Posts from Mergers and acquisitions

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%.

Continuing our discussion of M&A Issues, we are going to talk about breakup fees today.

A breakup fee is a payment made by the buyer to the seller if the M&A transaction doesn't close.

Many M&A transactions do not include breakup fees, particularly smaller transactions. But as the value of the transaction rises and the potential disruption to the seller's business increases, it is more likely that the transaction will include a breakup fee. The negotiation of the breakup fee can be an important part of the letter of intent (LOI) negotiation and there are cases where merger deals have not happened because both parties could not agree on a breakup fee.

As a buyer, you want to avoid and/or limit the size of breakup fees as much as you can. And you want to be very specific about the circumstances in which you would pay them. You can and should carve out as many reasons for a deal falling apart from the breakup fee as you can.

As a seller, you want to include a breakup fee in the LOI for a bunch of reasons. First and foremost, it is a good way to make sure the buyer is serious about the transaction. It is a lot like a down payment in a contract to purchase a home. It forces the buyer to signal the seriousness of their interest.

In addition, the merger transaction can be very distracting for the seller and the seller's management team. If the selling company goes through a prolonged M&A transaction and then the deal does not close, there can be significant negative impact to the business and the breakup fee is a way to get protected from that negative impact. However, a one time cash payment is rarely the solution to the problems that result from such a situation.

When you are selling your company, ask your lawyer right up front about the appropriateness of a breakup fee. He or she will tell you whether it is typical in your kind of transaction. The smaller and quicker the transaction, the less appropriate it is.

But don't just listen to your lawyer. Decide in your gut whether the seller is serious about the deal or not. And try to anticipate how disruptive the transaction will be to your business. If you have any qualms about the seller's intentions or the disruption that will ensue, ask for a breakup fee. And if the buyer is unwilling to include one, think hard about whether you want to do the transaction.

Continuing our discussion of M&A Issues, this week we'll talk about governmental approvals. When two companies combine, the government can sometimes get involved. It mostly happens when two large businesses combine and the most common reason for governmental review is antitrust considerations. It is also possible that foriegn governments can take interest in a business combination.

The most common governmental review process for an M&A transaction is a review by the DOJ/FTC of anti-trust considerations. These reviews are done under provisions laid out in the Hart-Scott-Rodino Act. Wikipedia has a decent description of the provisions of that act. If a transaction is for more than a certain amount of value, the government will review it. From that same Wikipedia article:

The rules are somewhat overlapping to some degree, but the basic requirements are that all transactions of $252.3 million or more require a filing. All transactions worth more than $63.1 million require a filing if one of the parties is worth at least $12.6 million, the other is worth at least $126.3 million and the total amount of assets now owned by the acquirer reaches $252.3 million.

The DOJ and the FTC will look at every transaction over these amounts and try to determine if there are antitrust considerations. If they are concerned, they can negotiate provisions to the deal to remedy the concerns or they could simply not approve the transaction.

A similar process can happen in the EU. The Google Doubleclick transaction, for example, received very close scrutiny in europe.

There are other government agencies that can also be interested in an M&A transaction. They include the SEC, the FCC, and other agencies with specific oversight over certain businesses (EPA for example).

These governmental approvals are important for a bunch of reasons. First and foremost, they can prevent a transaction from happening. And they can also require significant changes be made to the transaction which may not be acceptable to the buyer. Bottom line, the government can mess with your deal.

For transactions that are large enough to merit review, governmental approvals represent risks to the transaction that need to be considered upfront. From the buyer's perspective, they will want to be confident they can get the deal approved in a reasonable time frame without significant concessions. From the seller's perspective, they do not want to be tied up in a long governmental review process, be in limbo business wise, and risk not getting the transaction closed.

The way that most letters of intent deal with these risks is they establish a breakup fee that the buyer pays the seller if the transaction does not close on substantially similar terms. The breakup fees can be considerable.

From the seller's perspective, a long review followed by a failed transaction is a horrible outcome. And a large breakup fee may be suitable compensation for that kind of damage. But it may not. Imagine having your entire team thinking they are going to be working for someone else, being in limbo for a long time, and then hearing that it is back to business. It is hard to get back the operating mojo once your team has adopted a different mindset.

If your M&A transaction is small, you don't need to worry about this stuff. But if it is a large transaction, you need to focus on the government approvals you will need and you need to consider what should happen if the approvals are not forthcoming. This stuff matters a lot.

We continue our discussion of M&A Issues this week on MBA Mondays. Today we are going to talk about the "stay package."

When a company acquires your business, they are buying the people as much as anything. Experience has shown that the most successful acquisitions require the team to stick around, at least for a while. But if everyone is getting cashed out day one, there is very little incentive to stick around. Therein lies the stay package.

There are a number of different variations on the stay package to deal with different deal scenarios. I will group them into three main categories for the purposes of this blog post but there are many variations around these three main categories. Every deal is different. There is no standard deal in the M&A business.

1) When the employee and founder equity is worth a lot of money and much of it is unvested – In this scenario, the buyer usually assumes the unvested equity, converts it to unvested equity in its cap table, and uses the remaining unvested equity as the bulk of the stay package. The buyer is likely to adjust the stay package by issuing new employee equity or cash bonuses to certain members of the team to further incent them to stay.

2) When the key employees have equity of significant value and most/all of it is vested – In this scenario, the buyer is going to have to come up with a large new employee equity grant or cash bonuses for the key employees and it often comes out of the sale price. Let's say your company is getting purchased for $300mm and the buyer believes it will take $30mm of cash or equity in the buyer to incent the key team members to stay. It is typical to see the purchase structured as $270mm for the company and $30mm for a stay package for key employees. In this scenario, the rest of the team usually has remaining unvested equity and will typically be treated similarly to scenario 1. It is common practice, but by no means standard practice, for the employee equity and investors equity to be split up and treated differently in this kind of situation. In one situation I was involved in, the founders owned 40% of the company and the investors owned 60%. The company was sold for $100mm and the investors were cashed out for $60mm and the founders got a two year stay package for $40mm plus some additional equity in the buyer's stock.

3) When the key employees' equity is worthless – This usually happens when the company is being sold for less than the total invested capital. The deal most investors make is they get their money back before the founder and employee gets paid out. In an investment that doesn't work out well, this means the founder and employee capital is worthless in a sale. But the buyers know this and won't allow all of the sale consideration to go to the investors, who don't matter to them, and none to the employees, who matter a lot to them. So what buyers typically do in this situation is create a carveout for founder and employee equity. The carveout can often be as high as 25% of the total consideration. I have seen buyers propose 50% or more but those deals don't get done because investors usually control the exits and they need to feel that they are being treated fairly. The founder and key employee carveout is usually paid in cash over a two to three year period.

The typical stay package is for two to three years. The consideration is generally paid ratably over that period. But it can be back end loaded to further incent the team to stay.

Some deals can include an "earn out" which is additional consideration based on the performance of the business. Earn outs can be for the entire shareholder base or can be made available only to the key employees. Earn outs can work well when the business is being left alone and the metrics are easy to establish and the team feels confident they can meet them within the confines of a larger organization. I don't consider earn outs to be stay packages. They are a different beast for a number of reasons. But they can be very effective at keeping the key employees around.

I'll end this post by saying that I can't think of a founder or key early employee of one of our portfolio companies that has stayed at a buyer for more than three years. Most are gone after two years and some leave well before that. There are a host of reasons for this, and most have to do with the psyche of founders. So it is wishful thinking to expect a founder or early key employee to stick around for the long haul, but getting them to stick around for a couple years can be done and should be done. So make sure your deal has a well thought out stay package. It is in everyone's interest to do so.

Last week we got a primer on the WhatCounts story and events leading up to the decision to sell the company. This week we are going to hear what a sale process looks like.

There are a bunch of great lessons that come out of this story but my two favorites are doing your diligence on the buyer and only doing a deal with someone you have shared values with and getting the deal worked out in the LOI stage. I see so many people make mistakes in these two areas.

As we did last week David Geller and I will be in the comments responding to questions and comments.

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Last week I shared with you some of the history of WhatCounts, the company I started almost ten years ago that was recently acquired. The focus was that Brian Ratzliff, my cofounder, and I had self-funded the business. We didn’t refuse VC funding. We simply didn’t pursue it with vigor at any time during our tenure running the company.

Today’s post isn’t about the merits of self-funding or when it’s appropriate or wise to seek VC. Instead, it’s to share the experience we went through in selling the company. It’s a story I would have enjoyed reading myself had it been written just six months ago.

Just to set expectations properly, I’m not going to share financial details about the transaction. I’m bound by an agreement that prevents me from disclosing specific details. My company was engaged in a very competitive market with strong, well-financed players. It would be foolish for me to give our competitors additional ammunition.

Negotiating our deal started in June and ended in December. It took a month to negotiate the letter of intent (LOI) with the rest of the time devoted to performing due diligence and, eventually, negotiating the stock purchase agreement (SPA). The total cost of carrying out the deal was many hundreds of thousands of dollars. Some of that went to pay legal bills, some of it went to fees associated with our M&A firm, some went to paying bonuses tied to the deal.

Let’s roll the clock back to June. That’s when we received a call from a company named The Mansell Group asking if we would be interested in selling our business. It turns out that we were actually already considering selling our company. The economy appeared to be recovering and the M&A market was rebounding.

We had developed a relationship with The Corum Group, a Seattle M&A firm, and were planning to pursue all the steps necessary to sell WhatCounts. The process can take anywhere from a few months (rare) to as many as 8-12 months or even longer depending upon the size and complexity of the deal.

We were preparing for a long and complex process of attracting buyers for our company when one of them, The Mansell Group of Atlanta, initiated a call to us. At first our position was one of pragmatism. We would continue working toward finding one or more potential acquirers while, at the same time, continuing to nurture the opportunity that had turned up from Mansell.

After our initial call with The Mansell Group we gave a status report to Corum. This was a little strange because, certainly in the beginning of an acquisition process, the M&A firm generally provides updates to the seller. Here we were, essentially, driving the process with one particular, potential buyer.

The rest of June was spent running the business in a normal manner. It included preparing for an important customer summit planned for August and working with our M&A firm.

FINANCIAL AUDIT
It is not uncommon for a company being acquired to go through a full financial audit. While these can certainly be conducted by one of the big accounting firms, we thought a regional accounting firm might serve our needs just as well and be less expensive. A full financial audit for a small company might run $35-50K using a mid-size regional firm. Expect to pay more with a big name firm. To a great degree, though, the timing of the audit, whether it is done before or after you begin looking for an acquirer, or even done at all, depends on your circumstances.

As I noted in last week’s article, our company was tightly controlled and profitable. The beauty of running a business in this manner is that when it comes time to have discussions with a potential buyer it is very easy to answer their financial questions quickly and precisely. Additionally, when it comes times to consider whether you actually need an audit you can conduct frank conversations with your M&A firm and potential acquirer and seek their opinion. If your business is like ours everyone might agree that the expense and time required for an audit isn’t necessary.

In mid-June we received a follow-up to that first phone call. The investment committee from Riverside Capital, the PE firm working closely with The Mansell Group, had approved plans to buy our company. New meetings were arranged and our first in-person event would take place when they agreed to visit our office the beginning of July.

Of course we were still working with our M&A firm to ferret out other, potential acquirers. We had not yet received a letter of intent (LOI) from Mansell. There was interest, but nothing concrete. So, logic dictated that we keep on with our original plan. Run the business but continue seeking other acquirers. The challenge we were facing in reaching out to other potential buyers was that things tend to slow down in the M&A space during the summer. Vacation schedules impeded efficiency of communications.

Conversations with Mansell and Riverside, though, continued. Plans were set so that principals from both firms were to visit Seattle in early July. We met in our main conference room and then again for dinner, inviting some of the executive staff to meet our guests.

SECRECY
At this point our plans to have the business acquired were known to only five  people in the company and our attorneys. It is almost certainly advantageous to maintain the utmost secrecy about acquisition deliberations for as long as possible, no matter the size of your company. Discussions of a merger or acquisition, while exciting, can be disruptive to both employees and customers. That situation benefits only your competitors. So, keep it simple by keeping it completely secret.

We already knew that our potential acquirers had previously reached out to some of our customers, trying to find out as much about our company and our management team as possible. Similarly, a few days before our first in-person meeting, I initiated a small due-diligence exercise myself. It was important for Brian and me to know who might one day be running the company and taking over relationships with our employees and customers. I contacted one of Mansell’s largest customers with the cover that we were considering entering into a business relationship with them (which we were). I was able to get what I believed was an honest, candid overview of the company and how they treated their customers. I liked what I had heard.

Had I heard horror stories would I have attempted to shut down discussions with them? Yes, without question. What if a formal offer had been made – one that matched our financial expectations? Same answer. We had invested considerable time and effort in developing our reputation with both employees and customers and were unwilling to risk diminishing that. It was paramount that we find an acquirer that held similar values of professionalism and dedicated service toward our customers.

RECEIVING THE LOI
The beginning of August brought the official letter of intent (LOI) for our company to be acquired. We had just a few days to respond. At this point we engaged the law firm that would end up representing our interests through the rest of the process.

Of course we already had several corporate attorneys. But, this was something new. Something different. We had been given a recommendation to work with a firm well known for helping technology companies. Besides a sterling reputation, the firm’s offices were in our building. We already knew there would be lots of meetings, both telephone and in-person, that would require privacy. Convenience and reputation were only two of the factors that convinced us to use the new firm.

It was also important that we fully understood all the potential costs to be faced in selling the business. Our new attorney understood our expectations and their prior M&A experience (from a cost and time perspective) allowed them to estimate costs for completing the deal. For a relatively small company to be acquired it’s safe to estimate something between $50-$100K in legal fees. The buyer will have their own attorneys and, depending upon their size, might end upon spending a great deal more money to complete the deal.

We eventually agreed upon a hybrid, fixed-fee structure with our attorney. We also set up some simple ground rules related to what work would require review and approval by us before being pursued.

Keep in mind that you can ask your attorney almost anything related to the deal. It could be about taxes, deferred revenue, non-compete agreements, the closing process – literally anything. Be aware, though, that he or she will do their very professional best to answer your question. That might require extensive research. It might require consultation with their colleagues or other expert attorneys. Something you may casually ask on a Friday afternoon might deliver a beautiful, succinct answer the following Monday. But it may have required ten or more hours of work over the weekend. If you’re not careful and willing to control the process tightly legal expenses can become alarmingly large.

Discussing these things with your attorney at the very beginning of the relationship is critical to determine expectations and understand and agree upon limitations. You don’t want to start working only to be surprised by an outrageously large bill the first month.

THE BETTER THE LOI, THE BETTER THE DEAL
One of benefits of engaging The Corum Group for our M&A work was that they had extensive experience selling high-tech companies and had successfully completed several deals with Seattle firms with which we were familiar. Two of their deals had been done with Google and some of that work had shaped a philosophy to do as much detailed work in the initial LOI as possible. Once we had received the LOI it was up to us to review it and suggest and request changes. Our initial response was due quickly, but the overall process of negotiating and finalizing the LOI took nearly a month. There was lots of back and forth and this is where the Corum’s deal prowess proved particularly valuable.

At the very end of August the LOI was signed and delivered back to Mansell/Riverside. From this point forward things would begin to operate in a more structured manner. Deliverables would be assigned. Dates would be set. We suspended all efforts to find other acquirers. Our course was set and our goal of selling our business to Mansell had been cemented.

Another in-person meeting was scheduled for September. This time Mansell would learn even more about the inner workings of our company. Source code would be shared (in a controlled setting); our data center would be toured; and we would begin the formal due diligence process where pretty much everything about our business would be exposed – in detail.

DUE DILIGENCE
What does due diligence look like? How is it performed? For our transaction it began with a shared data vault that everyone could access electronically. Mansell and Riverside delivered a document detailing requests for information relating to our finances, our agreements and contracts (with employees and customers), leases and examples of marketing materials.

Almost all of our contracts and agreements were not only archived in paper but copied and saved as PDF documents. This proved to be a huge time saver. We literally completed our early document delivery tasks within a couple of days thanks to our having kept electronic versions of our materials.

Everything wasn’t perfect, though. One of the things we neglected to do over the years was centrally organize notes about all our electronic documents. While all of them were organized within specific folders, there was no quick and easy way to, for example, determine which customers had which versions of our sales agreement (we had three over the years). Or, in the case of employee documentation, which employees had signed invention assignment documents? Which had executed NDAs? We literally had to go through and read our documentation, whether on paper or electronically, to answer some of the questions we had been asked.

SCHEDULING THE CLOSING EVENT
As the end of September approached everyone seemed to realize and agree that an October close, even on the very last day, was unlikely. We were concerned because we were trying hard to complete the transaction in 2010 before any changes to the long term capital gains tax could be made. Similar to Summer where M&A activity seems to temporarily slow down while everyone vacations, late Fall events can be hampered by weather and Thanksgiving Holiday plans.

At the end of the first week in October the stock purchase agreement (SPA) was delivered.  The first few days of the next week were spent reviewing the document with our attorneys and M&A firm. Early efforts to detail issues in the LOI proved valuable as the SPA contained very few new issues of great concern.

We continued to review and discuss the SPA while documents continued to be prepared and delivered into the data vault. As November approached we were literally weeks away from a closing event. It was both thrilling and exciting.

Once the SPA had been agreed to by both sides the mechanics of the close event started to be discussed in detail. How would the funding take place? What would happen to the cash in the business? How and when would the attorneys and M&A firm be paid?

On December the 2nd previously signed signature pages were released by both sets of attorneys. Stock certificates that had been held in escrow were sent by Fedex to the new owners. All that remained was to complete the funding event by initiating a series of well-orchestrated wire transfers. These would occur the next morning on the third, which was a Friday.

The new buyers had flown out over the weekend and were present when news of the event was revealed for the very first time to our staff Monday morning. Approximately the same time our meeting was concluding a previously scheduled email was instantly delivered to every WhatCounts customer using our own platform. At 10am that same morning a story appeared in TechFlash, a regional Technology Blog run by John Cook and Todd Bishop, describing the event publicly. Congratulatory calls and emails from friends, former colleagues, vendors and competitors started to arrive moments later.

Two exciting additional items were revealed that morning. The first was that instead of WhatCounts operating as a Mansell Group Company, Mansell would be rebranding and adopting the WhatCounts name. Second, Brian Ratzliff was invited to join the new Board of Directors.

This is the first post on the "acquisition finance" series we started last week in MBA Mondays. I am going to try to lay out the basics of mergers and acquisitions in this post. Then we can move on to some details.

As the term M&A suggests, there are two types of deals, mergers and acquisitions. Acquisitions are way more common. It is when one company is taking control of the other. A merger is when two like sized businesses combine. An example of a merger is the AOL/Time Warner business combination ten years ago. I am not a fan of mergers. I believe it is way better when one company is taking control of the other. At least then you know who is in charge. Mergers are very complicated to pull off organizationally.

I have done a few mergers in the startup world. The best example is Return Path and Veripost which merged in 2002. The two companies started at about the same time, both got venture funding, and built almost identical businesses. They were beating each other up in the market and getting nowhere quickly. The management teams knew each other and the VCs (Brad Feld and yours truly) knew each other. We finally decided to put the two companies together in a merger. It worked because we decided that Matt Blumberg, Return Path's CEO, would run the combined companies and because Eric Kirby, Veripost's CEO, was fully supportive of that decision. Even so, it was not easy to execute.

Acquisitions are way more common and I believe way better. Most of the deals you can think of in startupland are acquisitions. A larger company is acquiring a smaller company and taking control of it.

The next distinction that matters a lot is how the consideration is paid. The most common forms of payment are cash and stock. In fact, you'll often hear corporate development people say "it's a stock deal" or "it's a cash deal." Companies can pay with other consideration as well. Debt is sometimes used as consideration, for example. But in startupland, you'll mostly see stock and cash.

Most people think cash is preferable. If you are selling your company, you want to know how much you are getting for it. And with cash, that is clear as crystal. With stock you are simply trading stock in your own company, which you control, for stock in someone else's company, which you don't control.

However, over the years in maybe a hundred deals now I have made more money in stock based deals with the acquirer's stock than I have lost in acquirer's stock. I don't know if that is just my good fortune or not. But I certainly have had the experience of taking stock in an acquisition and having that stock crumble and lose it all. So if you are doing a stock based deal, make sure you do your homework on the company and its stock.

The third and final distinction we will cover in this post is what the acquirer is purchasing. Typically the purchaser can either buy assets or buy the company (via its stock). If you are selling your company, you'll generally want to sell the entire company and thus all of its stock to the buyer. The buyer may not want to entire company and may suggest that it wants to do an "asset deal" which means it cherry picks what it wants and leaves you holding the bag on the unwanted assets and some or all of the liabilities.

For obvious reasons, fire sales are often done as asset deals. Healthy companies with bright futures are not often purchased in asset deals. They almost always sell the entire company in a stock deal. If you are selling your company you should try very hard to do a stock deal for the entire company.

That's it for this post. We've covered the three most important distinctions; merger or acquisition, paying with stock or cash, and buying assets or the entire business. We'll get into more detail on each of these issues and more in the coming weeks.