Preparing a VC-Backed Company for an Exit Event
By Stephen M. Callegari, Stefan Jović
Initial public offerings (IPOs) and M&A exits are the two most common means of achieving liquidity in a private company. This article addresses an acquisition transaction, which requires preparation and oversight that many founders and managers need to learn as they go. Although getting to an M&A exit event is by no means a guarantee, nor is it the desired path for every founder, there are several things that founders and the company management team can do to ensure that the M&A process goes smoothly.
Internal Agreement on a Sale
The first priority is forging an internal agreement among the company’s management and investors to start the sale process. The following are questions that should be answered as a company undertakes an M&A process:
Would the founders resist ceding control of the company they started or be excited about the opportunity to cash in on all their hard work?
Are there any employees who are key to running the business? How would the employees feel about potentially joining a larger organization? Would they be excited about the opportunity, or would there be issues with retention?
How about the company’s investors? Venture funds are driven largely by where they are in the fund’s life cycle and by overall fund performance. An M&A process is sometimes necessary because the investors have clearly messaged that there is no further appetite to continue to fund the company. Even if that message hasn’t been delivered, it makes sense to consult your key investors early on to see if they are interested in an M&A exit and, if so, at what purchase price/level of return.
Initiating the Process
Although M&A opportunities may arise opportunistically, M&A activity typically is driven by the market. All things being equal, sellers typically prefer to sell during favorable market conditions when there are typically multiple bidders, higher valuations and more favorable terms, thus maximizing the consideration received by the sellers.
Timing the M&A market, like trying to perfectly time any market, is a nearly impossible task; however, there are steps founders and management teams can and should take. Perhaps the most important is proactively managing the company’s burn rate. Generally, you can expect the sale process to take anywhere from 6 to 12 months. So, while a company should be looking at doing their next round of financing with 18 – 24 months of burn left, once a company has only 12 months of burn remaining, then management should begin dual tracking an M&A exit event and a financing. Doing so provides greater negotiating leverage and, more importantly, also helps prevent a distressed sale down the road.
The M&A Team
Once the timing is right and there is sufficient support to begin a sale process you will want to identify the team that will help guide you through the sale process. In addition to company management, an investment banker and the company’s financial and legal advisers form the core of the M&A team.
Legal Team — Experienced legal teams serve as the “quarterback” for most deals. They will help ensure a deal progresses and that the company and sellers are protected (so you can keep the proceeds you make from the sale). It is critical that a company’s legal team has experience in M&A and understands the company’s business and potential legal pitfalls. The legal team should be one of the first advisers you bring on, and they should be involved in negotiating an engagement letter with the investment banker, reviewing term sheets from bidders, assisting with sell-side legal diligence, negotiating the purchase agreement, and ultimately guiding the deal to a successful close. Legal counsel can also help management maintain proper corporate records and clean up any issues identified as part of the transaction.
Finance Team — On the financial side, a combination of an experienced CFO/controller and a regionally or nationally recognized accounting firm can preempt any red flags in the financial diligence phase. Having audited financial statements and using generally accepted accounting principles (GAAP) or another recognized accounting methodology provides financial transparency and can help maximize a company’s valuation. Financial advisers can also effectively address other thorny deal issues, such as taxes and working capital calculations. Financial statements that deviate from buyer expectations, which are typically grounded in GAAP standards, can cause a deal to unravel.
Investment Banker — If a company is running a bidding process, it is best to engage an investment banker to prepare the marketing materials, solicit bids from potential buyers, and engage in negotiations.
Legal Housekeeping
Outlined below are some key legal housekeeping considerations that management will want to be aware of to avoid triggering any red flags or requests for special indemnities by a buyer as a result of legal diligence findings. In-house legal counsel and external company counsel can assist with all of these, and it’s generally best to handle this cleanup early in the M&A process.
Cap Table Management – Maintain complete records for each equity issuance, which helps prevent rogue founders or investors from surfacing during the deal or post-closing and demanding a cut of the pie.
Option Issuances - Any option issuances should occur before a term sheet is signed in order to take advantage of a lower stock valuation. Once a term sheet is signed, options lose most of their benefit because they will likely be close to the price paid by the buyer in the M&A transaction. An employee bonus plan should be considered if there is a need to provide additional compensation after the window to issue options has closed.
Internal Data Room – Start preparing for the diligence process by organizing documents, such as formation documents, company minutes, board consents, and customer and supplier agreements, in an internal data room. Ensure that all agreements, including commercial agreements, have been properly executed by the parties and renewed, where applicable.
Reviewing Agreements – Review the main commercial agreements for any notice and consent requirements that would be triggered by a contemplated transaction structure. For example, if the sale is structured as an asset sale, anti-assignment provisions will be triggered. Review organizational documents for requisite stockholder consent to preempt any problems at the deal stage.
Intellectual Property – Make sure trademarks and patents are properly registered and any renewal deadlines have been calendared. Ensure that employees and independent contractors have signed invention assignment agreements.
Compliance with Regulatory Regimes – Buyers increasingly focus on a start-up’s compliance with evolving privacy and data security regulations, as well as other applicable regulatory regimes. Work with counsel to maintain an appropriate privacy policy based on the company’s operations and other internal mechanisms to comply with relevant regulations. Ensure that all blue-sky securities and other corporate filings have been made.
The Term Sheet
Typically, the more inbound interest a company receives through multiple indications of interest and term sheets, the more advantageous its bargaining position is. Where there is sufficient interest, it may be beneficial to run an auction process; this is typically run by the investment banker. In this process, the company will put out a bid draft purchase agreement and disclosure schedules and would, in turn, expect to receive both a term sheet as well as a markup or comment memo to the purchase agreement by potential bidders.
While economics (i.e., the purchase price and payment terms, including any potential earnout consideration or rollover equity requirements) often drive the ultimate choice of counterparty, it is important for the company to review any term sheets received (and any markups to the bid draft purchase agreement if running an auction process) with their legal counsel to ensure that the appropriate protections have been negotiated for and no off-market terms are being agreed to at the term sheet stage. Once a company enters exclusive negotiations with a potential purchaser it loses much of its negotiating leverage, and it is very difficult to undo anything agreed to at the term sheet stage.
Conclusion
The M&A process can take anywhere from several months to a year. While the outcome can be very financially rewarding for the founders and investors of a venture-backed company, preparing for and engaging in the process is demanding. Starting early with the proper mix of financial and legal advisers, being on top of legal housekeeping, and diligently negotiating the term sheet can simplify the process and lead to a very rewarding outcome for all parties involved.