Secrets of Sand Hill Road #5 – Exits

Today’s post is our fifth visit to Scott Kupor’s book Secrets of Sand Hill Road.

Board duties

Chapter 13 of the book continues the theme of governance and looks at the legal duties of directors.

Here are the main ones:

1. Duty of Care
   • This says that you need to maximise value for the common shareholders.
   • Which in turn requires you to be reasonably informed about the business of the company (show up, read documents, ask questions).
2. Duty of Loyalty
   • This prevents you from enriching yourself at the expense of the company.
   • It can become an issue because of the dual fiduciary status of VC board members.
3. Duty of Confidentiality
   • Pretty straightforward – you can’t blab about things you learn in the course of your duties as a director.
   • Sometimes this requires the creation of Chinese Walls internal to VC firms who have partners on the boards of two competing startups – which in turn usually comes about because one of the startups has pivoted into the product space of the other.
   • Where the same VC partner is on both boards, he might have to recuse himself from parts of board meetings – in which case, a better long-term solution would be to replace him with another partner from the VC firm.
4. Duty of Candor
   • This just means that board members have to disclose all relevant information (they can’t lie by omission).

Common vs Preferred

Board members do not owe fiduciary duties to the preferred stock. Preferred rights are purely contractual in nature; they are negotiated by the parties to the financing agreement at the time of the funding.

This still allows preferred shareholders to sue if their contractual rights are being violated.

• They just can’t invoke fiduciary responsibilities.

The Business Judgement Rule (BJR)

Courts are loath to second-guess a board decision as long as, at the time the decision was made, the board acted on an informed basis, in good faith, and with the honest belief that the action taken was in the best interest of the corporation and its common shareholders.

Which means that the decision need not turn out to have been the right one.

The courts will look to evaluate the process of the decision-making to ensure that it complies with the duty of care. Make sure that you keep good minutes of the meetings to reflect the frequency and level of deliberations.

Entire Fairness

If a common shareholder can show there was some fraud or self-dealing (that the duty of loyalty was violated), the burden of proof changes to a concept known as “entire fairness”.

The directors bear the burden to prove that they were acting in the company’s best interest. Board members need to prove two things: (1) the process was fair and (2) the price was fair (which really means what the common shareholder got from the deal).

Directors can’t indemnify themselves against breaches of duty of loyalty.

The typical situation where there will be a conflict is an out-of-the-money acquisition where the VCs get only their liquidation preferences, the executives benefit from some incentive plan, and the common shareholders get nothing.

• But even then, the courts might conclude that the common was worth nothing before the acquisition (since no-one was willing to fund the rest of the business plan).
• And therefore they might award no damages whilst noting the conflict.

In order to demonstrate a fair process and a fair price, boards often hire bankers to run the acquisition process.

• Some might also allow a vote of the common shareholders on the takeover.

Difficult Financings

Chapter 14 looks at down rounds and recapitalisations.

Strategies include:

•  (Voluntarily) reducing existing liquidation preferences
• Pull-ups, where one VC carries forward some of their liquidation preference in return for new cash, and
• Reverse splits of preferred stock into common (sometimes by up to 10 to 1)

In such situations:

 – It’s really important to do a market check and run a full process with outside investors. If you can hire a banker to run this process, even better.
– Be careful not to entangle new option grants to employees too closely with the inside financing.
– Give other investors (and particularly major common shareholders) the opportunity to participate in the deal [via] a rights offering.
– Implement a go-shop provision in the insider financing round. It specifically allows the company to shop your term sheet to other potential investors.
– Approval from the disenfranchised common shareholders will be very helpful.
– Make sure the minutes of the board meetings reflect the board’s understanding of the potential conflict of an insider round and demonstrate an attempt to take into account the interest of the common shareholders.

Winding Down

The next section covers US redundancy laws, so we can skip most of it.

The key principle is not to continue to trade when you are insolvent.

• Which includes not keeping on employees beyond the point to which you can pay them, or acting in bad faith with creditors.

Exits

A good exit is an IPO or a high-value acquisition (takeover).

• Note that the startup is not exiting anything – the terminology is framed from the VC’s perspective.

Scot advises startup execs to get to know firms who might eventually acquire them.

Even if you are not interested in an acquisition, these companies may often be good business development partners as they likely have existing sales channels into some of the markets you are planning to enter.

Most importantly, companies get bought, not sold. It’s very difficult to wake up one day and decide you want to sell your company. The far better strategy is to have potential acquirers solicit your interest in being acquired.

Acquisitions

If you look at VC exits today, more than 80 percent come via acquisition, a far cry from the fifty-fifty split between acquisitions and IPOs that dominated most of VC history.

Some acquisitions use shares from the acquiring firm, rather than cash.

• In such a case you’ll need to take a view on the fair valuation of those shares (relative to the market price).

Sometimes a collar will be used to protect against share price movements outside of a predefined range during the acquisition process.

• Some of the money (10% to 15%) is usually placed in escrow in case problems emerge in the first 12 to 18 months after the deal closes.

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VCs will also need to establish what happens to outstanding options in the startup companies stock.

• they might be “assumed” into the acquirer
• or replaced by equivalent options
• or accelerated (vested immediately)

The acquirer will also create a list of key personnel who need to be retained as part of the deal.

• The deal may depend on securing some or all of these staff.

Acquirers may also insist on a supermajority vote (say 90%) of the preferred and/or common shareholders in favour of the deal.

• And deals usually have an exclusivity period (between the initial signing of the term sheet and the closing of the deal) where the startup is not allowed to solicit alternative buyers.

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Boards are held to an intermediate standard (between BJT and entire fairness) during acquisitions, known as Revlon duties.

While the board has no obligation to sell the company, if the board decides to proceed down that path, it must seek to maximize the value of the common stock. The board must explore all reasonable options to get the best price.

To satisfy Revlon duties, boards should: (1) run a broad outreach to multiple potential acquirers, with the help of bankers where possible; (2) consider other possible paths forward (e.g., is there a financing alternative whereby the company remains a stand-alone entity to maximizes shareholder value?); (3) consider incorporating a go-shop provision into an offer they receive from an acquirer to permit other competing bids to surface; and (4) document a well-vetted process that shows the board considered all available possibilities to maximize shareholder value.

The board is not obligated t take the highest price; it just has to reasonably maximize shareholder value. The board can take a slightly lower offer if it feels that the offer is more likely to close or the form of consideration (stock versus cash) is more favorable.

IPOs

IPOs used to be popular because it was difficult to raise large amounts of cash privately.

• This is no longer the case.

The IPO was also an important branding event.

• But now unicorns are famous years before they come to market.

There’s also a degree of business credibility for B2B firms, who prefer suppliers and customers with transparent financials.

• And listed shares can more easily act as bargaining chips during M&A activity.

But the main reason for an IPO is liquidity.

• Or if you prefer, the ability for insiders to cash in (or out).

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The IPO process starts with a beauty parade of investment banks.

• The winner will underwrite the float perhaps with the help of a couple of runners-up.

A prospectus will be drafted which contains all relevant disclosures for prospective investors.

• In the US, the JOBS Act (2012) provides for a streamlined IPO for “emerging growth companies” (EGCs).

Once the prospectus is public, the banks organise a roadshow of institutional investors in order to “build the book” (obtain commitments to buy stock in the IPO).

• This process feeds into decisions on how many shares to offer, and at what price.

IPOs are generally priced so that the share price rises (at least initially – many IPOs hit a bump in the first year or two).

• But at the same time, VCs and startup execs don’t want to leave too much money on the table.

The “green shoe” allows underwriters to sell an extra 15% of stock into the market at IPO (assuming the price goes up).

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Outside of the stock released in the IPO, VCs and execs usually have a lock-up period of at least six months, during which they can’t sell additional shares into the market.

Most VCs like to exit public shares once the lock-up is over so that they can focus on their primary asset class.

• But sometimes they retain 10% or more of the stock and sit on the board.

A VC exit can be handled via a secondary offering (a placing to existing large shareholders).

Secondary issues sell shares that are already owned by someone, whereas IPOs usually create new shares to sell.

The World Is Flat

In the final chapter of the book, Scott muses on how the VC world has changed.

• Money is easier to access, and startups require less of it, so there are more of them, which makes it harder to win.

And they take longer to come to market.

Microsoft went public in 1986 at a $350 million market capitalization. Today, Microsoft has a market cap of approximately $800 billion. That’s more than a 2,200x increase as a public company. Facebook went public at a $100 billion market cap and now trades around $400 billion.

For the public market investors to eventually earn the same multiple on Facebook as for Microsoft, Facebook would have to reach a market value of more than $220 trillion. Global domestic production is about $80 trillion. Normal retail investors may be losing out.

Conclusions

That’s it – we’ve reached the end of the book.

• It’s been an entertaining read, and an informative one.

I’ll be back with a summary of the five articles in a few weeks.

• Until next time.