By Don Keller (Partner, Emerging Companies Practice in Silicon Valley, Orrick, Herrington & Sutcliffe LLP)
It used to be that when entrepreneurs started their companies, the idea of going public and making it big was on top of every founder or CEO’s checklist. Nowadays, it seems that startups are constantly looking to build a great product that will attract the most users and then cross their fingers that the Googles or Microsofts of the world will acquire the company (or the team). I gave a presentation yesterday at RocketSpace, an accelerator for seed-funded technologies in San Francisco, about best practices and top mistakes companies make during acquisitions. So for those of you who are interested in going down that route, here are some things to note as you prepare your company and team for the road to acquisition-ville.
1. Founder Equity – Make sure founder equity is held in the form of shares, not options. Shares allow founders to get all of the appreciation taxed at capital gain rates, whereas options typically result in the appreciation being taxed at ordinary income rates. This can make a huge difference in the amount of take home pay.
2. Protect Your IP - One of the biggest mistakes companies make in the early stages of their development, is not dotting all their i’s and crossing their t’s when it comes to protecting their intellectual property. Make sure that when IP is involved, you work with a good lawyer to ensure that your IP is not owned by a former employer and that all of the IP has been properly assigned to the company. The last thing you want is for your company to take off and then get hit with a notice that your IP is not actually your IP.
3. Keep Your Options Open – To maximize your price, companies should leave themselves with alternatives to the buyers they are targeting. You want to make sure that you’re not selling yourself short and putting all your eggs in one basket. This does not make for a good negotiation strategy and is less likely to get you the best price. If a buyer knows that you have only one alternative, the price will fall like a rock.
4. What to Avoid Selling – Avoid selling the company for private company shares in a transaction that is taxable. There is typically no market for private company shares so getting someone else’s private shares in an acquisition and having to pay tax on those shares, leaves you with an out of pocket cost and nothing to show for it other than some shares you cannot sell. If the transaction is properly structured, the receipt of the buyer’s shares can be nontaxable (at least until you sell those shares) which is what you want.
5. The Art of Negotiating – When negotiating on price, make sure you understand all of the adjustments to the price such as escrows, legal fees, balance sheet adjustments, and special indemnities. Once you sign the 60 or 90 days no shop agreement, the buyer has all the leverage. You don’t want to learn at that point that the price they said they would pay is before massive deductions. It’s important to negotiate the terms right out of the gate so there are no surprises when it comes time to seal the deal.
6. Open Source – Make sure you understand open source and how it’s used in your product. Always double check to make sure that you have complied with the open source license terms. It doesn’t happen often, but every now and then, this can be a deal breaker for buyers.
7. Keep Up with the Kardashians…I mean Housekeeping – Do not, and I repeat, do not wait until the last minute to catch up on cleaning your minute books and stock option pricing (409A issues). It is important that your documents are maintained and updated on a regular basis. If you wait until the last minute, it can create unnecessary headaches and disorganization. The last thing a buyer wants to see is a company that can’t keep their documents up to par.
8. Don’t Wait Until the Last Minute – Rolling over from #7, another important thing to note is that you shouldn’t leave the negotiation of employment and non-compete agreements until the last minute. These are things that should be brought up as soon as discussions begin. Time and again, these agreements are negotiated at the last minute with lots of pressure on the founders to sign and be happy. Don’t let that be your situation.
9. Be Wary of Earn-Outs – Earn outs are a lawyer’s dream. They almost always end in disputes about whether the buyer tried hard enough to generate revenue to meet the earn out thresholds. Don’t count on any earn out payments and negotiate accordingly.
10. Pay Attention to Your Board Members and Investors – It’s very important to listen to what your board members and investors are saying during this time. You want to keep an ear out for biases for or against a sale and also take heed to strategic investor reactions to a sale.
There is no full proof way of being certain that by following the advice above, the road to acquisition will be an easy route. However, best practices can provide entrepreneurs a clearer path and hopefully increase the likelihood of your company’s success.
About Don Keller: Don is a Partner in the Emerging Companies Practice at Orrick’s Silicon Valley office. He advises emerging companies, public companies, venture capital firms and investment banks and has represented clients on more than 60 public offerings, 75 acquisition transactions and several hundred venture financings. Don has worked on transactions for companies including Apple, Google, Oracle, and Rambus and represents clients such as eHarmony, OPOWER, and LS9, among many others. For more information, you can visit his full biography.