What is Carrot Equity?

Carrot equity is a special kind of common stock in the United Kingdom. It gives investors an extra incentive called a “kicker.” This kicker lets investors buy more stock later if the company does well and meets specific goals.

How Carrot Equity Works

When a company issues carrot equity, it is selling shares of ownership in the company. But it adds something extra to sweeten the deal for investors. That extra incentive is the option to buy more shares in the future at a set price.

The company and the investors agree on performance targets the company needs to hit. These could be goals for profits, sales, or other important measures. If the company meets those targets by a certain date, the kicker part of the deal activates. The investors then get the right to buy more stock, usually at a good price.

Why Companies Use Carrot Equity

Companies like to use carrot equity when they want to get investors excited about buying their stock. The kicker makes the stock look more attractive.

Carrot equity also motivates the company to work hard and do well. If they hit their targets, it makes their stock more valuable. Their investors are happy and the company gets more money to help it grow.

Risks and Rewards for Investors

Investors can see carrot equity as a chance to make more money. If they buy the stock and the company does well, they get to buy even more stock at a set price. This could be very profitable if that price is less than the stock sells for on the open market.

But there are risks too. The targets might be too high and the company might not meet them. Then the investors don’t get to use their kicker. The company could also do poorly and the stock price could go down. So investors have to research carefully before buying carrot equity.

How Carrot Equity is Different

Carrot equity is not the same as regular common stock. With regular common stock, what you see is what you get. One share is one share. There are no extras or kickers involved.

It is also not the same as other stocks with selling restrictions, like:

• Restricted stock which you can only sell during certain times or to certain buyers
• Stock options which give you the choice to buy stock later at a set price

The key to carrot equity is that the kicker gets triggered by company performance. It is meant to motivate the company and excite investors.

An Example of Carrot Equity

Imagine a company called UK Co. wants to sell stock to raise £10 million. They work with investment bankers and decide to issue carrot equity.

Here is what they offer:

• 1 million shares of common stock at £10 per share
• A kicker that says investors can buy 1 extra share at £10 for every 4 shares they own if UK Co. hits £100 million in sales within 3 years

Several large investors buy all the carrot equity shares. They pay £10 million to own 1 million shares. UK Co. now has the money it needs to grow.

The investors are betting UK Co. will hit the £100 million sales target. If it does, the investors can use their kicker rights. They can spend another £2.5 million to get 250,000 more shares at £10 each.

Let’s say that in 3 years, UK Co. does hit the goal. Its stock is now trading at £15 per share. The kicker activates and the investors buy 250,000 more shares for only £10 each.

As soon as they buy, those shares are worth £15 not £10. The investors spent £2.5 million to get stock worth £3.75 million. They make an instant profit of £1.25 million thanks to the kicker.

Carrot Equity and Company Valuations

Carrot equity can affect how experts value a company. When a company trades on a stock exchange, investors look at things like the company’s price-to-earnings ratio. They want to know how much the company is worth compared to how much profit it makes.

But carrot equity makes this harder to figure out. The kicker means there could be more stock in the future. But valuing the company based on the kicker assumes it will meet the targets – which is not certain.

Because of this, carrot equity often comes with rules about how to handle the kicker rights when valuing the company. The company and investors have to be clear about what happens if the targets are not met or if the company is sold before the end date.

The uncertainty around kickers means carrot equity is more complex than regular stock. Companies have to give clear details on the terms and investors have to understand them before buying.

Carrot Equity and Investor Dilution

Another thing to consider with carrot equity is the risk of dilution. Dilution happens when a company issues new stock and the new shares cut into the value of existing shares.

When a company uses a kicker, it is agreeing to possibly issue more shares later. If it does, it will have more total shares. But the company itself will not automatically be worth more. So each share might be worth less – this is dilution.

Other investors who did not buy the carrot equity would see the value of their stock go down if the kicker is used. The same company value would be spread over more shares.

The investors who do have the kicker rights would be better off. They get to buy more stock at a set price. But the other shareholders could be unhappy that their shares are worth less.

Companies have to manage this risk of dilution carefully when issuing carrot equity. They could put a limit on how many new shares can be created by kickers. Or they could offer kickers to all investors, not just new ones.