Tuesday, August 26, 2008

What really happens in an acquisition

Money is almost out, but there is light at the end of the tunnel. A last minute offer has come in to acquire the company and it looks like everyone will survive to fight another day.

Rewind 6 months to the painful realization that the company should not be funded again and needs to find a buyer. Should they engage a banker? (need another Blog on this). How many months did the investors & founders spend arguing over the liquidation preference and management carveout?

Typically, when the market is poor, management teams negotiate a carveout in the event of sale to overtake the liquidation preference of the investors and assure the team of some return. What’s interesting about this situation is how common it is and how it is reversing the urban myths of VCs reneging on deals. In this case management is reneging--they took the investor’s money and promised a return, agreed to preferences, probably participating preferred and liquidation, maybe anti-dilution to boot--so what’s going on here!?!

Do contracts mean nothing? Damn, sue them!!!

The only people I know who shout that are people who have never been involved in a lawsuit. Generally it's the battle cry of a fool. So the team gets a management carveout of typically 10%. I’ve seen many months wasted in this type of negotiation but it always seems to end up at 10%. I’ve also seen management argue that the investors shouldn’t get any of the earnout in the deal, unless the investors beat them to it with the argument that investors should get all their portion of the earnout up front since they have no control over the team’s ability to deliver the earnout ;-(

So let's look at what happens when the investors don’t negotiate an carveout--the acquirer has acquisition costs--the price he pays for the company, and the retention bonus for the team. If the acquirer can roll the latter into the deal price it’s a better position for them. Finisar did a number of acquisitions in the telecom downturn, and I can't think of one where they didn’t override the VC imposed carveout structure with something more suitable to the acquirer to reward the team. Earnouts rarely went to the investors, and new carveouts were imposed to reward the team and keep them in place. The counterpoint to this is obviously getting the deal done--in a competitive environment the buyer has much less chance to impose deal structures.

The upshot of all this is very simple--as an entrepreneur you can spend an inordinate amount of time negotiating complex deal structures and fretting valuation, and likewise the investors can impose all types of downside protections. But in the end value is generally rewarded. So despite liquidation preferences, anti-dilution, and a host of other issues that probably cost 6 months of painful negotiation, in the end the buyer decides who gets what.

The team is most of the value in a deal, and if they don’t get rewarded the deal doesn’t happen. So while all the power may seem to reside with the VCs because they have the money, in fact it resides with whomever delivers the value. At the time of initial funding the value is mostly the $, but once the company is established that power shifts ;-)

2 comments:

Anonymous said...

I think it's a pairing of 2 sides that need each other. Unfortunately, some innovators don't know their value and let VC's think they have more power than they really do. Without entrepreneurs, inventors and innovators, VC's are just getting 5% at the bank.

Anonymous said...

Larry, this seems a timely subject seeing Arasor's fortunes on the ASX slide. Will a CEO/Funder/Founder pair like Simon Cao and yourself ride out the current rough patch, no matter what, and if you don't, how do you manage pulling up stumps on such a venture while maintaining your professional and VC's reputation. Is it viable to find a buyer for Arasor in its current state, or was spinning out the PPLN fab the first signs of an impending implosion?