One of my most popular blog series ever was on Term Sheets. I’ve been pondering another series for a while and a reader inspired me this morning to start one on Financial Statements.
I think your post this morning opened up a subject area you might wish to develop further. Your point was start with the cash flow because of the confusing nature of GAAP. In fact almost all sophisticated readers of financial statements start with the balance sheet or the cash flow and read the P&L last. I think some posts on balance sheet and cash flow analysis techniques or working capital management for a startup would be useful, for the following reasons:
Having taught these subjects for several years and been involved in several workouts/turnarounds, I am confident that balance sheet/ cash flow analysis is not either obvious or well understood (even after an MBA). Good working capital and balance sheet management leads to capital efficiency, a theme I know is dear to your heart.
At the risk of being tedious, boring, ponderous, dull, and monotonous I’m going to take on Financial Statements over the next few months. I hope you eventually find them as stimulating as I do.
Bill Burnham has an excellent rant up on GAAP accounting titled Is It Just Me or is GAAP Completely Broken? In case you don’t know, GAAP stands for “Generally Accepted Accounting Principles” and is a term regularly thrown around when staring at an income statement, balance sheet, statement of cash flows, or any other “supplemental information.”
I’m not a public market investor so I don’t have the twisted experience that anyone that deals with a public company has with GAAP since I don’t really care about understanding the financial statements of public companies (in any great depth.) Bill is – and he does a nice job of covering why GAAP has become such a mess in the public arena.
GAAP is also a mess in the private company arena. I get monthly financial statements for all the companies I’m on the board of (and quarterly for all the companies I’m an investor in.) The presentation varies, but it always includes a balance sheet, income statement, and statement of cash flows. I learned the value of understanding the financial statements early in my life – we were obsessed with them in Feld Technologies (my first company) and I was particularly fascinated with them when I started seeing them from other companies. Numbers stick in my brain and I can do straightforward math on the fly, so it’s easy for me to look at a set of financial statements and figure out what is going on pretty quickly.
Except for when the accountants get in the way. SaaS business models, revenue recognition, FAS xyz rules, tax vs. book, and option value / accounting creates a mess in private companies. All of a sudden I’m starting with the cash flow statement and working backward to actually understand what is really going on.
The irony of all of this is that most young private companies struggle to conform to GAAP, yet present their financials in a way that is clear and helpful – until they start trying to conform to GAAP. Of course, we have the accountants do an audit each year, at which point they ultimately restate things (sometimes minor, sometimes major) – almost always impacting the balance sheet and income statement, but rarely impacting the cash flow statement.
The arcania involved has radically increased in the past few years. I’m finding auditors reversing themselves within one year cycles – at one point they say “do things this way” and then nine months later they say “do things a different way.” It’s especially entertaining when you remind them of their previous approach, they say “we never said that”, and then you present them with the email they originally sent. Any accountant worth his paycheck knows how to say “yes, but it’s different now.”
It’s remarkable what a total waste of time and energy this is, especially when you get into the second order effect of actually trying to figure out what is really going on.
My advice to all entrepreneurs (and investors) is make sure you can read a statement of cash flows. Start there – not with the income statement. Once you understand the actual cash flows for a period, the chances of you catching the GAAP nuances of the income statement and balance sheet are much greater.
In 2005, Jason Mendelson (my partner and co-author of AsktheVC) wrote what has become an extremely popular series dissecting the “term sheet.” The feedback we got from it encouraged us to write several more series of blogs and ultimately led to us deciding to start writing AsktheVC to answer random questions from entrepreneurs.
Last Friday I pointed to a post from Dave Naffzinger (Judy’s Book) about Stock Options from an Entrepreneurs Point of View. I woke up today to two more great entrepreneur posts on term sheets. The first is from Dick Costolo (FeedBurner) titled Venture Terms – Liquidation Preferences and Participation. The second was titled Term Sheet Hacks was on a new blog titled Venture Hacks and written by Naval Ravikant (Vast.com) and Nivi (EIR at Atlas Ventures.)
When I started this blogging thing back in May of 2004, I stated that I was motivated by Fred Wilson’s post on Transparency. I love that smart entrepreneurs are adding to the body of knowledge out there around the funding process. I’ve always been befuddled that a financing (both angel and VC) and the “term sheet” are such as mysterious thing. It has been rewarding to get thousands of emails over the past two years thanking me / Jason for what we’ve written – and it is fun to see some smart entrepreneurs continuing to add to the demystification of the term sheet.
Rick Segal is in the middle of a negotiation and is having some frustration with his co-investor – a “US VC” – around settling on a few terms that he thinks are silly. I agree with two of them but struggle with the third.
Rick – don’t worry about the “US VCs” – if they are offended by the philosophy of Canadians, just offer to take them to a hockey game.
Every now and then I run into a new VC term in a term sheet that I’ve never seen before. My legs tremble with excitement as I stare at the words to dissect what they mean. On Friday, a long time friend sent me the following new and exciting term.
Compelled Sale Right: So long as VC (together with its permitted transferees) continues to hold at least 10% of the outstanding common shares (on an as-converted basis), and so long as an IPO has not been completed, then, at any time from and after the seventh anniversary of the transaction, if VC or the Company shall receive a bona fide offer from an unaffiliated third party to purchase 100% of the equity of the Company, VC shall have the right to cause each other stockholder to sell such stockholder’s equity securities on the same terms and conditions applicable to VC.
My first reaction was “what the fuck?” My second reaction was “eh – this is just a different twist on redemption rights.” But – then I thought about it some more and thought “you’ve got to be kidding me!”
So – after seven years, if there hasn’t been a liquidity event, a VC that owns at least 10% of the company can force all the other shareholders to sell their shares to an unaffiliated third party. Read it slowly and think about it. Basically, this term gives a minority shareholder the right to sell the company after 7 years, with no input from any other shareholders.
Be forewarned – this is not a nice term.
As Jason and I close out our Letter of Intent series, we thought we’d cover one last item that has screwed many a seller – the case where a public company acquires a private company for unregistered stock. Some buyers will try to ignore this – a good seller should work hard up front to get agreement on what type of stock and what kind of registration rights they will be receiving. Expectation setting is key in this situation.
One thing to consider here is the non-binding nature of a “promise” to register shares. The buyer will argue that they can’t guarantee to register the shares because they don’t control the SEC. The past history of the buyer with the SEC is crucial, including knowing the current status of SEC filings, any outstanding registration statements, and any promises that the buyer has made to shareholders of other companies it has acquired.
We’ve had several unfortunate situations where we’ve been “promised” a quick registration from a buyer, only to have them drag their feet on the filing after the deal, or get the filing hung up in the SEC. In today’s SOX environment, we’ve been amazed by the poor behavior of several of the big four accounting firms who “don’t have time” to work on merger accounting questioned by the SEC, especially in situations where the accounting firm is not going to be the merged company’s auditor going forward. Be very careful here as stock isn’t tradeable until it’s registered and the 12 month automatic waiting period for unregistered stock to become registered (in the absence of a registration statement filed with the SEC) can be a long time (and a lot of volatility) to have to wait for.
While I much prefer sex (as in “The Joy of …”), sometimes I have to settle for registration rights. With this post, Jason and I end our Letter of Intent series. We hope you’ve enjoyed it – feel free to comment and email me additional questions to address.
While watching the Sopranos tonight, I saw the magic manilla envelope stuffed with cash get passed to Tony and thought “what would a good deal be without some fees?” Remember – it is important to make sure that the lawyers and bankers can afford their fancy sports cars.
A letter of intent will usually be explicit about who pays for which costs and what limits exist for the seller to run up transaction costs in the merger. The transaction cost associated with an agent or banker, the legal bill, and any other seller-side costs are typically included in the transaction fee section. While it’s conceivable that the buyer will punt on worrying about who covers transaction fees, in today’s M&A world most savvy buyers are very focused on making sure the seller ends up eating these, especially if they are meaningful amounts.
Occasionally the concept of a break up fee if the deal doesn’t close, or the seller executes a deal with another buyer, comes up. This is rare in the context of private company VC-backed M&A but prevalent in the context of public company M&A deals (where one public company is acquiring another public company.) We generally fight any request of an buyer to institute a break up fee and tell the potential buyer to rely on the no shop clause instead. Most buyers of VC-backed companies are much larger and more resource rich than the seller it seeks to acquire, so it strikes us as odd why the buyer would receive a cash windfall if the deal does not close, especially since both parties will have costs incurred in the process.
No matter how you structure things, most fees end up coming out of the seller’s proceeds, so tread carefully.
Since it’s a Saturday morning, I thought I’d cover a topic in our Letter of Intent series that my wife Amy would never agree to. Signing a letter of intent starts a serious and expensive process – for both the buyer and seller – as you both work to consumate a deal. As a result, you should expect that a buyer will insist on a no shop provision similar to the one that we discussed in our term sheet series. In the case of an acquisition, no shop provisions are almost always unilateral, especially if you are dealing with an acquisitive buyer.
As the seller you should be able to negotiate the length of time into a reasonable zone (45 to 60 days). If the buyer is asking for more than 60 days, you should push back hard as it’s never in a seller’s interest to be locked up, especially for an extended period of time. In addition, most deals should be able to be closed within 60 days from signing of the LOI, so having a reasonable deadline forces everyone to be focused on the actual goal (e.g. closing the deal.)
Since most no shops will be unilateral – the buyer has the right but not the obligation to cancel the no shop if they decide to go forward with the deal – this time window is particularly important since the seller is likely to be tied up for the length of the no shop even if the deal doesn’t proceed. Rather than fight the no shop, we’ve found it more effective to carve out specific events – most notably financings (at the minimum financings done by the existing syndicate) to keep some pressure on the buyer.
When you are asked “Hi – it’s been fun to date. Will you marry me?” you usually don’t expect the person asking the question to say “Oh – and it’ll only happen if my mother says it is ok.” (although I expect this happens occasionally, especially if the person asking hasn’t had enough therapy.)
Buyers are like this and will normally include certain conditions to closing in the LOI. These can be generic phrases such as “Subject to Board approval by Acquirer,” “Subject to the Company not having a material adverse change,” or “Subject to due diligence and agreement on definitive documents.” They can also be phrases that are specific to the situation of the seller such as “Subject to the Company settling outstanding copyright litigation,” or “Subject to Company liquidating its foreign subsidiaries.” We generally don’t get too concerned about this provision, because any of these “outs” are very easy to trigger should the buyer decide that they don’t want to do the deal.
Instead of worrying about whether or not the provision is part of the LOI, we tend to focus on the details of the conditions to close, as this is another data point about the attitude of the buyer. If the list of conditions is long and complex, you likely have a suitor with very particular tastes. In this case, it’s worth pushing back early on a few of these conditions to close, especially the more constraining ones, to learn about what your negotiation process is going to be like.
As the seller, you should expect that once you’ve agreed to specific conditions to close, you’ll be held to them. It’s worth aggressively addressing them early in the due diligence process so you don’t get hung up by something unexpected when you try to “liquidate a foreign subsidiary”, especially if you’ve never done this before.