Are you a startup CEO about to sign an LOI/MOU to sell your startup and you are scratching your head to figure out if the deal makes sense? Below we look at “small print” legal that translate into your money at exit. Our observations are mainly tailored for US style deals but can also be applicable to European deals.
Understanding your startup’s capital is crucial when preparing for an exit. What? This means that you need to verify your startup’s capitalization table against the Board of Directors actions, venture capital financing documents, ESOP as well as stock option grants. You need to verify that the company has enough authorized shares for any conversion preferred share conversion to cover the all fully diluted shares (see our Medium post about fully diluted capitalization here). This should allow you to confirm if the shares of stock have been properly authorized (you might be missing a signature of a director for example). In this step you can also verify if any option is going to accelerate upon the change control. Finally, as CEO founder you want to understand if if your shares are going to accelerate at a change of control. Who? If you are seasoned CEO you can do this yourself or delegate this to your COO. Next Steps? Information should be built into an exit scenario spreadsheet.
THE CERTIFICATE OF INCORPORATION
A review of the certificate of incorporation is necessary to confirm that it, along with all other amendments, was properly filed and executed. What? The certificate of incorporation should be reviewed along side the minute book to verify that required Board of Directors and stockholder approvals occurred prior to filing each amendment to the certificate of Incorporation. Again in the rush to close certain financings there might be a missing signature on a resolution or the certificate was filed without proper authorization. Who? The COO should do this and confirm with company lawyers.
The liquidation preference dictates the payout order in case of a corporate liquidation. What? The liquidation preference should be reviewed to determine whether it will be triggered by the acquisition, (i) how the transaction consideration will be distributed among stockholders, (ii) when and if the holders of preferred stock have an incentive to convert to common stock. Here you need to confirm the investors’ waterfall payments (stack vs. pari passu) and type of liquidation preferences (participating vs. non-participating) and how they translate into exit payouts for the founders, investors and employees. In the US the liquidation preference is spelled out in the company’s charter and European style deals its in the Articles of Association or the investment agreement. Who? CEO should review this with the CFO and/or company counsel. Next Steps? Information should be built into an exit scenario spreadsheet.
The automatic conversion should be examined to determine whether or not the conversion mechanism contained in the certificate of incorporation will be triggered by the acquisition. The automatic conversion provision is mostly triggered by an initial public offering (IPO) or by a specific vote of the holders of the startup. The automatic conversion provision automatically converts all outstanding preferred stock to common stock. As it relates to M&A exit transactions, the automatic conversion is important to the examination of the type and amount of consideration to be given to each stockholder according to their liquidation preferences, and thus should be reviewed in connection to the liquidation preference. If the liquidation preference makes it more beneficial for the target’s preferred stockholders to convert their preferred stock to common stock, then the automatic conversion will be used to convert all outstanding shares of preferred stock or a specific series of preferred stock to common stock. Who? CEO should do this with the CFO and/or company counsel. Next Steps? Information should be built into an exit scenario spreadsheet.
What? Protective provisions in the certificate of incorporation should be analyzed to determine whether or not the acquisition requires stockholder approval. Protective provisions may require a separate vote of all preferred holders as a class to approve an acquisition or may require separate series votes and/or require that a vote other than a majority. Also, these provisions may provide for only an asset sale, which is different from a merger or acquisition, but still involves a significant transfer of the target’s assets. Basically, protective provisions should be analyzed to find out if difficult votes are needed so that the target and acquirer may draft documents or restructure the transaction. Who? CEO should do this with the CFO and/or company counsel. Next Steps? CEO should socialize the initial deal terms with the different classes of stockholders.
What? The bylaws of the startups should be reviewed with a core focus on bylaw provisions that lay out approval requirements of the transaction and the timeline for obtaining such approvals. Many times, the bylaws are an orphaned child after the incorporation process and reappear as a priority in the M&A context. Who? The startup’s counsel should alert the CEO of abnormal notice provisions for board meetings or stockholder consent to ensure that timing expectations properly set.
What? Stockholder agreements should be examined to determine what their rights are, and which stockholders may be affected. Referred to as investor rights agreement, these agreements provide rights that “drag along” votes that are useful to obtaining votes required to approve the merger. Drag-along provisions must be verified and summarized by counsel. Investor rights agreements should also be reviewed alongside financing documents to verify that all the documents have been properly adopted and amended by the Board of Directors and stockholders of the startups. Again, missing signatures can be an issue here. Who? A review of these agreements will help the CEO ascertain whether or not the required number of investors and founders, signed each document and the amendments to those documents. It might also be important to determine if the investor rights agreements terminate automatically or if they should be terminated at the closing of the acquisition.
It is very easy to get tied down in trivial details and get distracted from relevant issues. The key is to look at each document with a view to identifying the issues that are key to the M&A transaction, prioritize these issues, and decide how the document will affect the acquisition as well as the combined company.