Category: Mergers and Acquisitions
Today’s post of the day is from my partner Seth Levine (Foundry Group) and is titled Trends in M&A Deal Terms. Seth has been involved in several significant acquisitions recently, including Google’s acquisition of AdMeld and Federated Media’s acquisition of Lijit, so he’s been deep in the contemporary negotiating dynamics. He also includes a great link to an M&A deal terms report from Shareholder Representative Services.
Note: This was actually a question that I received from a colleague via email, but thought I’d post it here given the content.
Q: My company is close to signing a contract to sell the business. Although I’m prepared to do the role, one of the board members has suggested that we consider using a third party shareholder representation firm instead. Jason – I see that you’re involved with Shareholder Representative Services, the firm my board member suggested. I’m pretty committed to my company so what are the advantages and disadvantages of going with a third party rather than just doing it myself? BTW, I’m currently the CFO and plan on staying on for at least a while post closing.
A: (Jason) My short answer is that under most circumstances you want to avoid this job if at all possible. The shareholder rep issue is a problem that we and many other VCs have been struggling with for years on our M&A deals. Most buyers require that the stockholders appoint someone to have power to speak for all of the stockholders following closing to ease the administrative process. On most of our prior deals, somebody (usually one of the VCs) had to be the rep, and usually nobody wanted to do it. To be blunt, the job sucks. It takes a lot of time and is a big distraction if the person does the job properly, and not doing it properly can subject the person to risk of being sued under some legal theory like negligence, breach of fiduciary duties, unequal treatment, conflicts of interest or something similar.
In your particular situation, you have the added complexity of inherent conflicts of interest. If you are going to work for the buyer following closing, which is effectively what will happen if you continue to work for the company, you’ll have the problem of having to argue on your former stockholders’ behalf against your new employer if any claims come up. That significantly adds to the legal, ethical and emotional challenges you’ll be facing if you serve as the representative, especially if you personally have financial interests on one or both sides.
For all these reasons, I got involved with Shareholder Representative Services. I serve on their advisory board, but more importantly, our funds have used them on a few of our recent exits and have been very pleased. The selling company hires SRS to serve as the shareholder rep, and they professionally manage the entire process. We’ve found that we get better information and quicker responses from them than if one of the other investors serves as the rep, we get to avoid the risk and burdens of being the rep, and we still maintain significant involvement in the decision making process when material issues do arise.
Because of SRS, we’ve determined as a fund that it is highly unlikely that we’ll ever serve as the rep again – it would have to be a deal with unusual circumstances that I can’t think of right now. It’s not a good use of our time and is not in the best interests of our fund or our LPs. Besides, we hire professionals to manage every other aspect of the M&A deal process. Why wouldn’t we do the same with respect to the post-closing period?
Q: Do venture capitalists require audited financials from the companies they’re considering for an investment? Will “reviewed” financials suffice? For that matter, how do acquirers think about audited financials? Will they help speed an acquisition or is it overkill?
A: (From guest writer, our partner, Chris Wand).
We have a requirement that all of the companies that we’ve invested in get full year-end audits from an audit firm we’re comfortable with. It doesn’t necessarily have to be one of the big national firms (such as PwC, Ernst & Young or KPMG); in many cases we’re comfortable with a reputable regional firm with strong capabilities and resources. However, a small shop with a handful of people or a solo practitioner isn’t like to make the cut from our perspective.
Most entrepreneurs who have grown their business beyond a basic startup stage (i.e. they’re generating more than nominal revenues and have more complex or significant operating expenses) will find it helpful to have audited financials when talking with venture capitalists, since that just takes the entire issue off the table. However, not all venture capitalists will require audited financials before investing in a company (even though virtually all venture capitalists will require their companies to be audited after the investment).
Ultimately it’s a judgment call as to whether we (or any other venture firm) would require audited financials before making an investment. If it’s a small, early stage company with a handful of employees, a relatively low expense base and nominal revenues, we’re probably not really valuing the business (and hence our investment in the business) based heavily on the company’s historical financial metrics, so audited financials aren’t that important to us.
On the other hand, if a meaningful part of the valuation dynamic of the business is the company’s historical financial metrics (i.e. the company is arguing for a certain valuation based on market multiples and the company’s revenues), then we need to make sure that the financials are properly presented in order to get comfortable making the investment. The same could probably be said if a company had weird expenses (i.e. issues of capitalizing vs. expensing certain expenses, etc.) but that’s less of a specific concern for us given the types of businesses we invest in and the fact that we view cash outflows as more indicative/important than expenses (using the accounting meaning of that term) for early-stage companies.
As for being prepared for an acquisition, you definitely want to have audited financials before you embark on an M&A process. We find that very few acquirers (and certainly not large public acquirers) are eager to acquire a company without seeing audited financials before signing the deal. While I’m sure there are exceptions, it’s generally too significant of a diligence item for an acquirer to overlook. So it becomes a question of whether you want to get your financials audited now or whether you want to be under the gun getting an audit when you’re in the midst of an M&A process.
If you think an M&A process is likely at some point in the near-to mid-term, then you should get audited financials rather than reviewed financials, since again that keeps it from becoming a distraction (at best) or a barrier (at worst) to a deal.
Q: I work at a startup in the valley, and I’m wondering what happens to unvested shares in the event of acquisition? I.e., should I expect that they are canceled, accelerated, or stay on the same vesting timeline?
A: (Jason) The answer is “all of the above.” Any of these are potential outcomes in an acquisition. It really depends on the negotiating strength of the companies involved.
Most “standard” employee option plans have a provision in it that says if the acquirer does not assume the option plan and does not keep the options on the same vesting schedule and other similar terms, they vest immediately prior to the close of the merger. So in this case, they are accelerated.
However, there are plenty of times that the option plan is simply assumed by the new owner of the business. Rarely, have I seen all of the unvested options be canceled with no payout to employees, as this would lead to the acquirer angering all of its new employees.
Note also, that when exercising options prior to the closing of a merger, one heavily negotiated item is who gets the exercise cash, the acquirer or the target company? Usually, we see this go to the target company unless it’s a distressed deal.
Question: I’m part of a small company that has been bootstrapped and grown organically over the last 4 years. We are at the point now where large competitors are very interested in us. We are seriously considering an exit. I have two questions:
1. What do you feel about auctions versus dealing with one party? In general, do you feel that auctions always the best way to get the best deal?
2. I’ve seen numerous posts on preparing decks when seeking funding. What goes in the book when it is time to sell? Basically the same? How is the story different?
(Jason). First of all, congratulations on the interest. It’s always nice to be loved.
I’m a big fan of auctions. It’s really important to get some market validation of any deal that you are considering. That being said there are many different types of auctions that you can run. At one extreme, you hire investment bankers and enter into a formal process whereby you test the market. If you have one large competitor that is interested, likely you’ll others interested as well.
On the other hand, if you really like the deal at hand and you are on a tight time frame, you might want to quickly survey the market yourself and have these conversations. It’s a balancing act, clearly, as some cases allow you to have time to run an auction and others don’t – you certainly don’t want to do anything that will kill your “bird in hand” deal.
Regardless if you use a banker or not, make sure someone on the team is experienced in selling the company. I’d suggest that person should be outside of the executive staff (banker, board member, etc.) because you’ll need someone to play “bad cop” and you really don’t want to have the executives (who will work for the acquirer post merger) to have to play this role. For this reason alone, it might be nice to have a banker with you regardless if you do a formal auction or not.
As for what goes into a good selling deck – it’s relatively the same as fundraising, but you might focus more on how efficiencies can be derived from the larger platform that you are considering.
Part 2 of David Shanberg’s article on M&A Due Diligence. Part 1 addressed what to expect from the due diligence process. This time David addresses “How To Be Protect Your Confidential Information While Still Moving the Process Forward.”
Potential acquirers are typically trustworthy and sincere in their intent when conducting due diligence, with making an acquisition the goal rather than gathering competitive intelligence. However, some may enter the process with both goals, and a few may actually have bad intentions.
With that in mind, there are three actions that a company can take to decrease the odds of wasting time and unnecessarily parting with sensitive information, while not overly encumbering the acquisition process:
A. Gauge the seriousness of the potential acquirer (covered below)
B. Stage the flow of information (to be covered in the next post)
C. Be on the lookout for warning signs (to be covered in a future post)
A. Gauge the seriousness of the potential acquirer
In addition to the intentions of the potential acquirer, judging their seriousness at the beginning of the process and throughout can save a target company lots of time and frustration. In my experience, frequently a company would like to make an acquisition but simply is not in a position to do so.
There are number of easy ways to test for this, including the following.
Evaluate the company’s financial ability to make an acquisition. Do they have the cash to make a cash deal? Do they already carry a large debt burden, or do they have the ability to borrow to finance the deal? In the case of a public company, it is feasible to consummate a stock deal? The company should be able to provide a clear and realistic plan on how they would structure and finance the deal.
Evaluate the means of initial contact. Was it through a senior executive or board member, or through a person with less authority? If was through an intermediary, how credible is the intermediary, and is it formally representing the company?
Q: We are in the midst of negotiating a carve out with an investor on the East Coast. Two stumbling blocks have occurred. The first issue is what is an appropriate option pool size and does it vary from East to West coasts? The investor tends to believe that there are a significant differences in sizes of pools for Boston based companies vs. Bay Area-based companies.
Secondly, we are debating whether or not it’s appropriate/acceptable for management to have a carve out and maintain participation in the ESOP should an exit be large enough to be in the money?
A: (Jason). Most of the compensation reports that we’ve seen, as well as evidence from our own portfolio would indicate that there are not significant differences in option pool sizes between coasts. That being said, the range of option pools can be anywhere from 10-30%, so the there is a wide variance, but our opinion is that this is fact specific, not location biased. It really depends on how many rounds of financing the company has consummated and, to some extent, company performance. Recaps tend to decrease the size of the pool to the minimum amount to keep current employees properly incentivized and not much extra.
With respect to your question regarding the carve out and employee participation in the ESOP (Employee Stock Option Plan), we assume the following:
1. The company has enacted a carve out plan for employees on the assumption that a liquidation event will not properly compensate employees due to the potential size of the liquidation event and the liquidation preferences ahead of the common stock underlying the employee options. For background on management carve out plans, see our prior post here; and
2. The employees have options / stock issued from the ESOP, which depending upon the size of the liquidation event may or may not yield any return.
The way we’ve seen management carve out plans and options mix at the time of liquidation events are fairly standard. In short, we’ve seen a reduction in the aggregate carve out once the employee options are in the money. Let’s create an easy mathematical example and look at two potential outcomes.
– Carve Out Plan: 10% of aggregate liquidation proceeds.
– Range of liquidation events that would return nothing to employee options / stock: $0 to $50M dollars. (In other words, any event that would return $0 to $50M to the company would offer no return to employees due to liquidation preferences).
– Employees would receive 20% of any amounts of consideration above $50M.
From $0 to $50M, the carve out provides 10% of proceeds to the recipients of the carve out plan. At $50M, $5M would be the carve out. With a $60M dollar deal, the employees would receive $2M on their options. So what happens to the carve out?
The carve out is normally reduced – how much is a negotiation. In some cases, it’s a dollar-for-dollar reduction. In our case that would mean that at $50M, employees get $5M and at $60M employees would get $5M, but at $60M, the carve out piece would only be $3M, while the option payout of $2M would pick up the rest. In this case, you’ll note there is a “flat spot” for employee return until the deal size is above $75M.
One could argue that in order to incentivize management to maximize the value of the deal above $50M, there should be a “sharing” of the proceeds. Instead of a dollar-for-dollar reduction, maybe it’s a 75 cents reduction for every dollar. Again, it’s a negotiation.
If you read our term sheet series, you know that we spent a fair amount of time discussing liquidation preferrences. Jesse Fried and Brian Broughman, a professor and graduate student at Berkeley, respectively, recently published a paper about the emergence of common stock carveouts and some of the reasons why they belive venture capitals are not getting the liquidation preferences that the VCs originally bargained for.
It’s an interesting read. I agree with most of their conclusions, but am not sure that state law plays as big of a factor as they think. Jesse and I are shooting emails back and forth about this and I have found the discussion robust and intelligent.
The abstract of the paper:
The literature on venture capital contracting implicitly assumes that VCs’ cash flow rights – including their liquidation preferences – are fully respected. Using a hand-collected dataset of Silicon Valley firms sold in 2003 and 2004, this paper is the first to document that common shareholders often receive payment before VCs’ liquidation preferences are satisfied. We show these carveouts are larger when governance arrangements give common shareholders more power to impede the sale. Our study shows how VCs’ control rights and cash flow rights interact to affect VCs’ cash flow outcomes, and contributes to a better understanding of VC exits.
You can find the paper here, it’s downloadable from bottom of the page.
Jesse’s bio is here.