I was speaking at an event last month to a group of CEOs and was surprised by the number of CEOs that were worried about the value of their common stock in a M&A transaction.  Due to aggregate liquidation preferences that may exceed the acquisition price in an M&A deal, common stock may be rendered worthless.  For example, if a company has raised $20M in venture financings by issuing non-participating preferred stock, the holders of common stock will not receive any proceeds from an M&A transaction unless the transaction value exceeds $20M.  If you can’t figure this out yourself, you should probably build a liquidation preference spreadsheet to model how liquidation preferences work depending on M&A transaction value.

In response to the problem of worthless common stock, some companies have implemented employee retention plans, which are also referred to as M&A carveout plans. This was particularly common from 2001 to 2003, after the dot-com crash when companies had raised a large amount of venture financing at high valuations.

Below are some common structures for employee retention plans and issues related to each alternative.  I have intentionally not covered all of the corporate law implications of designing and implementing a retention plan or provided a comprehensive analysis of any particular tax or accounting issues, as they are fairly complex and depend on specific facts.  A company’s board of directors will need guidance from counsel on meeting their fiduciary duties when implementing a retention plan.

1. Change of Control Bonus Plans

Under a change of control bonus plan, eligible employees are entitled to certain benefits upon change of control transactions as specifically defined in the plan documents.  This can be simple as an agreement with an individual employee that says “if you are still employed when the company is sold, you will receive $X.” 

More complex plans set aside a pool of money for employees and a mechanism for dividing the pool.  In addition, the plan could pay a fixed amount under the plan to the individuals, regardless of the value of the triggering event.  Alternatively, the plan could pay a percentage of the proceeds from the triggering event (e.g. 10% of the size of the deal). In some cases, the payout may be a sliding scale (e.g. 10% of the first $5M in proceeds, 15% of the next $5M in proceeds, and 20% of the amount over $10M).  In plans where the size of the payout is dependent on the size of the transaction, the definition of the transaction value needs to account for situations such as assumption of debt by the acquiror, earnouts, escrows, and illiquid stock as acquisition consideration, among other things.  In addition, given that the plan is intended to solve for situations where common stock is worthless, they should terminate above certain transaction values, or payouts should take into consideration the value of the common stock.

2. Straight Retention Plans

Under straight retention plans, eligible employees are entitled to certain benefits or payments that are not contingent upon any triggering event, such as a change of control.  These bonus payments may be paid as long as the employee is employed on a certain date (i.e. 50% of base salary if still employed 6 months later).

The following issues relate to both change of control bonus plans and straight retention plans:

• Currency. The company must determine the currency with which to pay the eligible employees. Typically, employees receive stock, cash or a combination thereof.  A retention plan that pays employees in acquiror stock is less common than a cash payment plan as payment in acquiror stock will be ordinary income to the employee, and receiving illiquid acquiror stock in a taxable transaction is not desirable in most situations.

• Participation. The company must determine which employees are eligible to participate in the program. Executive management is typically the key participant, however, participation may be determined by time of service or benefits can be given to all employees.

• Allocation. Once the company has determined who is eligible, they must further determine how to allocate the units or stock to be issued to the employees. Alternatives include position, time of service, current equity holdings or other metrics as determined by the company’s board of directors.  The board can set aside some of the “retention pool” for future issuances. However, it must determine when establishing the plan what will happen to the pool upon certain triggering events.

• Vesting. The company must determine whether the stock or cash distributed will be fully vested at the time of grant or will vest over time. The company must further determine which, if any triggers, will accelerate vesting and to what degree.

• Last Man Standing. Related to vesting issues, the company must also determine whether benefits will be forfeited if employees are terminated within a certain period of time of the change of control and whether the forfeited benefits will be redistributed to remaining employees.  If the employee needs to be employed at the time of the change of control transaction, this may lead to a perverse incentive for company management to terminate employees, especially if the forfeited benefits are redistributed to remaining company management.

3. Junior Preferred Stock

Some companies have implemented junior preferred stock, which often receives a certain percentage liquidation preference on the sale of the company.  The junior preferred can be created as an option plan or sold directly, with or without vesting.  The junior preferred is often junior to existing preferred stock, but senior to common stock, in order to provide liquidation preference for certain classes of employees, senior to common stock.  Participation, allocation and vesting issues are similar to those described above.

I’ve had some comments and emails asking if I would publish a liquidation preference spreadsheet.  Basically, when a company is thinking about an M&A deal, the first thing that everyone wants to know is how much money does everyone get from the merger proceeds.

Download Sample Liquidation Preference Spreadsheet

The spreadsheet is fairly straightforward.  You can plug in the deal value (merger proceeds) and spreadsheet automatically figures out exactly how much each founder gets and what the return per share is for each class/series of stock.  The spreadsheet determines if a series of preferred stock should convert based on whether the series would receive more merger proceeds as a holder of preferred stock or common stock.

The spreadsheet also takes into account whether options and warrants should be exercised or not.  For example, if the deal value is too low, the common stock merger consideration price per share may be lower than the exercise price for options.  Then the options will not be exercised.  Whether the options are exercised or not will affect the number of outstanding shares of common stock and therefore, the common stock price per share.

This spreadsheet assumes three rounds of financing with non-participating preferred stock, a couple of tranches of warrants (as a result of a bridge loan or two), and options with various exercise prices.  In my redacting of information in the spreadsheet, I’m sure that there is something broken.

I might post a spreadsheet in the future with more bells and whistles, such as the ability to easily manipulate the formulas for senior preferred and participating/non-participating preferred, as well as graphs to show the merger proceeds per share as aggregate merger proceeds increases. Please don’t expect any support or explanation on how the spreadsheet works. I already told someone who had emailed me that I might consider providing a tutorial if she brought my a decaf soy latte and a Sprinkles cupcake some afternoon.

[The following post is courtesy of Priya Cherian Huskins, Esq., a partner and senior vice president at Woodruff-Sawyer & Co., an insurance brokerage headquartered in San Francisco, California.  Priya specializes in director and officer liability and its mitigation through both insurance and corporate governance solutions.  This article was first published in the 2008 edition of Boardroom Briefings: Mergers and Acquisitions, and has been republished here with Priya’s permission.  Priya was previously an attorney at WSGR.]

Consider this scenario: a company’s CEO tells his board that he has received a compelling offer for the sale of the company.  Upon reviewing the offer, the directors agree that the offer is attractive, and think that the shareholders would be well-served to accept the offer.  However, as experienced board members, they know that the potential sale of a company is an inflection point for litigation.  After all, 24% of securities class action law suits include merger-and-acquisition-related allegations[1], and shareholders often bring breach-of-fiduciary duty suits in connection with M&A activities.

The board’s next steps are critical, both to maximize shareholder value and to avoid litigation that may result from failing to do so.  This article outlines the fundamental duties of a board considering the sale of a company.  The article also details what a board can do – beyond diligently fulfilling its duties – to protect itself from liability and thereby focus entirely on promoting the interest of shareholders.

What Are a Director’s Duties under the Law?

When it comes to directors’ duties, it is always useful to think in terms of the golden triad of the duties (1) care, (2) loyalty, and (3) appropriate disclosure.  As is the case in other situations that call for director action, this triad provides a useful framework for thinking about the sale of a company.

1.  Duty of Care.  The duty of care requires that directors diligently pursue the interests of the shareholders who elected them.  Consistent with this duty, and articulated in the well-known Revlon[2] case and its progeny, once a company is up for sale directors of the company must “undertake reasonable efforts to secure the highest price realistically achievable given the market for the company.”[3]

If the board’s efforts are subsequently challenged, the court will review the process set up by the directors for reasonableness.  This is a tougher standard of review than the usual “bare rationality” standard that courts apply to other board decisions, referred to commonly as the business judgment rule.  As one Delaware Chancery Court opinion described it, “this reasonableness review is more searching than [the business judgment rule’s] rationality review, and there is less tolerance for slack by the directors [emphasis added].”[4]

Recognizing that one size will not fit all, Delaware courts have declined to provide boards with the comfort of a “judicially prescribed checklist of sales activities.”[5] Instead, directors must use sound business judgment to construct a deliberate, systematic sale process reasonably designed to maximize shareholder value.

One sale process that most would agree is designed to maximize shareholder value is to conduct an auction of a company.  There is, however, no requirement to conduct an auction of the company.  In the June 2007 Delaware Chancery Court decision concerning the sale of the baseball card maker Topps Company, Inc., the Court noted that in light of a failed auction attempt two years earlier there was no need for the company to conduct an auction when it decided to sell itself.  The Court ruled this way in part because Topps did not have a poison pill in place that would otherwise discourage other buyers from approaching the company.[6]

Nevertheless, companies should be on guard against prematurely cutting off alternative buyers.  Consider, for example, the proposed sale of Netsmart Technologies, Inc.  In its March 2007 decision concerning that company’s sale process, the Delaware Chancery Court was unimpressed by the board’s consideration of only private equity buyers.  The Chancery Court took special note of the board’s failure to consider strategic buyers when it decided to sell the company.  In the words of the Chancery Court “it was incumbent upon the board to make a reasonable effort to maximize the return to Netsmart’s investors. On the existing record [which supports no serious consideration of strategic buyers], I cannot conclude that their approach to this issue is indicative of such an effort.”[7]

Part of a board’s ability to put together a reasonable sale process will depend on the board’s familiarity with a variety of sophisticated deal-protection devices such as no-shop provisions, break-up or termination fees, matching or topping rights, and the like.  In addition to understanding the mechanics of these types of provisions, a board must also understand the impact these types of provisions will have on the board’s ability to maximize value for its shareholders.

This is an area where the board is well-served by seeking advice from independent litigation counsel and having its discussions with counsel protected by the attorney-client privilege.  Consistent with the public policy that supports attorney-client privilege, a board will want an opportunity to freely ask questions about the proposed transaction and to debate the merits of the deal.  The possibility of future litigation can chill this kind of back and forth.  Directors may fear that in future litigation their genuine and sincere questions will be misconstrued as evidence of nefarious intent.  In light of all of this concern, the board should ask outside counsel specific questions about how to protect the privilege, and then to follow the protocol outside counsel recommends.

Finally, in addition to having a good sale process, a board is well-served by documenting its sale process in a timely and diligent manner.  A too-casual approach can result in few formal meeting minutes or worse still the exercise of approving minutes after litigation has commenced.  The board will not want to appear casual if it finds itself in the midst of hotly contested litigation over the adequacy and diligence of its efforts.

2.  Duty of Loyalty.  The duty of loyalty requires that directors act in an independent manner and with regard only to the concerns of the shareholders.  In the context of the sale of company, it is inappropriate to favor one buyer over another for reasons other than the maximization of shareholder value.

One way to violate the duty of loyalty is to give preferential treatment to a buyer that plans to keep current management and/or board members around after the sale has closed.  The possibility that a potential buyer was treated more favorably by management due to promises made to keep management in place post-closing was exactly the conflict of interest issue that was brought to the Delaware Chancery court’s attention in the earlier-described Topps transaction.  In reviewing the facts of the case, the Chancery Court found that the bid of a potential acquirer that would likely have replaced management was treated less favorably compared to the treatment accorded another bidder that had promised to retain management.[8] This was part of the reason that the Court was unwilling to allow the merger vote to move forward without giving the badly treated potential buyer an opportunity to communicate directly with Topps’ shareholders.

Forming a Special Committee of the board composed of outside directors to drive the sale process is a way to mitigate the potential conflict-of-interest issues with respect to incumbent management.  If the board decides to go in this direction, the board should form the Special Committee sooner rather than later to get the maximum benefit of the Committee.  One decision early in the process that is best undertaken by a Special Committee-and not management-is the scope of the types of offers and buyers the board will entertain.[9]

The Special Committee should avoid delegating too much authority to any member of the management team who has a conflict of interest.  Doing so considerably weakens the protection that the formation of a Special Committee can offer.  In its June 2007 decision concerning the sale of the Lear Corporation, the Delaware Chancery Court specifically addressed the issue of putting in charge of negotiations a CEO who had a clear personal interest in having a sale consummated.  Although the Court ultimately decided that there was no evidence that putting this CEO in charge of negotiating this particular sale “adversely affected the overall reasonableness of the board’s efforts to secure the highest possible value,” the court still referred to the Special Committee’s decision in this matter as ” infelicitous.”[10] In other words, the Special Committee got lucky with the Court’s “no harm, no foul” ruling.

3.  Appropriate Disclosure.  It is uncontroversial that directors have a duty to disclose to shareholders all information that is material to a shareholder’s decision to vote on the sale of a company.[11] More specifically, directors are required to disclose balanced, truthful, and materially complete information.[12] In the heat of a sale transaction, it can be all too easy for management and boards to neglect to adhere fully to this requirement.

This was an issue raised in the 2007 Netsmart Technology decision.  The board and management’s failure in this regard caused the court to require the company to provide more information to shareholders prior to holding a vote on a proposed merger. Specifically, the Chancery Court wanted to make sure that the shareholders had a chance to review the discounted cash flow analysis that the company’s investment bankers prepared because the shareholders were being asked to rely on a fairness opinion that itself relied on these projections.  In the words of the court, “[o]nce a board broaches a topic in its disclosures, a duty attaches to provide information that is materially complete and unbiased by the omission of material facts.”[13]

What Else Can Directors Do to Protect Themselves?

Even the best board with a laser-like focus on its duties of care, loyalty and disclosure may find itself the target of a suit brought by disgruntled shareholders or perhaps a disgruntled bidder.  A board’s concern over such suits can result in excessive caution, which is not in the best interest of shareholders.  Consequently, the natural next question is “what can board members do to protect themselves from personal liability?”

First and foremost – and well before any potential sale event – directors should update their personal indemnification agreements with their companies.  Rather than rely on a contract that may be many years old, directors should ask someone who represents the board to review the indemnification agreement to ensure that they have the most protective language possible.  This review should pay special attention to change-of-control provisions.  For example, indemnification agreements should expressly require an acquiring company to assume the selling company’s indemnification obligations in writing.  This exercise of updating the board’s indemnification agreements ultimately inures to the benefit of the company’s shareholders by allowing the directors to put concerns of personal liability aside and focus instead on the business at hand.  It is also consistent with public policy position expressed by Delaware corporate law.  Delaware’s corporate law allows companies to protect their directors with expansive indemnification protections.

Next, and again well before any potential sales event, directors should confirm that their D&O insurance policies are well-designed.  If there has not been an independent check of the D&O policies for a number of years, conduct one.  D&O policies are highly technical contracts, and can be properly analyzed only by an expert in the field.  Among the provisions that should be analyzed are the change-of-control provisions, as well as provisions that prevent the knowledge and acts of another person – an officer, for example – from being attributed to a board member to his or her detriment.

Finally, when a company is ultimately acquired, the company’s board will want to make sure that a “tail policy” is purchased for the acquired company’s D&O insurance policy.  Typically six years in duration, a tail policy holds open the acquired company’s current D&O policy so that it will respond to new claims that are made against the acquired company’s directors after the sales transaction has closed.  The directors of the acquired company may not be in a position to demand protection from the acquiring company after the sale is closed.  Consequently, it is essential that the board of the selling company put this protection in place before the sale is consummated.  One way to do this is to have the directors’ personal indemnification agreements include the right to a tail policy should the company be acquired.

Serving Your Shareholders, Protecting Yourself.  In summary, the sale of a company is a high stakes event for shareholders, management, and directors.  The role of the board is to seek an outcome that is the best available to the shareholders.  To meet the demands of this role, directors must understand what is required with respect to the duties of (1) care, (2) loyalty, and (3) appropriate disclosure.  In exercising their duties, shareholders are not served when directors act with excessive caution.  Instead, shareholders are best served when directors can exercise judgment that is unclouded by the concern that, notwithstanding their good faith efforts, they will be faced with a shareholder suit.  To alleviate this concern, directors should take proactive steps before a sale is even on the horizon to obtain state-of-art indemnification agreements and D&O insurance policies.  With advance planning, a board will be well positioned to handle a sale in a way that effectively and properly promotes the interests of shareholders.

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[1] Woodruff-Sawyer & Co. Proprietary Securities Class Action Litigation Database.

[2] Revlon, Inc. v. MacAndrew & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1985).

[3] In re Netsmart Technologies, Inc. Shareholder Litigation, 2007 WL 1576151 (Del. Ch.).

[4] Netsmart at *15.

[5] Ibid.

[6] In re The Topps Company Shareholder Litigation, 2007 WL 1732586 (Del. Ch.) at 50.

[7] Netsmart at *18.

[8] Topps at 61 and 62.

[9] Netsmart at *21.

[10] In re Lear Corporation Shareholder Litigation, 2007 WL 1732588 (Del. Ch.).

[11] Arnold v. Society for Savings Bancorp., Inc., 650 A.2d 1270, 1277 (Del. 1994).

[12] Netsmart at *21

[13] Netsmart at *24.

The sale of a venture-backed company is typically structured as triangular merger, where the acquiror forms a merger sub that merges into the target company. The stockholder vote requirements for a merger are governed by state law and the company’s charter (Certificate of Incorporation in Delaware or Articles of Incorporation in California) and bylaws. (Occasionally, the company’s charter will need to be amended in connection with the merger to change the flow of merger consideration or other reasons. In this situation, the stockholder approval to amend the Company’s charter is also relevant.) The stockholder vote requirements under Delaware law and California law for a merger are outlined below.

Delaware

General. Delaware corporate law provides that a merger requires the approval of a majority of the outstanding stock entitled to vote. Companies cannot “contract out” of the Delaware law requirement. (In order to address the minimum vote requirements, some venture funds insist on drag-along provisions, which require stockholders to vote in favor of a merger if certain conditions are met.)

Practical answer. Generally, the necessary stockholder approval for a merger of a Delaware corporation will be (i) a majority of all shares on an as converted to common basis, (ii) any other approval required by the protective provisions in the Certificate of Incorporation, such as a separate series approval or super-majority approval, and (iii) any other approval requested by the acquiror in the merger, such as a super-majority approval in order to limit the number of stockholders that may exercise dissenters rights (to be covered in a future post). Acquirors asking for an extremely high percentage, such as 90% or 95% approval, is not particularly unusual in the sale of a private company, especially if there may be dissenting stockholders.

California

General. California corporate law provides that a merger requires the approval of a majority of the outstanding shares of each class of the corporation. This means preferred stock as a class and common stock as a separate class. Companies cannot “contract out” of the California law requirement. (In order to address the minimum vote requirements, some venture funds insist on drag-along provisions.)

Practical answer. Generally, the necessary shareholder approval for a merger of a California corporation will be (i) a majority of all common stock, (ii) a majority of all preferred stock on an as converted to common basis, (iii) any other approval required by the protective provisionsin the Articles of Incorporation, such as a separate series approval or super-majority approval, and (iv) any other approval requested by the acquiror in the merger, such as a super-majority approval in order to limit the number of shareholders that may exercise dissenters rights (to be covered in a future post). Acquirors asking for an extremely high percentage, such as 90% or 95% approval, is not particularly unusual in the sale of a private company, especially if there may be dissenting shareholders.

The fact that holders of common need to approve a merger of a California corporation is one reason why venture funds prefer Delaware. Venture funds don’t want common holders to have the ability to block a merger.

Section 2115 of California General Corporation Law and Examen, Inc. v. VantagePoint Venture Partners 1996

Section 2115 of California General Corporation Law (CGCL) provides that certain sections of the CGCL apply to non-California incorporated corporations if: (i) more than 50 percent of the corporation’s business is conducted in California; and (ii) more than 50 percent of their outstanding voting securities are held of record by persons having addresses in California. Except for corporations that are exempt (such as public companies), Section 2115 provides that California law supersedes the law of the jurisdiction of incorporation with respect to various matters including:

• the annual election of directors;
• removal of directors for cause or by court proceedings;
• a director’s standard of care;
• officers and directors indemnification;
• the liability of directors and shareholders for unlawful distributions;
• cumulative shareholder voting;
• class votes with respect to the approval of mergers;
• dissenters’ rights; and
• shareholders rights of inspection.

Section 2115 makes the merger approval provisions under California law applicable to “quasi-California corporations.” This means that a merger must be approved by the outstanding shares of each class, which means a class vote for preferred stock and a class vote for common stock.

However, the Delaware Supreme Court decided against the preferred stock having a class vote pursuant to Section 2115 in a case called Examen, Inc. v. VantagePoint Venture Partners 1996. Examen was incorporated in Delaware, privately owned and headquartered in California. Examen entered into a merger agreement with Reed Elsevier, Inc. Although Examen’s board of directors approved the merger, VantagePoint, holder of 83% of Examen’s preferred stock, claimed that it was entitled to a separate class vote on the merger pursuant to Section 2115.

Under California law, VantagePoint would be entitled to vote as a separate vote on the merger, which would have given VantagePoint a veto over the merger with Reed Elsevier. The Delaware Supreme Court held that Delaware law should be respected and VantagePoint would not receive a separate class vote, even though Examen qualified to be treated as a California corporation for the purposes of CGCL Section 2115. However, California courts are not obligated to follow the decision of the Delaware Supreme Court, so most attorneys still advise companies to obtain a separate common class vote and preferred class vote to be cautious.