Posts from Contract

The Nature Of The Firm and Work Markets

Those who watched the video I posted on Sunday saw me talking about this. But I didn't do it justice so I'm going to do a full post on this.

The brilliant Nobel prize winning economist Ronald Coase (who is still alive!) wrote a seminal essay called The Nature Of The Firm in 1937. This is an important work and something everyone should read. It is short, only 20 pages.

The entire essay

The wikipedia page on the essay

In The Nature Of The Firm, Coase investigates why "individuals choose to form partnerships, companies and other business entities rather than trading bilaterally through contracts on a market."

Coase argues that transaction costs that make "trading bilaterally through contracts" expensive spur the organization of firms. And if those transaction costs could be eliminated, more individuals would choose to trade with each other rather than forming partnerships, companies, and other business entities.

Enter the internet and having a computer in your pocket into this model and things change. Technology has been causing these transaction costs to drop precipitously for years now and the result is we have seen the emergence of work markets in which "individuals trade bilaterally through contracts."

Our firm is seeing these work markets sprout up all around us and if there is a single investment theme that is dominating our deal flow right now, this would be it. Christina touched on this in her recent blog post on the USV blog (the section she titled "work is shifting to a peer to peer model").

We have one investment in this category, appropriately called WorkMarket, and we will certainly make others as long as we can be sure they are not competitive with each other. And we can thank Ronald Coase who laid out this investment thesis for us only 75 years ago!

#VC & Technology

M&A Issues: Reps, Warranties, Indemnities, and Escrows

Yet another post on issues in M&A. This one is about the things you will sign up to when you sell your business and the money you will set aside to cover them.

First things first. I am not a lawyer. And this post is about legal stuff. I barely know how to spell indemnities. I had to double check that I was spelling it correctly. So I am going to put a bunch of stuff on the table but if you really want to understand this, talk to a lawyer. This kind of stuff is why you have a lawyer and why they are valuable. That said, here goes.

When you sell your business you will make a bunch of representations to the buyer (reps). You will tell them you own all of the assets you have on your balance sheet. You will tell them that you have no more liabilities than you have listed on your balance sheet. You will tell them that you own all the intellectual property you claim to own. You will tell them that you have all the contracts with customers you claim to have. I could go on and on. The list of reps in a purchase agreement is long.

This is a contract. You need to take this stuff seriously. If you are repping to something, you should be very careful and read every rep and make sure it captures the situation accurately. There will be schedules for most, if not all, reps. Read them too. You are making promises to the seller. Make sure they are correct.

Reps are about what is true today. Warranties are about the future. You will also be asked to warranty a number of things in a sale contract. Read them carefully as well. Make sure you are confident of them. Lawyers write these contracts but people have to live up to them. So don't just treat a contract as a piece of paper to be signed. Understand what is being agreed to, take the time to understand it. If you don't understand it, make your lawyer walk you through it, line by line if need be.

An indemnity is the amount of money that is to be paid from the seller to the buyer if any of the reps and warranties turn out to be false. They will be set up in the contract. Understand how much liability you are taking on for the reps and warranties.

The buyer will require a percentage of the purchase consideration be set aside to back up the indemnities, usually for one year. The percentage is most often 10%, but can be more or less depending on the type of deal it is. The escrow is the money the buyer can come after based on the indemnities without having to sue the seller.

There will be an escrow agent represeting the selling shareholders. It is most often the lead investor. Our firm has done this many times. It is a thankless task, but an important one. If there is a fight over the escrow amounts or a larger claim, the shareholder representative will be the one dealing with the buyer.

One area that has been particularly problematic in M&A for tech startups is IP reps, particularly patent issues. An announcement of a large purchase of a tech company is a big fat target for patent trolls. The patent infringement suits will come out and the seller's escrow will be the target. My partner Brad has been dealing with one of these for years. It is ugly.

Most of the time, the escrow is paid without much haggling by the buyer on time (usually a year later). But sometimes the buyer has legitimate claims and the escrow is used up paying the indemnities. It is rare (at least in my experience) for the buyer to come after more than the escrow. That is most common in outright fraudulent transactions.

In summary, you will be asked to make a bunch of statements of fact and future performance to the buyer when you sell the company. Take them seriously and make sure you understand what you are signing up to. Be prepared to set aside at least 10% of the purchase price to back up these statements. And if things go wrong, expect to lose some or all of that 10%.



#MBA Mondays