PRINT THIS PAGE How to avoid ruining a successful exit
17/10/2007. Source:IVCJ (Israel Venture Capital & Private Equity Journal). Mimi Zemah (Zellermayer, Pelossof & Co.)
The consequences of a poorly structured investment can be severe – even to the extent of impeding a potential buyout. In this IVCJ article, Mimi Zemah, partner at law firm of Zellermayer, Pelossof & Co., explains how VCs can avoid mistakes that can negatively impact a portfolio company’s eventual exit. As a lawyer who represents VCs as well as start-up companies through their various rounds of financing, I often find myself having to deal with problems that could have been avoided had the relationship between the company and the VC been structured differently at the outset. In advising a start-up company or a VC fund investing in one, a lawyer must be able to anticipate future issues and convey to the company or the investors the consequences of their decisions.
Several years ago, for example, VC funds insisted on receiving a liquidation preference that was two or even three times the money that they invested. The idea was to guarantee a reasonable return on their investment. In most cases, however, the result was exactly the opposite of that intended. The founders, who were crucial to the success of the company, lost their incentive to put their whole life and soul into the company, realizing that, due to the liquidation preferences of their VC investors, they would only see a profit if a huge and unlikely exit were to occur.
An inherent conflict of interest developed. The VCs were willing to settle for a relatively small but reasonable exit event (merger or sale) that would generate their promised liquidation preference. The founders, on the other hand, were willing to assume great risks in order to create a company with high value. The result was that most companies failed. Today, VCs understand that they need to settle for less of a guaranteed return in order to increase the chances of profiting from their investments. This can be achieved in various ways, such as securing a smaller liquidation preference or promising the founders a preference, too.
The following are some additional considerations that a company and investors should take into account when deciding upon a corporate structure or in structuring a potential investment.
Ownership of Intellectual Property. An innovative idea may be developed at one’s home, or place of work or research (oftentimes a university). It is at this early stage that decisions are made, even unknowingly, that may be critical to a future company. For example, if the company founder is a researcher at an academic institution, any idea that is developed and related to his research with this institution may belong to the institution. Similarly, if the founder was in the employ of the army, or even in the reserves, the army may have a claim on any such idea, even for a period after the employment or military service has ended. If the founder does not handle this correctly, he may find himself with a great idea and product that is not his. A release from the research institution needs to be obtained (often by granting the institution an interest in the company, product or patent) at this early stage. The price of trying to negotiate a release with the institution at a later stage, when the economic potential of the idea is already clear, may be very high.
When and where to form a company and transfer intellectual property to it are also critical decisions for a founder. Timing is important. The later that IP is transferred by the founders, the greater its value may be, and hence the larger the potential tax consequences of such a transfer.
There are several considerations regarding the location of the IP. An advantage to having a company registered in Israel and owning the IP lies with the availability of government incentives, such as grants from the Chief Scientist or the Investment Center. However, the price – often ignored by the founders who are in desperate need of quick funding – is the conditions attached to government incentives. These require the IP to remain in Israel and royalties to be paid to the Chief Scientist once revenues are generated from a product developed with research grants. These may not seem to be of immediate concern to a newly formed company, but they may have an impact on the company’s ability to raise money from investors or its ability to undergo a merger or acquisition, especially with a foreign acquirer.
Tax considerations. Tax considerations must be taken into account from the beginning. Volumes can be written about this issue without covering every potential problem, yet I’ll present just one example that demonstrates the importance of thinking about all tax consequences in advance.
A reasonable investor would want to guarantee that the founders remain in the company, at least during the early, critical years of its life. One of the most common ways to do so is by conditioning the founders’ stake in the company on their continued involvement by subjecting their shares to vesting or reverse vesting (i.e. the right of the company to repurchase the founder’s shares if he leaves). However, under US law (to which the founder may become subject if, for example, he relocates to the US when the company grows), the mere imposition of the vesting or reverse vesting mechanism may subject the founder, upon a sale of his shares, to income tax (that may reach the rate of 50 percent or more on profits) rather than capital gains tax (that is much lower). To avoid this, the founder must take certain actions immediately upon the imposition of the vesting restrictions, which cannot be made retroactively.
Finder’s Fee. When in desperate need of funding, start-up companies are often willing to promise the sky to whoever is able to bring financing. However, in their haste to obtain financing, they often neglect to discuss the details of the finder’s agreement with the finder, such as issues relating to termination, when entitlement commences and what constitutes facilitation of an investment. If the agreement with the “finders” is not drafted correctly, once funding is raised, many companies find themselves owing a fee to several “finders,” most of whom were not even involved in the fund raising.
Options to Employees. Structuring an incentive plan for company employees is a challenging endeavor. In addition to general considerations, such as the terms of the vesting, scope of the plan, etc., issues relating to the rights associated with the option shares are of major import and could even inhibit the company’s ability to operate or conclude a desirable merger or sale.
Typically, the scope of an option pool is between 10 percent and 20 percent of a company’s share capital. When all options are granted and vested, this percentage can alter decisions at a shareholders’ meeting. A company can avoid this situation by granting employees options to purchase non-voting shares or by a provision in the plan that conditions employee exercise of the options on their granting a proxy to vote their shares to the CEO, VC representative or trustee, who will undertake to always vote the shares with the majority. By so doing, the shares will never have a real effect on decision-making. Additionally, the plan could include a “bring along” provision, whereby a majority of company shareholders can force all the employees to exercise their options and sell their shares in a contemplated merger. The drafting of such a “bring along” clause needs to be done carefully, as there are relevant provisions in the Israeli Companies Law that apply to a “bring along” scenario and need to be qualified to the maximum extent permissible.
In a recent merger negotiation in which I represented the potential acquirer, options in the target company were to be exchanged for options in the acquirer. However, the acquirer was only willing to grant options to those employees it wanted to retain. As for employees it did not wish to keep, it was willing to “buy them out” by making a cash payment for the value of their vested options. However, the option plan of the target company did not allow for discriminating treatment among employees. Some employees (who otherwise would not have been retained) used this to negotiate a higher price for their options or to negotiate a position with the acquirer that they otherwise would not have received. With advanced planning (through a provision allowing for discriminating – yet fair – treatment among employees), this expensive drill could have been avoided.
The issues raised here are just of few of those faced by early stage companies. My intention was to show that attention must be given to even the smallest detail in forming, operating and investing in a start-up company, which can facilitate companies and investors in reaching a desired exit.
Zellermayer Pelossof has extensive experience in structuring investment vehicles, including new and successor venture capital funds that invest in a variety of high-tech industries – telecommunications, biotech, medtech, homeland security, cleantech, software and more. Zellermayer Pelossof is frequently called upon to represent entrepreneurs starting new companies – from inception and seed financing through their mature stages.
This article appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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