All posts by Robert Schaul

About Robert Schaul

Email: RSchaul@mccarthyduffy.com
Tel: +1 312 726 6395

Robert Schaul is an associate attorney at McCarthy Duffy LLP. His practice primarily focuses on corporate, private investment and financing matters, including representing start-ups, private equity investors and domestic and international corporations with organizational and capital formation and structure, corporate governance, private placement offerings, mergers, stock and asset acquisitions and dispositions, commercial and private financings and compliance and administrative issues.

Counseling Early Stage Companies: Advance Preparation for the Exit

Representing early stage, high-growth companies often involves supporting a team of entrepreneurs to take a business from an idea, through commercial launch and market penetration, to a successful exit, often through an acquisition by a strategic or financial purchaser.  The speed and intensity of the client’s activity can be tremendous.  Under the pressure of achieving critical product development or revenue milestones – often driven by the client company’s investors – management will sometimes forego certain basic contracting, human resources and capitalisation  management measures.   Unfortunately, these short cuts will surface during the exit transaction, where the acquirer’s due diligence on the target company will spot these shortcomings in order to identify potential risks as well as opportunities to revalue the target company’s assets and business and reduce the purchase price.  The attorney representing the early stage company can streamline the exit transaction and minimise adverse due diligence discoveries by helping the client institute the following four relatively simple disciplines at the company’s outset (or at least at the outset of the counsel’s engagement), well in advance of any merger and acquisition considerations.

  1. Protect and Preserve Company Intellectual Property. For many early stage companies, intellectual property assets can represent the core of the company’s value at exit.  Those assets, of course, are generated by employees and contractors working on behalf of the company.  In the course of the company’s history, employees and independent contractors come and go.  However, sophisticated acquirers will often probe the target company’s files for potential intellectual property “leaks” or gaps – situations where employee or contractor inventions or developments may not clearly belong to the target company.The simple but often neglected solution to this due diligence red flag is drafting and religiously using a standard employment agreement or independent contractor/consultancy agreement with all new employees and service providers. These standard agreements should contain the following basic covenants:I. Confidentiality: Provisions prohibiting an employee or independent contractor from disclosing or otherwise using the company’s confidential information both during the relationship and for multiple years beyond the term of the agreement.ii. Invention Assignment: Provisions indicating that all “inventions, original works of authorship, trade secrets, concepts, ideas, discoveries, developments, improvements, combinations, methods, designs, trademarks, trade names, software, data, mask works, and know-how, whether or not patentable or registrable under copyright, trademark or similar laws” developed during the term of employment or contractor service belong to the company.  This covenant should similarly include an acknowledgement that all copyrightable material is a “work made for hire.”  Note that company counsel should confirm the impact of the applicable state laws on these covenants. For example, the “work made for hire” clause should be excluded from independent contractor/consultancy agreements governed by California law, as California law dictates that individuals subject to this type of covenant in a services agreement may be deemed employees under the California Labour Code .  Avoid the temptation to limit company ownership of employee or contractor developments to only those generated “on company time” or “using company resources.”  This limitation will only act to invite ownership ambiguity – an unnecessary impediment in the acquisition due diligence process.iii. Pre-existing Intellectual Property Disclosure and Licenses: Provisions obligating employees or contractors utilising pre-existing intellectual property in their work for the company to (i) clearly identify the pre-existing IP and (ii) grant the company a perpetual, transferrable license to use, in the course of its business, any relevant pre-existing IP included in works created by the employee or contractor for the company.
  2. Facilitate Shareholder Decisions. The decision to exit the business will naturally require the approval of both the Board of Directors and the shareholders of the company.  Minority shareholders who are no longer associated with the business, or who have a different perspective on the company’s direction and objectives, can seek appraisal rights, demand certain concessions, or take other steps to block or disrupt the transaction.  While reverse merger structures can be used to minimise the disruption caused by dissenting minority shareholders, these structures increase both transaction costs and the potential liability to the target company.The pre-emptive solution here is a basic shareholder agreement, prepared and negotiated when the early stage company’s shareholder base is relative small and cohesive. The shareholder agreement should include the following elements:i. Dragalong Rights. Terms requiring minority shareholders to support and vote with the majority on fundamental company decisions, including a vote to sell the company and/or waive of appraisal rights.ii. Buy/Sell Arrangements. Structures that ensure that the equity interests of disaffiliating shareholders are (or can be) repurchased by the company or the remaining shareholders;iii. Joinder Provisions. Requirements that all new shareholders (including those acquiring their equity interests through the conversion of debt) become signatories to the shareholder agreement.
  3. Simplify Contract Assignment. A major factor in the acquired business’ valuation is the status of its contractual relationships with customers, vendors, strategic partners and other third parties, and how easily an acquirer can continue to take advantage of those contracts following the acquisition. Contracts that include non-assignability clauses – provisions requiring counterparty’s consent prior to assignment – can greatly obstruct this transition, particularly if the transaction is structured as an asset sale (vs. a stock sale or merger). At best, these clauses can delay a closing while the target company pursues the counterparty’s consent, who may see an opportunity to extract a contractual concession from a vulnerable target.  At worst, the target company’s inability to obtain a counterparty’s consent may result in the termination or rejection of the contract by the acquirer, which can reduce the target company’s valuation.Since non-assignability clauses are often a standard part of the “boilerplate” sections of many agreements, and since solving the anti-assignment clause problem once the contract has been signed is difficult, if not impossible, company counsel should help the client implement the following prophylactic measures at the outset of the negotiations:i. Removal: Generally, the absence of a non-assignability clause in a contract allows both parties to assign the contract freely.ii. Change of Control Carve-Out: An exception that eliminates the need for the counterparty’s consent when the contract is assigned to a successor organization in the event of a merger, spin-off, or other reorganization, or any sale to any entity which buys all or substantially all of the assigning party’s assets, equity interests or business can eliminate the issue in an exit transaction.iii. Reasonableness Standard. As a fallback, incorporate a requirement that the counterparty’s consent to a contract assignment may not be “unreasonably withheld.” While this does not eliminate the need to secure the counterparty’s consent, it will impose a baseline legal standard which may facilitate the assignment negotiation.
  4. Maintain Good Corporate Capitalisation Hygiene. While cases of mystery shareholders appearing at the closing of an acquisition transaction are rare, confusion over the accuracy of the capital structure of the target company, as well as the identification of non-compliance with securities laws, can materially disrupt an exit transaction.  Common causes of capitalisation problems most often relate to (i) failing to either register or file a registration exemption with the Securities and Exchange Commission and/or state authorities in connection with the sale of private securities issued by the target company to early investors, which are usually friends and family, (ii) issues involving the company’s equity incentive plan, including unsigned documents, unclear vesting schedules, and uncertain stock repurchase provisions and exercise; and (iii) overlapping and conflicting convertible securities, including securities with conflicting conversion terms or circular conversion formulas. Many buyers will avoid assuming any risks associated with an ambiguous capital structure or improperly issued shares, preferring instead to let the target company identify and resolve discrepancies before closing.As with the other sets of issues described in this article, the preventive solutions are straightforward and, in most cases, inexpensive:i. Comply With Applicable Federal and State Securities Laws in Securities Offerings: Most states and the SEC have numerous exemptions allowing early stage companies to issue securities without the need for a formal registration.  The exemption process, however, often requires the issuing company to file a registration exemption with the appropriate securities regulator. Failing to file a registration exemption may not require the company to register its shares, but it may prevent the company from utilising a “safehabour ” in future transactions, including an exit transaction with another private company.  Filing the necessary registration exemption forms will not only help ensure securities law compliance; it will also provide assurance to a potential acquirer that these registration exemptions will remain in effect in future transactions.ii. Invest in a Commercial Cap Table Management Software. There are a number of quality, low cost software solutions on the market that can help track and automate company cap tables and “date-stamp” capital structure changes, in order to allow for a simple analysis of capitalisation changes and confirmation of issuances.iii. Automate the Effect of Certain Equity Incentive Plan Triggers. For example, if a company’s restricted stock plan provides for the buyback of unvested shares if the employee terminates, the company’s repurchase of those unvested shares should occur automatically.  Relying on the affirmative action of the company (and potentially the memory, or filing system, of the company’s executives) can result in inconsistent equity incentive plan operation and unintended equity ownership.

    iv. Create Pro Forma Models to Reflect the Terms of Convertible Securities. Going through the exercise of translating the terms of convertible securities – particularly where different securities are issued at different times to multiple parties – will help pressure test the conversion terms and validate that they function as intended.

The foregoing measures, designed to minimise exit disruption, are neither difficult nor time-consuming.  In fact, the most difficult task is often convincing the client company to expend the time, effort and resources to implement these disciplines, even years in advance of a potential exit.  As noted above, it is ultimately time and energy well spent.