It’s no surprise that in a crummy market, money disputes tend to surface more than when everyone is feeling flush. But it may surprise you to learn that those disputes are taking place over startups sold as long ago as in mid 2007.
San Francisco-based Shareholder Representative Services (SRS) is seeing the trend from the frontlines. The firm — which enters the scene as a company is acquired, representing its collective shareholders should claims arise — says that fully 12 of the 30 companies it currently represents are duking it out with their buyers over cold, hard cash.
“When business is booming, a buyer may not care about a quarter-million-dollar issue,” says Paul Koenig, a trained M&A attorney and one of SRS’s cofounders. “When it’s not, they start looking for every nickel.”
Because more than 50 institutional investors, including Kleiner Perkins Caufield & Byers and Sequoia Capital, have enlisted SRS to make their post M&A headaches disappear, I asked Koenig and his cofounder, Mark Vogel, to tell me more.
You’re seeing a lot of disagreements. Are these at startups that have been recently sold and whose value has since plummeted?
MV: Some are recent. Some are companies that sold 12 to 36 months ago. The buyers are being very aggressive in many cases, too.
On what are these disputes centering?
PK: They’re all over the map, but in some cases it’s third parties alleging infringement of the startup’s patents. The buyer is then claiming that the startup didn’t fully disclose something. We’re seeing disputes over working capital price adjustments–
Which are what?
PK: They’re disputes over what the working capital should have been at the time of closing, which is a far more complicated affair than checking a bank account balance. It’s usually a combination of a startup’s current assets minus current liabilities with dozens of provisos thrown in. Once you bake all that into your purchase agreement, there’s lots of room for disagreement, typically beginning two or three months after closing.
MV: Also, quite a few of these deals in this market are distressed deals, and when a company is in that stage of winding down and they’ve laid off staff, sometimes the books aren’t as comprehensive as if you had a full finance staff.
And in many cases, especially deals that happened 12 to 18 months ago that are reaching the end of their indemnification life, buyers aren’t getting the returns they thought they’d make, and they’re looking at provisions and asking: is there some way we can get some of our money back? Buyers get mad.
What recourse does the buyer have? What are its options?
PK: Usually there’s a meaningful escrow account with money to go after. Company X says we’ll give you $80 million at closing, and put $20 million in an account for 12 to 18 months until we can verify that everything you’ve told us is true. Buyers are trying to get at that.
MV: Companies are also using the fact that they often have different accounting policies. They’re trying to adopt and put in claims based on their policies and not the seller’s policies.
Who’s at risk here?
PK: Well, remember that claims are against stockholders, not the company itself. And stockholders are often these big venture funds. Most merger agreements say you go after the escrow account first, but in some claims, you go after the stockholders themselves.
That sounds a little alarmist. Have you had a buyer go after a venture capital firm?
PK: We haven’t had a deal yet where they’re trying to do that; it’s highly unusual and it’s usually for a claim or fraud, as in: you didn’t really have the authority to do this deal. But you do have pretty wealthy venture firms on other side if it comes to that.
But what leverage does a seller or its shareholders have if a big buyer says, I’m furious, and I want the money in that escrow account? I can’t imagine venture firms want to go to war over these disputes, or can even afford to right now.
MV: Our role is to investigate the claims, evaluate them, then on behalf of the shareholders, defend them or negotiate with the buyers.
What’s there to negotiate?
MV: Most deals do have working capital purchase price adjustments. So in virtually all the deals we’ve done, there’s been some discrepancy between what the sellers estimated was their working capital and what the buyers believe it is. We sometimes meet somewhere in between.
PK: You’re right, though. Buyers have a lot of advantages. They have greater financial resources. After closing, they control the files and data and information. Selling stockholders have significant disadvantages when it comes to the muscle and leverage that they can apply.
MV: What we also have are the merits of the argument, assuming we have an argument to make. And the buyer has the incentive to get this wrapped up quickly and on reasonable terms, too.
Keep in mind, too, that things can go the other way. Where buyers have laid off accounting staff and are left with people who don’t know everything about the transactions, their books and records may not be in the most pristine condition, so we’ll say: hey, you forgot this particular deal. And I’ll tell you that often, they do forget.
Have SRS resolved some of these disputes yet?
PK: Several. Some of these claims began to surface nine months ago.
Do you think any others will wind up in litigation?
PK: It’s certainly a possibility but we hope not.
What can companies and their shareholders do to mitigate post-closing risks in this environment?
PK: Make sure that you set up a meaningful expense escrow account, and that doesn’t necessarily mean an amount that scales to the size of a deal. An $8 million acquisition isn’t necessarily less risky than an $800 million deal. It’s based more on how contentious the negotiations are. Typically the amount in the account is between $100,000 and $250,000.
MK: Be very careful about how you define working capital price adjustments to minimize the potential for ambiguities that could lead to an dispute.
PK: Also, use objective criteria when negotiation earnouts. If it’s a pharamaceutical deal, it’s easy to say that the full amount is based on FDA approval. That’s pretty binary. If it’s based on your projection that the seller will see at least $50 million in sales by 2010, that’s not only hard to identify, once the company is absorbed, but it’s also subject to all sorts of manipulation. If you fire half the seller’s salespeople after the closing, the company is probably not going to hit that number, and there probably won’t be an earnout.
MV: Not last, make sure that inside the company being sold that its accounting policies are well documented, and that its cap table is up to date and validated. There are invariably going to be a lot of questions about both later on.
(FYI, SRS is paid between two to six basis points on the deal side to shepard the process from the day a sale closes. Vogel and Koenig tell me that’s for the life of the deal, no matter how long they’re involved in the process.)
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