Assuring the Benefit of the Bargain for All Parties
Acquisition of a tech-backed startup can be a shrewd tactic by an established tech company and a magical moment for stakeholders of the startup. All too often, however, the structure of the deal reflects misunderstandings and overreaching that derail the tech company’s ambitions and sour the outcome for the startup’s founders, employees and VCs. Due diligence, honest appraisal of motivations and appropriate structuring of the transaction make it more likely that the transaction will work for all parties.
Significantly, if the company is in a highly regulated field such as banking, insurance or securities trading, the transaction should be structured to pass regulatory muster and documents should allow ample time for all regulatory approvals, and the VCs should be briefed on their disclosure obligations underlying the approval processes.
Starting with the Startup
The value of the startup is in its technology, people and customer traction. Given synergies with the acquirer, that value may well best be realized within a larger company. Unfortunately, the act of acquiring endangers the elements of value the acquirer seeks. For all involved, the challenge lies in structuring the transaction to best realize that value and gain an equitable share of it.
It is a complicating factor that the startup has stakeholders with sometimes divergent interests and levels of control that can affect the structure. However, there are recurring patterns among the usual suspects:
Founders: Many founders are willing to sell but unwilling to cede control now or forever. Others feel they have just run a marathon in Death Valley and willingly collapse at the acquisition line in glorious and terminal victory. Most fall somewhere along this continuum.
Employees: Some employees are thrilled to join a more established company. Others fear being returned to the prison from which they had just escaped. Most are happy to join the acquirer at least for a couple of years to maximize the value of their options, be they professional or equity-based.
VCs: The VC is driven by the cycles of its funds and their performance. It might give the investment time to develop or it might need a quicker realization of value even if it does not maximize expected return. Portfolio considerations might influence its view of a proper acquirer and an acceptable price. Its ability to influence value post-acquisition largely disappears. Upfront liquid stock or cash is most important.
Hearing What the Acquirer is Saying: Identifying Types
“We’ll Take it From Here.” The acquirer believes it can realize the startup’s value without its founders or employees.
“You Won’t Even Know We’re Here.” The acquirer is willing to grant substantial autonomy perhaps even going so far as to preserve the corporate structure and independence of the startup.
“Hear, Hear.” In the most common case, the acquirer is willing to give some autonomy but wants its directions followed. Listen to what we are saying or else.
Matching the Pieces
It is critical that the form of consideration, continued equity interest and/or earn-out match the motivations of the relevant parties. Some decisions the startup makes well before any deal will also influence its flexibility in an acquisition. These include stock options plans and employment agreements but extend also to the control and other provisions of the preferred stock they issue the VCs.
Continuing Equity Interests: Where founders and employees are critical to the on-going success of the startup’s activities, assuring continuing equity interests is essential. This can have added benefits. If the deal consideration includes sufficient equity, it may be possible to achieve a tax-free transaction that can be beneficial for all the startup’s stakeholders and potentially reduce the acquisition price for the acquirer.
Startups should consider in advance the practical implications of the vesting provisions of their stock plans. As attractive as it sounds to have full accelerated vesting provisions for restricted stock and options upon a change of control, this can significantly reduce the value of the startup to the acquirer. If human expertise is likely to leave after the acquisition, the acquirer’s goals may be subverted and its willingness to pay diminished.
This may necessitate the acquirer having to grant additional equity at closing and that may reduce the total purchase price and thus the return to certain stakeholders, especially the VCs. In this sense, founders and employees can overreach with excessive restricted stock/option vesting and VCs generally try to keep this tendency in check. Consider instead partial vesting provisions at closing with additional vesting after acquisition upon termination without cause or for good reason.
Earn-Out: Earn-outs make sense for the “you-won’t-even-know-we-are-here” and also the “hear-hear” acquirer. Continued motivation of the startup team and its ability to affect the earn-out are a virtuous circle for the acquirer and the startup stakeholders. VCs generally don’t like earn-outs, however, and generally have the rights to veto some or even all deals so startups should take care in negotiating the preferred stock they issue. For the “we’ll-take-it-from-here” acquirer, earn-outs make little sense and serve primarily to bridge disagreement on valuation but generally create a perfect storm for conflict.
Cash: Cash is always welcomed, especially by the VCs, however, it is taxable and generally can be less motivating for founders and employees than equity, especially for the marathon-running founders and employees who see the cash as a nice place to collapse.
Keep in mind that the pieces of the puzzle may not always fit together but appropriate acquisition consideration and deal structure make it more likely that an acquisition will succeed for all concerned. Startups should plan ahead to make sure they have the flexibility they need.
Kim Larsen is principal in charge of the Washington DC office of corporate law firm Bressler, Amery & Ross, P.C. Tobias Ziegler of the firm’s corporate practice contributed to the article. Larsen has been an investor and attorney on a range of corporate matters, with an emphasis on M&A, joint ventures and commercial transactions. He has been instrumental in forming many VC-funded companies, some of which have gone public and more of which have been acquired. Individually and as founding member of Blu Venture Investors, an angel investor group in D.C., Larsen has participated in over 25 tech start-ups. He is reachable at email@example.com and you can follow the firm at @BresslerLa