Category: Term Sheet
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.
My partner Heidi pointed out that the analogy (or is it a metaphor – I can never remember – another one of my brain quirks) that I used in my Letter of Intent: Structure – Asset vs. Stock post could have been better. An asset (or “artichoke” deal) is actually like eating the artichoke heart and leaving the leaves untouched since the heart is the good part and the leaves have thorns.
While price is usually first issue on every seller’s mind, structure should be second. While there only two types of deals (asset deal vs. stock deal), there are numerous structural issues surrounding each deal. Rather than trying to address all the different issues, Jason and I decided to start by discussing the basics of an asset deal and a stock deal.
In general, all sellers want to do stock deals and all buyers want to do asset deals. Just to increase the confusion level, a stock deal can be done for cash and an asset deal can be done for stock – don’t confuse the type of deal with the actual consideration received (if you start getting confused, simply think of an asset deal as a “artichoke deal” and a stock deal as a “strawberry deal.”)
Sarcastic venture capitalists on the seller side will refer to an artichoke deal as a situation “when buying a company is not really buying a company” (kind of like eating the artichoke leaves but leaving the artichoke heart untouched.) Buyers will request this structure, with the idea that they will only buy the particular assets that they want out of a company, leave certain liabilities (read: “warts”) behind, and live happily ever after. If you engage lawyers and accountants in this discussion, they’ll ramble on about something regarding taxes, accounting, and liabilities, but our experience is that most of time the acquirer is just looking to buy the crown jewels, explicitly limit their liabilities, and craft a simpler deal for themselves at the expense of the seller. We notice that asset deals are more popular in shaky economic times, as acquirers are trying to avoid creditor issues and successor liability. One saw very few asset deals (in proportion) in the late 1990’s, but in early 2000 artichokes became much more popular and there is still a significant hang over today.
While asset deals are “ok” for a seller, the fundamental problem for the seller is that the “company” hasn’t actually been sold! The assets have left the company (and are now owned by the buyer), but there is still a shell corporation with contracts, liabilities, potentially employees, and tax forms to file. Even if the company is relatively clean from a corporate hygiene perspective, it may take several years (depending on tax, capital structure and jurisdictional concerns) to wind down the company. During this time, the officers and directors of the company are still on the hook and the company presumably has few assets to operate the business (since they were sold to the buyer).
In the case of a strawberry deal, the acquirer is buying the entire company. Once the acquisition is closed, the seller’s company disappears into the corporate structure of the buyer and there is nothing left (except possibly some t-shirts that found their way into the hands of spouses and the company sign that used to be on the door (oops – did I say that?) just before the deal closed.) There is nothing to wind down and the historical company is well – history.
So is an asset deal “bad” or is it just a “hassle”? It depends. It can be really bad if the seller has multiple subsidiaries, numerous contracts, employees with severance commitments, disgruntled shareholders, or is close to insolvent. In this case, the officers and directors may be taking on fraudulent conveyance liability by consummating an asset deal. It’s merely a hassle if the company is in relatively good shape, is very small, or has few shareholders to consider. Of course, if any of these things are true, then the obvious rhetorical question is “why doesn’t the acquirer just buy the whole company via a stock deal?”
In our experience, we see stock deals the vast majority of the time. Often the first draft of the LOI is an asset deal, but as sellers that is the first point we raise and we are generally successful ending up with strawberries except in extreme circumstances whereby the company is in dire straits. Many buyers go down a path to discuss all the protection they get from an asset deal – this is generally nonsense as a stock deal can be configured to provide functionally equivalent protection for the buyer with a lot less hassle for the seller. In addition, asset deals are no longer the protection they used to be with regards to successor liability in a transaction – courts are much more eager to find that a company who purchase substantial assets of another company to be a “successor in interest” with respect to liabilities of the seller.
The structure of the deal is also tied closely to the tax issues surrounding a deal and – once you start trying to optimize for structure and tax – you end up defining the type of consideration (stock or cash) the seller can receive. It can get complicated very quickly and pretty soon you can feel like you are climbing up a staircase in an Escher drawing (or running the Manhattan part of the New York Marathon – each time you turn you expect to get to go downhill and see the end, but instead you continue to wind uphill forever – even when you’ve turned 180 degrees and are running the other direction.) We’ll dig into tax and consideration is other posts – just realize that they are all linked together and usually ultimately impact price which is – after all – what the seller usually cares most about.
Jason and I have engaged in a little foreplay with you in our Letter of Intent series. While you might think the length of time that has passed since my last post is excessive, it’s often the length of time that passes between the first overture and an actual LOI (although there are plenty of situations where the buyer and the seller hook up after 24 hours, just like in real life.)
As with other “transactions”, there’s a time to get hot and heavy. In most deals, there are two primary thing that the buyer should have on his mind – price and structure. Since the first question anyone involved in a deal typically asks is “what is the price?” we’ll start there.
Unlike in a venture financing where price is usually pretty straightforward to understand, figuring out what the “price” is in a merger situation can be more difficult. While there is usually some number floated in early discussions (e.g. “$150 million”), this isn’t really the actual price since there are a lot of factors that can (and generally will) effect the final price of a deal by the time the negotiations are finished and the deal is closed. It’s usually a safe bet to assume that the “easy to read number” on the first page of the LOI is the best case scenario purchase price. Following is an example of what you might see in a typical LOI.
Purchase Price / Consideration: $100 million of cash will be paid at closing; $15 million of which will be subject to the terms of the escrow provisions described in paragraph 3 of this Letter of Intent. Working capital of at least $1 million shall be delivered at closing. $40 million of cash will be subject to an earnout and $10 million of cash will be part of a management retention pool. Buyer will not assume outstanding options to purchase Company Common Stock, and any options to purchase shares of Company Common Stock not exercised prior to the Closing will be terminated as of the Closing. Warrants to purchase shares of Company capital stock not exercised prior to the Closing will be terminated as of the Closing.
Hmm – I thought this was a $150 million dollar deal? What does the $15 million escrow mean? 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, in so much as each provision of the escrow is spelled out, including the percentage of the holdback(s), length of time, and carve outs to the indemnity agreement. In other cases, there is mention that “standard escrow and indemnity terms shall apply.” We’ll discuss specific escrow language later (e.g. you’ll have to wait until “paragraph 3”), but it’s safe to say two things: first, there is no such thing as “standard” language and second, whatever the escrow arrangement is, it will decrease the actual purchase price should any claim be brought under it. So clearly the amount and terms of the escrow / indemnity provisions are very important.
Well – that working capital thing shouldn’t be a big deal, should it? True – but it’s $1 million. Many young companies – while operating businesses – end up with negative working capital at closing (working capital is current assets minus current liabilities) due to debt, deferred revenue, warranty reserves, inventory carry costs, and expenses and fees associated with the deal. As a result, these working capital adjustments directly decrease the purchase price in the event upon closing (or other pre-determined date after the closing) that the seller’s working capital is less than an agreed upon amount. Assume that unless it is a “slam dunk” situation where the company has clearly complied with this requirement, the determination will be a battle that can have a real impact on the purchase price. In some cases, this can act in the seller’s favor to increase the value of the deal if they have more working capital on the balance sheet than the buyer requires – often the seller has to jump through some hoops to make this happen.
While earn outs sound like a mechanism to increase price, in our experience, they really are tool that allows the acquirer to under pay at time of closing and only pay “true” value if certain hurdles are met in the future. In our example, the acquirer suggested that they were willing to pay $150 million, but they are only really paying $100 million with $40 million of the deal subject to an earnout. We’ll cover earnouts separately, as there are a lot of permutations, especially if the seller is receiving stock (instead of cash) as their consideration
In our example, the buyer has explicitly carved out $10 million for a management retention pool. This has become very common as buyers wants to make sure that management has a clear and direct future financial incentive. In this case, it’s explicitly built into the purchase price (e.g. $150 million) – we’ve found that buyers tend to be split between building it in and putting it on top of the purchase price. In either case, it is effectively part of the deal consideration, but is at risk since it’ll typically be paid out over several years to the members of management that continue their role at the acquirer – if someone leaves, that portion of the management retention tends to vanish into the same place lost socks in the dryer go.
Finally, there’s a bunch of words in our example about the buyer not assuming stock options and warrants. We’ll explain this in more detail later, but, like the working capital clause, can affect the overall value of the deal based on what people are expecting to receive.
As Jason and I launch into our new series on the Letter of Intent (LOI), we thought we’d start out like most LOI’s do – with a little foreplay. To keep it simple, assume there are two primary parties in an M&A transaction – the “buyer” and the “seller” (for the time being, let’s not worry about complex deals that have more than two parties – this is a family blog after all – well, not really.)
By the time the buyer presents the seller with an LOI, there have been meetings, discussions, dinners, expensive bottles of wine, lots of conference calls, and an occasional argument. However, the buyer and the seller are still courting so they tend to be on their best behavior. The LOI is typically the first real negotiation and the true ice breaker for the relationship.
In ancient times, when the first LOI was presented, someone crafted an introductory paragraph that starts off with something like the following:
Dear CEO of Seller:
We have greatly enjoyed our conversations to date and are honored to present you with this letter of intent to acquire <Seller’s Company>. We look forward to entering into serious discussions over the next several months and reaching an agreement to acquire your company. We’d like to thank you for entertaining our proposal, which follows:
While every company has their own style, most LOIs start off with some variation of this boilerplate paragraph. Of course, you’ll find – later in the LOI – a qualifier that states that most everything in the LOI is non-binding, including the appearance of civility as part of the negotiation. What would you expect in a world where ABC can launch a series called “Commander in
The West Wing Chief”?
Next up – some real stuff – namely a discussion about one of the keys terms in the LOI – price.
Coming off the high of a manic Monday in the tech business, Jason and I have decided to follow our Term Sheet series with a new series scintillatingly called “Letter of Intent.” Deals like eBay / Skype (wow – what a deal – congrats to DFJ, Bessemer, Index, and especially the Skype guys) have to start somewhere, and often the first real “document” that gets negotiated after the foreplay turns serious is the infamous “letter of intent.”
Now – our friend Jack Bauer doesn’t bother with these – he rarely has time to call the lawyers or review documents. However, most deals – especially those involving private companies – involve a letter of intent. This sometimes delightful and usually non-binding document (except for things like a no shop agreement) is also known as an LOI, indication of interest (IOI), memorandum of understanding (MOU), and even occassionally a term sheet.
As with the Term Sheet, there are some terms that matter a lot and others that don’t. There are plenty of mystery words that an experienced deal maker always knows how and where to sprinkle so that he can later say “but “X” implies “Y”, often resulting in much arguing between lawyers. We’ve had LOIs get done in a couple of hours and had others stretch into periods of several weeks – experience, knowledge, and understanding matter and the LOI negotiation is usually a first taste of the actually negotiating style you will experience from the other party.
We look forward to walking you through this and hopefully concluding before Jack comes back.
Jason and I hope you enjoyed reading our term sheet series at least as much as we enjoyed writing it. While we won’t be competing with our friend Jack Bauer for any drama awards (I tried to make it 24 posts, but could only get to 20), we’ve tried to take a balanced and pragmatic approach to explaining the mysterious “VC term sheet.” Remember – we’re not lawyers (ok – Jason is) and this isn’t legal advice so you should not rely on it for anything, yada yada standard disclaimers follow. In other words, use at your own risk.
For ease of reference, following are the various sections (linked to their corresponding post) that we covered.
- Liquidation Preference
- Board of Directors
- Protective Provisions
- Drag Along
- Redemption Rights
- Conditions Precedent to Financing
- Information Rights
- Registration Rights
- Right of First Refusal
- Voting Rights
- Employee Pool
- Restriction on Sales
- Proprietary Information and Inventions Agreement
- Co-Sale Agreement
- Founders Activities
- Initial Public Offering Shares Purchase
- No Shop Agreement (also Unilateral or Serial Monogamy)
If you have any questions, comments, or suggestions for things we missed, email me anytime. We have had numerous requests for republishing this content – if you are interested, please contact me. We’re usually happy to oblige – we just want to make sure we know about it. Until next season …