Secrets of Sand Hill Road

by Scott Kupor

  Speaking of closing conditions, another important one in most deals is the set of voting approvals the seller is required to get. We’ve talked before about protective provisions and which votes are in fact required for a deal. Although most companies will require only a majority of common and preferred (voting as separate classes, meaning that a majority of each group needs to approve the transaction) to vote in favor of a deal, acquirers will often demand a higher threshold. By the way, this is also where drag-along provisions come into play; they are a handy mechanism to force at least a subset of often larger investors to vote in favor of a deal even if they are not thrilled about it. Acquirers will often want to see at least 90 percent of the shareholders vote in favor of a deal; the main purpose here is to reduce the surface area of potential shareholders who may ultimately object to the deal and potentially seek legal redress.

  In most acquisition scenarios, the buyer doesn’t pay the full purchase price up front. Rather, it puts some percentage of the purchase price into an escrow account (this just means an account that is managed by a third party) to cover potential surprises it may discover after the deal closes. Escrow sizes vary but are often between 10 and 15 percent of the purchase price. The term of the escrow account also varies, but is often between twelve and eighteen months post-closing. The types of contingencies that the escrow is intended to cover often include, among others: (1) basic representations from the company (e.g., its share count is accurate); (2) any litigation that might arise after closing relating to something the company did before closing; and (3) ownership and any potential claims against intellectual property.

  There are x-number of bells and whistles that can apply to the escrow. Sometimes, for example, the acquiring company agrees to a minimum dollar threshold below which it will eat the costs and not access the escrow. Other times, if the dollar threshold is exceeded, the acquirer will hold back the full amount of the claim, or it may only hold back the amount in excess of the threshold. Sometimes, the escrow amount is the only remedy that an acquirer has for breaches of the agreement; other times the acquirer can sue the company to recover amounts in excess of the escrow. And, finally, the time frames may vary by type of claim. Some claims, for example, that arise after the twelve-to-eighteen-month escrow period are simply irrelevant, whereas others (sometimes intellectual property claims) may survive beyond the escrow period.

  Another big-picture economic item—and, trust me, we have glossed over a lot of issues that practitioners in the field spend a lot of time on—deals with our favorite topic: indemnification. In general, the buyer wants the selling company to indemnify it from any number of claims that may arise post-closing. The escrow is of course intended to be the first line of defense for such claims, but buyers often look for more protection.

  The big negotiations in this area tend to center on a few areas.

  First, which claims can be covered beyond the escrow account? That is, if a third party brings a big intellectual property claim and it has a damage amount greater than the escrow, can the acquirer get that excess money back from the sellers? If there is a limit on the recovery, is it capped by the purchase price of the acquisition, or can sellers be on the hook for even greater amounts? And, finally, can individual members of the selling group potentially be on the hook for liabilities that other members of the selling group either don’t have the money to pay or otherwise refuse to pay? In other words, can one seller be forced to pay more than her pro rata share of the damages, or is she responsible only up to her pro rata amount?

  Finally, let’s mention exclusivity periods. Recall that we talked about no-shops in chapter 10, which essentially prevent a startup from shopping a term sheet with other potential investors for some reasonable period of time (often fifteen to thirty days) for the purpose of allowing the investor who has proposed the deal time to finish due diligence and complete legal docs.

  The same concept exists in acquisition, and goes by the term “exclusivity period.” This is the time between signing of the term sheet and (hopefully) closing of the transaction during which the seller is engaged to the buyer. The form of that engagement generally means that they can’t shop the term sheet to other buyers, nor can they solicit interest from other potential buyers. Not surprisingly, buyers want this period to last as long as possible, but for many startup deals, the time frame should really be gauged by the amount of remaining due diligence and legal documentation time required. Thus, thirty to sixty days tends to be the reasonable range of exclusivity period for such acquisitions.

  Acquisitions: Board Responsibilities

  What does a board have to do when considering an acquisition offer?

  Recall that we talked about the business judgment rule as the default form of review of corporate actions, and entire fairness in the case where you have a conflicted board. There is an intermediate legal standard in the case of normal acquisition transactions. For the sake of clarity, note that we are talking here about situations where you don’t have a conflicted board and are considering what we like to think about as a good acquisition transaction.

  The responsibilities of the board in this circumstance are generally referred to as “Revlon duties,” named after the Revlon legal case that codified the standard of review for acquisition-related activities. (There was a case subsequent to Revlon called Paramount that further clarified the board’s duties; nonetheless, most people still refer to Revlon as the moniker for board acquisition duties.)

  In short, Revlon says that, while the board has no obligation to sell the company, if the board decides to proceed down that path, it must seek to maximize the value of the common stock. This means that the board must act in good faith to get the best price reasonably available (and explore all reasonable options to get the best price). And the courts are permitted to retrospectively review both the board process and the reasonableness of the price in determining whether the board satisfied its Revlon duties.

  These duties apply in most acquisition scenarios where, as the courts have said, there is no tomorrow for the common shareholders. That is, this is the last chance for the common to enjoy the economic value of its holdings, so the board should do what they can to get the best price reasonably available. Thus, the time-based focus of the board shifts from maximizing the long-term value of the common shareholders to focusing on maximizing the short-term value via the transaction. This is often thought of as an intermediate level of review between the business judgment rule and the entire fairness standard that we reviewed previously.

  As we covered in the previous sections, the process matters here.

  To satisfy Revlon duties, boards should: (1) run a broad outreach to multiple potential acquirers, with the help of bankers where possible; (2) consider other possible paths forward (e.g., is there a financing alternative whereby the company remains a stand-alone entity to maximizes shareholder value?); (3) consider incorporating a go-shop provision into an offer they receive from an acquirer to permit other competing bids to surface; and (4) document a well-vetted process that shows the board considered all available possibilities to maximize shareholder value.

  The board is not obligated in all cases to take the highest price; it just has to reasonably maximize shareholder value. So, for example, the board can take a slightly lower offer if it feels that the offer is more likely to close or the form of consideration (stock versus cash) is more favorable. Ultimately, the processes of negotiating with the buyer and evaluating the various alternatives are likely to be sufficient as long as the price is within a range of reasonable prices.

  There is much more to cover here in the acquisition context—and this is the reason why M&A agreements often run into the hundreds of pages—but we’ve covered some of the high-level considerations.

  Obviously, an acquisition can be a great validation of what you—as an entrepreneur—have tirelessly built over the years. Sometimes, it’s an opportunity to keep building and real
izing your product vision, albeit with a new set of owners and colleagues. Other times, it may be the end of a chapter and the opportunity to either take a break or begin anew the startup process.

  Amid all the excitement of the deal, what should you as CEO be thinking about in the M&A context?

  First, your employees. As noted above, you’ll be asked to help the acquirer figure out which employees are going to be part of the go-forward team and which, unfortunately, may need to look for new opportunities. For those who are staying, part of your job will be to make sure they are properly incented financially and organizationally to help deliver whatever the acquirer is seeking to achieve from the deal. Key to this will be understanding—and potentially influencing—the organizational structure that the acquirer is contemplating post-acquisition: Will your team get folded intact into an existing organization, will the team get distributed across various functional organizations in the company, or will the business be run as a separate entity (with or without you as the leader)? Depending on the answers to these questions, the acquirer will be looking to you not only to help place employees in the best spot but also to help make sure that the employees are excited and well prepared to execute on the business plan.

  For those employees who may not have an opportunity to come along as part of the acquisition, you of course want to make sure they exit the business with the same level of respect and appreciation for their accomplishments as when you first welcomed them onto the team. As noted above, hopefully these employees are able to at least enjoy the financial benefits of the acquisition while they go on to new adventures. Regardless, the startup community is a small one, and many people are repeat players in the ecosystem, so your reputation will be earned—and remembered—based upon how you treat departing employees.

  Once all those issues are sorted, then it’s time for you to finally think about yourself. If you are a critical part of the post-acquisition organization, you should expect to spend a lot of time with the acquirer, planning for what things will look like post-acquisition. You will of course have had a number of conversations with the acquirer during the pre-deal phase, but the hard work of integration remains.

  Overview of the IPO

  Let’s move on to the IPO, the other major form of exit for a venture-backed company.

  Although you wouldn’t know it from the current trends, the IPO was once the most sought-after prize for venture-backed startups. From 1980 to 2015, the median time to IPO for a venture-backed company was about seven years; since 2010, though, that has increased to more than ten years. There are lots of reasons for this—we mentioned a few earlier in the book.

  Putting aside the reasons why more companies are choosing not to go public, let’s focus for a second on why companies do in fact go public.

  Raising capital—This is an obvious one, but interestingly has declined in importance over the years as a major driver for companies to go public. It used to be that companies needed to go public because the private market tapped out pretty quickly when you started to contemplate raising $100 million-plus financing rounds. Now those are a dime a dozen, and we see some companies raising billions of dollars in the private marketplace—e.g., Uber, Lyft, Airbnb, and Pinterest, among others. There’s an ongoing chicken-and-egg debate about what created this—did the big financial players start investing in the private markets because startups were delaying going public, or did startups start delaying going public because they could raise huge sums of money in the private markets? It’s not worth debating here, other than to note that the attraction of the public markets as an important source of large capital raises is clearly diminished.

  Branding—There also once was a time when startups were not on the front page of every news source and not followed by popular, dedicated technology reporters. As a result, for many companies, an IPO was an important public branding event—an opportunity for them to tell their story directly to their customers and to the broader financial community, helping drive new business along the way. Today, who hasn’t stayed in an Airbnb, taken a ride with Lyft, or pinned on Pinterest? And if you haven’t personally done these things, you have certainly read about them in the popular press, even if you live outside of Silicon Valley. So, strike number two against going public is there; the branding value of the coming-out event just simply isn’t as needed as it once was.

  Liquidity—Finally, a partial check in favor of this one. Even employees who have stock options (and, of course, investors) and love their company will ultimately want some ability to convert their appreciated investments into cash. As we mentioned before, to sell your stock, it either has to be registered (for which the IPO process is an important first step) or you have to have some other exemption from registration. Thus, selling your stock in the private markets is far more challenging than just hitting the SELL button from your Schwab account once the company has gone public. In most cases, if you want to sell your private stock, you need to find a third-party buyer (who is sophisticated enough to legally purchase your shares) and, at a minimum, get the participation of the company whose shares you are trying to sell to effect the transaction. As we noted earlier, sometimes as an employee you may not even have the right to sell the stock—for example, if you have a blanket transfer restriction on your shares. And, in cases where that doesn’t exist, you might be bound by a right of first refusal, which you’ll recall might prevent buyers from engaging, since they know that the company could ultimately usurp them by buying the shares itself. In some startups today, the companies are offering partial liquidity to employees through the form of tender offers. This is a structured sale often organized by the company in which the employee is allowed to sell some portion of her shares to an approved set of buyers at periodic intervals, maybe once per year. It helps release the pressure valve a bit for employees, but doesn’t go all the way toward providing a liquid market for broader stock sales. Thus, an IPO still has real value in achieving the liquidity goal.

  Customer credibility—This one is particularly relevant for companies that sell critical technologies to other companies (i.e., B2B). In some cases, the potential customer who may be contemplating a purchase of a network security device wants to know that the startup is going to be around for a while and not go bankrupt tomorrow and leave the customer high and dry. Thus, being a public company and having transparent financials for your customers to review can sometimes remove an impediment to the sales process. Of course, private companies can also share their financials with potential customers (and being a public company in and of itself doesn’t mean that you can’t go bankrupt), but the financial discipline and visibility associated with being a public company can often be helpful in B2B selling.

  M&A currency—Technology companies build products. Those products have product cycles that hopefully go up and to the right for a long time. However, as with all things, what goes up often comes down, and a product’s growth when it gets to the end of a product cycle is no different. Thus, to maintain growth, technology companies need to either build or acquire new products to ride the wave of another product cycle. Acquisitions do tend to be an important part of that strategy for technology companies and, while companies can of course make acquisitions while they are still private, it’s easier to do so when you have a public currency. Why? Because the stock market gives you a daily report card in the form of your stock price to tell the seller exactly what your stock is worth if the acquirer is proposing to use it as currency for an acquisition. In the private world, because of the discontinuous nature of private financings, there’s always a healthy debate about how to value the stock on any given day.

  The IPO Process

  Assuming a startup does in fact decide to go public, the process is a well-worn and highly orchestrated one.

  It starts with picking the investment banks, otherwise known as the underwriters. This process is often euphemistically called the “beaut
y contest” or “bake-off,” as it involves various banks pitching their wares to the startup.

  There are several important factors that a startup might consider in picking a bank. First, their domain expertise in the industry, including who the research analyst is who is likely to publish research on the company post-IPO. (Research analysts generally work for investment banks and interact frequently with institutional investors who may be buying or selling a public stock. Some of that interaction comes in the form of published research reports that lay out their thesis on the stock, including its potential for generating financial returns to shareholders. For a newly public company, research analysts are even more important, as they help educate the institutional investors, particularly in the early days post-IPO where the company is not yet well known.) Second, their relationships with institutional investors who could be buyers of the IPO (and, in some cases, relationships with retail investors). Third, the strength of the banks’ sales and trading desks to not only place the stock at the IPO with institutional investors but also help create an orderly trading environment, particularly in the first few weeks following the IPO. And, finally, their capabilities post-IPO to be able to help with M&A advice, follow-on financings, debt issuances, and other capital markets issues. And, of course, relationships factor in a lot; many bankers are picked on the basis of having cultivated the board and CEO relationships for a long time prior to the bake-off.