M&A Posts

How common is accelerated vesting on change in control (AVCoC)? Noam Wasserman from HBS has the answer in Unlocking Your Golden Handcuffs:

“I recently got an email from a serial entrepreneur who has been brought on as the head of finance and operations in a mobile-services start-up. One of his questions was: How often do new-venture executives get AVCoC? If it’s not common for them to get it, he wouldn’t push for it and would focus his negotiating leverage on another term, but if it’s common, he wanted to push hard for it. (He felt that the start-up might be the subject of M&A activity in the future, and had already experienced working for a large company after a prior venture of his had been acquired.)…

“Overall, the percentage of executives receiving AVCoC was 65.5%. However, as shown in the chart below, the percentage varied from a high of 76.4% for CEOs down to 46.3% for the Head of Human Resources. (I only show the positions for which I had at least 100 data points.)…

“I also analyzed AVCoC at the team level, which is the focus of your first (“side note”) point. At the team level, 36% of the teams (429 ventures) had a “mixed” approach to AVCoC, wherein some executives had AVCoC and some did not. In those ventures, executives would seem to have been negotiating AVCoC on a case-by-case basis, in the absence of a consistent plan adopted across the team/venture. Of the other ventures, 47% (561 ventures) had AVCoC across all of the executives in the survey. Those 47% might include some ventures that adopted a consistent plan and others where the AVCoC’s were put in place on a case-by-case basis. Finally, 17% did not have a single executive with AVCoC (yet?).”

There is also a great discussion of AVCoC in the comments to Noam’s post.

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Suzanne Dingwall Williams is publishing M&A hacks on her excellent blog, Venture Law Lines. She call the series: ‘Selling the Startup’,

Selling the Startup: Can you sell your subscriber base?

“Recently, a new client received a very favourable takeover offer for her business, including its subscriber base. Problem: the privacy policy did not permit her to provide the account information for her subscriber base to the acquirer. Same thing with the user license: it was non-transferable. We had to go back and rectify the matter in a ponderous way before closing.”

Selling the Startup: Providing Price Protection in the Term Sheet

“As a general rule, [M&A] term sheets provide for price adjustment based on revenues and a closing balance sheet, and based on the results of the buyer’s due diligence (this is really a price reduction clause, as no one ever finishes due diligence and concludes “By God, they’re really onto something here. Raise the price!”). Here are three other areas where you, as seller, need to consider providing for some price protection…”

A couple more gems from her excellent blog:

On Being An “Off the Grid” Startup

“The reality is that 95% or more of North American startups are created outside of Silicon Valley. Many are created in fairly robust business generation centres such as Boston, and emerging centres such as Chicago and Raleigh-Durham. Just as many are created in regions where the startup infrastructure is small or non-existent. Do the practices, deal terms, and operational decisions typically made by startups in the overheated Valley, with its cadre of serial entrepreneurs and super-angels, have any application for the rest of us, who are off the Silicon Valley grid?”

If Venture Capital is Dead [in Canada], What’s Next?

“Venture capital in Canada is no longer an industry, but a financial product offered by only a handful of players…

“When someone finally says this, I’ll agree. But I’ll also say that, as someone who advises entrepreneurs, I don’t particularly care. All this tells me is that companies will now use different financial tools to feed growth, using business plans that are not shoehorned into the somewhat artificial venture capital model for growth—i.e., in and out in 3-7 years.”

Suzanne’s resume includes roles as Founder of Venture Law Associates (a Canadian law firm with flat rate service for inventors and early stage companies), Principal at BCE Capital, and Senior Counsel at Nortel.

Image Source: Despair.

Q: Should I sell my company or raise capital and go for it?

Sell if it dramatically changes the lives of the founders and the early team. Every dollar after your “fuck you money” is icing—get your financial independence first and make the icing at your next company. You can also use an earn-out at the acquirer to capture some of the potential upside of raising money.

If you raise capital, you risk your current value for a chance to capture your future value. Is there a difference between capturing future value at your current company and your next company? You can create future value at your next company after you’ve captured your current value and done your time at the acquirer.

Also consider selling if you are at a local maximum, e.g. your company or market is going sideways and the company will be worth less before it is worth more. Of course, smart buyers will wonder if they should be buying when insiders are selling.

One alternative to an acquisition is to cash-out some of the founder’s shares so they’re wealthy enough to feel comfortable with the risk of building a bigger business. I’m guessing the Facebook founders have been cashed-out to some degree.

Q: What does it take to be a successful entrepreneur?

Successful entrepreneurs delight their customers, execute relentlessly, and enjoy lots of luck. You recognize great entrepreneurs when you see them (like porn) and you get better at recognizing them every day.

Q: What does it take to be a successful investor?

To be an investor, you need access to capital. There is no IQ test.

To be a successful investor, you also need great dealflow, good judgement in picking companies, and, in competitive markets, the competitive advantage to win deals.

Note: These excellent questions are adapted from Ashkan Karbasfrooshans’s Venture Hacks interview.

Image Source: Richard Seaman.

“AOL almost sold to Compuserve in 1991 for $60M. The VCs wanted to sell. [Steve] Case won by 1 vote. 10 years later, [AOL was] worth $100 billion.”

Mark Pincus

Summary: Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. They protect the preferred, who are minority shareholders, from unfair actions by the common majority. However, the preferred shouldn’t use protective provisions to serve their other interests.

Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. Roughly, they state that

“The Company requires the consent of the holders of at least X% of the Company’s Series A Preferred to (i) effect a sale or merger of the company, (ii) sell Series B Preferred with rights senior to or on parity with the Series A, (iii) et cetera…”

To understand why investors want protective provisions, you first need to understand how the preferred and common classes control the company.

The board mostly controls the company.

The common and preferred classes control the company through

  1. Board seats, which require each board member to serve the interests of the company as a whole. Board members cannot simply serve the interests of their particular class of stock.
  2. Shareholder votes, where the preferred vote as if they held common shares. In legal-speak, the preferred vote on an as-converted-to-common basis. The preferred usually gets one as-converted-to-common share for each of their preferred shares. The preferred and common use shareholder votes to serve their own interests.
  3. Class votes, which require a majority of the preferred and a majority of the common. We will cover this mind-numbing topic in a future hack. The preferred and common use class votes to serve their own interests.
  4. Protective provisions, which allow the preferred to veto certain actions, such as selling the company or raising capital. In some companies, each series (Series A, Series B…) has their own protective provisions. In other companies, all of the series exercise their protective provisions as a class.

After the common and preferred classes select their representatives on the board, the board takes it from there. The board, not the shareholders, usually approve management decisions. (We previously showed you how to hack the allocation of seats on the board.)

However, some major actions require shareholder votes and class votes in addition to board votes. For example, Delaware corporations require a shareholder vote to sell the company or raise money.

Protective provisions protect the preferred minority from the common majority.

The preferred usually owns 20%-40% of the company after the Series A. If the common is united, the preferred can’t influence shareholder votes—they don’t own enough shares. Nor can they influence board votes if a united common controls the board (e.g., the board consists of two common seats, one preferred seat, and no independents).

If the common controls a Delaware corporation’s stock and board, the preferred need protective provisions to stop the common from:

  • Selling the company to the founder’s cousin for $1 and wiping out the preferred stock.
  • Selling $1M of the founder’s shares to the company so he can get a great haircut.
  • Issuing a bazillion shares to the founders and diluting the preferred to nothingness.

Protective provisions protect the Series A minority from unfair actions by the common majority. That’s why they’re called protective provisions. In future rounds, protective provisions can also protect each series of preferred stock from the other series of preferred stock.

Investors argue that protective provisions encourage good governance.

Some investors claim that they need protective provisions because they can’t use their board seat to serve their own interests. They correctly argue that board members have to serve the interests of the company as a whole, not the interests of their class of stock.

These investors will claim that protective provisions let them serve their interests as investors, so they can serve the interests of the company through their board seat:

Say the company receives an offer to acquire the business. Management thinks it’s in the company’s interest to sell. The board defers to management since management is doing a good job running the company. But the investors think the company is the home run in their portfolio—they don’t want to sell the company now. So the investors use their board seat to vote for the sale and use their protective provisions to veto the sale.

Investors should use protective provisions to protect themselves, not to serve their interests.

We don’t agree that investors need protective provisions to serve on the board without succumbing to their own interests.

In fact, any investor who makes that argument is raising a big red flag. They’re implying that they can’t fulfill their duty as board members without additional veto powers. They’re implying that the interests of their fund can outweigh the interests of the company.

Your response to this argument goes like this:

“I don’t think you mean that you can’t serve the interests of the company without these additional protective provisions. I’m sure you will use your board seat to do the right thing for the company, always.

“You control the company through (1) board votes where you serve the interest of the company and (2) share and class votes where you serve your own interests.

“Protective provisions protect you against the common majority. But they’re not a tool to serve the interests of your fund at the expense of the company.”

They're called protective provisions, not mis-alignment provisions!

We would rather have an “evil” investor who uses his board seat to serve his interests, than an investor who planned to use protective provisions to do anything other than protect himself. At least the “evil” investor’s power as a board member is in proportion to his share of board seats—his protective provisions give him a blanket veto that is wildly out of proportion with his ownership of stock and allocation of board seats!

The next few hacks will show you how to attenuate the protective provisions, reduce this mis-alignment, and leave enough protective provisions in place to protect the preferred.

Image Source: Jennifer Juniper (License)

Summary: Convert your debt into equity if you can’t pay it on time. Determine your lender’s return if you sell the company early. Reserve the right to raise more debt. Finally, reserve the right to amend the debt agreement.

Previous convertible debt hacks have discussed

  1. The benefits of debt in a seed round
  2. The economics of debt vs. equity
  3. Making your debt attractive to investors
  4. Keeping your Series A options open

This article collects 4 convertible debt microhacks you can use to supersize your convertible debt.

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Convert the debt into equity if you can’t pay it on time.

Your Series A financing may not occur before the debt comes due. In that case, the company should have the right to

  1. Pay the debt and interest back, or
  2. Convert the debt to common or preferred stock at a predetermined valuation.

Note that the company makes the decision to convert the debt to equity—not the investors. This term lets the company avoid defaulting on the loan. See this great article by Yokum Taku for more details.

Determine your lender’s return if you sell the company early.

The company may be acquired before the Series A. In that case, the debt holders should have the right to

  1. Get their money and interest back, or
  2. Convert their debt to common stock at a predetermined valuation.

The lender chooses between these two options at the time of sale. This term simulates the liquidation preference of preferred stock. You can use the same valuation that you negotiated in the microhack above.

Reserve the right to raise more debt.

If you are raising $500K in debt, you should reserve the right to use the same documents to conduct subsequent closings up to some cap, say an additional $250K of debt.

Many debt agreements don’t require you to get the current lender’s permission to raise more debt in the future. But it is better if your current debt investors clearly understand this possibility. And it will be cheaper if you can use the same documents to close the additional debt.

Reserve the right to amend the debt agreement.

The company and a majority of the lenders should be able to amend the debt agreement and make the changes binding upon the other lenders. This is much easier than getting agreement from every single debt investor.

Examples of amendments include changing the date that the debt matures or the size of a qualified financing.

This term is especially useful if one of your angels is inexperienced or malicious. Without this term, he may try to negotiate a better deal when you request the amendment.

What are your debt microhacks?

Use the comments to share your experiences and questions regarding debt microhacks. We’ll discuss the most interesting comments in a future article.

Summary: Seed investors often argue that debt doesn’t incent them to (1) help the business and (2) increase the share price of the eventual Series A. Actually, (1) debt does incent investors to help the business and (2) equity may also incent investors to decrease the Series A share price. That said, you can make your debt much more attractive to investors with a few concessions.

Although convertible debt is often the best choice for a seed round, investors often argue that debt does not incent them to contribute to the business:

If I buy debt and contribute to the business, the share price of the eventual Series A goes up and the number of shares I get for my debt goes down. Debt doesn't incent me to help the business and increase the price of the Series A.

Debt holders are incented to help the business.

Your response to an investor’s claim that “(1) debt doesn’t incent me to help the business”:

“If you buy $100K of debt, you get $100K worth of shares in the Series A, plus some shares for your discount. You’re not losing money by contributing to the business—the Series A share price may go up but your share value remains $100K, plus a discount.

“And… as you contribute to the business, the company’s risk goes down, opportunity goes up, and the net present value of your debt goes up. You’re still incented to help the business when you buy debt.”

That said, equity incents an investor even more. If an investor buys $100K of equity in the seed round and locks in his share price, he makes a paper profit if the share price increases in the Series A.

Note to entrepreneur: You don’t need to make this argument on your investor’s behalf.

Equity holders are also incented to decrease the Series A valuation.

Your response to an investor’s claim that “(2) debt doesn’t incent me to increase the eventual share price of the Series A”:

Rational investors are

  1. Insensitive to the next round’s price if they plan to maintain their percent ownership,
  2. Incented to increase the next round’s price if they plan to decrease their percent ownership, and
  3. Incented to decrease the next round’s price if they plan to increase their percent ownership.

(We’ll explain how the math works in the comments.)

Some seed stage funds maintain or decrease their percent ownership in the Series A. These funds tend to focus on seed stage companies.

Other seed investors try to increase their percent ownership in the Series A—if the company is doing well. These funds tend to invest in most stages of a company’s growth.

Ask your investors about their track record and strategy for follow-on investments. If they like to increase their percent ownership in their best investments, they have an incentive to drive down your Series A valuation whether they buy debt or equity in the seed round.

Make your debt attractive to investors.

Rather than debating the finer points of your investor’s incentives, you can make your debt much more attractive to investors with a few concessions (ordered from small to large):

  1. Don’t let the company pre-pay the debt. Your investors don’t want you to repay the debt just before you raise a Series A or sell the company.
  2. Anticipate a potential sale before the Series A and negotiate your investor’s share of the sale price. Your debt investors want to make money if you sell the company before the Series A.
  3. Increase the discount by a fixed amount and/or 2.5% per month, up to a maximum that can range from 20% to 40%. A higher discount yields a higher return for your investors. For example, a 40% discount guarantees your investors a 1.7x return on paper when the Series A closes.
  4. Set a maximum conversion price for the debt.
    The debt could convert at the lesser of (1) $X/share and (2) the actual Series A share price. This cap effectively sets a maximum valuation for your debt investors and protects them from a high Series A share price. This is a great way to maintain the benefits of convertible debt while rewarding your debt investors for investing early. The maximum conversion price can be significantly higher than any valuation you could negotiate easily.

How have you made debt attractive to investors?

Use the comments to share your experiences and questions on making debt attractive to investors. We’ll discuss the most interesting comments in a future article.

“We talked to a lot of different angel investors and venture capitalists, but no one really ‘got’ what we were doing — that is until we met Google.”

Dennis Crowley, Founder of Dodgeball, May 2005

“It’s no real secret that Google wasn’t supporting dodgeball the way we expected. The whole experience was incredibly frustrating for us — especially as we couldn’t convince them that dodgeball was worth engineering resources, leaving us to watch as other startups got to innovate in the mobile + social space… It was a tough decision to walk away…”

Dennis Crowley, Founder of Dodgeball, April 2007

Summary: Negotiate some acceleration if you sell the company ahead of schedule — you don’t want to stay at the acquirer for an unreasonable period of time. Also negotiate 100% acceleration if the acquirer terminates you and deprives you of the ability to vest your stock.

Your vesting should accelerate upon a change in control of the company, such as a sale of the business.

Negotiate both single and double trigger acceleration.

Your options for acceleration upon a change in control, from best to worst, include

  1. Single trigger acceleration which means 25% to 100% of your unvested stock vests immediately upon a change in control. Single trigger acceleration does not reduce the length of your vesting period. It only increases your vested shares (and decreases your unvested shares by the same amount).
  2. Double trigger acceleration which means 25% to 100% of your unvested stock vests immediately if you are fired by the acquirer (termination without cause) or you quit because the acquirer wants you to move to Afghanistan (resignation for good reason). The hack for acceleration upon termination already provides double trigger acceleration and provides sample definitions of termination without cause and resignation for good reason.
  3. Zero acceleration which is a little better than getting shot in the head by the Terminator:

The most common acceleration agreement these days combines 25% – 50% single trigger acceleration with 50% – 100% double trigger acceleration. The median of this range is probably 50% single trigger combined with 100% double trigger.

Justifying single trigger acceleration.

You can justify single trigger acceleration by arguing that,

“We didn’t start this company so we could work at BigCo X for two or three years. We’re entrepreneurs, not employees. We’re willing to work at BigCo, but not for that long.

If we sell the company after two years, that just means we did what we were supposed to do, but we did it faster than we were supposed to. The investors will be rewarded for an early sale by receiving their profits earlier than they expected. We shouldn’t be penalized for an early sale by having to work at BigCo for years to earn our unvested shares.

Single trigger acceleration reduces the effective time we have to work at BigCo and rewards us for creating profit for the investors ahead of schedule.”

Justifying double trigger acceleration.

You can justify 100% double trigger acceleration by arguing that,

“The aim of vesting is to make me stick around and create value — not to put me in a situation where I am deprived of the opportunity to vest because I am terminated for reasons beyond my control or I resign because the environment is intolerable.

So, if I am terminated with no cause by the acquirer, I should vest all my stock. Or if the conditions at the acquirer are intolerable and I resign for good reason, I should vest all my stock.”

The risk of termination at an acquirer is much greater than the risk of termination in a startup. Investors are generally investing in the future value of a startup — they’re investing in people. Acquirers are generally investing in the existing value in a startup — they’re investing in assets.

Acceleration agreements give you leverage upon a sale.

When you sell a company, the acquirer, founders, management, and investors will renegotiate the distribution of the chips on the table. It isn’t unusual to renegotiate existing agreements whenever one party has a lot of leverage over the others. To quote the fictional Al Swearengen,

“Bidding’s open always on everyone.”

Negotiating your acceleration agreement now gives you leverage in this upcoming multi-way negotiation.

If an acquirer doesn’t like your acceleration agreement, they can decrease the purchase price and use the savings to retain you with golden handcuffs. A lower purchase price means less money for your investors. This provides you with negative leverage against your investors — you can decrease your investor’s profit if you refuse to renegotiate your acceleration.

Or, the acquirer can increase the purchase price in return for reducing your acceleration. A higher purchase price means more money for your investors. This provides you with positive leverage against your investors — you can increase your investor’s profit if you agree to renegotiate your acceleration.

Visible contributors benefit the most from the renegotiation.

After this renegotiation, the CEO and key members of the management team often end up with better acceleration agreements than everybody else. That’s not a big surprise — the CEO is leading the renegotiation.

Founders who are perceived as major contributors by the board and acquirer may also benefit from the negotiation. If you’re the Director of Engineering, you’re probably invisible to the acquirer — if you’re the VP of Engineering and involved in the negotiations, you may do much better.

As always, the best defense against these shenanigans is to create a board that reflects the ownership of the company and to make a new board seat for a new CEO.

What are your experiences with vesting upon a change in control?

Submit your experiences and questions regarding vesting upon a sale in the comments. We’ll discuss the most interesting ones in a future article.

Appendix: Definition of ‘Change in Control’

A sale of the company is an example of a change in control. Your lawyers will help you define change in control. A definition that we have used in one term sheet follows.

    “Change in control” shall mean the occurrence of a sale of all or substantially all of the Company’s assets or a merger or consolidation of the Company with any other company where the stockholders of the Company do not own a majority of the outstanding stock of the surviving or resulting corporation; provided that a merger, the sole purpose of which is to reincorporate the Company, shall not be treated as a change in control.