By Alon Harnoy Esq. and Moty Ben Yona, Esq.

The sale of a venture-backed company symbolizes the conclusion of a long journey. After conceiving a commercial idea, devising a business plan, building a management team, going through rounds of investment, creating an engine to produce revenue and profits and finding a willing buyer to take it all over, the founders can finally celebrate their epic triumph – or can they?  In the case of a company that has gone through one or more rounds of venture capital financing, an exit in the form of a sale does not necessarily produce home run returns for the founders and senior management of the company.  While such a scenario is possible, we have witnessed cases when this realization was only discovered during the pendency of an M&A transaction resulting in constituencies of selling shareholders reassessing their support for the deal.

In this article, we explore how founders are often so eager to receive venture capital financing during early stages of their company’s development, that they do not fully assess the consequences of issuing participating preferred stock on their actual returns from a sale of the company.  The practical advice we wish to dispense here is (i) founders, initial investors and senior management of a company should be well aware of the dilutive impact of venture capital finance rounds on their interests in the company and proceeds from its sale, and (ii) all shareholders should be well aware of the various hurdles of sale consideration that must be achieved before different classes of equity receive proceeds from such sale.  We wish to note that some of the practical considerations described herein are geared more toward advising company founders or senior management, as opposed to venture capital investors, as we have seen such parties caught unaware during M&A exits.   We recognize that there may be cases where venture capital investors can and should obtain the preferred returns described herein, and when we represent venture capital investors we often recommend they obtain such preferences.

Shareholders considering a proposed venture capital investment round for their company should take into account the proceeds to be received by shareholders in a future sale transaction, while giving effect to the preferences provided pursuant to the proposed venture capital round.   In addition, following the closing of such a venture capital round, company management should maintain capitalization spreadsheets that demonstrate allocation of sale proceeds among the classes and the shareholders, as it is important that seller parties realize exactly how sales proceeds are distributed among themselves in determining whether an offer is adequate.It is important to remember that the investment agreements of the last round of a company’s financing, will govern the manner in which the proceeds of a future sale transaction will be distributed among its shareholders.  Accordingly, it is necessary to analyze and understand the terms the venture capital investors are to receive for their investment including their “liquidation preference” and whether their preferred stock is a “participating preferred stock”.

A sale of a company is customarily defined as an “M&A Event” or a “Deemed Liquidation Event”, which triggers the “Liquidation Preference” clause in the company’s certificate designating the rights of its preferred stock. In most cases, assuming there are adequate sale proceeds, the Liquidation Preference clause will provide the holders of preferred stock (principally the venture capital investors) with rights to receive sale proceeds prior and in preference to any distribution to the founders, angel investors, management and the remaining holders of common stock.  Investor-friendly agreements will provide the holders of preferred stock with the right to receive a preference amount equal to one, two or even three-times the amount invested by such holders, as well as any cumulative unpaid dividends.  In addition to the customary liquidation preference, investor-friendly agreements might provide investors with “participating preferred stock”, which would allow them to additionally participate on a pro-rata basis with the holders of common stock in any remaining distribution. Therefore, investor-friendly agreements can provide preferred investors a “double-dip” of company sale proceeds, first in the form of a preference, and second in the form of a right to participate together with holders of common stock on remaining proceeds.  While company founders and management are often eager to receive venture capital investment at the time it is funded, this double-dip for the holders of preferred stock may drain most of the proceeds from a prospective sale, leaving very little remaining for founders and management.

There are various ways to protect the interests of holders of common stock in the proceeds of a future sale during a round of investment.  For example, in cases where the holders of preferred stock are provided with participation rights, it is possible to cap or limit the participation right to a certain amount in order to ensure that the founders and the holders of common stock will have a reasonable share in the proceeds of the sale after the payment of the preference amount to the preferred holders.

However, in many cases, limiting the second-step participation amount of the holders of preferred stock will not provide a comprehensive solution for the holders of common stock. In some cases the relatively high preference amounts awarded to the preferred holders in the first step may lead to a “liquidation preference over-hang”, which will limit or perhaps even prevent the holders of common stock from participating in the distribution of company sale proceeds.  A “liquidation preference over-hang” occurs when the aggregate amount of the liquidation preference exceeds the actual value of the company. In such cases, holders of common stock, which include founders and management, would receive little or none of the proceeds generated by the sale of the company.

Although theoretically the value of the company can be increased over time and solve a liquidation preference over-hang problem, the main concern for holders of common stock, is a possible sale of the company during the “liquidation overhang period”.  Management of a venture backed company should be familiar with the liquidation preferences of a company’s holders of preferred stock and whether an actual or projected valuation of the company in a possible sale transaction would cause a liquidation preference over-hang problem to exist.

In cases where a liquidation preference over-hang exist, we have seen solutions involving the adoption of a “carve-out plan”, which ensures that a certain percentage of the total sale proceeds be distributed to specified persons (such as founders and certain key employees) prior to the distribution of the preferred stock liquidation preference.  In order to protect the interests of the holders of preferred stock it is possible to establish a “basket” and determine that no amount will be distributed under the carve-out plan in the event that the total sale proceeds fall below a specified amount.  Similarly, it is possible to set a “cap” for distributions under the carve-out plan, to ensure that distributions to the founders or company employees- will not exceed an agreed amount.

Some carve-out plans foresee a reasonable possibility that a potential acquirer will require that the acquisition agreements will include a “retention provision” with respect to key employees to make sure they remain employees of the acquirer after the closing of the sale transaction.  Therefore, some carve out plans require that the employees participating in the plan will remain employees of the acquired company as a pre-condition for distributions under the plans.

In conclusion, a sale of a venture backed company requires planning and an understanding of the key elements likely to have an effect on the distribution of sale proceeds to the shareholders.  In order to best serve the interests of shareholders in a future sale transaction, founders and management are advised to consider the implications of a proposed venture capital round on such future sale transaction at the time of negotiating their investment agreement and well in advance of the actual sale of the company.

Leave a Response