Sellers Alleged Breach of Stock Purchase Agreement Did Not Excuse Buyer in M&A Transaction from Its Own Performance

Guest post by Philip D. Amoa, Associate – McCarter & English, LLP

Original Title: Delaware Law Updates: Sellers Alleged Breach of Stock Purchase Agreement Did Not Excuse Buyer in M&A Transaction from Its Own Performance; Right of Set-Off Did Not Apply to Unliquidated Claims

According to the Merriam-Webster Dictionary, the word “unliquidated” is defined as “not calculated or established as a specific amount.” The Post Holdings case (Post Holdings, Inc., and Michael Foods of Delaware, Inc., v. NPE Seller Rep LLC, C.A. No. 2017-0772 AGB [Del. Ch. Oct. 29, 2018]) shed light on how a party’s right of set-off was construed to have limited applicability. The case also showed how a party may be excused from its obligations under a contract.

Continue reading

Is Delaware Really a ‘Sandbagging State’?

Guest post by Daniel E. Wolf, Partner, Kirkland & Ellis LLP

In the private M&A context, “sandbagging” refers to a buyer, who despite having knowledge of a breach of representation or warranty by a seller at some time before closing, proceeds with the closing and then seeks indemnification from the seller for the breach of representation or warranty of which it had prior knowledge.

Continue reading

Delaware Court of Chancery Finds a Material Adverse Effect and Permits Termination of Merger Agreement

Post from Insight & Analysis: Wilson Sonsini Goodrich & Rosati

In a 246-page post-trial decision issued this week, the Delaware Court of Chancery ruled that a buyer could terminate a $4.75 billion public company acquisition because of material adverse effects that had occurred at the seller following signing.1 The decision is the first Delaware case to reach such an outcome and provides critical guidance for such situations going forward.

Continue reading

Term Sheets: Important Negotiating Issues

It is customary to begin the negotiation of a venture investment with the circulation of a document known as a term sheet, a summary of the terms the proposer (the issuer, the investor, or an intermediary) is prepared to accept. The term sheet is analogous to a letter of intent, a nonbinding outline of the principal points which the Stock Purchase Agreement and related agreements will cover in detail. The advantage of the abbreviated term sheet format is, first, that it expedites the process. Experienced counsel immediately know generally what is meant when the term sheet specifies “one demand registration at the issuer‘s expense, unlimited piggybacks at the issuer‘s expense, weighted average antidilution,” it saves time not to have to spell out the long-form edition of those references.

Important Negotiating Issues

Entrepreneurs who are in the process of effecting a venture capital financing for their start-up or emerging companies will negotiate with one or more venture capital firms on a number of fundamental and important issues. These issues are generally initially set forth in a “Term Sheet” which will serve as the basic framework for the investment. It is important that the company anticipate these issues and that the Term Sheet reflect the parties’ understanding with respect to them.

The following are some of the more important issues that arise:

  • The Valuation of the Company. While valuation is often viewed as the most important issue by the company, it needs to be considered in light of other issues, including vesting of founder shares, follow-on investment capabilities by the venture investors, and terms of the security issued to the investors. Significant financial and legal due diligence will occur and entrepreneurs should ensure that their companies’ financial projections are reasonable and that important assumptions are explained. Venture investors will consider stock options and stock needed to be issued to future employees in determining a value per share. This is often referred to as determining valuation on a “fully diluted” basis.
  • The Amount and Timing of the Investment. Venture investors in early stage companies often wish to stage their investment, with an obligation to make installment contributions only if certain pre-designated milestones are met.
  • The Form of the Investment by the Venture Investors. Venture investors often prefer to invest in convertible preferred stock, giving them a preference over common shareholders in dividends and upon liquidation of the company, but with the upside potential of being able to convert into the common stock of the company. There are strong tax considerations in favor of employee-shareholders for use of convertible preferred stock, allowing the employees to obtain options in the company at a much reduced price to that paid by the venture investors (a pricing of employee stock options at 1/10th of the price for preferred stock is common among Silicon Valley companies). Often times, venture investors will seek to establish interim opportunities to realize a return on this investment such as by incorporating a current dividend yield or redemption feature in the security. [Redemption rights allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemptionrights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.]
  • The Number of Directors the Venture Investors Can Elect. The venture investors will often want the right to appoint a designated number of directors to the company’s Board. This will be important to the venture investors for at least two reasons: (1) they will be better able to monitor their investment and have a say in running of the business and (2) this will be helpful for characterization of venture capital fund investors as “venture capital operating companies” for purposes of the ERISA plan asset regulations. Companies often resist giving venture investors control of, or a blocking position on, a company’s Board. A frequent compromise is to allow outside directors, acceptable to the company and venture investors, to hold the balance of power. Occasionally, Board visitation rights in lieu of a Board seat is granted.
  • Vesting of the Founders’ Stock. Venture investors will often insist that all or a portion of the stock owned or to be owned by the founders and key employees vest (i.e., become “earned”) only in stages after continued employment with the company. The amount deemed already vested and the period over which the remaining shares will vest is often one of the most sensitive and difficult negotiating issues. Vesting of founder stock is less of an issue in later stage companies. Another issue with the founders can arise if the VC insist that the founders lock-up the issuer‘s representatives and warranties. Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. [Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders.
  • Additional Management Members. The investors will occasionally insist that additional or substitute management employees be hired following their investment. A crucial issue in this regard will be the extent to which the stock or options issued to the additional management will dilute the holdings of the founders and the investors.
  • The Protection of Conversion Rights of the Investors from Future Company Stock Issuances. The venture investors will insist on at least a weighted average anti-dilution protection, such that if the company were to issue stock in the future based on a valuation of the company less than the valuation represented by their investment, the venture investors’ conversion price would be lowered. The company will want to avoid the more severe “ratchet” anti-dilution clause and to specifically exempt from the anti-dilution protection shares or options that are issued to officers and key employees. It is also sometimes desirable from the company’s perspective to modify the anti-dilution protection by providing that only those investors who invest in a subsequent dilutive round of financing can take advantage of an adjustment downward of their conversion price, a so-called “pay to play” provision. If the formula states that if the number of shares in the formula is “broadest” based, this helps the common shareholder. [If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.]
  • Pre-emptive Rights of the Investors to Purchase any Future Stock Issuances on a Priority Basis. The company will want this pre-emptive right to terminate on a public offering and will want the right to exclude employee stock issuances and issuances in connection with acquisitions, employee stock issues, and securities issuances to lenders and equipment lessors.
  • Employment Agreements With Key Founders. Management should anticipate that venture investors will typically not want employment agreements. If they are negotiated, the key issues often are: (1) compensation and benefits; (2) duties of the employee and under what circumstances those duties can be changed; (3) the circumstances under which the employee can be fired; (4) severance payments on termination; (5) the rights of the company to repurchase stock of the terminated employee and at what price; (6) term of employment; and (7) restrictions on post-employment activities and competition.
  • The Proprietary Rights of the Company. If the company has a key product, the investors will want some comfort as to the ownership by the company of the proprietary rights to the product and the company’s ability to protect those rights. Furthermore, the investors will want some comfort that any employees who have left other companies are not bringing confidential or proprietary information of their former employer to the new company. If the product of the company was invented by a particular individual, appropriate assignments to the company will often be required. Investors may require that all employees sign a standard form Confidentiality and Inventions Assignment Agreement.
  • Founders Non-Competes. The investors want to make sure the founders and key employees sign non-competes.
  • Exit Strategy for the Investors. The venture investors will be interested in how they will be able to realize on the value of their investment. In this regard, they will insist on registration rights (both demand and piggyback); rights to participate in any sale of stock by the founders (co-sale rights); and possibly a right to force the company to redeem their stock under certain conditions. The company will need to consider and negotiate these rights to assure that they will not adversely affect any future rounds of financing.
  • Lock-Up Rights. Increasingly, venture investors are insisting on a lock-up period at the term sheet stage where the investors have a period of time (usually 30-60 days) where they have the exclusive right, but not the obligation, to make the investment. The lock-up period allows the investors to complete due diligence without fear that other investors will pre-empt their opportunity to invest in the company. The company will be naturally reluctant to agree to such an exclusivity period, as it will hamper its ability to get needed financing if the parties cannot reach agreement on a definitive deal.

Form of Term Sheet.

They are intended to set forth the basic terms of a venture investor’s prospective investment in the company. There are varying philosophies on the use and extent of Term Sheets. One approach is to have an abbreviated short form Term Sheet where only the most important points in the deal are covered. In that way, it is argued, the principals can focus on the major issues and not be hampered by argument over side points. Another approach to Term Sheets is the long form all-encompassing approach, where virtually all issues that need to be negotiated are raised so that the drafting and negotiating of the definitive documents can be quick and easy. The drawback of the short form approach is that it will leave many issues to be resolved at the definitive document stage and, if they are not resolved, the parties will have spent extra time and legal expense that could have been avoided if the long form approach had been taken. The advantage of the short form approach is that it will generally be easier and faster to reach a “handshake” deal. The disadvantage of the long form approach from the venture investors’ perspective is that it may tend to scare away unsophisticated companies.

Lagniappe Terms:

The Charter: (Certificate of Incorporation) is a public document, filed with the Secretary of State of the state in which the company is incorporated, that establishes all of the rights, preferences, privileges and restrictions of the Preferred Stock.

Accrued and unpaid dividends are payable on conversion as well as upon a liquidation event in some cases. Most typically, however, dividends are not paid if the preferred is converted.

PIK” (payment-in-kind) dividends: another alternative to give the Company the option to pay accrued and unpaid dividends in cash or in common shares valued at fair market value.

“Opt Out”: For corporations incorporated in California, one cannot “opt out” of the statutory requirement of a separate class vote by Common Stockholders to authorize shares of Common Stock. The purpose of this provision is to “opt out” of DGL 242(b)(2).

Preferred Stock: Note that as a matter of background law, Section 242(b)(2) of the Delaware General CorporationLaw provides that if any proposed charter amendment would adversely alter the rights, preferences and powers of one series of Preferred Stock, but not similarly adversely alter the entire class of all Preferred Stock, then the holders of that series are entitled to a separate series vote on the amendment.

The per share test: ensures that the investor achieves a significant return on investment before the Company can go public. Also consider allowing a non-QPO to become a QPO if an adjustment is made to the Conversion Price for the benefit of the investor, so that the investor does not have the power to block a public offering.

Blank Check Preferred: If the punishment for failure to participate is losing some but not all rights of the Preferred (e.g., anything other than a forced conversion to common), the Certificate of Incorporation will need to have so-called “blank check preferred” provisions at least to the extent necessary to enable the Board to issue a “shadow” class of preferred with diminished rights in the event an investor fails to participate. Because these provisions flow through the charter, an alternative Model Certificate of Incorporation with “pay-to-play lite” provisions (e.g., shadow Preferred) has been posted. As a drafting matter, it is far easier to simply have (some or all of) the preferred convert to common.

Redemption rights: allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend). In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. While it is possible that the right to receive dividends on redemption could give rise to a Code Section 305 “deemed dividend” problem, many tax practitioners take the view that if the liquidation preference provisions in the Charter are drafted to provide that, on conversion, the holder receives the greater of its liquidation preference or its as-converted amount (as provided in the Model Certificate of Incorporation), then there is no Section 305 issue.

Founders’ representations are controversial and may elicit significant resistance as they are found in a minority of venture deals. They are more likely to appear if Founders are receiving liquidity from the transaction, or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution or the Founder was formerly with another company whose business could be deemed competitive with the Company), or in international deals. Founders’ representations are even less common in subsequent rounds, where risk is viewed as significantly diminished and fairly shared by the investors, rather than being disproportionately borne by the Founders. Note that Founders/management sometimes also seek limited registration rights.

Registration: The Company will want the percentage to be high enough so that a significant portion of the investor base is behind the demand. Companies will typically resist allowing a single investor to cause a registration. Experienced investors will want to ensure that less experienced investors do not have the right to cause a demand registration. In some cases, different series of Preferred Stock may request the right for that series to initiate a certain number of demand registrations. Companies will typically resist this due to the cost and diversion of management resources when multiple constituencies have this right.

Break Up Fee: It is unusual to provide for such “break-up” fees in connection with a venture capital financing, but might be something to consider where there is a substantial possibility the Company may be sold prior to consummation of the financing (e.g., a later stage deal).

Snap Judgment: Unicorns Under Pressure and Addressing Risks of Private Lawsuits

 

 

By: Joshua M. NewvilleWilliam Dalsen and Alexandra V. Bargoot of Proskauer

The recent IPOs of Snap, Inc. and Blue Apron indicate that while the IPO pipeline continues to flow, there may be a cautionary tale for “unicorns” – venture-backed companies with estimated valuations in excess of $1 billion.

After Snap went public in March, it posted a $2.2 billion loss in its first quarter, yielding a 20% same-day drop in stock price that erased much of the company’s gains since its IPO. A snapshot of Snap’s stock price shows the obvious risks faced by late-stage investors in unicorns.  High valuations are not a guarantee of continued success, particularly where historical performance and profitability are lacking.  Although one commentator recently asked: “Are Blue Apron and Snap the worst IPOs ever?”, there is plenty of time for those stock prices to recover, especially in the months after their insider lockup periods expire.

Less well-known is how those risks can create conflicts that lead to litigation in the private fund space. The unicorn creates a dilemma for the private fund backing it.  On the one hand, an exit through a public offering is desirable as demonstrating cash-on-cash return is generally better than maintaining an illiquid holding, particularly when the company is facing the potential for down round funding to survive.  On the other hand, going public puts the unicorn’s financials in public view, and employees and private funds risk losing big if the company cannot sustain its predicted value.

Ultimately, a choppy IPO outlook for unicorns will lead to tightening of markets. As more unicorns linger and fall into distress, some will fail, leading to litigation.  Overly optimistic valuations lead to inflated expectations, especially those of employees expecting a payout and investors expecting gains.  Below are some types of disputes that can arise.

Employee claims: Employees paid in common stock may sue in the event of a dissolution or bad sale ahead of a public offering.  As in the case of former unicorn Good Technology, a bad sale may involve a payout on the common stock that amounts to only a fraction of its estimated value.  Employees of Good Technology (who held common shares) filed claims asserting that the company’s board breached its fiduciary duties by approving the sale.  They alleged that the board (whose members represented funds that owned preferred shares) favored the preferred over common shareholders.  While the case has been slow to progress, its outcome will inform the market whether such suits will provide viable recourse when employee shareholders believe their interests have been disadvantaged.

SEC Scrutiny: As we’ve previously noted, valuation-related regulatory risks increase as the time lengthens between purchase and exit. The SEC’s exam and enforcement staff have been focused on valuation of privately held companies for years. Further, the SEC sees itself as a protector of investors, even when those investors are employees of a private startup.   We are likely to see a disclosure case against a pre-IPO issuer relating to Rule 701 under the Securities Act.  That rule requires disclosure in certain circumstances of detailed financial information to employees in connection with certain stock or option grants.  This would lead to a spillover effect for funds that have supported those companies.

Claims arising in an acquisition: If the company is fortunate enough to reach some liquidity in a private sale, the acquiring company may pursue litigation against the board or other investors. The buyer may later allege fraudulent inducement and breach of contract on the grounds that the company and its investors misrepresented the company’s value.  In addition, investors can often break even in a merger by holding preferred shares with liquidation preferences.  However, like employees, investors still may sue the board or the company to try to recover a better return on their investment.

Fund LP/GP disputes: Unicorns are no different than other portfolio companies, in that when they fail, there may be disputes between a fund’s GP and its LPs. Those claims may vary.  For example, the fund’s designee on a failed unicorn’s board of directors will typically owe fiduciary duties to both the portfolio company and the LPs.  An LP may allege that the board representative favored the interests of the company over the interests of the LPs, or failed to adequately address or disclose concerns raised to the board level.  Furthermore, LPs may allege that the fund manager failed to address the potential for conflicts between the adviser and the funds.

While unicorns can generate extraordinary returns for early investors, they may also carry increased litigation risk even when they are successful. In addition, as more unicorns linger and fail to achieve successful exits, there is a higher likelihood that investors or employees will seek to recoup losses through litigation.  Fund managers should keep in mind the potential for these conflicts before a unicorn stumbles.  Addressing these relationships at early stages of the investment can help minimize litigation risk.

Going Public Transactions For Smaller Companies: Direct Public Offering And Reverse Merger

Guest Post by Laura Anthony, Esq – Legal & Compliance, LLC

Introduction

One of the largest areas of my firms practice involves going public transactions.  I have written extensively on the various going public methods, including IPO/DPOs and reverse mergers.  The topic never loses relevancy, and those considering a transaction always ask about the differences between, and advantages and disadvantages of, both reverse mergers and direct and initial public offerings.  This blog is an updated new edition of past articles on the topic.

Continue reading