Book Digests

Book Digest: Venture Deals

Posted on by Mike Pinkel

Brad Feld and Jason Mendelson’s Venture Deals (2nd edition)* is a perfect introduction to the key terms and strategic dynamics of venture financing. Their thesis is that founders should focus on terms relating to the economics of the deal and the control of the company and not be distracted by peripheral matters.

Introduction

  • Two elements of the term sheet matter: economics and control

Chapter 1: The Players

  • The Entrepreneur
    • Founders need to stay involved in the financing
    • Relationship between founders may deteriorate with time due to business stress, competence, personality, or changing life priorities
    • A founder may leave; it’s important to anticipate these issues
  • The Venture Capitalist
    • Senior people: Managing Director (MD) or General Partner (GP). They have the real power to get your deal done.
    • Principals: Middle level, have some deal responsibility, but can’t move a deal without support from a partner
    • Associates: Lower level, do analysis, prospecting and diligence
    • Analysts: Lowest level, right out of college, work on spreadsheets in an office with no windows
  • Entrepreneurs in residence (EIRs)
    • Experienced entrepreneurs who help make introductions, network, or do due diligence during a temporary (3-12 month) stay at a venture firm
  • Angel investors
    • Normally defined as an early stage individual investor
    • Pay-to-play rights and drag along rights are designed to constrain angel behavior in later rounds
    • Don’t let angels hold you hostage by inertia or intent. You can set up a special purpose partnership that one angel investor controls that is the investment vehicle for all of them. This means you’ll have only one decision maker to deal with.
  • The Syndicate
    • A collection of investors. Having a lead investor for the syndicate makes it easier to get decisions made.
  • The Lawyer
    • Experienced lawyers focus on the right issues and negotiate well; inexperienced lawyers do the opposite
    • Very early stage financings can be done for $5,000-$10,000—late stage are $25,000-$40,000
  • The Mentor
    • They help you because someone once helped them

Chapter 2: How to Raise Money

  • The goal is to get several term sheets so you can play the VCs off against each other
  • Decide on a specific amount of money to raise, not a range. Ranges make you look uncertain
  • Choose the amount based on the length of time you want to be funded for or the milestone you hope to hit
    • Seed stage software companies should be able to make a lot of progress within a year
    • Getting a drug approved by the FDA will take at least several years
    • Don’t let the milestone turn into something you “have to” achieve in the terms
  • Don’t try to raise too much—you don’t want to be short of your goal. It’s better to set your goal a little low because investors like to join oversubscribed rounds.
  • Required investor materials:
    • Short description (aka: the elevator pitch)
      • One to three paragraphs that describes your product, team, and business
    • Executive Summary
      • One to three page description of your idea, product, team, and business
      • Include a description of the problem you’re solving, why your product is better than what currently exists, why your team is the right team to pursue the idea, and some high level financial projections for how the business will perform
    • Presentation
      • Communicate the same information as the executive summary
      • All the VCs care about is the problem you solve, the size of the opportunity, the strength of the team, the level of competition, your plan, and your current status
  • Other materials:
    • Demo
      • Investors love these. It’s ok if it’s early stage and prone to crashing.
    • Business plan
      • Shouldn’t be necessary because it’s useless. It’s a 30 page document for B school people.
    • Private Placement Memorandum (PPM)
      • A business plan + legal disclaimers. This is even more unnecessary.
    • Detailed financial model
      • 100% of revenue predictions are wrong so don’t sweat these
      • Expense projections are important because you can control your expenses. Seeing your projections gives the VC a window into how you’ll manage the business.
      • VC cares about the assumptions behind your revenue forecast and your cash burn
  • Finding a lead VC
    • The lead VC puts down the term sheet and will be the active new investor
    • “Maybe” and “slow no” are hard to deal with—when people stop responding, treat them as a no and stop investing time in them
  • How VCs decide to invest
    • Associates scour the world looking for deals but don’t have power to get a deal closed
    • Once you arouse interest from an MD or partner, you’ll progress to informal due diligence
    • Most will accept the packet of materials you’ve prepared for investors generally
    • Some will demand custom items; provide these only if a partner is really interested
    • When they start doing diligence on you, do diligence on them by talking to other investors they’ve worked with
    • If they pass on you, ask for feedback as to why
  • Closing the Deal
    • First you sign the term sheet, then you sign the definitive documents and get the cash. The vast majority of executed term sheets lead to a closed financing.
    • Deals almost always close if there are no smoking guns in diligence, the investor is professional, and you don’t do anything stupid.
    • Don’t let your lawyers waste time on things you don’t care about.

Chapter 3: Overview of the Term Sheet

  • VCs care about two things: economics and control
    • Economics are the return that the investor gets in a liquidity event: a sale or an IPO
    • Control means either affirmatively directing the company or vetoing certain decisions
  • Founders and employees get common stock, VCs get preferred

Chapter 4: Economic Terms of the Term Sheet

  • Economics go beyond the price of the deal to include a variety of other economic terms
  • Price
    • Prices are on a fully diluted basis, assuming the conversion of preferred stock to common stock, the exercise of all existing warrants and options, and usually some increase in the company’s option pool
    • A pre-money valuation is the value of the company prior to the investment
    • A post-money valuation is the value including the contemplated investment
    • Investing $5 million at a valuation of $20 million yields different ownership percentages depending on whether the $20 million valuation is pre-money or post-money
      • Post-money: 25% of the company ($20 million/$5 million)
      • Pre-money: 20% of the company (($20 million pre-money + $5 million)/$5 million)
      • Hint: The percentage of ownership is always calculated based on the post-money valuation, the value of the company after the investment. After all, the VC always owns a percentage of the company after the investment. So if the quoted valuation is pre-money, then you have to add the money to calculate the value of the company and the percentage ownership.
    • The size of the option pool and whether it’s measured pre-money or post-money changes the final ownership shares
      • If the option pool increase happens pre-money, then it effectively dilutes the current owners and lowers the effective pre-money valuation.
      • VCs will want to minimize future dilution by making the option pool as large as possible up front
    • Warrants
      • It’s like an option, the right to purchase shares at a defined price for a certain number of years
      • They tend to create a lot of complexity
      • Warrants are common in bridge loans, which are issued when an investor is planning a financing but needs more time to get investors
      • Bridge loans typically get convertible debt, which either converts at a discount to the next round (as a reward for the risk) or has warrants that are at a discount to the next round, often of about 20%
    • Factors that impact price
      • New investors want the the lowest price that still incentivizes the employees
      • Existing investors want a high price to avoid any sort of dilution
      • Early stage company valuations depend a lot on the experience and background of the founders
      • At the latter stages, financial performance and competition matter a lot more
  • Liquidation Preference
    • Comes into play when the company or most of its assets are sold. If there’s an IPO, usually the preferred shares convert to common shares.
    • Two components: Actual preference and participation
    • Actual preference: A multiple that a set of stock gets before any other stock gets any money
    • Participation is the amount of money the shares get after the preference is satisfied. There are three types of participation:
      • Full participation: the shares participate on an as converted basis (as if they were common stock) even after getting their preference
      • Capped participation: they participate up to a specified multiple of the original investment
      • No participation: the shares do not participate
      • Preferred shareholders almost always have the ability to convert their shares to common stock if they wish, so they get the best of either their liquidation preference + participation or the same return as the common shareholders
    • Participation matters a lot if the company does poorly, if it does well then it matters less.
    • When a company raises multiple rounds the preferences can either be stacked (so that later rounds get their preference first) or blended (in pari passu)
    • In early stage financings, everyone benefits from a simple liquidation preference and no participation. The early stage terms become the floor for later stages, so early stage investors that take too much will lose out as later rounds take more.
  • Pay-to-Play
    • Pay to play provisions require that investors participate ratably (proportionately) in future rounds or have their shares converted to common stock.
    • They have to participate (pay) to keep their preferred share benefits (play).
    • Useful in down rounds where the company needs more financing
    • Surprisingly, some investors like these provisions because it forces their co-investors to stand up and agree to stand by the company in future rounds
  • Vesting
    • Normal vesting period is four years with a one year cliff and monthly vesting after the cliff
    • Founders often get one year of vesting credit when the first round closes in exchange for all their work prior to the financing
    • Vesting benefits founders as well; one founder may leave early and shouldn’t get all his shares
    • Unvested founder stock is usually reabsorbed, lowering the # of shares outstanding and increasing everyone’s ownership %
      • Founders sometimes receive the right to purchase their unvested shares at the price of the last financing round
    • Unvested employee stock usually goes back into the options pool
    • Accelerated vesting on a merger
      • Single-trigger vesting means that all shares vest on a merger
      • Double-trigger vesting means that all shares vest in the event of a merger if the employee is fired
      • Double-trigger is much more common
      • Acquirers often want some unvested equity to remain after an acquisition to give people a forward-looking incentive and to get key people to stay for one to two years after the acquisition
  • Employee Option Pool
    • VCs often try to increase the amount of the option pool on a pre-money basis; this gives them some more of the economics of the deal
  • Antidilution
    • Antidilution provisions protect investors in the event that the company issues shares at a lower valuation
      • Full ratchet antidilution protection: If the company issues shares at a lower price, then all of the shares with antidilution protection get the lower price retroactively
      • Weighted average antidilution protection: The number of issued at the new, lower price is factored in to determine how much to lower the price of the prior round
      • The outcome is a conversion price adjustment, not a grant of more shares

Chapter 5: Control Terms of the Term Sheet

  • While VCs often own less than 50% of the company, they often get effective control over the company
  • Board of Directors
    • VCs often want a board observer in addition to official members
    • This is influential; most decisions are based on the sentiment of the room rather than a vote
    • Normally early companies have five board members: two founders, two VCs, and one outside member
    • Later stage companies get to seven to nine members with more outside board members
  • Protective Provisions
    • Veto rights that some investors have over actions by the company
    • Entrepreneurs want none; VCs want many
    • Common protective provisions:
      • Changing terms of VC stock
      • Creating more stock
      • Buying back common stock
      • Selling the company
      • Changing the certificate of incorporation or bylaws
      • Changing the size of the board
      • Paying or declaring a dividend
      • Borrowing money
    • Successive rounds can either each get their own protective provisions (ie either Series A or series B could veto) or can share protective provisions (ie Series A and B can together veto)
  • Drag-Along Agreement
    • Gives a subset of the investors the right to force all the investors to agree to a sale; regardless of how the others feel
      • Acquirers often want 90% of the shares to consent
    • Often used by VCs to force a sale that pays the VCs but doesn’t leave much for the founders or employees
    • A compromise position is to allow a majority of a class of stock to drag along the other shareholders in their class; such that common shareholders could force other common shareholders to consent to a sale
  • Conversion
    • Gives VCs the right to convert their preferred shares to common at any time
    • This is non-negotiable; VCs want the ability to convert their holdings to common if they’d do better than they would as preferred
    • At an IPO, the I-Bankers will want everyone converted to common stock
      • There’s often a threshold for such conversion; if the offering is above that threshold then conversion is automatic

Chapter 6: Other Terms of the Term Sheet

  • Dividends
    • VCs don’t care about dividends; exits provide their returns and dividends make little difference if the company does well
    • Dividends make sense where the expected return multiple from share price appreciation is lower than in venture deals, such as in a private equity or buyout deal
    • Don’t let a dividend clause in that could put you into the zone of insolvency
  • Redemption rights
    • Provide downside protection and a guaranteed exit for investors
    • They force the company to buy-back the shares at the purchase price plus some amount of return
  • Conditions precedent to financing and other provisions
    • Factors that let the VCs back out of the deal; usually VCs can back out for most any reason
    • Don’t agree to pay VC legal fees unless the deal is completed
    • Watch out for these conditions precedent:
      • Approval by investors partnerships; signals that VCs don’t have authority to do the deal
      • Rights offerings to be completed by company; requires that prior investors be offered the right to participate, which can add time to getting the deal done
      • Employment agreements to be signed by founders as acceptable to investors; be aware of the full terms before signing the agreement
  • Other provisions that are less important
    • Information Rights
      • Define the type of information that a VC has access to and the time frame during which they have a right to it
      • These don’t matter very much to the entrepreneur but they matter a lot to the VC
      • Normally, this includes things like the right to see financial statements and the company budget
      • You might put a share threshold on these rights so that only investors with a certain number of shares can demand the information
    • Registration Rights
      • Define the rights that investors have to register their shares when there is an IPO
      • These matter very little. If there is an IPO, the investment bankers will decide how to structure it and the arrangements you make in the term sheet will matter very little.
    • Right of First Refusal (also known as a pro rata right)
      • Lets investors participate in future rounds up to a given multiple of their shares. Usually, this multiple is one; any more than that is not very standard.
      • Entrepreneurs can sometimes negotiate to limit this right to major investors with a given threshold number of shares
      • Some version of a right of first refusal will always be in the term sheet and doesn’t normally harm the entrepreneur. More participation in subsequent rounds is usually a good thing.
    • Voting rights
      • Standard language noting that the common stock and preferred stock vote together on issues unless it is specifically stated that they vote separately
    • Restrictions on sales
      • Standard clause that states that sellers of common stock must give the company the right of first refusal when selling their shares. If the company doesn’t exercise the right, then the company must transfer the right to the investors
      • This keeps the number of shareholders in the company small which lessens administrative headaches
      • However, it also makes it harder for shareholders to unload their stock
    • Proprietary Information and Inventions Agreement
      • Standard provision that requires that employees and consultants sign a proprietary information and inventions agreement
      • This lends force to the company’s representation that it owns its IP
      • Entrepreneurs should build these into their hiring processes from the very beginning
    • Co-Sale Agreement
      • Provides that, if a founder sells shares, the investors have a right to participate in the sale on a pro rata basis, until the company goes public
      • Some version of this almost always ends up in the term sheet
      • You could ask for a floor on the provision, such that it only applied to sales above a certain number of shares. This would enable the entrepreneur to sell a few shares so he could buy a house.
    • Founders activities
      • Provision that requires that founders spend 100% of their professional time on the company
      • Common provision; only experienced entrepreneurs have much chance of pushing back on it
    • IPO Shares Purchase
      • Requires that the company use its best efforts to get the investment bankers to let the investors buy a small percentage of the shares offered as part of a “friends and family” or directed shares program connected with an IPO
    • No-Shop agreement
      • This is part of the shift to “let’s get the deal done” mode and helps the VC know that he’s not just a stalking horse to get a better deal from someone else
      • The entrepreneur typically agrees to not solicit other offers; in exchange the right is time limited such that the VC has an incentive to get the deal done in a reasonable time frame
    • Indemnification
      • Requires that the company indemnify investors and board members to the maximum extent allowable
      • Often satisfied by buying directors and officers (D&O) liability insurance
      • Part of virtually every financing
    • Assignment
      • Typical; not worth negotiating
      • Lets the investors transfer their shares to any affiliates
      • Be sure that the assignee is bound by the terms of the stock purchase agreement

Chapter 7: The Capitalization Table

  • Summarizes who owns what part of the company before and after the financing

Chapter 8: Convertible Debt

  • Many angels will only invest with convertible debt
  • Convertible debt has the following terms:
    • Amount
    • Discount percentage to either the next round or the prior round
    • Cap for the conversion price (sometimes)
    • Interest rate (usually small because the investor’s return for his risk is the future equity upside)
  • Normally, the debt converts into equity at a price equal to the next round’s price minus the discount; but at a price that is no higher than the cap
    • For example, if there is $500,000 in convertible debt with a 20% discount to the next round and the next round’s price is $1/share, then the debt becomes 625,000 shares ($500,000/(.8 * $1/share))
  • The discount is the early investor’s compensation for the risk of lending the money
  • Is convertible debt a good way to raise money?
    • Pros: (1) no negotiation over the price, (2) less legal complexity because it has none of the control rights of preferred stock
    • Cons for investors: (1) the next round may be set at a price that is higher than the one they would have accepted; they may therefore cap the price such that this cap is the highest price at which their shares will convert, (2) the investors in the next round may not like someone getting shares at a lower price than they’re paying
    • Con for entrepreneurs: price caps from the convertible debt round may set a ceiling on the share price you can get from your investors
  • Conversion mechanics
    • Often, conversion of the debt into equity can be forced by the company Companies like forced conversion because debtholders can sometimes have even more control over a company than equity holders
    • If the company is sold before another round is raised, there are two options:
      • The convertible debt gets its money back plus interest and a multiple of the original loan
      • Conversion occurs
  • Warrants
    • Instead of having a discount, you can issue warrants as part of issuing convertible debt
    • The lender gets convertible debt plus warrant coverage equal to some percentage of the loan
    • Warrants introduce additional complexity
    • Warrants are an option to buy shares at a given price, which could be the next round’s preferred price, the last round’s preferred price or at some other price
    • Normally, warrants are priced at the level of the last round
    • A holder of convertible debt with warrants gets shares equal to both the conversion of their debt into equity at the next round’s price and from their right to exercise the warrants at the specified price
    • Warrants should expire on an acquisition; acquirers hate having warrants survive that create a right to shares in the acquiring company
  • Other terms
    • The term of the warrants can vary; shorter is better for the entrepreneur
    • Pro rata rights
      • Some convertible debtholders will want the right to participate ratably in future rounds
      • They may ask for super pro rata rights (a multiple of their original investment) because the dollar value of their original investment is low
  • Early stage vs. late stage dynamics
    • Convertible debt used to be issued by late stage companies that needed more funds to get them to a place where they could raise funds in a priced round
    • Earlier stage companies now raise it to avoid having to set a price
  • Convertible debt can be dangerous if the company is in the zone of insolvency. In that case, the board may owe fiduciary duties to the debt holders.

Chapter 9: How Venture Capital Funds Work

  • Understanding VCs motivations will help you understand what they’re likely to do
  • Typical VC Structure
    • The management company
      • Owned by the senior partners
      • Lives on no matter how many separate investment funds are raised
    • The limited partnership (LP) vehicle
      • This is the “fund.” A VC firm may have many separate funds operating at any one time.
    • The general partnership (GP) entity
      • The legal entity that serves as the GP for each fund
    • Key point: The management company is a separate entity from each fund
  • How firms raise money
    • VC firms raise from pension funds, companies, banks, insurance companies, high net worth individuals etc
    • VC firm normally keeps very little money on hand; when they need money they make a capital call on funds that the LPs have agreed to put up
    • There is an active secondary market for LP interests that people want to sell
  • How VCs Make Money
    • Management fees
      • 1.5%-2% of money committed to a fund per year
      • Average total fee usually works out to 10-15% of the committed capital over the ten year life of a fund due to some nuances in the way the fees are calculated
      • Pays day to day operating expenses and the VC’s salary
      • The more funds the firm raises, the more money it makes on the management fee
      • Because a fund usually lasts ten years, even an unsuccessful fund will live on for another decade
    • Carried interest
      • They normally get 20% of the profits after returning invested capital (the “carry”)
      • Senior partners tend to get a lot more of the carry; this can create conflicts if there’s a mismatch between who is creating positive returns and who is getting the money
      • Carry can be clawed back if a fund generates returns early (therefore paying carry) but then loses the profits later in its life. The LPs are entitled to get that carry back since there were no profits in the end.
    • How time impacts fund activity
      • The commitment period
        • The period during which the fund may identify new companies to invest in; usually five years of a fund’s 10 year life
        • After this period, the fund may invest more money in companies it’s already invested in but cannot invest in new companies
      • Funds usually last ten years with an option to extend for an additional two to three years
      • This can create pressure for liquidity as the lifespan of a company from seed stage to IPO could easily be ten years
      • Funds may sell their interest to a secondary buyer to create liquidity for their LPs
      • The secondary buyer may have an interest in driving the company to a liquidity event
    • Reserves
      • The amount of investment capital allocated to each company that a VC invests in
      • At the time of the initial investment, the VC will reserve additional funds to invest in follow-on rounds
      • Where there’s a pay-to-play provision, a VC with insufficient reserves may resist additional financing rounds even if that’s not what’s best for the business
    • Cross-fund investing
      • A VC may invest in a company out of two separate funds
      • This can create problems because each fund may get a different return profile, yet the VC owes equal fiduciary duties to each
      • In some cases, the interest of each fund may even conflict
    • Departing partners
      • Most VC firms have a clause defining what happens when a key person or several key people leave the fund
      • In such cases, the LPs may have the right to suspend the fund from making new investments
    • Fiduciary Duties
      • VCs owe equal fiduciary duties to their management company, the GP, the LP, and to each board they serve on
      • These duties can conflict

Chapter 10: Negotiation Tactics

  • Goals
    • Achieve a good and fair result
    • Preserve personal relationships
    • Understand the deal you’re striking
  • Preparing
    • Understand what you want, what you are willing to trade, and when you’re willing to walk away
    • Everyone has an advantage over everyone else. For example, VCs have the money but you have more time to spend on the negotiation.
  • Game theory
    • Defined: Mathematical theory that deals with maximizing gains and minimizing losses under prescribed conditions
    • VC financing allows for win-wins, you don’t negotiate in a vacuum, and it’s a repeated game
    • Acquisitions are more like the prisoner’s dilemma, customer negotiations often feel like a single shot game, litigation is always a single shot game
    • You will have an ongoing relationship, the VC cares about his reputation
    • You can ask what their top three wants are and you should be prepared to supply your top three wants as well
  • Negotiating styles
    • The bully
      • They aren’t smart; they try to win by force
      • Respond by chilling out while the other person overheats
    • The nice guy
      • Impossible to pin down on anything; he always needs to consider the issue and get back to you
      • Being tough can help you move things forward
    • The technocrat
      • Has a million issues but can’t decide what is most important
      • Let him talk himself out
    • The Wimp
      • You can take his wallet but getting too good of a deal will come back to haunt you
    • The Curmudgeon
      • Doesn’t care about the details but is never happy with the position you take
      • Be patient and upbeat; don’t worry about pissing him off because everyone pisses him off
    • Always be transparent
      • In a negotiation where your reputation and relationship are at stake, be transparent and easy-going
      • In a single round game, take no prisoners
    • Walking away
      • Know your walk-away point before you start the negotiation
      • To set your walk-away point, consider your best alternative to a negotiated agreement (BATNA)
  • Building Leverage
    • Get competing term sheets from multiple VCs in the same time frame
    • Don’t disclose what other VCs you’re talking to
    • When you get a term sheet, control the pace of the negotiation so you can get multiple active term sheets at the same time
    • When negotiating points on the term sheet, decide the order in which you want to address the points
    • Don’t let the other side get agreement on a point by point basis in a manner that stops you from seeing whether the overall deal is fair
  • Things to avoid
    • Don’t present your term sheet to a VC—you have no idea what they’ll offer you and you don’t want to aim too low
    • If in doubt, shut up. You can’t make unnecessary concessions if you’re not talking.
    • If the other side forces you to discuss issues point by point in an effort to get you to lose sight of the whole deal, don’t concede, tell them that you’ll consider each of their positions in light of the deal as a whole
    • If they say “it’s market,” ask why that market condition applies to you
    • Never assume that the other side shares your ethical code
  • Great lawyers vs. bad lawyers vs. no lawyers
    • You need a great lawyer
    • That may not be an expensive lawyer at a big firm—who may pass you off to someone junior
    • You may want someone at a smaller firm that has a good reputation
  • Can you make a bad deal better?
    • If your next round is led by a new investor, you can sometimes clean up problems with the prior round
    • When the exit happens, deal terms often hinge on retention for the management team; you can use that leverage to fix problems

Chapter 11: Raising Money the Right Way

  • Don’t ask for NDAs. VCs can’t comply with them because they may fund your competitor.
  • NDAs will prevent a VC from talking to other VCs even if the other VC might be a good co-investor
  • Don’t be a solo founder. Nobody can do everything alone and it’s a bad sign if you can’t get even one other person to be excited about your idea with you.
  • Don’t overemphasize patents. In software, they’re just defensive weapons. You need to execute well on a good idea.

Chapter 12: Issues at Different Financing Stages

  • If you get too high of a valuation at the seed stage, you may dilute your original investors in the next round when you can’t get a higher valuation
  • The terms in early rounds can carry over to later rounds. For example, a liquidation preference dramatically reduces returns for common shareholders.
  • Try to collapse protective provisions so that all shareholders vote together regardless of series rather than having each series get its own veto
  • In later stages, investors will likely control the board unless you manage this early
  • Too high a valuation can persuade the VCs to hold out for an unrealistic exit price
  • Don’t sell common stock to your investors; if you do it pegs a price on your common stock that you want to give to your employees with low priced stock options

Chapter 13: Letters of Intent – The Other Term Sheet

  • Letters of intent (“LOIs”) are the first formal step in an acquisition
  • Only the price and the structure of the deal matter
  • Price: The price on the first page of an LOI is the best-case purchase price
    • Escrow/holdback: Money that the purchaser holds back to satisfy any issues that come up later after the transaction is consummated. Sellers should be willing to put money into escrow with a 12-18 month holding period.
    • Working capital requirements: Money the company must have after liabilities are subtracted. Often detracts from the purchasing price.
    • Earn-outs: Company must meet certain targets in order to get additional funds.
    • Management retention pool: Funds held back to keep key members of management in place. This allocates funds away from common shareholders and drives a wedge between management and ownership.
  • Asset deals vs. Stock deals
    • In a stock deal, the buyer buys the stock. In an asset deal, the buyer buys the assets
    • Buyers want to do asset deals so they can take just the crown jewels and leave the problems behind
    • Sellers don’t like asset deals because the company still exists and has to be wound down, which requires dealing with all the liabilities
    • Courts often find that the acquiring company in an asset deal is the “successor in interest” and owns all the liabilities
    • Sellers want to do stock deals. In stock deals, the former company disappears into the acquiror and everything is simple.
    • The structure of the deal may be determined by tax considerations
  • Form of consideration
    • Cash is king, everything else is worth less
    • If you’re selling your company for stock in the acquiror, you need to know how liquid (sellable) the stock is
  • Assumption of stock options
    • Defined: Whether the stock option plan is assumed by the buyer and whether it’s subtracted from (netted against) the the purchase price
    • Most option plans automatically vest if the plan isn’t assumed
    • This allocates the economics toward the unvested options holders and away from the preferred shareholders
    • For buyers, this means that the employees have no incentive to stay (or alternatively that you get happy employees)
  • Representations, Warranties, and Indemnification
    • Reps and warranties (reps) are assurances that one party gives the other
    • There are consequences (indemnification) if the rep breached
    • You can qualify the rep by saying “to the extent currently known”
  • Escrow
    • Money that the buyer holds back in order to satisfy any issues that are discovered
    • Escrow is usually the only remedy for breaches of the reps, except for certain issues that are known as “carve-outs”
    • Carve-outs usually include fraud, capitalization, taxes, and sometimes the IP
  • Non Disclosure Agreements (NDAs)
    • Mandatory in acquisitions. If the deal doesn’t go forward, each side has confidential information about the other.
  • No-shop clause
    • Buyers will insist on a no-shop clause, prohibiting you from going to other buyers as a condition of investing in due diligence. 45-60 days is reasonable.
    • Sellers can carve out events like financings from the no-shop clause
  • Fees, fees, and more fees
    • Buyers usually make the seller pay the professional fees
    • Breakup fees (fees in the event that the deal doesn’t close or the seller sells to someone else) are common in public company transactions but not in private
  • Registration rights
    • If you’re taking stock, you need to know if the stock is registered and therefore freely tradeable
    • If they promise to register in the future, this isn’t enforceable; the SEC can take a long time
    • Unregistered stock becomes tradeable after 12 months
  • Shareholder representatives
    • Many obligations survive the closing of the deal; the shareholder representative handles these. This is a thankless job.

Chapter 14: Legal Things Every Entrepreneur Should Know

  • Intellectual Property
    • Establish ownership upfront
  • Employment
    • Make everyone an at-will employee, consider whether to pre-bake severance terms into an offer letter
  • Accredited investors
    • Only rich and sophisticated people (accredited investors) can buy stock in private companies
    • If you sell to non-accredited investors, they can force you to buy back their shares at the purchase price
  • Filing an 83(b) Election
    • File the 83(b) election within 30 days of receiving your stock or you’ll lose capital gains treatment and will therefore pay 3x the taxes you should normally pay
  • 409A Valuations
    • Though you need to provide stock options at fair market value, that value can be set by a private valuation company that you hire. In practice, their valuation will be honored.
    • You can normally get a 409A valuation of common stock at 20-30% of the preferred stock

*This blog post is not legal advice, no representations or warranties of any kind are made and no guarantees of any kind are offered. Talk to a lawyer.

Mike Pinkel