- Cynthia Smith
Venture capitalists (“VC”) have a choice between two primary methods to achieve a return on their investment: an initial public offering (1 merger/acquisition. Considering the low IPO activity in equity markets during the past three years, mergers and acquisitions have been a popular exit for VC investments. Most mergers or acquisitions of VC-funded companies consist of a smaller, VC-funded company merging or being acquired by public or private company. Mergers of companies equal in “size” do often they occur only to ensure the company’s survival and do not typically result in a return on investment for the VC. The acquisition/merger is also a efficient way for the acquirer of a VC-funded company to enlarge its business by adding product lines or services already developed by the VC-funded company. Furthermore, the VC-funded company may already have established market share. When a VC-funding company or larger private company, the VC’s participation in the company generally ends and, in the case of a merger, so does the independent status of the VC-funded company.
It is best for a VC to think about its exit before the initial investment is made. While there is never a guarantee of return on investment, the VC and its counsel should endeavor to devise a strategy to ensure that the VC is in the best possible position to receive its projected return on investment when the opportunity to merge or sell the company arises.
This article discusses considerations for a VC in structuring its initial investment in a company, and for structuring the subsequent merger or acquisition of the company so the VC can achieve optimal return on its investment.
The VC’s exit strategy must be kept in mind during the entire process evaluating and negotiating the initial investment. Preferred stock is typically the investment vehicle of choice for VCs. The terms of the preferred stock must provide the mechanics necessary to protect the VC and to maximize its return. The following is a short discussion of the terms of the preferred stock that directly relate to the subsequent merger/acquisition exit of a VC investment.
A VC typically invests through the purchase of a company’s preferred stock because the terms of the preferred stock can be customized to each particular investment transaction. It is different from common stock, which is typically b y the founders of the company and possibly other shareholders, including angel investors. We will discuss preferred stock issued by C-corporations, though discussion applies equally to a preferred membership interest of an limited liability company.
The terms of preferred stock are negotiated between the VC and the target company. These terms are limited only by the company’s certificate incorporation, bylaws and other organization documents, as well as the laws of the state in which the company is incorporated. There are various terms to the preferred stock, and some of these will have a greater effect on the future merger or acquisition than others. For example, certain terms impact when the company may entered into a merger or acquisition, others dictate what return on investment the VC will receive upon its exit and some impact the terms of merger or acquisition itself. Since the terms of the preferred stock have such an influence on the return of investment for the VC, it is important to ensure that at the time of the VCs initial investment, these terms are negotiated with a merger or acquisition exit in mind. The following discussion highlights certain customary terms of preferred stock that directly affect the process of a merger or acquisition of the company.
The primary term of the preferred stock that will affect the return received VC is what is known as the liquidation preference. Liquidation preference is the amount that will be received for each share of preferred stock upon a liquid event, which is defined under the terms of the preferred stock in the comp certificate of designation in the certificate of incorporation. A merger or acquisition is typically considered a liquidation event. Thus, the liquidation preference has a direct connection with the return a VC will receive for its investment. The liquidation preference will not only provide a dollar per amount to be received for the preferred stock upon liquidation, but it will determine the priority as to who receives the consideration derived from the transaction.
In almost all circumstances, the VC wants to ensure that preferred stock preferred liquidation preference over other classes of stock, as that will protect, at a minimum, its initial investment. For example, if a VC makes a $2 million investment in exchange for fifty percent (50%) of the company, a simple liquidation preference provides that the VC receives its $2 million investment before the common shareholders receive proceeds, but the VC does not share in any other consideration received. This is not beneficial to the VC for reasons, the most important of which is that it is the VC outlaying a large investment and thus taking on a significant part of the risk. For that risk there ought to be more than a simple return of the initial investment.
At a minimum, the VC wants to ensure it receives back the full amount it paid hare before any of the funds received are distributed to other shareholders that it shares in some manner in the remaining distribution of consideration. Before, the VC will negotiate to receive participating preferred stock, which ensures the VC will receive its full return on the initial investment and then e pro rata in further distributions as if the preferred stock had converted to common stock. To illustrate, if a VC makes a $2.5 million investment for 50% of equity ownership of the company and the company is then valued at $10 million, at the time of the merger or acquisition, if the preferred stock is participating, the VC will receive the $2.5 million return on its initial investment will also receive 50% of the remaining consideration of $7.5 million, for a I return to the VC of $6.25 million.
Another approach is for the VC to negotiate for fully participating preferred stock. To illustrate, assume a company has a pre-investment valuation of $1 million based upon contributions from the founders and other shareholders. The invests $5 million for 25% of the company. Assuming the company does not increase in value and is later sold for $20 million, the VC will receive $8.7 million and the original shareholders will receive $11.25 million or 75% of the value they had before the VC investment. The difference between this and the above participating preferred stock is that after the VC has received a full return on its initial investment, it will then share pro-rata in the remaining portion c funds, not based upon a post investment valuation as above, but on a post investment valuation of the company.
Yet another approach to liquidation preference is to set the liquidation preference as a percentage of the purchase price per share. For example, the VC could negotiate a liquidation preference of 150% of the purchase price. The VC could stop there or it could further negotiate that after it has received that initial amount of liquidation preference, it would share pro-rata in any further distribution of merger or acquisition consideration as if it had converted its preferred stock to common stock. For example, if the VC invests at a share price of $2.00 per share, the liquidation preference of 150% will yield a return of $3.00 per share. The VC could then also share in any funds not initially distributed as if they had converted to common stock.
The danger for the company is that there could be instances, depending on the price paid for the company, where the VC could receive a return on investment, but the remaining shareholders could receive little or nothing for their shares. For example, in the case of participating preferred stock, if the VC million investment and the company is sold for $3 million, the VC will receive its initial investment of $2 million and then share pro-rata in the remaining 1 million, as if its preferred stock had converted to common stock. h situation, the amount received by the other shareholders will, in most instances, not reflect the “sweat equity” they have put into the company to place it into position to be acquired or merged.
The VC should balance the amount of liquidation preference with the incentivizing management to keep up their efforts on behalf of the con’ management is not running the company well, the VC will have a much more difficult time receiving a return on investment. An example of such cot is to have the liquidation preference where the VC receives a priority its capital invested and then the common shareholder receive a priority as to their capital invested and then all the parties share pro rata thereafter remaining distribution as if the preferred shareholders had converted to stock.
The VC, as holder of preferred stock, will want to have the right to significant corporate transactions of the company, such as an: acquisition. This is fair because the VC has provided significant capital is taking on risk. Alternatively, the provision may provide that the VC’s consent is required but the board of directors of the company ultimately has the final say. In other instances, the VC will have a member on the board of directors of the company and the terms can be structured so that the consent of such member must be required before the rest of the board can vote or on moving forward with the merger/acquisition. The VC would rather have the final vote since this would provide the VC with a de-facto veto as to whether the company will indeed enter a merger or acquisition. On the other hand, the company would rather have the board of directors have the final vote since the other shareholders will then have some influence as to whether the company will merge or be acquired and the board of directors will have to take into consideration their interests.
In addition, the existence of a shareholders’ agreement may affect the effectiveness of a VC’s consent to a merger or acquisition. For example, a stockholders’ agreement may provide for what is known as “drag-along” rights. ; is where a large group or majority of shareholders, typically the common shareholders, may vote to move forward with a merger, and the remaining shareholders are consequently “dragged along” in their consent whether or not they agree with the decision of the majority. In such a situation, it is all the more important for the VC to negotiate for a veto-style consent, especially if the VCs not hold a majority of the voting shares of the company. Without such consent, even though the VC may vote in favor of the merger, a majority of common shareholders may prevent it. Depending on the terms of the preferred stock, the decision may still require the approval of the company’s board of directors
Due diligence by the VC generally takes place before the investment is made in considering an investment, it is very important that the VC, along wit stance of counsel and other professionals, conduct an extensive due diligence examination of the target company. This will help the VC understand the legal and financial risks in making the investment. Thorough due diligence by the VC, as well as effective supervision and participation in the company by the VC throughout its investment, will benefit everyone involved. Also, the acquirer of funded company in a merger or acquisition will likely conduct at least the level of due diligence, and the seller (the VC-funded company) should cooperate. Failure to conduct proper due diligence may not only impact the VC initial investment, it may also affect the VCs return on investment when the company is sold. The following discussion describes some of the issue its counsel should examine during the due diligence process.
The VC should examine whether the company’s intellectual proper protected through patents, trademarks and copyrights, and whether t has been protected through proper employee non-compete and co agreements. If this protection does not exist, the VC should appropriate levels of protection are put in place. If intellectual material to the business of the company, lack of protection of property may prevent an acquirer from moving forward with a merger or acquisition, or it may diminish the price the acquirer is willing to pay.
Another area that deserves careful examination is whether the company’s agreements or organizational documents contain any arrangements under which a change of control of the company will trigger another event. A typical change of control provision provides that a merger or acquisition is a change of control. For example, a change of control might trigger cancellation of an agreement, or require the company to get the consent from the party to the agreement before the agreement will be transferred to the acquirer. A change of control may trigger a golden parachute in an employment agreement. A golden parachute provides lucrative benefits to executives if a change of control occurs that results in the loss of their job. These benefits are typically large severance payments, bonuses and accelerated vesting of stock options. The existence of golden parachutes may deter the acquiring company from moving forward with a transaction, as it may increase the price of the transaction. In addition, whatever part of the merger consideration is paid to the executives under their employment agreements will directly reduce the amount of return the VC is entitled to receive.
It is also important for the VC to be aware of any supermajority voting provisions contained in the company’s organizational documents or other agreements. These provisions may effectively provide the present common shareholders voting control of the company, such as where their votes represent a greater percentage than the number of shares they actually hold. A supermajority provision may entitle the common shareholders to a vote equal to or greater than the VC, even though the VC may hold a majority stake in the company. If possible, the VC should negotiate to have such provisions removed before the initial investment takes place, or negotiate that the VC’s consent to merger or acquisition activity is required. Otherwise, a small minority of shareholders could control the decision of whether to move forward with a merger, and the VC will consequently lose its influence over such a decision.
The consideration paid by the acquirer for the stock of the VC-funded company can come in the form of cash or stock of the acquirer, or a combination of each. Cash consideration presents few issues. If consideration is paid in stock of the acquirer, the VC must determine its value and liquidity. The VC should conduct the same type of due diligence on the acquirer that it conducted on the target company, prior to its initial investment, to the extent it can. It is important to asses the “value” of the stock rather than just its present trading price, if the acquirer is a public company. Such due diligence will allow the VC to determine, to the extent possible, the true value of the shares to be received as consideration and whether such consideration is a fair price for their interests. This is more difficult if the acquirer is a private company. If possible, the VC and other shareholders should negotiate the terms of the stock to be received, such as requiring registration rights for the stock, if the stock to be received is restricted stock. The outcome of this negotiation will depend on the size of the acquirer and the relative bargaining power of the parties.
A major concern for the VC will be the liquidity of the stock received as consideration. A public acquirer, in most instances, will issue unregistered stock as consideration, because this saves the acquirer substantial time and regulatory oversight. There is, however, a disadvantage for the VC receiving unregistered stock because the stock is relatively illiquid. The VC (and other shareholders) cannot sell unregistered stock unless an exemption from federal and state securities laws is available or until the stock is registered with the Securities and Exchange Commission (the “SEC”). The most common federal exemption for sale of unregistered stock falls under Rule 144 or Rule 145 of the Securities Act of 1933, as amended. These rules generally require that the stock must be held for a year, or possibly two, before the shares can be sold. The alternative to selling the stock under Rule 144 or Rule 145 is to have the acquirer register the stock with the SEC so that the shares can be freely and publicly sold. The acquirer can register the stock on either a Form S4 or a Form 5-3. Registering the stock prior to consumption of the merger or acquisition will add 60 to 90 days to the transaction. There are some advantages using a Form S3, however, the acquiring company will be required to keep the registration statement regularly updated with the acquirer’s current information. Also, not all companies qualify for the use of a Form S3. If time is an issue, where the merger or acquisition cannot stay open for the time pending to register the shares, the VC can negotiate for the right to require the acquirer to register the shares at a later point in time. If the acquirer is a private company, and the consideration is stock, which is typically not the case, the VC will want to ensure that it has registration rights for such private company’s stock as well.
In some instances, the VC may be required to invest more money into the company to keep it operational during the merger process. In this situation, the VC will want to ensure that it receives some sort of preferred return in exchange for the additional funding.
A merger or acquisition is governed by the agreement between the seller arid acquirer and sometimes certain shareholders. Merger or acquisition agreements typically follow the same format and contain the following sections:
• price and mechanics of transfer
• representations and warranties of buyer and seller
• covenant of buyer and seller
• conditions to closing
• termination and remedies
• miscellaneous legal components
Categories that encompass especially important details and merit further attention are discussed below.
Representations and warranties provide a snapshot of the selling company at the time the merger or acquisition agreement is signed. Initial negotiations between the parties should include discussing the nature and scope of the representations and warranties to be made by the seller in the agreement. Generally, the seller wants to limit disclosure made in the representations and warranties, whereas the acquirer desires that disclosure be as broad and extensive as possible. The narrower the representations and warranties given by the seller, the less risk the seller will breach such representations and warranties, and the less risk the seller will fail to satisfy a closing condition, thus not providing the acquirer the right to walk from the deal prior to closing, such right being typically provided for in a customary purchase agreement. If the breach happens post-closing, the seller will be exposed to liability for indemnification provisions contained in the agreement.
The seller’s representations and warranties will be much more extensive and in depth than those of the acquirer, which typically only represents and warrants that it has due authority to enter into and consummate the transaction. For example, the seller will have disclosed its financial statements to the acquirer in the due diligence process and, in the agreement, the seller will represent and warrant to the acquirer that those financial statements are accurate. Similarly, the seller will disclose information about any environmental conditions that may exist on it properties during due diligence and, in the agreement, the seller will represent and warrant that the information given is true. If exceptions exist as to the representations and warranties, schedules are attached to the agreement that will represent the exceptions to the party’s representations and warranties being made.
There are several ways for a seller, in this case the VC funded company, to reduce its exposure under the representations and warranties. One way is to limit the representations and warranties to what the seller and acquirer consider material to the transaction. Even though it may be difficult to exactly define what is “material” in and of itself, in most instances the parties will agree that “material” means information relevant to the business at hand. In some cases parties can agree to a minimum dollar threshold for what will be deemed material. During negotiations, an acquirer may declare that all items are material and that every fact should be known in order to help alleviate the risk of buying the business. The seller will have to accommodate the acquirer or convince them otherwise
Even though it is in the acquirer’s best interest to have the broadest representations and warranties possible, the acquirer should understand that in buying a business there will inevitably be risk. Hence, in most cases there will be some give and take in regard and to the representations and warranties by the acquirer& If the seller objects to making certain representations and warranties, the acquirer should investigate further and should question the seller to determine the source of the seller’s hesitation. If the acquirer can understand the seller’s motivations, then perhaps those concerns can be met in a way other than by carving back the representations and warranties. For example, the acquirer could agree not to terminate the agreement prior to closing for a simple breach of a representation or warranty; rather, the acquirer could only terminate if the damage caused by such a breach exceeded a minimum threshold, and the seller could have a right to cure the breach. This would protect acquirer in that the representations and warranties will not be carved back and seller will be satisfied that the acquirer could not walk from the deal for a simple breach by the seller. The consequences of the breach of a representation or warranty often comprise a major area of negotiation.
Another way in which a seller, and thus the VC, can narrow the scope of the representations and warranties and limit its risk is the use of phrases such as “in the ordinary course of business” and “to best of our knowledge.” The acquirer should be careful to limit use of knowledge qualifiers by the seller since they will deprive the acquirer depth in the representations and warranties that will help the acquirer avert a substantial amount of risk, A knowledge qualifier is customarily used in representations about litigation since there could exist potential, threatened litigation of which the company may not yet be aware. Knowledge qualifiers are also often used in intellectual property representations Since it may be difficult to he familiar with intellectual property as it relates to the business of the seller, it is possible that one could infringe on another party’s intellectual property without knowing it if the acquirer is requiring certain shareholders to represent and warrant specific items, and ii) the VC is part of such designated group, then the VC will want to qualify those representations and warranties. The argument here is that the VC is not involved in the day-to-day operations of the company and thus should be allowed to qualify their representations and warranties.
The acquirer should also be careful not to allow the representations and warranties to be given “as of the date hereof.” In most cases, there is a time gap of several weeks or months between the signing of the merger or acquisition agreement by the acquirer and seller and the closing of the transaction. If possible, the acquirer and seller will want to close on the transaction as soon as possible after the signing of the agreement. The more time that passes between the signing of the agreement and closing, the more time there is something to be altered in the company, thereby affecting the representations and warranties or covenants provided for in the agreement. If the dosing is to take place weeks or months after the execution of the Agreement, the acquirer will want to ensure that the representations and warranties are still are true on the date of closing. The seller is typically required to give a “bring down” certificate at closing certifying that the representations and warranties given in the agreement continue to be true.
The seller should attempt to also insert a provision that all the risk of a defect of which no one is informed at the time of closing is consequently allocated to the acquirer. The acquirer will not wish to agree to have such phrase inserted. It is with that in mind that a balance should be sought when the seller and acquirer confront representations and warranties. The seller and acquirer should also be aware that not each representation and warranty is as important as the others and the transaction will dictate which representations and warranties require more time than others. For example, a seller which does not own any real property need not spend a great deal of time on a representation and warranty concerning real property. The seller should simply warrant that it does not own any real property. There is always going to be some degree of uncertainty in purchasing a business, and negotiation of the representations and warranties is essentially an allocation of the risk of that uncertainty between the parties.
The covenants are intended to ensure that nothing will change between the time of signing of the merger or acquisition agreement and the closing of the transaction. This is especially important when there is a gap between signing and closing because it is possible that changes could occur during this time. In general, covenants lay out what the seller can and cannot do prior to closing and indicate when consent of the acquirer is necessary before it may take certain actions. One covenant that is very important and is often heavily negotiated is the covenant concerning the continuing of the seller’s business in the ordinary course prior to closing. The acquirer will want the seller to agree to run the business such that there are no changes from what has been presented in the representations and warranties when it comes time to closing the deal. It will also want to require the seller to obtain the acquirer’s consent before taking any actions outside the ordinary course of running the business. On the other hand, the seller will want flexibility as it continues to operate the business. It will want the ability to take action that it believes necessary to keep the business running and will not want the acquirer to be able to interfere with such decisions. If the covenant is drafted too rigid, the seller will have to obtain the consent of the acquirer for every small change in operations. One way of dealing with this issue is to use a materiality qualifier so that there are some circumstances in which the seller can act without having to obtain the acquirer’s consent.
Conditions are the prerequisites to closing. The most negotiated condition when there is a gap between signing and closing is the so-called “bring down” condition. As previously discussed, this condition stipulates that the representations and warranties must be true on the day they were made, which is the day the agreement was signed, as well as on the day of closing. If this is not the case, the seller may have breached the representations and warranties, giving the acquirer the ability to walk away from the deal or to seek a remedy under the indemnity. This condition ensures that the company the acquirer is purchasing at closing is the same company that the seller represented to the acquirer on the date of signing the agreement.
Another condition that may become an issue is the “financing out clause.” This provides that the transaction will not close if the acquirer does not have the financing necessary to close the deal. It is an “out” for the acquirer, and hence sellers typically do not like such a clause. The acquirer has a strong interest in having such a condition, because there are instances where financing arrangement may become unraveled and the acquirer may use this as an opportunity to get out of the transaction without violating the agreement. Without such a clause, if the acquirer’s financing becomes unraveled and it is unable to close the transaction under the terms of the agreements it will be in breach of the agreement and the seller can then seek a remedy under the agreement.
In the merger or acquisition context, indemnification is compensation for damage or loss due to a breach of a representation, warranty or covenant in the agreement. Indemnification can provide for protection of other events that are particular to the deal. In general, indemnification provisions protect the acquirer. These provisions can also protect the seller in the limited circumstance where indemnification is provided to the sellers. One of the major issues in negotiation of indemnification clauses is the size of the basket. The basket is the dollar amount of the loss that must be suffered by the acquirer before it can recover damages from the seller under the indemnity provisions. Basket size is customarily between 1-2 percent of the purchase price. After the basket amount has been reached, which the acquirer typically absorbs, the seller will be liable for the remaining amount under indemnification. As an acquirer, you do not want to negotiate and agree to a basket amount too early in the transaction, because the basket amount can be used as negotiating leverage for the basket or other sections of the agreement. The other major issue is whether there is a cap on the amount of indemnification to be provided. In some instance, parties will agree to cap liability at an amount such at the purchase price. The sellers should negotiate such at a minimum.
If there is more than one shareholder in the acquired company, the shareholders will desire to limit their liability under the agreements indemnity provisions to several liability rather than being jointly liable with the other shareholders The VC should ensure that they are protected in this way. Several liability provides that if one shareholder cannot satisfies its liabilities, the other shareholders will not be liable for the defaulting shareholder’s portion. One can see why this would be in the VC’s favor. In addition, if there are any representations and warranties that are specific to a shareholder or to a number of shareholders, the other shareholders will want to assure that they are not liable for a breach of that specific representation and warranty. Finally, the seller should attempt to negotiate a limit on the amount of liability to be paid by the shareholders under indemnity provisions. The purchase price may be a good boundary, but the acquirer will be resistant to this limit as the acquirer will want to be indemnified for all losses above the basket amounts
In the context of a merger or acquisition of a VC-funded company, it is generally a private company that is being merged into a larger public or private company. The two areas of law that predominately affect these transactions are federal and state securities and tax laws. State corporate law may also be implicated for specific issues though in most circumstances the transaction will comply with state law requirements without much effort.
Federal and state tax laws may affect the merger or acquisition transaction by impacting its structure as, at a minimum, the sale will cause a tax event for one or more of the parties. It there is a way to reduce the tax cost of a transaction that the acquirer and seller should work together to reach that objective. Generally, a seller will be taxed on the consideration received from the sale, unless the transaction is structured such that it is tax-free. However, there are certain requirements that must be fulfilled before the transaction can be stated as tax-free.
There are three basic structures for an acquisition: asset purchase, stock purchase or the merger. In the context here, the most popular structures are the stock purchase and the merger. The following is only a general description of the tax implications, and both acquirers and sellers will want to spend time with tax counsel to explore the most beneficial way to structure the transaction to minimize state and federal taxes.
Federal and state securities laws will also play a role in each transaction. These laws will play a larger role in the transaction if the seller is receiving stock of the acquirer as described above, these laws impact the issuance of the stock and its liquidity, including registration of such stock, and may also implicate other compliance issues.
This is a brief overview of major points to keep in mind when a VC-funded company is seeking a merger or acquisition exit to its investment. There will be transaction specific issues that may not have been covered here in detail or at all. One general point that a VC should remember is that VCs and their counsel should have an exit in mind when structuring the initial investment. Management companies that seek venture capital should understand that the VC will be looking for such an exit for its investment. when structuring the initial investment Management of companies that seek venture capital should understand that the VC will be looking for such an exit for its Investment, such as a merger or acquisition Management should ensure that proper protections and governance. procedures are in place so their company can take advantage of an M&A opportunity then if that is the case, to successfully execute its business plan, the VC will be in the best position to receive a return on the investment in the context of an M&A exit.