Terminology

letters of intent:

 

A startup will receive a Letter of Intent (LOI) from another organization (buyer) interested in acquiring the startup(seller). You will find that the LOI and term sheets share many of the terminology that you would see in a typical term sheet. Since we have already covered many of the terms in the discussions on term sheet, I shall focus on terms relevant during an acquisition. By the time a company receives an LOI, a company has matured and has better insights into its future, its competancy and thus its valuation. For these reasons a detailed LOI is better than a loosely worded LOI.

 

Asset Vs Stock Deal:

 

Now that you received the LOI; you want to review what is being offered. The buyer may either offer an asset deal or a stock deal and there is big difference between the two. Asset deal refers to a deal where the buyer is not buying the company in its entirety but buying assets belonging to the company. Structuring an asset deal permits buyer to not inherit liabilities. What the seller needs to keep in mind is that though the buyer has bought assets, the company is not yet sold and that they are still liable for any existing liabilities (debt, taxes, wages, litigation etc).

 

In case of a stock deal, the buyer is acquiring the entire company; buying all its stock outright. Once the deal closes, the company as it formally existed, ceases to exist. At times, a buyer may retain a company’s name for the purpose of branding, but the corporate structure would have changed.

 

Forms of Consideration:

Forms of consideration terms define how the seller is paid in an acquisition. The most common form of consideration is a combination of cash and stock of the buying company. Let me explain with a simple example: ABC Inc. is buying XYZ Inc for $50,000,000 of which $20,000,000 is in cash and $30,000,000 is in stock of ABC Inc., valued at $1/share. If ABC Inc is a publicly traded company, there is some level of liquidity for the stock (issued stock needs to be registered). In case ABC Inc is a privately held company, the stock is illiquid. Additionally, the structure of ABC Inc and liquidation & participation preferences it has with its investors will have a very significant impact in case the liquidity event for ABC Inc. is an acquisition. Let’s assume ABC Inc investors have $100,000,000 in liquidation and participation preferences. If ABC Inc. gets acquired for $140,000,000, only $40,000,000 is passed down to the common stock holders. This would include the original ABC Inc stock holders and the new common stock issued to XYZ Inc in their buy out; thus drastically devaluing the $30,000,000 portion of the stock based buyout of XYZ Inc. The bottom line is…CASH IS KING. Key things to look out during an acquisition would be: corporate structure of the buyer, liquidation and participation preferences of investors in the buying company and in case the buying

 

Registration Rights:

 

As discussed previously, a buyer may often pay the seller partially or completely in stock. In case the buyer is a publicly traded company, the newly issued stock needs to be registered through a regulatory body like the SEC before it can be traded on a stock exchange. It is important that the seller understands the rights of the newly issued stock and steps taken by the buyer to register the stock. In the US, unregistered stock is automatically registered after a one year waiting period.

 

Assumption of Stock Options:

 

I had previously talked about employee options and vesting schedule in context with term sheets. During an acquisition, the treatment of options would come into play if the size of the deal is greater than the liquidation and participation preferences of the preferred stock holders on the seller's side. The buyer is faced with the decision of assuming employee options. Assumption of options pool by the buyer means the existing stock holders of the seller receive more of the proceeds of the sale. Additionally, the buyer creates a future incentive for the employees that are being transferred from the seller. If the buyer does decide to assume options, the buyer will incorporate pricing based on fully diluted options (both vested and unvested). If options are not assumed by the buyer and the provisions for options pool does not incorporate acquisition scenarios, the employees risk losing unexercised options. Since options form a major incentive for startup employees, it is up to the founders and investors to see that employee get to participate in the up side of an acquisition.

 

Typically, a well-structured employee options pool would incorporate acquisition scenarios and changes to vesting schedule. Most common scenarios will have all pending options fully vest just prior to acquisition. Full vesting and exercising of the entire option pool can change the capitalization table and have a bearing on the decision making during the acquisition as options holders have now become common stock holders. The original investors, founders and common stock holders would also have to share the proceeds of an acquisition with employees. Additionally, the conversion of a large options pool to common stock may mean changes to the decision making process within a company. To add to the complexity of the deal; though options are fully vested, an employee may choose not to exercise their options. This decision would depend on whether the acquisition is a cash or stock consideration. If the acquisition is a stock consideration, the liquidity of the stock in the “buyer” company would depend on whether the company is public or private.

 

Similar to options, an acquiring company has to choose to assume investor warrants in the selling company.

 

Representation, Warranties & Indemnification:

 

These terms loosely define indemnification in case reps or warranties are breached. 

 

Escrow:

 

During an acquisition, the buyer will hang on to some portion of the sale price for a fixed period of time as a security against any post acquisition issues; this provision is referred to as escrow (also referred to as holdback). Often, purchase price may be negotiated based on the amount set aside in escrow and the duration for which the amount is held in escrow. If the buyer and seller can negotiate a maximum amount that a buyer may claim for post-accquisition issues, it is referred to as the escrow cap. Buyers will prefer negotiating uncapped escrows. Carve-outs to escrow may occur in case of fraud, capitalization and taxes where the buyer feels that the escrow does not provide ample protection. It is important to make sure that an carve-out claim is not greater than the aggregate value of the deal as it would mean that the seller has to give the buyer more money than they paid for the deal. Additionally, escrow structure should also be dependent on the form of consideration. For example, lets assume the deal is a combination cash and stock deal. A topic for negotiation would be what portion of the deal (stock, cash or stock & cash combination) is held in escrow. If stock is held in escrow, the seller needs to be aware of the stock volatility and liquidity (particularly if the buyer is a private company). If the escrow cap does not account for such variations in stock price, it can hold the seller liable for money it did not receive from the buyer. Post-acquisition scenarios can get complicated and for this reasons the seller needs to pay attention to how the escrow is structured.

 

Non-Disclosure Agreement:

VCs will almost never sign a non-disclosure agreement when dealing with startups but in case of acquisitions, both buyer and seller are disclosing very sensitive information to one another. LOIs always involve a NDA to protect one another in case the deal falls apart.

 

No-Shop Clause:

 

LOI will include a unilateral no-shop clause that would prevent sellers from seeking  or negotiating with other potential buyers while the current deal is being negotiated. The time line for negotiations and no-shop should be well defined and are typically no more than 60 days. The no-shop provision is also seen in term sheets between a startup and investors.

 

Conditions to Close:

 

As the name suggests, these are conditions that a buyer wants the seller to meet prior to concluding the acquisition. An example of such a condition could be “Subject to settling pending litigation”.

 

Structure of a Deal:

 

We have only gone through some of the terms associated with a letter of intent for acquisition of a company. The purchase listed on the LOI typically comes with numerous strings attached and the eventual pay out to seller is a lot lower. As we discussed earlier; a portion of the sale price (10-30%) is retained by the buyer in escrow for a fixed duration of time (1-2yrs). The buyer may also require the seller to have a minimum working capital on hand at closing. A lower working capital at closing can decrease the purchase price. If the seller has more working capital than the agreed upon value, the seller may be in a position of asking for a higher purchase price. Another term included in a deal is earn-out. While escrow is held for the sake of representation, warranties and other scenarios to protect from indemnification, earn-outs are meant to create incentives for the sellers side team to attain pre-defined milestones after the acquisition. Often, the buyer will under pay on the purchase price in comparison the sellers wants or valuation and will only achieve the full purchase price desired by a seller when combined with earn-outs. The buyer may provide additional cash for retention of key management team for a fixed period of time after the acquisition. If anyone from this team leaves after the acquisition, this incentive can be withdrawn.

 

Though I have not described many of the LOI terms here, please look for them on the LOI Coggle.