Preamble: As a member of any startup with options or equity, it is important to know how the capital proceeds of the company will be distributed in different circumstances. Whilst preference schedules, bridge-loan agreements and investor veto clauses appear rather abstract at the outset, these could all make a material difference to the capital proceeds you receive upon exit. This is something we discuss internally. As other startup teams will also be discussing this, we would like to open the discussion. In this post our CEO considers a common type of exit, and the distribution uncertainty typically associated with this type of exit. He proposes standardising the approach to capital distribution.
Hello, Startup World.
In this post I would like to kick off a discussion about best practice for when startups are acquired by other startups for equity.
Having been pottering about in London’s tech startup community since 2006, I have seen several of my peers selling their startups to other tech startups for equity. Sometimes the investors feel as though they have received a bad deal. Sometime the founders feel mistreated. Sometimes both parties walk away after acquisition feeling as though they have been wronged.
In this post I would like to make a proposal. Our team very much look forward to your thoughts on the matter.
Suppose that company A is to be acquired by company B for equity. Suppose also that there is a preference schedule associated with company A’s equity.
Without loss of generality, let’s suppose that the investors have put $500k into company A for 25% of the company’s equity and investors have a 1-times non-participating preference whilst founders have the remaining 75% of the company’s equity and they have no preference. The 1-times non-participating preference means that if the company sells for an amount up to $500k, investors will receive all the proceeds. If the company sells for an amount between $500k and $2 million, then investors will receive $500k and founders will receive the rest. If the company sells for more than $2 million, then all shareholders—investors and founders—will receive proceeds pro-rata according to their shareholdings.
Typically three possible deal structures are discussed during the acquisition process of company A by company B.
Company A’s preference schedule is ignored, and all company A’s shareholders get shares pro-rata according to their shareholdings in acquiring company B. This is unlikely to please investors.
Company A’s preference schedule comes into force and investors potentially get all (or most) of the newly issued shares in acquiring company B. This is unlikely to please founders.
Company A’s preference schedule doesn’t come into force, but investors get compensated by getting a higher percentage of company B’s shares than they would have done had distribution been pro-rata. Neither investors nor founders are likely to walk away from this negotiation feeling particularly pleased.
Proposed Best Practice:
I am of the view that none of the above are ever appropriate. Rather, I contend that acquired company A should simply roll the preference schedule forward. And I don’t just see this as being just another possibility. I believe this to be the only reasonable way to structure this type of deal.
Let me explain.
No cash is changing hands, and without cash changing hands the preference schedule is ill-defined. It is ill-defined because the preference schedule is determined by absolute valuations, whilst this type of deal is only ever about relative valuations.
Anyone who has ever been involved in a startup will know that early valuations—say, during fundraising—are largely plucked from the air. Dubious appeals are made to comparables. Fantastical hockey-stick curves are considered. Most importantly, people talk about competitive tension (without shopping term sheets). The difference between a $1 million valuation and a $10 million valuation is often more than a little arbitrary. During discussions about one startup buying another for equity, some absolute figures will almost certainly also be plucked out of the air. “We are worth X million, because of Y.” However, what the conversation ultimately reduces to is relative valuation. “We are three times as valuable as you, because of Z.”
Suppose acquired company A is bought by buying company B for newly issued stock in company B equal to 25% of company B (after the acquisition). In the share purchase agreement, a valuation will ascribed to company A and also to company B.
Let’s suppose that company A is written as having a valuation of $500k and company B, before the acquisition, is written as having a valuation of $1.5 million. Because company A’s investors have 1-times preferred stock, this $500k valuation of company A would mean that investors are entitled to all the new equity issued by company B.
Let’s suppose instead that company A is written as having a valuation of $1 million and company B is written as having a valuation of $3 million. Then there would be no change to the deal structure. Company A’s shareholders would still get 25% of company B. However, company A’s investors would now get 12.5% of company B’s shares and company A’s founders would get 12.5% of company B’s shares.
Now let’s suppose that company A is written as having a valuation of $2 million and company B is written as having a valuation of $6 million. Again, there would be no change to the deal structure. In this case, however, company A’s investors would only get 6.25% of company B’s shares and company A’s founders would get 18.75% of company B’s shares—and the investor preference would not come into play.
With the same deal structure—with company A being bought for 25% of company B—it seems non-sensical to distribute proceeds to company A’s shareholders in the purely arbitrary ways illustrated above.
What ought really to happen, I propose, is that the company A’s preference schedule should simply be carried over to the post-acquisition company B.
But does this not mean the buying company B would need to incur unnecessary costs to introduce preference details just for acquired company A’s shareholders? Not so. There is a very simple strategy, which I advocate. Company B buys all company A’s IP, assets, goodwill, team, etc. and in return company B issues shares to company A. At this point company A will now simply be a holding company for founder and investor interests in company B—to the extent that company A’s shareholders still own their shares in company A and company A now owns shares in company B. If company B exits in the future, company B will distribute proceeds to company A according to company B’s agreements, and company A will then distribute its received proceeds to company A’s shareholders according to company A’s preference schedule.
As an added benefit company B will not have to deal with the overhead associated with many new voting shareholders. By having a holding company look after the interests of company A’s shareholders in company B, company B needs only to manage one new shareholder after the acquisition.
Please tweet us your thoughts.