← The Path to Exit
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- [00:02]
A
Welcome to the Path to Exit, a podcast to help software and Internet founders understand the process to raise capital or sell their business.
- [00:20]
B
Hello and welcome everyone. I'm Mike Lyon, Founder and Managing Director at VistaPoint Advisors and this is the Path to Exit. This this show is dedicated to helping founders of software and Internet businesses understand what it takes to raise capital or sell their business and how to do it well. My guest today is Brian Linehan. Brian is the co Chair of Choate's business department. He's a fantastic M and A attorney and has worked with many of our founders advising them on capital raises and recapitalization transactions. I first met Brian when he was advising on the opposite side of a transaction we were working on and I was so annoyed that is respected how he advised and negotiated for his client that we started referring him to our founder clients. He works on a lot of cross border transactions involving Canadian and UK companies. Please enjoy my discussion with Brian. Today's podcast is about common legal diligence issues that can become a roadblock on a transaction if you haven't been through an M and A transaction. The legal diligence and purchase agreement negotiation can be stressful and downright scary. Today Brian and I are going to discuss some typical items that come up during the diligence process. Brian, welcome to the show.
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C
Thanks Mike, Happy to be here. Appreciate you asking me.
- [01:22]
B
Thanks for joining. One of the things that happens a lot during transactions is when we're talking about the legal phase and the diligence phase, we'll talk about things like capitalization or employee misclassification. And I think founders misunderstand the details, right? They feel like they own their ip, the company's properly capitalized. But when you get into diligence, there's some technical things that come up that can really cause issues. So I thought we'd just walk through some of those. Let's start with maybe capitalization and the cap table. How does that work in diligence and what are some of the common things.
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C
That come up when you're dealing with founder backed companies that maybe haven't raised institutional capital and therefore haven't been through an institutionally led diligence process? Some of the common issues that we see on the capitalization side are that the equity backup may not match exactly what the founder thinks the ownership is. So for instance, he or she has promised 5% to a particular employee, but there's no documentation that's a common thing that we see. Other things we might see would be options have been granted at a particular strike price, but there's no backup for the fair market value determination of the strike price. Also when you're doing founder issuances and you have restricted stock making sure that the so called 83B elections have actually been filed and that you have evidence of that. So what I recommend for a founder that's going to start a process working with Vista, they would want to go through a little bit of a confirmatory analysis at the beginning just to make sure that their capitalization table, the Excel spreadsheet that they show to potential buyers matches up with the documentation that would support the various grants.
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B
Great advice. I think we see that all the time. Particularly the element you mentioned where maybe a founder's promise some equity but it's not really documented. I think that comes up a lot in terms of having this intent. And then there's also just the taxation question around equity. I think a lot of their employees and some founders don't realize that the options, if they haven't been vested and they've owned them for a year, they're really looking at ordinary income tax on that as opposed to long term capital gains.
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C
Yeah, for sure.
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B
So there's a lot there in terms of it sounds pretty simple is your cap table. Your cap table and then if they have raised a little bit of VC money, just understanding the preferences, I find a lot of founders don't really understand what the exit waterfall is really going to look like until the end. And that can lead to some misinterpretation around who's getting what part of the proceeds. I think that one's really common. Sounds really simple. But a lot of times there's loose ends around capitalization for sure.
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C
Totally agree. You raise a great point on the prefer because if some of the founder backed companies have raised a small amount of institutional capital, a lot of times it comes in as a participant so it gets its money back and then participates on a pro rata basis. But the liquidation waterfalls or the cap tables don't sometimes reflect that. They just show a percentage ownership. So I think that's a good point. I also think it's worth flagging on the options that most recipients of options are never going to get capital gains because in order to get capital gains you have to have exercised the option and held the underlying stock for 12 months. So options themselves are taxed if they're not exercised and held for a year at ordinary income. And sometimes that comes as a surprise to rank and file employees.
- [04:27]
B
Absolutely. Let's maybe talk a little bit about employee misclassification. I think this is something that founders just don't pay a lot of attention to as they're growing their business. Right. Whether it's a contractor, whether it's an employee, particularly if they have employees in different geographies, different states or countries. So maybe talk a little bit about that. I know this is a common one that comes up that you can usually get around, but we spend a lot of time trying to understand this and get the buyer comfortable with how these are classified.
- [04:51]
C
Yes, absolutely. This seems to come up in virtually every transaction at some level. So there's really two flavors of this. There's the, we'll call it the employee versus independent contractor categorization, and then separately the exempt versus non exempt. So a lot of times founders will be paying certain folks as 1099 contractors, and that's technically not doable. If the person is in fact satisfying all the requirements of being an employee, which is for the sake of this discussion, somebody who's working full time and not working for anyone else is likely to be considered an employee. And so if they're an employee, they need to be on W2, which means they're subject to FICA, Medicare and withholding on income. Income taxes. That's what the government most cares about, is that it's going to be getting its share of the payroll taxes and the appropriate withholdings. We see that fairly commonly where somebody's been on the books as a 1099 for many years, even though they're effectively working as a full time employee.
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B
Great point. And as you mentioned, this one comes up in almost every deal. Maybe let's move on to intellectual property and assignment and ownership. I think a lot of times when we talk to the founders, they interpret it as do I own the ip? And of course they say yes. Right. We built the ip. It's not like we took the IP from another company. But there's a big difference between their perception of what owning the IP means, but also having the right documentation around that. And this is particularly important with software companies where it's really all about ip. So can you talk about some of the issues that come up around assignment? And frankly, I feel like most founders miss this one just because they're not spending a lot of legal dollars on this upfront when they start the company. Maybe talk about that a little bit.
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C
Yeah, absolutely. You described it perfectly. So a typical SaaS company that's written a bunch of code as the primary IP for its service or product offering, to the extent that code is written by employees in the context of their employment, then under copyright concepts, it's owned by the employer. But if you had an independent contractor doing it, or you hired a third party software developer in Eastern Europe, for instance, we see that a lot. You need to make sure that the company has got what's called a present assignment of all of the intellectual property, right? Because otherwise it's owned by the quote author of that. That's the concept under copyright law, that the author owns that. So we just want to make sure if there's for instance a third party developer that they have signed an appropriate present assignment of all intellectual property rights back to the company. Most venture capital investors or strategic buyers or equity sponsors want to see the same contractual language with respect to current employees as well. The one area where you do need a present assignment for intellectual property rights is around patent rights. So this doesn't come up that often in the SaaS context, but there are certain SaaS companies that have particular types of patent protection a piece of what they're doing. And you do need to have a direct assignment from an employee in the context of making sure you have appropriate rights over patents. So we do like to, in a pre diligence process with a founder backed company, just go through the documentation that they have with their employees and their developers to make sure all that assignment language is in there. I'd also say my favorite little one is that usually we find out when we're doing the disclosure schedules that the domain name for the company is not owned by the company because it was registered by the founder on GoDaddy before he actually formed the lead. So we like to make sure that actually gets transferred at the registrar into the name of the company.
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B
Sounds familiar. And I actually realize I'm guilty of that right now just thinking about that. But that's obviously how it works, right? The founder gets the domain name pretty early. I think this issue comes up a lot and it's particularly problematic for founder led businesses for one reason. If you haven't raised a lot of money, generally the contractor is the first person you get to help with the ip. And you're obviously not focused on all this proper documentation. And at the end of the deal, if you need to go get that signature from someone who's not an employee, it's a little bit harder, right? You haven't been in contact with this person, you have a big deal riding on it. So it actually could be a leverage point for that contractor if they thought of it that way. So it's much easier to clean it up pre deal when really there's nothing riding on it. Maybe you have to pay them a small amount to get the signature. I think with employees, it's a little bit easier to get these signatures when you need them, because obviously they're an employee of the company. They're certainly easier to find. But you don't want to hand some leverage to a consultant that you worked with 10 years ago just because of timing. So it's a good thing to look at up front and just move that one off. Moving on to the next topic, this comes up pretty much in every SaaS deal I feel like we've worked on in the past 10 years. It's the sales tax issue.
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C
Yes.
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B
So basically, at some point you cross the threshold, you're supposed to pay sales tax. Maybe talk a little bit about what's going on here, and then I can give some context around how we see it play out in pretty much every deal and how you should think about handling this if you don't have this issue solved up front.
- [09:30]
C
I would say that I agree 100% with what you said. I don't think I've seen a SaaS deal where this hasn't come up. I think founders are a bit surprised as their business develops and they start having customers all over the United States that they might be subject to sales and use tax in a particular state. I think the number of states now that treat SAS as taxable, either as a service or some other basis, is 24. And I think there's an additional subset of states that treat it as taxable if there's a component of it that has to be downloaded. We see this come up in diligence all the time, because usually a strategic buyer who would inherit this liability has their internal internal tax team or their outside accountants doing a pretty detailed analysis of what the sales tax compliance is. And it usually ends up generating some form of a number that can be a negotiating point as to who's going to bear the cost for that.
- [10:22]
B
The way we advise our clients who are thinking about a transaction is not necessarily to go and clean this up in process, because it takes a while to deal with all these different states and jurisdictions. So you're never really going to get this solved unless maybe you start a year early. But how we see it play out in a deal is if you let the buyer do the calculation right, they're going to come up with the most aggressive form of liability. So they're going to look at all your liabilities. They're also going to look at every possible Penalty and fine that could be associated with that. In reality, when you go back to most of these jurisdictions, as long as you agree to pay what you owe in the back period and pay going forward, you generally aren't charged all those fines because they're trying to get people compliant. So I think we feel like the best strategy here and the best outcome is do your work ahead of time. We hire our own accounting firm to go do the analysis. What we think the liability is, share that with the buyer. They're obviously going to come up with a higher amount. And then I think where you want to end up is with an escrow and a plan to go remediate this. So post deal they'll hire a firm that will help you go get in compliance and then that money comes out of the escrow. Because if you just do a purchase price adjustment, which sometimes the buyer wants to do, that generally is going to be quite a bit higher than the actual liability amount because they're working worried about the risk. So I think that's what we typically see as a good outcome for sellers. Sometimes sellers just want to negotiate the number and be done. But I think if you're trying to optimize what you're going to pay and the least amount you're going to pay, it's the process I outlined, I think.
- [11:46]
C
That'S 100% on point. If this issue is going to be one that has to be resolved. We typically want to have a detailed covenant around how the buyer is going to do this through a so called VDA voluntary disclosure agreement process where with the states. I think every state has a process for this because as you said, they want to collect the taxes and they'll enter into agreements with companies that fail to follow the process. We usually end up negotiating some sort of arrangement in the purchase and sale contract that the VDA process will be administered by the buyer, but the seller will have rights in it and that there'll be reasonable review and consent over approaching and settling with various states so that the seller, if they're ultimately responsible for the financial impact of it, have oversight and a bit of say in the process.
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B
Great point. Yeah. As the seller, the last thing you want to do is just give the buyer open checkbook to solve this in the easiest way possible. You want to make sure they're doing it in a way that's favorable to the seller. So great point. A lot of detailed negotiation, how that process works on the vda. Maybe talk a little bit more about just some unique contract terms that come up like what are in the selling company's contracts that makes a transaction harder for a buyer. Change of control. Any other things you think would be worth talking about here?
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C
Particularly as a company's ramping up and they're maybe dealing with enterprise level customers that maybe they don't have them on click through terms and conditions yet, but they have to negotiate specific terms with some of their larger initial customers. We see all manner of thing that gets snuck into or negotiated into those contracts. Number one being change of control consent requirements. So a lot of large enterprise customers are going to want to make sure if they're going to be engaging with a smaller founder backed company that they know who they're dealing with. So sometimes they'll put in change of control consent requirements and we want to understand those in advance of a sale so we know who we have to go talk to for purposes of getting consent. If the buyer is going to insist upon getting consent from customers. The other things we see in there from time to time would be what we call like restrictive covenants where they might have non solicit of the employees of the customer or limitations on who they might be able to do business with if there's a competitor. That's less common because it's got antitrust implications. But sometimes you'll see that what we call MFN clauses, most favored nation clauses where an enterprise customer might negotiate very favorable pricing based on what the company offers to other customers. So sometimes you just want to make sure you have a good handle on that and then one that's probably not thought of at the beginning. But we see strategics focusing on this is and equity sponsors as well. There's typical language in contracts that talks about how it's binding on the company and its affiliates. That affiliate language can have unintended consequences because once it's no longer founder owned and in fact it's owned by a strategic as a wholly owned subsidiary, that affiliate concept picks up the buyer and all of its related companies. So you don't want to have some non solicit, for instance that says that the company and its affiliates agree not to do this. So we like to make sure that we limit it to just the company and not have this potentially broader reach that might not be applicable once it's while it's owned by a founder, but might be applicable when it's owned by a larger organization.
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B
Great point. And one thing that I've seen come up a couple of times and you want to know about this one early, if it's in there is a right of first refusal. So a lot of times a bigger strategic, if they're doing business with a smaller company, will just try and get this right of refusal in the contract and it really complicates the sales process. And it can particularly complicate it if no one knows about it. And then in the middle of the process you discover there's a rofer as the lawyers are spending more time in the documents. So right of first refusal basically just means or right of first offer means you have to go back to this buyer. It complicates the M and A process because the other buyers, once they know about that, are less likely to really want to spend a lot of time on diligence knowing that this other part has a right to just come take the deal at some point. So that's one if you have it, you'd like to try and get rid of it, but certainly know about it because there's strategies to deal with it. But if you don't know about it until later, it can present some problems.
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C
Excellent point. I've worked on a transaction recently where we were on the buy side and we didn't cover a bunch of ROFR provisions that were embedded in significant contracts. It turned out it was fine. We were able to get waivers of them. But still we would rather have had that be something that you knew about on the sell side in advance and had a plan to address it rather than having the buy side raising it.
- [16:07]
B
Yeah, not great. If the buyer discovers that, that's for sure. Seller loses some credibility. One thing that comes up a lot with founder owned businesses is affiliate owned real estate. So can you just talk about some of the issues that generally come up with that and maybe some of the solves for it.
- [16:20]
C
Founder backed companies. I'm always impressed with how founders are trying to in our lovely capitalist economy, figure out best ways to deploy their capital. So we see this over and over again where the founder either owns the real estate where the company is based or it's through some affiliated holding entity that might be through a family or something like that. And the lease terms for the most part are pretty favorable to the tenants. So in this case the company that's up for sale. So what we see a lot is a negotiation of market terms for a lease. This has become less and less important I think in our post Covid environment where a lot of companies have of smaller footprints for their actual real estate needs, but it still comes up fairly regularly. So what we typically advise is just in terms of if you're going to have an off market lease and that's going to be an item. Just flagging that in the front end and making clear that you would be willing to engage in discussions around making that more on market terms either in terms of the length of the lease and the rent and it's those types of issues.
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B
Yeah, it's interesting. The point you made, I think always surprised me initially is that usually the lease is actually under market, not over market. So as the founder who's selling the the business, you can probably get more from the rent. I think just some things to think about. You mentioned it coming out of COVID This is a little bit less important. But if it's a strategic buyer you're working with, there may be some synergies around office space if they have a big space in San Francisco or New York and that's where your business is located. So as you're renegotiating leases, it's important to think about that because you would like to have that as a synergy if possible. So just give some thought to that as you're planning leases. And if you think you're going to sell two years from now, probably not best to sign a five year lease. Right. You'd like some flexibility. So there can be some synergies for that if possible. Last thing Brian, I was hoping you could talk about is rep and warranty insurance. That product's been around for a while. I find it a great tool in a transaction because it takes a lot of the founder concerns away and frankly, I think simplifies the purchase agreement negotiation. Could you just talk a little bit about rep and warranty insurance, how that's negotiated and how you view that product for founders?
- [18:22]
C
For sure. Mike, when you and I started doing this business many years ago, this product did not exist and we would negotiate. Typical. We call them indemnities and escrows on sales of companies. So probably when you and I both started our careers, we were having 10% escrows for backstopping the representations and warranties that the company and the seller were making to the buyer maybe 10 years ago or so, maybe even more. At this point, rep and warranty insurance sort of emerged in the marketplace and now it's become very standard. I can't tell you the last time I did a typical indemnity deal. So what rep and warranty insurance is a buyer can go into and it's typically bought by the buyer into the insurance market and buy insurance coverage to backstop the representation and warranties that the seller is giving. So it effectively replaces the need for an identification escrow. So if you think of 10% as the type of coverage that buyer would want to get in the past, you can purchase representation and warranty insurance that will provide that 10% coverage to the buyer. And it's relatively cheap. It runs in the 3 to 4% of the overall enterprise value of the company. And the way that it works is that there is a, what we call a retention. It's the equivalent of a deductible where the first and it's usually 1% of the overall enterprise value is not covered by the insurance. The buyer is responsible for that. And if you liken it to what was done in a typical indemnification approach, you would have usually a threshold by which the buyer wouldn't be able to go back to the seller to get any recovery. So the retention is intended to sort of match up or mimic that deductible threshold. But above that amount, the insurance company will cover any indemnification claims against the seller up to the cap of the policy, which I said is typically around 10%.
- [20:11]
B
I think it's a great product for founders because a lot of founders who haven't been through an M and A transaction have heard lots of horror stories about post deal and what happens. This really takes the temperature down on. You're going to basically keep all the money you get at the deal when the deal closes and then there's going to be this insurance that covers any unknowns. It is important to point out though, anything that's known before the deal closes, obviously the insurance company is not going to cover that. Right. They're there to cover unknown things. And so the way the process typically works is the buyer completes all of their diligence. Any findings they have the insurance company knows about, those are carved out from the policy through exclusions. Like sales tax would be a great example of that. No one's going to cover sales tax because they expect that to come up. And then anything that's known before the deal, the buyer and the seller kind of split the liability or negotiate that. Is the buyer going to take the liability? Might there be a special escrow? But I think it's a great product. In my experience, if the deal is north of 30, 40 million, pretty much every private equity firm would use rapid warranty insurance. And a lot of the strategic buyers will. There's still a few strategics that aren't as comfortable with it, but I would say in most deals it's there. And even if you're dealing with a strategic that isn't going to allow rep and warranty insurance. It's important for them to know that everyone else is because it really changes the negotiation of the indemnification package if you have to do a traditional escrow. So if they know they're competing against rep and warranty insurance, you're probably going to end up in a much more favorable situation there.
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C
Agreed on that. Bully. I have seen rep and warranty insurance used at smaller deals under 30 million, but you're right it may not be as cost effective so you might have a more traditional indemnity there. I haven't seen though. Even when we have those smaller deals, usually the backstop for those indemnities might be if, say it's an add on acquisition for a platform of a private equity sponsor, the backstop for them may not be cash and might be rollover equity that the founder has taken as part of the consideration. But yeah, anything that's over $30 million for sure. It seems like rep and warranty has just become the standard for protection.
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B
Absolutely. And private equity firms I think did a good job early kind of weaponizing that against strategics because it was a great term for a seller. Now the whole market's kind of moved in that direction, so it's been great. Well, on today's podcast we talked about some common things that come up during transactions capitalization, employee misclassification, assignment of IP sales and use tax, and a few others. Brian, thanks so much for joining us on the podcast.
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C
Thanks, my pleasure, Mike. Good to talk to you and thanks for taking the time to do this.
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B
This is an educational recording. It does not represent legal advice for a specific situation and you should consult with your lawyer if you need advice for a specific situation.
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A
Disappoint Advisors is a founder focused investment bank that advises software and Internet founders through M and A and Capital raised transactions. We are a fully unconflicted investment bank who only works for founders on the seller side, so you know that we're always representing your best interests. Security is offered through VistaPoint Advisors member Finra Sipic. This has been provided for informational purposes only. It is not intended to address all circumstances that might arise. Testimonials from past clients may not be representative of the experience of other clients and there is no guarantee of future performance or success. Clients are not compensated for their comments. If you have any questions about the process of selling your business or raising capital, reach out to a member of our team or check out the four Founders section of our site by visiting Four Founders Guide.