Global Startup Blog : Startup Lawyer & Attorney : Reed Smith Law Firm : Corporate Law, Venture Capital

Divergent views of valuation is almost always the biggest hurdle to overcome when matching potential buyers and sellers in venture-backed M&A exits.  Buyers obviously want to take as little risk as possible, whereas sellers are highly motivated to seek the maximum sales price.  Earn-outs are often a way to bridge those gaps.  

In theory, earn-outs are great.  The parties come up with a "pay for performance" formula that eliminates a significant portion of the overpayment risk for buyers while still making sure that a seller receives maximum value, assuming that the acquired company performs as good or better than advertised.  In reality, earn-outs are fraught with risk due to the likelihood of post-closing disputes over the calculation of the earn-out payment, whether the buyer lived up to expectation in attempting to maximize the performance of the acquired business for purposes of triggering the full earn-out payment, and so on.

A recent Delaware Court of Chancery decision highlights some of the pitfalls that executives and attorneys should try to avoid when using earn-outs.  There are three principal takeaways from the case:

• Buyers should insist on express non-reliance provisions in all acquisition agreements that contain earn-outs or other post-closing obligations to ensure that any claim of detrimental reliance is decided within the four corners of the agreement.

• A Delaware court is unlikely to read into an agreement unwritten provisions or protections when a sophisticated party failed to failed to negotiate such provisions or protections into the agreement itself.

• Earn-outs, while a great way to bridge the valuation gap between buyers and sellers, should be handled with great care during drafting.

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Over the last few months, three technology darlings, Facebook, Zynga and Yelp, have closed deals with venture capital funds that included both an investment in new shares and also the acquisition of existing shares from employees and other major stockholders.  The secondary piece of those deals is somewhat unique because it gives those employees or stockholders the opportunity to liquidate some or all of their equity positions without the company filing for its initial public offering.  Illiquid securities sales facilitators like SecondMarket are also providing the opportunity for early liquidity by matching equity holders in venture-backed companies with willing buyers outside of the public markets.

The question, of course, is whether this new trend in venture capital investing or the emergence of SecondMarket is going to radically change the IPO market.

If by radically change, we are talking about reducing the numbers of offerings by elite technology companies, I'm not sure that anything can really move the needle significantly compared to the last two years when technology IPOs were about as common as Bigfoot sightings.  The fact remains, though, that employees often choose to join hot venture-backed companies and take annual base salaries below the current market in exchange for the dream of a quick infusion of cash thanks to an IPO or acquisition.  The market meltdown in late 2008 has dramatically affected the personal finances of those individuals, who are now forced to hold on to what has traditionally been illiquid stock for far longer than they would like.  The lack of exits certainly has hurt venture-backed companies attracting rock-star employees.  But the emergence of secondary pieces to late stage venture capital investments and facilitators like SecondMarket helps solve that problem.  It also dramatically reduces the pressure on a company's board of directors to take a company public.

As a result, I think that hot technology companies will now wait until there is a compelling reason to begin the IPO process.  IPOs have always been expensive transactions to consummate, both from a dilution standpoint and also in terms of legal and accounting fees.  But the maintenance fees for public companies weren't that big of a deal, until Sarbanes Oxley came along and completely changed the game on operating as a public company from a cost perspective.  And that change certainly wasn't to the benefit of companies, though the protections add a good layer of protection for stockholders of listed companies.  Thus, companies haven't been rushing to the IPO gates like in the pre-SOX days, and the emergence of the new liquidation avenues discussed above will only slow that race even more.

Nevertheless, I don't think that either secondary pieces to venture investments or illiquid securities sales facilitators will completely derail the need for companies to go public.  Indeed, both VCs and facilitators need robust exits for their strategies to continue to work, which is why these liquidity strategies aren't implemented in very young companies, opting instead to work with startups that have been around for several years and look like excellent IPO or acquisition candidates.  If anything, I think that the market for exits will be more robust, maybe not in terms of numbers of deals but in terms of quality of deals, as a result of these new liquidity strategies.

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For the first time in nearly a year, the venture capital industry showed a positive return, according to Cambridge Associates, LLC.  The Cambridge US Venture Capital Index returned 0.2% for the three-month period ended June 30, 2009, ending three consecutive quarters of negative returns.  Of course, in an economy still clouded in doubt and pessimism, the positive news was paired with a cautionary outlook.  Managing Director Peter Mooradian raised questions about whether the asset class can generate sufficient exits to provide healthy long-term returns. 

It will be interesting to see the figures for the current quarter after Google's recent acquisition of AdMob for $750 million and EA's recent acquisition of PlayFish for $300 million (with an additional $100 million in earnouts).   

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