Letter of Intent: Form of Consideration

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.