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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.
My partner Heidi pointed out that the analogy (or is it a metaphor – I can never remember – another one of my brain quirks) that I used in my Letter of Intent: Structure – Asset vs. Stock post could have been better. An asset (or “artichoke” deal) is actually like eating the artichoke heart and leaving the leaves untouched since the heart is the good part and the leaves have thorns.
While price is usually first issue on every seller’s mind, structure should be second. While there only two types of deals (asset deal vs. stock deal), there are numerous structural issues surrounding each deal. Rather than trying to address all the different issues, Jason and I decided to start by discussing the basics of an asset deal and a stock deal.
In general, all sellers want to do stock deals and all buyers want to do asset deals. Just to increase the confusion level, a stock deal can be done for cash and an asset deal can be done for stock – don’t confuse the type of deal with the actual consideration received (if you start getting confused, simply think of an asset deal as a “artichoke deal” and a stock deal as a “strawberry deal.”)
Sarcastic venture capitalists on the seller side will refer to an artichoke deal as a situation “when buying a company is not really buying a company” (kind of like eating the artichoke leaves but leaving the artichoke heart untouched.) Buyers will request this structure, with the idea that they will only buy the particular assets that they want out of a company, leave certain liabilities (read: “warts”) behind, and live happily ever after. If you engage lawyers and accountants in this discussion, they’ll ramble on about something regarding taxes, accounting, and liabilities, but our experience is that most of time the acquirer is just looking to buy the crown jewels, explicitly limit their liabilities, and craft a simpler deal for themselves at the expense of the seller. We notice that asset deals are more popular in shaky economic times, as acquirers are trying to avoid creditor issues and successor liability. One saw very few asset deals (in proportion) in the late 1990’s, but in early 2000 artichokes became much more popular and there is still a significant hang over today.
While asset deals are “ok” for a seller, the fundamental problem for the seller is that the “company” hasn’t actually been sold! The assets have left the company (and are now owned by the buyer), but there is still a shell corporation with contracts, liabilities, potentially employees, and tax forms to file. Even if the company is relatively clean from a corporate hygiene perspective, it may take several years (depending on tax, capital structure and jurisdictional concerns) to wind down the company. During this time, the officers and directors of the company are still on the hook and the company presumably has few assets to operate the business (since they were sold to the buyer).
In the case of a strawberry deal, the acquirer is buying the entire company. Once the acquisition is closed, the seller’s company disappears into the corporate structure of the buyer and there is nothing left (except possibly some t-shirts that found their way into the hands of spouses and the company sign that used to be on the door (oops – did I say that?) just before the deal closed.) There is nothing to wind down and the historical company is well – history.
So is an asset deal “bad” or is it just a “hassle”? It depends. It can be really bad if the seller has multiple subsidiaries, numerous contracts, employees with severance commitments, disgruntled shareholders, or is close to insolvent. In this case, the officers and directors may be taking on fraudulent conveyance liability by consummating an asset deal. It’s merely a hassle if the company is in relatively good shape, is very small, or has few shareholders to consider. Of course, if any of these things are true, then the obvious rhetorical question is “why doesn’t the acquirer just buy the whole company via a stock deal?”
In our experience, we see stock deals the vast majority of the time. Often the first draft of the LOI is an asset deal, but as sellers that is the first point we raise and we are generally successful ending up with strawberries except in extreme circumstances whereby the company is in dire straits. Many buyers go down a path to discuss all the protection they get from an asset deal – this is generally nonsense as a stock deal can be configured to provide functionally equivalent protection for the buyer with a lot less hassle for the seller. In addition, asset deals are no longer the protection they used to be with regards to successor liability in a transaction – courts are much more eager to find that a company who purchase substantial assets of another company to be a “successor in interest” with respect to liabilities of the seller.
The structure of the deal is also tied closely to the tax issues surrounding a deal and – once you start trying to optimize for structure and tax – you end up defining the type of consideration (stock or cash) the seller can receive. It can get complicated very quickly and pretty soon you can feel like you are climbing up a staircase in an Escher drawing (or running the Manhattan part of the New York Marathon – each time you turn you expect to get to go downhill and see the end, but instead you continue to wind uphill forever – even when you’ve turned 180 degrees and are running the other direction.) We’ll dig into tax and consideration is other posts – just realize that they are all linked together and usually ultimately impact price which is – after all – what the seller usually cares most about.
Jason and I have engaged in a little foreplay with you in our Letter of Intent series. While you might think the length of time that has passed since my last post is excessive, it’s often the length of time that passes between the first overture and an actual LOI (although there are plenty of situations where the buyer and the seller hook up after 24 hours, just like in real life.)
As with other “transactions”, there’s a time to get hot and heavy. In most deals, there are two primary thing that the buyer should have on his mind – price and structure. Since the first question anyone involved in a deal typically asks is “what is the price?” we’ll start there.
Unlike in a venture financing where price is usually pretty straightforward to understand, figuring out what the “price” is in a merger situation can be more difficult. While there is usually some number floated in early discussions (e.g. “$150 million”), this isn’t really the actual price since there are a lot of factors that can (and generally will) effect the final price of a deal by the time the negotiations are finished and the deal is closed. It’s usually a safe bet to assume that the “easy to read number” on the first page of the LOI is the best case scenario purchase price. Following is an example of what you might see in a typical LOI.
Purchase Price / Consideration: $100 million of cash will be paid at closing; $15 million of which will be subject to the terms of the escrow provisions described in paragraph 3 of this Letter of Intent. Working capital of at least $1 million shall be delivered at closing. $40 million of cash will be subject to an earnout and $10 million of cash will be part of a management retention pool. Buyer will not assume outstanding options to purchase Company Common Stock, and any options to purchase shares of Company Common Stock not exercised prior to the Closing will be terminated as of the Closing. Warrants to purchase shares of Company capital stock not exercised prior to the Closing will be terminated as of the Closing.
Hmm – I thought this was a $150 million dollar deal? What does the $15 million escrow mean? The escrow (also known as a “holdback”) is money that the buyer is going to hang on to for some period of time to satisfy any “issues” that come up post financing that are not disclosed in the purchase agreement. In some LOIs we’ve seen extensive details, in so much as each provision of the escrow is spelled out, including the percentage of the holdback(s), length of time, and carve outs to the indemnity agreement. In other cases, there is mention that “standard escrow and indemnity terms shall apply.” We’ll discuss specific escrow language later (e.g. you’ll have to wait until “paragraph 3”), but it’s safe to say two things: first, there is no such thing as “standard” language and second, whatever the escrow arrangement is, it will decrease the actual purchase price should any claim be brought under it. So clearly the amount and terms of the escrow / indemnity provisions are very important.
Well – that working capital thing shouldn’t be a big deal, should it? True – but it’s $1 million. Many young companies – while operating businesses – end up with negative working capital at closing (working capital is current assets minus current liabilities) due to debt, deferred revenue, warranty reserves, inventory carry costs, and expenses and fees associated with the deal. As a result, these working capital adjustments directly decrease the purchase price in the event upon closing (or other pre-determined date after the closing) that the seller’s working capital is less than an agreed upon amount. Assume that unless it is a “slam dunk” situation where the company has clearly complied with this requirement, the determination will be a battle that can have a real impact on the purchase price. In some cases, this can act in the seller’s favor to increase the value of the deal if they have more working capital on the balance sheet than the buyer requires – often the seller has to jump through some hoops to make this happen.
While earn outs sound like a mechanism to increase price, in our experience, they really are tool that allows the acquirer to under pay at time of closing and only pay “true” value if certain hurdles are met in the future. In our example, the acquirer suggested that they were willing to pay $150 million, but they are only really paying $100 million with $40 million of the deal subject to an earnout. We’ll cover earnouts separately, as there are a lot of permutations, especially if the seller is receiving stock (instead of cash) as their consideration
In our example, the buyer has explicitly carved out $10 million for a management retention pool. This has become very common as buyers wants to make sure that management has a clear and direct future financial incentive. In this case, it’s explicitly built into the purchase price (e.g. $150 million) – we’ve found that buyers tend to be split between building it in and putting it on top of the purchase price. In either case, it is effectively part of the deal consideration, but is at risk since it’ll typically be paid out over several years to the members of management that continue their role at the acquirer – if someone leaves, that portion of the management retention tends to vanish into the same place lost socks in the dryer go.
Finally, there’s a bunch of words in our example about the buyer not assuming stock options and warrants. We’ll explain this in more detail later, but, like the working capital clause, can affect the overall value of the deal based on what people are expecting to receive.
As Jason and I launch into our new series on the Letter of Intent (LOI), we thought we’d start out like most LOI’s do – with a little foreplay. To keep it simple, assume there are two primary parties in an M&A transaction – the “buyer” and the “seller” (for the time being, let’s not worry about complex deals that have more than two parties – this is a family blog after all – well, not really.)
By the time the buyer presents the seller with an LOI, there have been meetings, discussions, dinners, expensive bottles of wine, lots of conference calls, and an occasional argument. However, the buyer and the seller are still courting so they tend to be on their best behavior. The LOI is typically the first real negotiation and the true ice breaker for the relationship.
In ancient times, when the first LOI was presented, someone crafted an introductory paragraph that starts off with something like the following:
Dear CEO of Seller:
We have greatly enjoyed our conversations to date and are honored to present you with this letter of intent to acquire <Seller’s Company>. We look forward to entering into serious discussions over the next several months and reaching an agreement to acquire your company. We’d like to thank you for entertaining our proposal, which follows:
While every company has their own style, most LOIs start off with some variation of this boilerplate paragraph. Of course, you’ll find – later in the LOI – a qualifier that states that most everything in the LOI is non-binding, including the appearance of civility as part of the negotiation. What would you expect in a world where ABC can launch a series called “Commander in
The West Wing Chief”?
Next up – some real stuff – namely a discussion about one of the keys terms in the LOI – price.