The option pool is the amount of common stock a startup reserves (typically at each series of financing) for future issuances to employees, directors, advisors, and consultants.
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.
I previously mentioned that convertible debt is a good way to raise capital for most startups. The main reason why convertible debt is beneficial for startups is that it delays coming up with a valuation figure at the seed stage–the valuation conundrum is essentially punted to the Series A (or “qualified financing” stage).
But what happens to the convertible debt if you sell rather than raise capital?
In most situations, the investor will receive more than the interest due + principal balance of the loan. I’ve seen anywhere from 1.5X-3X the outstanding principal amount of the loan due the investor upon the closing of the “change of control” event. This 1.5X-3X payment is, of course, made in full satisfaction of the startup’s obligations to the convertible debt investor.
In this unique situation, your startup essentially skips the “qualified financing” and goes straight to the exit. If the convertible debt investor wasn’t able to enjoy the upside in the event of an acquisition, such investors would be more reluctant to invest this way (and you’d be left to grapple with the valuation debate). Or worse, the investor would demand a higher interest rate. Or much worse, they would require their consent to prepay the convertible note before the qualified financing or maturity date of the loan.
It looks as though private equity buyers better get used to seeing reverse breakup fees and other seller-friendly provisions in their merger agreements.
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.
A new online marketplace for buying and selling companies officially launched this week: BizTrader.com.
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.
The business purchaser needs to ascertain if intellectual property rights are needed for the continued operation of the business. Intellectual property rights that are important include trademarks, copyrights, service marks, and trade names.
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.