Why Your Governing Documents May Not Work

A lot of venture firms have been disappointed recently to discover that their portfolio company charters don’t work as well as they would have hoped especially in terms of exits. Problems arise when the merger includes escrow, holdback, and earn-out provisions and liquidation preferences are not fully met by closing proceeds.

Many company formation documents contain a provision that says that the preferred stockholders can either take their liquidation preference or take the portion of proceeds they would get if they converted their preferred shares into shares of common stock, but not both. This is the so-called “non-participating” preferred stock, but a similar issue can arise if the preferred stock participates up to a cap. This creates a problem if a sale contains a large amount of contingent consideration because the preferred stockholders may be stuck with the difficult choice of either (i) taking their preference from the payment made at closing but forfeiting the right to fully participate in the upside potential of possible future payments or (ii) converting to common stock and not getting all of their money back at closing in hopes that enough of the subsequent payments are made to make them better off. It can also raise an uncertainty as to whether the preferred stockholders should have a portion of their merger proceeds subject to the terms of the escrow. Common stockholders may believe that all contributions to the escrow account should be made pro rata based on gross merger proceeds receivable by all stockholders. The acquiring entity likely prefers this formulation too in order to ensure that the largest stockholders (who likely have representatives on the Board) have “skin in the game” with respect to the escrow and the quality of the representations and warranties. Preferred holders, however, may object to this formulation if a portion of the merger consideration is paid to common holders while preferred holders risk receiving less than a return of their capital should there be an indemnification claim.

The typical forms of company formation documents have been widely used in the industry for decades. Why have these potentially problematic formulas been broadly accepted for so long? It’s not totally clear, but there are a few explanations that seem to make sense. First, the parties may not want to navigate these issues when consummating a financing of a portfolio company. They may view these risks as somewhat remote or may want to stick with more material issues to start the relationship with the entrepreneur on favorable terms. In other words, the parties pick their battles and choose to punt on these issues. Second, these forms were drafted when the pooling of interests accounting rules were still live. Under those rules, the contingent consideration component of a deal couldn’t be very large for the transaction to still qualify for pooling treatment. Therefore, the difficult issues described above didn’t come up very often. Third, during the dot com boom, venture firms weren’t that interested in the exits that just got them their money back or a small return. The venture model focused on having a portfolio with a few home runs, and frankly, nobody focused much on the singles and doubles. Singles and doubles are much more important in today’s model.

The major law firms serving the venture community have terms in their standard forms that can address these issues, but on many deals they are not used. While the issues may seem insignificant (and maybe not even contemplated) when term sheets are negotiated, they can be become tricky when deal mechanics and payouts in a merger are complicated. Investors and entrepreneurs should strongly consider having this discussion at the investment stage to avoid having to deal with inter-shareholder controversies when trying to finalize a sale or merger of the company.