Preparation Is The Best Cure For Pre-Exit Squabbles

There is just one thing I hate about start-up company exits (sale or IPO): they can destroy relationships and bring out the worst in some people. In the start-up world, people work for years, often more than a decade, for one big payday, the exit, when their equity stake turns into spendable money, hopefully quite a bit of it. When a large amount of money finally flows, stakeholders often make demands, usually backed by threats, to recut the deal in their favor. People get very angry, relationships are lost, and the exit can even fall apart. Managing this problem is vital.

Companies have ownership structures that are designed to determine who will receive what payments if the company is sold, or who gets what shares if it goes public. These are carefully documented and enforceable in court. When key employees are hired, they receive equity awards (shares and options) that are part of this structure, as are the securities purchased by investors and sometimes granted to strategic partners. These transactions are documented carefully. The board of directors is responsible for administering these agreements. All this amounts to an explicit, detailed, and formal attempt to pre-bake who receives what when the exit finally occurs.

Alas, dividing up the proceeds is rarely straightforward, for two reasons. Over the years circumstances can evolve in ways the original documents did not anticipate. This creates both legal ambiguities (the documents don’t address the actual situation) or legitimate fairness problems that the board of directors needs to address. And, key people have leverage as an exit approaches. The company needs them to put on game faces and sell in the due diligence process. Major shareholders (e.g., founders no longer at the company) need to approve the transaction to allay the buyer’s concern about lawsuits. The buyer or IPO underwriters will want the key employees to pledge continued service to the company, as they are a big part of the value. And some investors have been known to make demands at the goal line, too. The legal ambiguities, fairness problems, leverage enjoyed by key employees/shareholders, and plain old greed can mix together, creating a toxic brew.

I was an investor in and board member of “Sparkle” (made-up name), a start-up company that a major industry player offered to acquire. One of the VPs (“Gus”, also a cypher) had come onboard in the last couple of years and received the standard equity incentive for a VP: about 1% of the company, vested (i.e., doled out) over four years. Hence he would receive only ~0.5% from an immediate exit. He came to the CEO and demanded immediate vesting of his equity. And, he threatened to poison the well during the due diligence process if his demand was not met. There was no legal ambiguity (the option award was well documented) and no fairness issue either: the other VPs had similar equity award percentages and vesting formulas, and they had served much longer: it would be unfair to them if their aggressive colleague received the same value from the exit. But Gus made a naked threat to torpedo a 9-figure acquisition. Regrettably, this kind of thing is pretty common.

Fortunately, the CEO was able to stand Gus down with a minor concession that was tolerable by peers. The CEO is a good manager who had built a good relationship with this somewhat difficult man. I wasn’t in the meeting with Gus, but I helped prepare for it. The case we made went: Gus was probably not important enough to kill the deal, and if he did somehow kill the deal he would have to face his colleagues and the shareholders the next day. If he was found to have lied to the acquirer, there could be lawsuits. The CEO is a calm man with a fatherly personality. Gus saw reason.

These situations are highly frustrating, sometimes painful. Here is how to minimize the pain.

Keep your documentation in good shape, especially documentation of liabilities, securities and equity awards. You’ll be glad you did.

Plan for the exit negotiations. For example, when you structure equity awards to key employees, delay post-exit payout of about half the award until the employee has remained with the buyer for about a year, provided s/he is offered a suitable job. Otherwise acquirers often force sellers to give employees extra incentive comp to stay on. Experienced employees know to expect this kind of deferral: they get that the mission is to build the company and then realize value via sale or IPO, and key man retention is necessary to mission success.

Keep the dialogue and relationship with key employees strong. Festering disputes and insults will erupt at exit time when stakes are much higher.

Pay attention to the buyer’s reputation. Some play it relatively straight and some are crafty folk who like to play games. The buyer’s games, e.g. the details of the key employee retention program, can add fuel to the fire described above. If you have a choice, you might prefer a more straightforward buyer, else be extra sure to have your house in order before entering the M&A process.

As you start the stakeholder negotiation to adjust payouts, make sure you have the key facts well documented and ready to share. People will have varying recollections of key facts and past conversations, recollections usually aligned with their interests. A shared understanding of the facts reduces the scope and impetus for re-negotiation.

Stay on top of the numbers: how much each person will get, how big a difference the disputed points make. In a great exit where everyone gets rich, it’s usually easier to work things out: there’s no hardship and a huge shared interest in closing the exit. The battles are most intense when management and investors have been working for a long time but have to settle for an exit that fails to pay back capital and leaves managers with small reward for long effort. Everyone may feel deep down that they deserve more, and this is the last chance to push for it. Reaching agreement can be very hard.

Listen to arguments about inequities seriously but remember that your job is not to be everyone’s friend. There usually are some situations that need equitable adjustment, for sake of fairness of expediency, but in most cases adhere to the contracts.

Last, do not let emotion take charge. Many stakeholders will quickly go emotional because the stakes are high, they have a lot of themselves invested in the situation, and they may think they can win that way. It’s usually good to listen carefully and show that you feel strongly too, but then you need to bring the temperature down and emphasize facts, standing agreements, the need for fairness on all sides, shared interest in getting the deal closed, and the value of maintaining relationships.

In my experience, most deals get done in the end, very few participants get everything they wanted, and not everyone parts friends. You’ll do better if you are prepared, patient, and cool in moment. Good luck!

First posted @ on May 8, 2018.