Welcome to Week 7! If you are an entrepreneur, then hopefully someday you will receive the OTHER term sheet that's one of the most important - the letter of intent (LOI). Usually the first step by a company that wants to acquire your company is to issue an LOI. Again, as term sheets go, there are some terms that matter a whole lot and others that don't. And again, it will be riddled with mysterious language that it would seem only the lawyers or experienced deal makers can decipher. Never fear, it can be a straightforward process.
- An LOI marks the point at which you go from discussions with multiple acquisition deals to a single acquisition deal
- Entrepreneurs should try to get to the place where signing an LOI means commitment to follow through on the dael
- Have conviction yourself to follow through
- Understand the level of conviction of the buyer
- Companies that regularly acquire and do a fair amount of deals are more reliable
- Most failures to close a deal occur due to inexperience of a lack of support on the buyer side rather than failures in the dilligence process
- Effectively an acquisition scenario term sheet
- The two party transaction with an explicit buyer is the most simplistic type
- More complex types do exist
- With regards to negotiating terms, the best BATNA is not to have to sell your company at all - just don't sell and keep running your business
- 2+ pages long, sections
- People tend to focus on the price they are getting
- Can be multiple components to the price - may not be a straightforward number
- For example:
- May be an 'earn-out' = extra payment over time
- May be an incentive program for management
- May be an escrow hold-out to ensure that terms are fulfilled
- Acquisition may be for stock or cash
- Private company stock is hard to value
- For example:
- Can be multiple components to the price - may not be a straightforward number
- There is no typical LOI process
- May be sudden or a long term development
- May be a single buyer or a competitive negotiation
- May be shopped around or may accept an initial offer
- May be forced due to time or money to sell the business, or may be cashflow positive and non-urgent
- Stages
- Dance leading up to the point at which negotiations begin with one or more parties
- Negotiating and agreeing to the Letter of Intent (LOI)
- Going from an LOI to a definitive agreement (much heavier weight process than the term sheet to final financing documents conversion)
- Some people advise entrepreneurs never to worry about the exit and focus on building a great company
- Do this, but recognize that you are likely on a path to be acquired
- Be open to inquiries and relationships from potential acquirers
- Often acquirers come from existing business relationships of some kind (eg. supplier/distributor/partner)
- Start to think about who potential acquirers are and actively develop relationships with them
- Provides cheap negotiating leverage in the case of a random acquisition inquiry
- ie. completely ignoring future acquisition is a mistake
- Be serious and deliberate about corporate records
- May seem like a nuisance
- Annual audits
- Much easier to put this stuff together along the way than at the last moment when acquired
- Be open to inquiries and relationships from potential acquirers
- Do this, but recognize that you are likely on a path to be acquired
- Badly and confusingly named
- Asset deals can be for stock
- Stock deals can be for cash
- Stock transaction is when the buyer buys your entire company (the stock of the company) and as a result your company becomes part of the buyer's company - all of it.
- Legal structure affords different dynamics in the transaction than an asset deal
- Fundamentally the buyer is buying everything associated with your company
- Historically, most sellers wanted to do a stock transaction
- More common in information based businesses where major assets are things like intellectual property and customer base
- Today stock transactions are perhaps more common as considered 'cleaner'
- Asset deal is a situation where the buyer is buying specific assets of the company
- Not buying the whole company
- Company remains a stand-alone entity
- Can include essentially the whole company - all assets
- Changes legal structure of the deal and the allocation of various liabilities
- Entire company is not being consumed by the acquirer
- Tax implications
- Preferred because of liability and ease
- Pick and choose the assets that you want (more prcise)
- Perception that it's easier to do such a transaction (once true, dubious today)
- Perhaps more popular in physical asset heavy businesses due to things like environmental liabilities
- Common in consolidated onwnership positions for founders, especially when corporate structure makes founders only shareholders (eg. through US Subchapter S organization type) versus a situation with investors
- Historically, most buyers want to do an asset transaction
- What form does your compensation come in?
- Cash
- Stock
- Banana chips? (Private company equity, potentially unmarketable or at dubious valuation)
- If a private company is buying your company, they should be willing to give you their financial statements
- How are they performing as a business?
- How much cash do they have?
- What financings have they done?
- 4NNA(?) valuation analysis of the various classes of stock including common stock
- Strangely due to tax it may be better for you in a private to private acquisition scenario to have a lower fair market valuation reflected there
- If taking private stock, fundamentally you want to be sure that it really has:
- the value you ascribe today
- the potential future growth they are claiming
- If taking public stock, it's usually closer to cash (easy to liquidate) if registered and freely tradeable with decent daily trading volume, however:
- Unregistered shares may mean a wait of 6 months or the company has to file a registration statement before you can sell the shares
- If volatility of the stock is very high then this must be taken in to account
- Make sure you are aware of the situation of the public company using available market information and it is a company that you are enthusiastic about being part of
- If taking stock quoted in dollar equivalent, make sure that the date at which the stock converts is the date at which the deal is signed or you may lose out due to fluctuation
- Stock can be specified in various ways:
- As a percentage
- As a dollar equivalent
- As a specific and fixed number of shares
- Be clear in stock deals whether the amount you will obtain is pre or post merger
- First question is do the stock options have any value or not
- In a lot of scenarios (eg. sale below the liquidation preference) the investors get all the money and the stock options have no value anyway
- Higher strike price stock options may be above transaction price (hence not exercisable)
- Second question will the stock options be assumed by the acquirer or not
- The way the stock option agreement is written and the type of transaction has an impact on this
- If they assume the stock options
- Many things must be understood around vesting, and in the stock option context what happens with acceleration, who has the options, what plan they turn in to on the buyer's side
- Motivation for assuming the unvested options is generally as a retention device for existing employees
- Sometimes they want people to stay for as long as possible, other times for a year or two
- If they don't assume the stock options
- It's likely the options are accelerating in vesting based on the way the plan works
- Consideration is going to have to go buying out the options in the plan (though not always the case)
- There are some situations where the options might cease to exist if they are not assumed
- Entrepreneurs must have a philosophy about how they want stock option holders to be treated
- Best option for employees is an accelerated vesting scenario
- Earn-out clauses generally create a situation in which the whole team staying together is in the earlier investor's interest which affects their perspective on stock option assumption dynamics
- Representations and warranties are things that you say are true about a variety of different aspects of the company
- Some may be associated with an escrow scenario, others outside
- Formalizing these forces the buyer to reveal their thoughts about these issues on the front-end of the negotiation
- Example representations and warranties
- Own all your own IP
- Capital structure of the company is true
- Full disclosure of legal issues has occurred
- No enviromental issues on property
- In compliance with taxes and applicable laws
- Indemnification is a specific statement that if something is not true in the representations and warranties then you will take responsibility for it
- A lot of this relates to prior knowledge
- A so-called 'knowledge qualifier statement' is a critical consideration here
- There is a spectrum from seller to buyer friendly, most are in the middle.
- Some buyers will ask sellers to make representations about things they can't
- Liability should be linked to escrow only
- Otherwise in case of issue, liability may be bigger than the actual deal value!
- Try to limit liability for each representation and warranty to a defined amount
- Also referred to as a 'hold-back'
- Held by a third party as security
- Typically escrow amount is 10-20% of the deal value
- Typically escrow lasts for 1-2 years
- Usually used to address breaches in representations and warranties
- There are two general scenarios
- People still working at the acquirer have knowledge of the issue and can help to work through it internally
- Nobody still working at the acquirer with knowledge to work through the issue, which means an escrow claim is generally the first line action for the acquirer
- There are two general deal types
- Totally clean (no escrow claims)
- A mess
- Either mediation or litigation may be used for escrow claims
- Generally mediation is based upon a clause within the paperwork
- In the context of a financing the VC will rarely or never sign and NDA
- In the context of an acquisition generally both parties sign a mutual NDA
- Covers all information going both ways plus the fact you are having the discussion at all
- In a private company to private company transaction, both parties may not want competitors to know about the transaction
- In a public company acqusition, many laws and liabilities ensure a mutual NDA must be in place
- NDAs should place equal expectations for secrecy on both parties, never accept a lopsided NDA
- Employees could acquire stock option acceleration, new plan from the acquirer, carve-out/incentive for sticking around, new job, higher profile employer on resume, opportunity to learn, or get no job
- Entrepreneurs and boards tend not to focus on the employee population other than founders and key employees until late in the process
- As an entrepeneur and a founder you should have a point of view about how you want to treat all of the employees during the acquisition and post-acquisition process
- Focusing on it too much before you know what the deal as a whole may look like is a mistake
- However, if this is not looked at early enough in the process, you can have a situation where you are close to getting a deal done then things like this come up and the buyer can feel you are squeezing them for every last bit of money, and you may not get the best result for your employees and they may not stay and work with you
- Usually not particularly contentious at higher levels of the organization where a certain number of executives signing retention agreements may be a prerequisite for the deal closing, however at lower levels of the organization it may not be so clear cut
- Decisions about when to inform employees about discussions with potential acquirers vary significantly between companies, from total transparency at all stages to post-facto notice.
- The deal's not done until it's done
- Often a clause "conditions to closing" exists to allow the buyer to walk away from the deal and to signal things that are very important to them
- Overall the conditions to close and in particular their specificity signal seriousness from the buyer
- There is generally no recourse for the seller
- Examples
- Successful completion of due dilligence
- Consent from 99% of shareholders
- Can be viewed as the transition from "OK do we have a deal or not?" to "Let's close the deal."
- Sometimes negotiable
- Agreement that you are not going to go sell the company to another acquirer for a certain period of time
- Typical time period is 30-60 (sometimes 90) days from the LOI being signed to the deal being closed or the deal stopping (buyer walking away)
- Often defined in such a way as to be legally enforceable, although damages are dubious, generally the buyer will walk away if violated
- Distress situations mean closing as quickly as possible
- Make the no-shop be short in duration
- Deals can close within 15-30 days
- If you are approached within a no-shop period by another acquirer you should say "not in a position to discuss that".
- Just get the best lawyer and pay for them
- Example lawyer fees
- Low end fees for a small M&A deal (clean, private:private acquisition) will be USD$25-50k
- Medium fees (typical deal) will typically cost USD$50-100k (sometimes $150k)
- High end deal (100s of millions of dollars) could cost USD$250-500k+
- Note that if you have complications (legal issues, bad corporate records, long and drawn out negotiation, etc.) fees will be higher
- Buyer often pushes cost of your legal fees to you, but pays their own
- Sometimes there is a 'break-up fee' if the deal fails to go through, eg. multiple bidder situations (ie. leverage exists)
- Sometimes a buyer will cover your legal fees anyway if it is their fault or they are nice people :)
- Venture Deals Chapter 14 - Letters of Intent - The Other Term Sheet
A Model Letter of Intent can be downloaded on the resources section of Ask the VC
Brad and Jason wrote a series of "Letter of Intent" blogs you can see here
For many startups the dream is to be acquired. For established companies, the hunt is often on for potential acquisitions. If you are a startup searching to be gobbled up, you must be prepared to pitch why your company is a "good buy". For this assignment, use the startup your team used in the first assignment. Your company has been doing very well and is actively looking to be acquired. Now you must find potential targets and pitch your company to them.