Equity Promises, Promises, Promises

“Your ego is writing checks your body can’t cash.” – Stinger – dialogue from” Top Gun”

When I started this blog over four years ago, I promised myself I would not repeat a topic, and to prevent that, I keep a file of all my blogs. Well today, I have to break that promise. The reason is simple; I spent a great deal of time on three new clients (and prospects) recently dealing with this issue. So I thought maybe visiting it again will prevent at least a couple of early stage companies from having to confront this dilemma. So let’s just take one case.

An entrepreneur contacts me for help with a series of acquisition transactions. He and his team of three have been working on this project for a little over a year – – none are taking salary but all have a promise of “a piece of the pie” once they get a bit further along. The good news is the CEO is calling to tell me an investor believes in what they are doing and just invested $200,000 for 10% of the business. They are also close to a Letter of Intent on the first target. We proceed to spend the next 2 – 3 hours talking structure, due diligence, and deal points and start to lay out a roadmap to completing the first transaction. All good so far.

Being obsessed with equity, I ask about the other three team members. The CEO had made a de minimis investment to get started and the other three joined shortly thereafter. I asked what their “deals” were, and as usual, there was nothing in writing, but verbal agreement that they would each get 5% of the business. Of course, they would all vest and all were expecting to get in at “founders’ share” (i.e. de minimis) prices.

So I asked the first question; was the new investor aware of the “promises”, and unfortunately, he was not. So in the end, the 15% (and perhaps more) will probably have to be taken out of the CEO’s shares. The next question was what would be the mechanics of the key employees’ deal? The answer was that now that there were funds, they could afford to get legal counsel to draw up the paperwork and issue the shares. I was amazed to find that though there was a bona fide transaction for the recent investment which valued the Company at about $2 million, the CEO thought he could issue these shares at the de minimis value.

The lesson here is while there are investment vehicles that may not establish value (convertible notes – often cited as “kicking the can down the road” on this topic), pure equity deals due create economic value that have to be considered when granting equity. In all of these cases, solving this issue is going to take money and time; two rare resources for an emerging growth company. So as I have said before, nail down the equity issues first and treat it like gold because I believe that though cash is king; today equity funds the monarchy. Be very diligent (use advisors) when determining when and how much equity others get because you do not want to “write checks your body (company) can’t cash.”

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Why Acquisitions Fail

“Everything’s so green!” – line by King Louis XVI from Mel Brook’s “History of the World”

Over the years, I have worked with many clients on dozens of acquisition transactions. When I think back to the early stages of any of these deals, it conjures up this line from “History of the World.” A potential deal was like a new love; everything looked fantastic and the benefits seemed to far outweigh any issues; leading to that often-used phrase “it’s a no brainer.” For my more strategic thinking clients, this was often the case. I can still picture a mosaic one of my clients created in the early years of his company, detailing product features he thought were required to capture the market. With a solid assessment of the company’s capabilities, he conveyed a clear vision as to what the company would develop and what they would acquire. This became one of many success stories. But what about the failures?

When a client would call, and indicate they were interested in acquiring a company for reasons such as the target company was available or they could be bigger with an acquisition, my antennae would always go up. I quite honestly rarely saw what I considered non-strategic deals for the sake of growth work. By the time those deals were done, they usually started to come undone as the expected returns quickly faded. So besides being poorly conceived, what caused these deals to fail? I can think of four reasons:

  • Growth over culture. Money never trumps culture and nowhere is this truer than in the case of an acquisition. If the deal is not a good cultural fit, it will fail.
  • Poor post transaction planning. The details on how you are going to operate post-deal is a major factor in its success. Broadly addressed as Post Merger Integration, poor execution in this phase is a major cause of deal disappointment.
  • Unrealistic synergies. You can’t just eliminate bodies without contemplating the consequences. As to the market and customers, there were probably good reasons the two companies existed before the deal and thinking one can handle what the other did without a well vetted understanding is fool’s play.
  • Seller’s remorse. An independent owner gets acquired and has the chance to bring his company to the next level as part of a larger organization. Sounds good in theory, but when an entrepreneur has not reported to others in a long time and now he must, it doesn’t always work. If there is an earn out involved, this often complicates the matter.

So, consider the tough stuff in the early stages of a deal when everything seems to be great. Ask the difficult questions and complete the full due diligence including what is going to happen when the honeymoon is over. With the right work, upfront you can avoid transaction failure and everything will look green – especially your bottom line.