Top Ten Commandments of Venture M&A

This morning I served on a panel discussing venture-backed Mergers and Acquisitions (M&A) at IBD’s DealMaker Forum.  M&A, as opposed to IPOs, accounts for the lion’s share of venture exits so it is a subject near and dear to most VCs’ hearts,    In the same vein, it is also near and dear to the hearts of most start-ups, because the management team realizes that despite their ambitions of world domination, the most likely outcome for them is a sale to a larger company.

Given the importance of M&A to both VCs and start-ups, it’s important to realize that the seeds for M&A success or failure can actually be sown quite early in a start-up’s life and well before any potential deal materializes.

With this in mind, I offer the following Top Ten M&A Commandments with the idea being that if a start-up follows these commandments it will be able to avoid some of the most common structural and financial issues that have the potential to blow-up a deal or dramatically reduce its value.   These commandments include:

1. Thou Shall Not Give a Strategic Investor a Right of First Refusal, Right of First Offer or a Protective Provision that Enables Them to Block a Sale.
   If you must have a strategic investor in your company (and in general I recommend against it) by all means do not give them a Right of First Refusal, a Right of First Offer, or an ability to block a sale in the event of M&A.   Most strategic investors will ask for some or all of these things, but offering any of them can seriously screw up a potential M&A deal.  Many acquirers are reluctant to invest time and effort in putting together a deal if they know that a strategic investor can trump or block their offer with ease.  About the only acceptable thing to give a strategic investor is a “notification right” in which you agree to notify them at least X days before closing a deal.  This has the added benefit of effectively allowing you to legitimately “shop” your deal without angering an acquirer. 
2. Thou Shall Require “Drag Along” Agreements In All Series of Stock.
   Most acquirers specify that a target obtain a minimum % approval for the deal from their stockholders.  Failure to do so can either blow-up a deal or lead to very onerous escrow and indemnity provisions.   “Drag along” agreements go a long ways towards addressing these concerns.  They typically specify that if a majority of a class of stock vote in favor of the deal, then 100% of the shares in that deal must be voted in favor of the deal.  This prevents one or two shareholders from holding out and screwing up the whole deal.  That said, drag alongs are not fool-proof as determined investors will be able to find others ways to make themselves an equivalent nuisance, but there’s really no good reason for not having them in a start-up’s standard docs from Day 1.  Drag alongs tend to work better for preferred stock than common because some states limit the ability to drag along common but there’s no harm in getting a drag along up front and letting someone try to invalidate it later.
3. Thou Shall Not Have More Than 3 Separate Series of Preferred Stock Outstanding At Any Given Time.
   As I mentioned in an earlier post, the more series of preferred stock a start-up has the greater the likelihood of “class warfare” between the different investors in each class of stock.  This risk is particularly heightened during M&A negotiations as the different series of stock may be looking at starkly different outcomes in a sale.  It is for this reason that any company considering issuing a Series D-Z should stop, take a deep breath, and instead figure out how they can recapitalize the company.  Waiting until an actual offer materializes to do this is way too late.
4. Thou Shall Not Give Later Stage Investors Both Preferences and Protective Provisions.
   Similar to a strategic investor, late stage investors should not be allowed to veto a sale with a protective provision.  If they want to be compensated for the risk that the company will be sold without generating a significant return for them, they should address that risk through preferences, not blocks.  In no circumstances should a late stage investor get both a super-preference and a block.  They should only get one or the other.   Ideally, there should be just a preferred-wide block.
5. Thou Shall Not Fire Founders Without Obtaining Releases and Drag Along Agreements.
   If the company fires a founder or significant common stock holder they should definitely work out a separation agreement which not only gets a complete legal release but also gets a drag along on any common shares owned by that founder.  Acquirers are very wary of potential lawsuits from former employees, especially ones that, for one reason of the other, feel like they might be getting screwed by a sale.
6. Thou Shall Not Enter Into Contracts That Create Liabilities More than 2 Years In Duration.
   When big companies buy small companies they want as few complications as possible.  Long term liabilities, such as 10 year leases or long term supplier contracts (which will no longer be needed if the acquisition goes through), usually won’t kill the deal, but they will lead to direct reductions in the price that the acquirer is willing to pay.  With this in mind it makes sense for start-ups to keep most of their agreements to as short a term as possible.  Even if a vendor or landlord is offering a significant discount for a 5 year deal as opposed to a 1 year deal, it actually makes more sense to take the 1 year deal, not only from an M&A perspective but also because start-ups are so dynamic that you never know what you will need 5 years from now.
7. Thou Shall Write All Customer Contracts And Partnerships Such That They Can Be Transferred to An Acquirer And/Or That Such Contracts Can Be Terminated With Reasonable Notice.
   Keeping with the observation that big companies want as few complications as possible, customer contracts and partnerships can cause major problems in some M&A situations.  When a small company is being acquired by a large company, customer contracts can sometimes even be a liability because the large company plans to integrate the seller’s technology into its core products and does not want to support a few random customers on a separate code base.   Similarly, if a start-up has a big distribution deal with an acquirers’ arch competitor that can’t be canceled for the next 2 years that can also kill the deal.  Start-ups should take care to write all of their customer and partner contracts so that on a change of control they have the flexibility to cancel these contracts within a reasonable amount of time.  Similarly, they should ensure that they can transfer all of their contracts to the acquirer without issue 
8. Thou Shall Not Enter A No-Shop Without Hammering Out All of the Key Terms and Conditions of a Sale First.
   Acquirers typically push very hard to get a company to sign a “no shop” agreement as soon as they enter the process.  Sellers will ultimately have to sign a no-shop but you should never sign a no-shop until you are sure that you have agreed on all of the “hard” M&A issues.  The hard issues involve much more than price and include things such as indemnities, escrow, non-competes, management roles/compensation, purchase price adjustments, and timing (to name a few).
9. Thou Shall Not Allow A Buyer to Interview Employees Until At Least An LOI is Signed.
   Most acquirers will try to get as much information as they can without making a formal commitment.  Interviewing rank and file employees seems like an innocuous request but it can be very disruptive.  First, many employees will freak out when they discover that the company is close to getting sold and if it doesn’t get sold they will freak out again thinking “there must be something wrong with the company” because it didn’t sell.  Second, if the acquirer has interviewed all of a company’s employees, there’s a decent chance they may try to poach some of them if they don’t go through with the acquisition.  This is a particular risk if you are a small start-up whose main asset is intellectual property and technology.
10. Thou Shall Discuss Exit Expectations With Management and Board Members Prior to Funding and At Least Twice a Year After That.
    Prior to making an investment in a company VCs should discuss their exit expectations with both the management and the board of the company.  They should do this A) to ensure that the management/board of the company are in fact committed to rationally considering any M&A offers B) that everyone understands, at least at a framework level, what kind of returns the VCs expect and how they are likely to respond to offers at different times in the company’s evolution.   If you never discuss people’s exit expectations until an offer arrives you may be surprised to find out that the founder’s always want to remain independent or that the new professional CEO doesn’t think a sale that makes him less than $5M is “worth his time” or that a late stage investor won’t sell until they reach their “minimum” return target of a X%.  Understanding just what everyone’s expectations are in advance can avoid a lot of wasted time and unpleasantness when a deal actually comes to the table.

If I had to sum it all up I would say that the most important point for start-ups and VCs to consider is that there are lots of things that a company can do over its life that will make a successful M&A exit easier to achieve.  With careful planning and an attention to detail, start-ups can avoid at lot of the pitfalls that usually come back to haunt them only when they are on the cusp of closing what they thought would be a relatively painless deal.

P.S. One of the other speakers at the IBD conference, Brad Feld, a great guy and former partner of mine, is just embarking on a series of posts on his blog detailing the specific terms of an M&A Letter of Intent (LOI).  Anyone who found these ten commandments interesting will probably also find Brad’s posts interesting as they will define in detail (with lots of useful commentary no doubt) many of the terms that I have thrown out in this post such as escrows, indemnities, no-shops, etc.