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June 20, 2012

Top 10 Mistakes Companies Make During Acquisitions (notes)

Here are my notes from Don Keller's (@dkellerjr) talk Top 10 Mistakes Companies Make During Acquisitions, presented today at RocketSpace in San Francisco.

1. Founder Equity

Have your founders issued stock from day one so that all the appreciation towards an acquisition is counted as capital gains instead of regular income (which would happen if the founders had options instead.)

RSUs (promises to issue stock in the future) you have to make sure there is a liquid market when they are issued because their issuance will result in a taxable event. This mainly worked for Facebook.

Founders shares can be subject to a vesting schedule in a similar way to options. The company retains the right to repurchase the shares that are unvested if you part ways with the company. (Repurchase happens at the original price that was paid to purchase them.)

If you are joining a company and have the funds available to actually purchase stock, it's preferable to taking options. Some companies will allow that, others won't.

If the company is trying to "hook up" a key hire with shares for free on hire, it can bonus them or even loan them the amount that they will need to pay in taxes. Just make the person aware that the loan might be due if the company is not doing too well.

2. Make sure that IP ownership is well documented

If you're creating a business that is similar to your current employer, they might well own it unless you have explicit written agreements that say otherwise. This issue might not come up until after a startup is founded, funded, etc… then you go to sell it and the buyer digs up the issue as part of their due dilligence.

Every new employee should sign an invention assignment agreement, to bring assurances that the company owns any IP brought over.

If you hire a consultant and they develop something for you, they own it (unless you have agreements that say otherwise.)

The level of scrutiny that your company is going to be subjected to on acquisition is much, much higher than at any other time, even when investments happen.

3. Keep your options open

To maximize price, Company should leave itself with alternatives to the buyer they are targeting.

Alternatives could be another buyer, another investor, that the company could continue with its current situation, that IPO is an option. Focusing on one buyer is important, but not to the exclusion of others. "Companies get bought, they don't get sold."

Going around and establishing partnerships with potential acquirers is very necessary. Pace those relationships, so that they mature at roughly the same time. Once an acquirer is interested, they're not going to wait they'll want to take advantage of you on price and sign a LOI right away at a good price, but then put a 60 day exclusive window in place for due dilligence, during which you can't go out and talk to others, but then they'll come back during that window and say "gee, we can't do 20 million, but we'll do 12 million instead." You want to have something to support resistance in that case.

Even when you get an unsolicited offer, you might want to not seem too excited in order to maximize their interest. If the buyer realizes that you don't have alternatives, the price will inevitably come down later.

4. Avoid selling the Company for private company shares in a transaction that is taxable.

In most cases, when a private company wants to buy you for equity, you don't know what the true value of that equity and what sort of liquidation preferences are ahead of you by holders of preferred shares.

Also, avoid selling assets for a price above your net operating losses. Particularly early stage companies should beware of double-taxation problems. Simplest way to avoid this problem is to do a merger instead, so that only the stock that is sold is taxed. Buyers in small transactions (<5 million) are usually paranoid about possible liabilities outweighing the benefits.

It's tricky, but generally speaking if the value of the deal comes in at least 50% stock, then the transaction is tax-exempt (until the shares received are sold.)

5. Make sure to understand the deductions from the negotiated purchase price.

There are many adjustments to the initial offering price that affect how much money you end up with:

  • escrows (money that is set aside to pay for unforseen liabilities, usually 10-20%, for 2-5 years)
  • legal fees (50k - 200k, depending on the purchase price)
  • balance sheet adjustments (liabilities push down the price)
  • special indemnities (like 409a concerns)

There's a real difference in east coast vs. west coast buyers and the terms that they demand. Be careful with how much the buyers demand as subject to clawback. Generally you want the rights to as much of the proceeds as possible.

Figure out and negotiate as much of these things asap before the 60-90 day "no shop" period. Push the buyer to get as much due dilligence and possibly even board approval before you agree to a lockup, so that the lockup is only the period needed to execute the deal.

Often buyers will put "residuals clause" in the NDAs, which dilute the value of the NDA in protecting the seller's secret sauce. Push off giving the seller access to important IP until very late in the process.

Back up the price that's put on the table with as much preparation as possible, especially if you're able to present real data.

6. Make sure you understand the open source code used in your product and that you own it in a way that is possible to sell.

Open source issues rarely are showstoppers, but often there are hangups related to the "black duck" analysis.

7. Mind 409 issues - company minutes, stock options.

Make sure your books are in order. Don't leave housekeeping until the last moment. Not doing so can really mess up a deal or push up the escrow requirements.

8. Don't wait until the last minute to think about and negotiate employment agreements and non-competes.

Generally, if there are considerable proceeds then non-competes of 3-5 years are very enforceable. Use your own counsel because the counsel for the company is representing the board and the company shareholders and that doesn't necessarily mean they are concerned about your views, since there is potential for conflicts of interest.

9. Be weary of earn-outs arrangements.

"We're offering 20 million, but only 1 million up front and then the rest if you meet certain expectations related to our business goals and projections." 50% of earnout arrangements end up in litigation down the road because expectations are not met in a way that is unfair to the seller.

10. Pay attention to sentiment of your board members and investors.

Look out for board member bias for or against a sale and be aware of a strategic investor reactions to the sale. For institutional investors, a lot will depend on where they are with regards to their own fund, are they near the beginning or are they in a hurry to close out so they can raise another fund.

Bonus Topic: Acqui-hire issues.

As a founder negotiating the deal, be careful with the buyer wanting to screw the existing investors. The biggest tension is the split between the proceeds going to the investors vs. employees over the next 4 years.

Bonus Topic: Bankers on the seller side?

In deals of $50-100 million, probably makes sense to hire a banker to represent seller's interest and maximize the deal terms. However, sometimes the buyer will balk if you try to get them to talk to your banker instead of you. The board might also balk at paying 1-2% in fees to the banker, but it should be worth it because of the resulting increase in the sell price.

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