As my body recovers from my recent marathon, my brain turns back to Letters of Intent. Jason and I left you hanging for a while in our Letter of Intent series – we plan to tromp to the finish line in the next few weeks.

In an effort to mix metaphors, while Jack Bauer tries to always look out for other people at CTU (except for say – in Ryan Chappelle’s case), it’s not always true that management is playing the same role in an acquisition.  In public company acquisitions, you often hear about egregious cases of senior management looking out for themselves (and their board members helping them line their pockets) at the expense of shareholders. This can also happen in acquisitions of private companies, where the buyer knows he needs the senior executives to stick around and is willing to pay something extra for it.  Of course, the opposite can happen as well, where the consideration in an acquisition is slim and the investors try to grab all the nickels for themselves, leaving management with little to nothing.

Since management’s (and the board’s) responsibility is to all shareholders, it’s important for management (and the board) to have the proper perspective on their individual circumstances in the context of the specific deal that is occurring.  Whenever I’m on the board of a company that is a seller, I prefer to defer the detailed discussion about individual compensation until after the LOI is signed and the management of the buyer and the seller have time to do diligence on each other, build a working relationship, and understand logical roles. Spending too much time up front negotiating management packages often results in a lot of very early deal fatigue, typically makes buyers uncomfortable with the motivation of the management team for the seller, and can often create a huge wedge between management and the other shareholders on the sellers side. We aren’t suggesting that management and employees “should not be taken care of appropriately” in a transaction – rather – there won’t be an opportunity to take care of folks appropriately if you don’t actually get to the transaction, and this is an area that often causes a lot of unnecessary stress if addressed too early in the negotiation.

While we don’t recommend negotiating the employment agreements too early in the process, we also don’t recommend leaving them to the very end of the process.  Many buyers do this so they can exert as much pressure as possible on the key employees of the seller – i.e. – everyone is ready to get the deal done, the only thing hanging it up is the employment agreements.  Ironically, many sellers view the situation exactly the opposite way – i.e. now that the deal is basically done, we can ask for a bunch of extra stuff from the buyer.  Neither of these positions is very effective – both usually result in unnecessary tension at the end of the deal process and occasionally create a real rift between buyer and seller post transaction.

As with most things in a negotiation (and in life), balance is important.  When it comes to employee matters, there’s nothing wrong with a solid negotiation – just make sure that it happens in the context of a deal, or you’ll likely never actually get the deal done.

It’s been a while since Jason and I wrote an entry for our Letter of Intent series.  Yesterday, as I read through a confidentiality agreement that I had been asked to sign, I was inspired to address another typical part of an LOI – the dreaded confidentiality / non-disclosure agreement.

While venture capitalists will almost never sign these in the context of an investment, they are almost always mandatory in an M&A transaction. If the deal falls apart and ultimately doesn’t happen, both parties (the seller and the buyer) are left in a position where they have sensitive information regarding the other. Furthermore, it’s typically one of the only legally binding provisions in a LOI (along with choice of law and break up fees.) Everything else is dependent upon the deal closing. If the deal closes, this provision largely becomes irrelevant since – well – the buyer now owns the seller.

The good news is that both parties should be aligned in their desire to have a comprehensive and strong confidentiality agreement, as both parties benefit. If you are presented with a weak (or one-side) confidentiality agreement, it could mean that the acquirer is attempting to learn about your company through the due diligence process and may or may not be intent on closing the deal.

Generally a one-sided agreements makes no sense – this should be a term that both sides are willing to sign up to with the same standard.  Public companies are often very particular about the form of the confidentiality agreement. While we don’t recommend sellers just sign anything, if it’s bi-directional you are probably in a pretty safe position.

Tim Wolters has written a post on anti-dilution clauses from an entrepreneurs point of view.  Tim promises to write more on other terms like liquidation preferences, reverse vesting, dividends, class voting rights, “and any other terms that have bitten [him] on the ass before.”  Tim is co-founder and CTO of Collective Intellect, a new company that just recently closed a Series A funding.  He was previously the co-founder and CTO of Dante Group, a company I funded that was acquired by webMethods.  Expect straight talk and some good insights from Tim.

Jason and I continue our Letter of Intent series with one of our “favorite” clauses (sarcasm intended). The escrow is another hotly negotiated term that often is left ambiguous in the LOI. The escrow (also known as a “holdback”) is money that the buyer is going to hang on to for some period of time to satisfy any “issues” that come up post financing that are not disclosed in the purchase agreement. 

In some LOIs we’ve seen extensive details – with each provision of the escrow agreement spelled out – including the percentage of the holdback(s), length of time, and carve outs to the indemnity agreement.  In other cases, there is simply a declaration that “standard escrow and indemnity terms shall apply.” Since there really isn’t any such thing as “standard terms” this is another trap for deferring what can become a brutal negotiation to the post LOI stage. Since whatever the escrow arrangement is, it will decrease the actual purchase price should any claim be brought under it, the terms of the agreement can be very important since they directly impact the value that the seller receives. 

While there is no typical mechanism or agreement, we can say in our recent experience an escrow is set up which is the sole remedy for breaches of the reps and warranties, with a few exceptions (also called “carve-outs.”) Normally between 10% and 20% of the aggregate purchase price is set aside for between 12 and 24 months to cure issues. You should note that while this is usually where the deals end up, it can take a herculean effort to get there. It’s not uncommon for a buyer to start by asking for uncapped indemnity if anything goes wrong, personal liability of company executives and major shareholders, and – in some cases the ability to capture more value than the deal is worth. 

The carve-outs typically include fraud, capitalization, and taxes. Occasionally a buyer will also press for intellectual property ownership to be carved out. We’ve also started to see liabilities resulting from lack of 409A compliance be carved-out in escrow agreements under the argument that 409A is like “taxes.”  In all cases, the maximum of the carve-out should be the aggregate deal value (e.g. you shouldn’t have to come up with more than you got paid to satisfy an escrow claim).

A lot of buyers will say something like “well – I can’t figure the specifics out until I do more due diligence.”  We say “bah” to that – we’ve yet to meet a buyer that was unable to put an initial escrow proposal – with some detail – in the LOI – subject to due diligence of course.

Finally, the form of consideration of the escrow is important.  In a cash deal, it’s easy – it’s cash.  However, in a stock deal (or cash and stock deal), the value of the escrow will float with the stock price.  There are lots of permutations on how to best manage this on the seller side – you should be especially thoughtful about this if you have concerns that the buyer’s stock is particularly volatile. Imagine the situation where the stock price declines but the buyer’s escrow claims are of greater value then the stock in escrow represents.  Reasonable people should be able to agree that the seller doesn’t have to come up with extra money to satisfy the claims (note the “reasonable people” assumption.)

Well – the first business day of the year is officially over.  Apparently Yahoo just rejected an offer from Microsoft for $80 billion because it wasn’t enough.  My guess is that Microsoft forgot to include the “!” in Yahoo! and pissed someone off (the “!” has got to be worth at least $20 billion.)  I felt like shit all day today, but my cold (the first one I’ve had this year) at least had a side effect of getting me out of a trip.

Regarding our Letter of Intent series, we are starting to get into the sticky stuff (if you need a visual, think of when you were a kid and you superglued your fingers together.) Every LOI will have some mention of representations and warranties (if you want to sound like you are in the know, you can call them “reps and warranties”, or just “reps”) being made by the seller in favor of the buyer. In our experience, the usual language of this paragraph is usually light in substance, but this section can have a profound effect on the deal and consume a ridiculous amount of legal time during the negotiation of the definitive agreement. 

The first thing to note is “who” is making the reps. Does it say the selling company will be making the reps, or does it say the selling company and its shareholders are on the hook? Or – more typically – is it silent as to who exactly is stepping up to the plate? Given that many shareholders (from VCs to individuals who hold shares of the seller) are unwilling or unable to represent and warrant to the seller’s situation, try to get this spelled out in the LOI as most buyers will eventually accept that the company (and not the shareholders) is making the reps. Even though this is not something that you will want to have the lawyers fight over as they’ll spent hours exhausting all the theoretical arguments, this is usually how it plays out, at which point the business people have to get involved to get resolution on this (think superglue and fingers again.)

All LOIs also will have something regarding indemnification in the event that one of the reps or warranties is breached. Considering how important this provision is to a merger, it’s a wonder why so many term sheets say: “The Company shall make standards representations and warranties and provide standard indemnification to Acquirer.” To us, this is code for “we are really going to screw you on the indemnification terms, but don’t want to tell you at this stage so that you’ll sign the LOI and become ‘pregnant’ with the deal.  Really – trust us – our deal guys and lawyers are nice and cuddly.”

Depending upon the situation of the seller (perhaps the seller is in a position whereby it wants to get the buyer ‘pregnant’ more than vise versa and is willing to take its chances with the lawyers arguing), we’d suggest that you at least sketch out what the indemnification will look like. Again, once the lawyers get involved, arguments like “it’s market and it’s non-negotiable” or “I get this on all of my deals” get bantered about and little good comes from it.

Oh – the buyer usually makes some reps also, but since they are paying for the seller, these are typically pretty light weight unless the buyer is paying in private company stock.  If you are a seller and you are getting private stock from the buyer, a completely logical starting point is to make all the reps and warranties reciprocal.  If you need a refresher on why, it’s analogous the to Unilateral or Serial Monogamy discussion that Tom Evslin and I had when the price of oil first hit $67 a barrel (or – if you just want a simple comeback when the buyer says “no way”, you can say “what is sauce for the goose is sauce for the gander.”)

In our previous post – which started to get long and unwieldy (ah – the need for an editor – where are those guys when you need them) – we didn’t cover two critical issues: (1) What happens if the acquisition is in cash vs. public stock vs. private stock, and (2) Who pays for the “basis” of the stock options?

The form of consideration of the acquisition can be a many spendored thing. We’re going to ignore tax considerations for this post (although you shouldn’t – we just don’t want this to be 12 pages long.) If I’m an employee of a seller, I’m going to value cash differently than public stock (restricted or unrestricted?) differently than public stock options differently than private stock (or options). If the buyer is public or is paying cash, the calculation is pretty straightforward and can be easily explained to the employee. If the buyer is private, this becomes much more challenging and is something that management and the representatives of the seller who are structuring the transaction should think through carefully.

The “basis” of the stock options (also known as the “strike price” or “barter element”) reduces the value of the stock option. Specifically, if the value of a share of stock in a transaction is $1 and the basis of the stock option is $0.40, the actual value of the stock option at the time of the transaction is $0.60. For some bizarre reason, many sellers forget to try to recapture the value of the barter element in the purchase price and allow the total purchase price to be the gross value of the stock options (vested and unvested) rather than getting incremental credit on the purchase price for the barter element.

Yeah – a little confusing, but lets assume you’ve got a $100 million cash transaction with $10m going to option holders, 50% of which are vested and 50% are unvested. Assume – for simplicity – that the buyer is assuming unvested options but including them in the total purchase price (the $100m) and that the total barter element of the vested stock is $1m and the barter element of the unvested stock is $3m. The vested stock has a value of $4m ($5m value – $1m barter element) and the unvested stock has a value of $2m ($5m value – $3m barter element). So – the option holders are only going to net $6m total. Often the seller will catch the vested stock amount (e.g. vested options will account for $4m of the $100m) but the full $5m will be allocated to the unvested options (instead of the actual value / cost to the buyer of $2m). This is a material difference (e.g. the difference between $91m going to the non-option holders versus $94m).

Of course, all of this assumes that the stock options are in the money. If the purchase price of the transaction puts the options out of the money (e.g. the purchase price is below the liquidation preference) all of this is irrelevant since the options are worthless.

It’s been a little over a month since Jason and I wrote posts for our Letter of Intent series. We took a time out for our 409A series and for actually selling two companies (Commerce5 to Digital River and another that hasn’t been disclosed yet) rather than writing about selling companies. This is the first time in four years where I personally haven’t been actively trying to close the sale of a company over the holidays, so I thought I’d put some time in and finish up this series.  2005 was an awesome year for M&A and all the pundits think 2006 will be equally good (or better), especially after all the M&A bankers get their year end bonuses in January and receive a new dose of forward motivation. 

After considering price and structure, it is time to discuss other major deal points generally found in an LOI. One item to note here: absence of these terms in your particular LOI may not be a good thing, as in our experience detailed term sheets are better than vague ones (although be careful not to overlawyer the detailed term sheet.) Specifically, this is the case because during the LOI discussions, most of the negotiating is between the business principals of the deal, not their lawyers, who will become the main deal drivers post signing of the term sheet. Our experience is that leaving material business points to the lawyers will slow down the process, increase deal costs and cause much unneeded pain and angst. Our suggestion would be to always have most of the key terms clearly spelled out in the LOI and agreed to by the business principals before the lawyers bring out their clubs, quivers and broadswords.

Today we are going to discuss the treatment of the Stock Option Plan. The way stock options are handled (regardless of how you address the 409A issues) can vary greatly in the LOI.  The first issue to consider is whether or not the plan is being assumed by the buyer and if so, is the assumption of the option plan being “netted” against the purchase price. In some cases, the buyer will simply assume the option pool in addition to the base consideration being received; however, it’s typically the case that if the buyer agrees to assume the option plan then the aggregate price will be adjusted accordingly as very few things are actually free in this world.

Let’s presume the option pool is not going to be assumed by buyer. The seller now has several things to consider. Some option plans – especially those that are poorly constructed – don’t have any provisions that deal with an M&A context when the plan is not assumed. If the plan is silent, it’s conceivable that when the deal closes and the options are not assumed, they will simply disappear. Obviously – this sucks and is not in the spirit of the original option plan.

Most contemporary option plans have provisions whereby all granted options fully vest immediately prior to a merger should the plan and / or options underneath the plan not be assumed by the buyer. While this clearly benefits the option holders and helps incentivize the employees of the seller who hold options, it does have an impact on the seller and the buyer. In the case of the seller, it will effectively allocate a portion of the purchase price to the option holders. In the case of the buyer, it will create a situation where there is no “forward incentive” for the employees (since their option value is fully vested and paid at the time of the acquisition), resulting in the buyer having to come up with additional incentive packages to retain employees on a going forward basis.

Many lawyers will advise in favor of a fully vesting option plan because it “forces” the buyer to assume the option plan, because if it did not, then the option holders would immediately become shareholders of the combined entities. Under the idea that “less” shareholders are better than “more,” this acceleration provision would motivate buyers to assume option plans. Of course, this theory only holds true if there are a large number of option holders.

In the past few years we’ve seen cases whereby the buyer has used this provision against the seller and its preferred shareholders. In these cases the buyer has explicitly denied assuming the options, wanting the current option holders to become target shareholders immediately prior to the consummation of the merger and thus receive direct consideration in the merger. The result is that merger consideration is shifted away from prior shareholders and allocated to employees whose prior position was that of an unvested option holder. This “transfer of wealth” shifts away from the prior shareholders – generally preferred stockholders, company management and former founders – into the pockets of other employees. The buyer “acquires” a happy employee base upon closing of the merger. Note, that this is only an option for the buyer if the employee base of the target is relatively small. Also note that the buyer can “re-option” the management and employees that it wants to keep going forward, so that in the end the only stakeholders worse off are the preferred holders and former employees / founders of the company.

Bottom line, the assumptions of stock options can be a more complex term than most people give it credit, as evidenced by this post.

For my 40th birthday, I got a couple of cool t-shirts with photos of me substituted for Jack Bauer on 24.  The only thing disconcerting was the image of me holding a handgun.  I was pondering how ripped I looked (on Jack’s torso) when two questions on term sheets came in from someone at Ernst & Young.  Being the excellent delegator that I am (much better than Jack, if you know what I mean), I forwarded the questions on to Jason who promptly answered them.  They are as follows:

1. What would you deem the most hotly contested points of the term sheet? The most hotly negotiated term (after price) is the liquidation preference. In a Series A deal, it is between the company and the investor. While it’s often an intense negotiation, it’s straightforward because there are only two interests to consider (the founders and the Series A investors). In later stage, the negotiations become even more interesting. Take a situation where you have a Series D deal with each Series (A, B, and C) having different prices. By definition each of the different Series investors will have different payouts on their previously purchased stock and the Series D investors will be negotiating with several sets of interested parties (the founders, the Series A investors, the Series B investors that are not in the Series A, and the Series C investors that are not in the Series A / B).  Of course, the notion of participating preferred plays into this negotiation also.

2. In your view, how has the role of legal counsel changed over time during the deal process (in the past 10 years or so)? Legal counsel is relied on more heavily these days to be a business arbiter, rather than a “take no prisoner negotiator” who must win every last deal point. These deals aren’t rocket science and any good lawyer knows that.  As a result, legal counsel (at least good legal counsel) is now much more of a deal maker than hard ass negotiator.

I had the following conversation recently.

Entrepreneur: “Brad, I just got an offer for my company for $15 million from Company X.”
Brad: “Awesome.  Who’s Company X – I’ve never heard of them.”
Entrepreneur: “It’s a private company funded by Venture Firm Y.”
Brad: “Cool – $15 million – is it a cash deal?”
Entrepreneur: “No, it’s all stock.”
Brad: “Hmmm – are you getting preferred or common stock?”
Entrepreneur: “Common stock – why?”
Brad: “How much money has the company raised?”
Entrepreneur: “$110 million”
Brad: “What’s the liquidation preference?  Is it a participating preferred?  What’s the valuation of the company?”
Entrepreneur: “Oh – I’m not worried about that stuff – the valuation is $300m and they say they are going public soon.”

If you’ve read our term sheet series, you know where this one is going.  The entrepreneur just received an offer for his company for 5% of the acquirer (actually 4.76% on a post-transaction basis) in an illiquid stock in a private company that is sitting under $110 million of liquidation preferences that are probably participating.  If my friend calls his friendly neighborhood financial appraiser to do a valuation analysis, he’ll find out the “$15 million” is actually valued at a lot less (probably good for tax purposes, not so good for buying beer, sports cars, and second houses.)

The form of consideration matters.  Cash is – well – king.  Everything else is something less.  And it can be a lot less – did you here the one where the acquirer offered “free software products” up to a certain amount in exchange for the company’s assets?  Gee, … er, “thanks.”

Obviously cash is easy to understand and to value. Stock can be more complicated.  If it’s stock in a private company, understanding the existing capital structure is a critical first step to understand what you are getting.  If it’s stock in a public company, you’ll want to ask a variety of questions, including whether the stock is freely tradeable, registered, or subject to a lockup agreement.  If it’s freely tradeable, will you be considered an insider after the transaction and have any selling restrictions?  If it’s not freely tradeable, what kind of registration rights will you have?  It can get messy quickly, especially if you try to optimize for tax (there’s that tax thing again.)

Bottom line – make sure you recognize that the “value of your company” and the “price you are getting paid” may not be the same.  Don’t let yourself get locked in early in the negotiation to a “price” until you understand the form of consideration your are receiving.