For example, if a startup has 5,000,000 shares of common stock outstanding immediately before the Series A round, a condition of the Series A round may will be the creation of an option pool, likely in the 10-20% range of the post-financing fully-diluted capitalization.

At the Series A round, the option pool only dilutes the founders and not the new investors, since the option pool is put into the pre-money. The higher the percentage, the greater the dilutive effect for the founders.

After the Series A round, as the startup develops and adds human capital, it will use the option pool reserve to provide equity compensation to such hires.

If the startup gets acquired, what happens to the unissued amount left in the the startup’s option pool ?

The answer is pretty intuitive — the unissued options get wiped out. But this is still probably a relief to some founders, since founders suffer a dilutive effect from the entire option pool when raising capital.

-No Shop or Go Shop Clauses: Can a party shop the deal to 3rd parties or is it prohibited?
-Expenses: Determine which party pays for (legal) expenses and which party’s counsel drafts the transaction documents.
-Confidentilaity: Keep the existence of the term sheet and contents confidential.

If a term sheet is not binding, then why draft one?

It’s a good starting point to help all parties involved define the deal, in addition to providing some safeguards if the contemplated transaction falls through during negotiation. Finally, if you can’t agree to a term sheet, it’s probably not worth proceeding with due diligence investigations along with drafting the transaction documents.

TheDeal.com details how reverse breakup fees are becoming industry-standard provisions in private equity LBO deals in a new article called “Desperately Seeking Certainty:”

Starting with the 2005 sale of Neiman Marcus Group Inc., LBO merger agreements often included a “two-tier” breakup fee, in which a buyer would pay a lower percentage in the event it couldn’t obtain financing and a higher one if it decided to walk from the deal in the absence of a contractual right to do so, such as a so-called material adverse effect at the target.

The McDermott and Debevoise lawyers found that those provisions remain standard. “All of the going-private deals signed since last October have explicitly provided that the seller will have no right to force the closing,” Schmidt wrote. “At least one deal did allow the seller the right to seek specific performance of the financing covenant, but for most, the only remedy if a buyer refuses to chase its lenders would be a claim for damages.”

Paul Shim, an M&A partner at Cleary Gottlieb Steen & Hamilton LLP, agrees: “The merger agreements in the deals that have been done since the bubble burst have largely followed the reverse break fee, no-financing condition, no-specific-performance paradigm.”

The article also mentions these deals are now coming with a greater level of contractual clarity regarding the buyer’s right to specific performance (i.e., forcing the private equity firm to close the deal) thanks to the decision in the collapsed buyout of United Rentals Inc. Although the Delaware Chancellor ultimately found in favor of the buyer (Cerberus Capital Management, LP), private equity firms are now making sure their deal documents clearly state the target does not have a right to specific performance:

The run of collapsed deals has led some observers to predict that sellers would demand greater contractual certainty from PE shops in merger agreements, but so far that hasn’t happened. Instead, sellers have gained some of the certainty they seek from more secure debt and equity financing arrangements while PE buyers have become more vigilant in rooting out dangerous ambiguities in contracts.

Of course, reverse breakup fees and other seller-friendly provisions may fall out of favor with the LBO market once the credit situation comes around. But until then, get used to them.

Read the entire thedeal.com article here.

What is a “reverse breakup fee?”

A reverse breakup fee is paid to the target company when the buyer backs out of acquiring the target. If the acquirer fails to close the acquisition because it can’t obtain financing, the reverse breakup fee provision is triggered. (Traditionally, acquirers insisted on including “financing out” clauses allowing them to decline to close acquisitions–without penalty–if they couldn’t obtain the necessary financing.)

What’s the reasoning behind reverse breakup fees?

Target companies believed that acquirers should share the risk that the proposed (and public) deal did not go through. These risks for target companies include:

(1) securities class action lawsuits;
(2) disruption of business operations; and
(3) the potential for an unstable set of management/employees.

Therefore, as acquisition targets gained bargaining power relative to their acquirers over the past few years, reverse breakup fees were increasingly inserted into acquisition documents to re-allocate such risks. According to Factset MergerMetrics, 76 percent of all going private deals involving U.S. target companies included a reverse breakup fee provision.

How much are typical reverse breakup fees?

Reverse breakup fees usually range between 1 to 3 percent of the acquisition price. That may seem like a nominal amount, but keep in mind 3 percent can be a massive dollar amount for private equity deals.

Do reverse breakup fees have any place in smaller acquisition deals?

While reverse breakup fees are found in private equity/leveraged buyout deals, they have a place in smaller deals. At a minimum, small targets also risk that a proposed acquisition will disrupt business operations and negatively affect management/employees (2 and 3 above). And one could argue that a smaller target would suffer more on the operations and personnel side compared to a larger company. Additionally, its inclusion could help entice smaller targets to enter into a proposed acquisition. The tradeoff is that increased language in acquisition documents may scare off the buyer or seller.

I believe BizTrader will be a strong competitor to the current company marketplace juggernaut, BizBuySell.com. Both BizTrader and BizBuySell charge customers monthly fees to list their business for sale starting at $39.95 per month for BizTrader and $59.95 per month for BizBuySell. Both also offer ancillary services, such as valuation services and help finding financing opportunities.

BizTrader will compete with BizBuySell by taking a global focus and pushing its listings with broad search-engine exposure. For an extra $20 a month ($59.95), BizTrader will promote your listing to broader search services like Google, Oodle, and Craigslist.

BizTrader also looks to be a step ahead of BizBuySell when it comes to referring professional help to their customers, such as accountants and attorneys. BizBuySell referrals seem to be limited to business brokers.

Check out BizTrader and let us know what you think.

While the LOI was “non-binding” in every way (and the seller kept repeating that), that wasn’t reason enough for my client to proceed. Basically, my client didn’t want to push forward without knowing more terms. And I can’t blame him. Why start the acquisition process without sufficient knowledge of basic terms?

I assume the seller was either not that serious about selling or is trying to gauge a potential buyer’s interest, but either way you run the risk of alienating potential buyers.

All of these IP rights are assignable. For example, the ownership of a copyright may be transferred in whole or in part by any means of conveyance. In addition, any of the exclusive rights included in a copyright may be transferred and owned separately. The owner of a trademark, service mark, or trade name may assign the mark or name or may license or franchise another to use the mark or name. An intellectual property assignment vests title and all right in the mark or name in the assignee, in contrast to a license or franchise that transfers only limited rights of use of the mark or name without transferring title.

Some intellectual property rights will obviously be needed to continue business operations. But it’s always a great idea to determine the intellectual property issues and obstacles during the due diligence period rather than post-close.

The letter of intent will set forth the proposed deal structure, price, payment terms, and other general terms–a transaction summary. But more importantly, the letter of intent spells out the preconditions to closing the deal, such as due diligence process issues, purchase agreement construction, and any nondisclosure requirements.

Most of the time, the letter of intent does not create a binding obligation for the parties to do the acquisition. But that doesn’t mean a non-binding letter of intent is a document without a purpose.

Blog selling is once again a hot topic. Most articles deal with what multiple of revenue or subscribers a blog will sell for on the open market. This article, however, will show you how to get the high end of any valuation formula or method. All you have to do is use a dash of corporate M&A strategy.

To fetch a high price for your blog (other than taking an unsophisticated blog purchaser to the cleaners), you must copy how the corporate world would handle a similar acquisition. The corporate world would:

(1) Stay around to blog after the sale; and

(2) Use an earnout provision in the blog sale agreement.

STAYING AROUND

In the corporate world, business buyers are concerned revenue will suffer after the purchase. If a buyer cannot reduce the risk of a post-purchase revenue dip, the seller will not get the company’s full valuation. The buyer will simply discount the valuation and pay the seller less.

Key personnel loss is the main reason why companies suffer post-purchase revenue dips. Obviously, a blog’s loss of its blogger fits right in with this scenario. A blogger is the de facto key personnel of its blog.

Corporate buyers typically require key personnel to stay around and work for a specific duration as if the purchase did not take place. This helps reduce the buyer’s risk of a post-purchase revenue dip, as the company can hopefully achieve a seamless ownership transition by the time the key personel leaves.

The blogosphere has generally realized that staying around is a good idea for the blog seller. And I’m seeing that some bloggers do stay around after the sale. For example, Blogging Fingers just sold and the selling blogger will stay on for at least one week. But one week is not long enough to achieve a smooth transition of ownership and adequately reduce the risk for potential losses. I recommend that a selling blogger stay around for at least 3 months, and if possible, 6 months. 6 months may seem like forever in blog time, but keep in mind that corporate earnouts (see below) can last for several years.

So if a selling blogger agrees to stay around after the purchase, what will ensure that he or she will put forth the same effort into the blog post-sale? And why would the selling blogger want to stick around for up to 6 months?

THE EARNOUT

An earnout is a type of business installment sale under which the final purchase price is not fixed—it is contingent on the company’s future performance. Earnout agreements are often used to resolve disputes between a seller’s asking price and a purchaser’s valuation.

Earnouts are particularly useful when the seller has a limited history or unproven, but promising prospects for revenue generation. (Sound like your blog?)

This is how a basic earnout transaction works:

Step 1: The buyer makes an up-front payment to the seller. This payment is accompanied by the buyer’s promise to pay an additional amount if the company reaches certain goals.

Step 2: The seller continues to work as if the company purchase never occurred for a specific time frame.

Step 3: At the end of the term (or at various intervals), the company’s performance is evaluated against the goal provisions of the earnout clause.

Step 4: The seller stops working for the company and receives additional amounts if the earnout’s goals were met.

WHY THE EARNOUT IS PERFECT FOR BLOG SALES

The use of an earnout when selling a blog has advantages in addition to providing the monetary incentive for the blog seller, including:

(1) The buyer’s initial guaranteed investment in the blog is reduced, as is the risk it assumes (buyer only pays more if the blog makes more);

(2) The buyer may find the purchase will pay for itself out of future profits;

(3) The buyer and seller will reconcile their differences over the blog’s valuation and purchase price (e.g., if future revenue is low, the final purchase price will be low; if future revenue is high, the purchase price will be high); and

(4) The seller may be able to obtain a much higher purchase price than he or she would have obtained if an earnout was not used.

One scenario where the earnout provision can be put to good use is when the blog to be purchased is generating some serious traffic or has many subscribers, but has not fully monetized for whatever reason.

Keep in mind that the goals of an earnout provision can be tied to other factors than revenue. There’s no reason why subscribers or unique visitors could not be substituted for or used in addition to revenue.

While the earnout is a perfect way to handle a blog sale, I’m not aware of any blog selling sites that allow blog sales to be structured with an earnout. Sitepoint doesn’t even mention anything about staying on board in their FAQs about selling a website. It’s somewhat understandable, however, because earnouts can sometimes be difficult to set up. Yet they are well worth the hassle for both seller and buyer.

CONCLUSION

If you are selling your blog, you must realize that you have just entered the corporate world. Thus, you have two choices: (1) stay around after the sale, use an earn-out provision, and get paid for all your blog is worth; or (2) allow someone to purchase your blog at a discount, thereby wasting a large chunk of your blog optimization efforts.

##UPDATE: This post was chosen to be published in the February 2008 issue of the Texas Bar Journal. Check out how it looked here (PDF format).

Typically, large acquisition targets like having a go shop provision because it allows their board of directors to fend off shareholder criticism for not obtaining maximum price for the buyout. For example, a go shop clause was used when Kohlberg Kravis Roberts & Co. bought First Data Corp., the world’s largest processor of credit-card payments, for about $25.6 billion in one of the largest leveraged buyouts ever. First Data had 50 days to seek out higher bidders under the go shop provision. However, the use of go shop provisions is not limited to these mega deals.

Small acquisitions can also benefit by using go shop clauses. The small target company may not have a million shareholders to please, but there will likely be a valuation disagreement amongst the target’s co-founders.

Inevitably, one co-founder with caviar dreams will come up with some sky-high valuation based upon another (dissimilar) deal or some (unscrupulous) business broker’s pitch.

In reality, the valuation is what the market will actually pay for the company. The go shop clause ultimately accomplishes this task. After sufficient time on the market, the target’s co-founders should now understand what their company is really worth, and more importantly, they should all be on the same page.

Therefore, when acquiring a company, allowing your target to shop around can actually increase the chances of an acquisition, depending on the circumstances.

It may not seem natural to include LBO talk in this Startup Lawyer Blog, but I believe every entrepreneur should be aware of such a strategy. LBO transactions can be a way to grow your companies–or sell them.

Three main issues arise in drafting the basket clause:

(1) Size–Typical basket amounts are in the 1 to 2 percent range of the purchase price, but amounts up to 5 percent are not out of the ordinary.

(2) Which party absorbs the amount below the basket amount? (For example, if a basket amount is $300,000 and the damage is $500,000, is the seller responsible for the entire claim or just the amount in excess of the basket, i.e., $200,000?) Typically the acquiring entity absorbs the amount up to the basket amount.

(3) Are individual claims aggregated to satisfy the basket amount? (For example, let’s say the basket amount is again $300,000, but in this case four different claims add up to the $500,000 amount. Is the basket amount satisfied?) If you are the seller, you do not want any small claims aggregated and quite the opposite if you are the purchaser.

All of these issues should be contemplated, negotiated and then drafted into your acquisition agreement’s indemnity clause.

Sellers should find this clause acceptable, but be prepared for them to counter with a time limit for the no shop. The seller doesn’t want to be tied up forever and will hope the time constraint gets you going faster so that the deal won’t fizzle.

The earnout is useful when buyer and seller do not agree about the company’s future profit stream. A buyer should be willing to pay a higher price for greater future profit, if realized, allowing the seller to get paid the company’s full value as the seller represented at the time of the deal.

Two factors must be considered to answer this question:

(1) Your capacity. You are an attorney (not an I-banker). That law-school corporate finance elective or that undergrad finance degree might have defined “leverage,” but it likely fell short of detailing highly-leveraged transactions. Realize you don’t have the background to comment on the particular deal’s finances–and that your client probably hired someone else to do just that. And if your client hasn’t hired this financial guru (the bank financing the deal doesn’t count), suggest your client find one immediately.

(2) Your role. You are an attorney (and a counselor). While you may not have the background to evaluate the acquisition’s financial terms, the better attorneys consider more than just their clients’ legal well-being. Thus, a question like “How do you feel about the financing terms?” could start an invaluable conversation for both you and your client.

In most cases, the parties will expressly state that all information is confidential unless otherwise provided and that the obligation of confidentiality survives the term of the letter. Additionally, the parties should agree to the level of confidentiality that will be required regarding the terms of the letter of intent, the ongoing negotations, and any other information deemed confidential.