawback” more equity in the Company. The clawback is usually associated with lack of performance and also has some form of an additional penalty attached. The term became most popular during the early to mid eighties for venture capital companies wanting to make sure certain benchmarks were achieved.
Well, the world has evolved into a nicer place and ugly words with bad connotations have been replaced with more acceptable and gentler connotations, so too has the clawback been replaced by a new term, the “make whole” provision. The flavor or essence has been changed but the economics have not. This term is showing up in more and more investment documents in the private equity, venture capital, hedge fund and investment banking world. Regardless of industry, geography and management these make whole provisions are really being embraced by all classes of funds.
The make whole provision allows the funds to earn back a percentage of equity if the underlying company misses its benchmark. The benchmark is always pre determined prior to an investment and typically it is on top line sales, net income and or EBITDA. Although the benchmarks can include esoteric items such as percentage increase in market share, selling of a non-core division, financial ratios and even on cost containment. The make whole provisions are really where the rubber meets the road. Management of these companies now must think long and hard as to their ability to hit these benchmarks so that the equity is preserved. In many cases a large portion of the equity, whether from management themselves or newly issued shares, will be held in an escrow account until the benchmark(s) have been achieved. Unfortunately, in this tightening credit environment, management may be somewhat optimistic (or desperate) and agree to benchmarks that will ultimately be challenging to meet. When this happens there is a tendency for acrimony to build up regardless of who is at fault. Fund managers must be somewhat sensitive when it comes to determining benchmarks and make them as realistic as possible. No one wins when management and the investment fund are at odds because of unrealistic benchmarks.
In reality, a make whole provision is put in place to make sure that expectations are managed correctly and if the provisions are not met, why? It aligns management’s interests with the investor’s interest while providing accountability. Any entrepreneur, business owner or C level executive will need to know the ramifications of these make whole provisions as it will ultimately come into play when raising capital with professional investors.
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