INSUBCONTINENT EXCLUSIVE:
BowersContributorAndrew P
DixonContributorFor many founders, building and selling a successful venture-backed company for cash is the ultimate goal
However, the reality is that some companies will instead receive an equity-funded acquisition proposal in which equity of another private
venture-backed company, rather than cash, represents all or a significant portion of the purchase price.Because all equity is not created
equal, it is important for founders to understand how to negotiate for better equity in the context of such an acquisition proposal
This article explores what better equity looks like and some strategies founders can use to negotiate for that equity.To know what
“better” equity is for the seller, it is necessary to understand what the “worst” and “best” stock is in the context an
equity-funded acquisition by a private company buyer
The “worst” stock is plain common stock which does not enjoy any special rights and is subject to contractual restrictions which
diminish its liquidity profile
Common stock sits at the bottom of the priority stack (after debt and preferred equity) in the event the company dissolves or is sold —
thus, it is least valuable
Variations of transfer restrictions (e.g., a prohibition on private secondary sales) may further diminish the desirability of common stock
by making it difficult or impossible for the holder to achieve liquidity outside of an M-A event or initial public offering (IPO).In
contrast, the “best” stock is (1) the acquirer’s most senior series of preferred stock, coupled with (2) additional contractual rights
enhancing such stock’s liquidity profile
For our purposes here, we’ll call this “enhanced preferred stock.” All things being equal, founders and VCs should have a strong
preference for enhanced preferred stock in an equity-funded acquisition for several reasons:Usually, the most senior series of preferred
stock will enjoy a liquidation preference ensuring that a certain amount of proceeds (commonly equal to invested capital) from a sale of the
company flow to stockholders of that series before proceeds are distributed to junior preferred and common stockholders.Unique contractual
rights not shared by common stockholders, like special voting rights with respect to major events and transactions, unique information
rights, pro rata investment rights with respect to future financings, rights of first refusal and co-sale rights, increase the stock’s
relative value.Beyond the standard set of rights that are usually enjoyed by all preferred stockholders, additional contractual rights of
and reduced restrictions on enhanced preferred stock make it more likely that the holder of such equity will achieve liquidity of some or
all of its holdings prior to an M-A event or IPO
Such additional rights may include one or more of the following: time or event-based redemption rights (i.e., the right to force the
acquirer to redeem equity at a specified price in the future), other liquidity rights tied to future financings or commercial transactions
(e.g., the right to sell stock to the investors in the next equity financing), covenants of the acquirer to permit and support private
secondary sales and registration rights (i.e., the right to force the acquirer to register stock with the SEC, thereby allowing for
unrestricted resale by the holder).“Better” stock lies somewhere on the continuum between the common stock and enhanced preferred stock
poles, with the type of stock and bundle of rights associated with such equity determining its precise location
Additional contractual rights and reduced restrictions may significantly improve the desirability of common stock and perhaps place the
holder in a better position than it would have been as a preferred stockholder
For example, a seller able to negotiate the right to sell a certain amount of common stock to investors in the acquirer’s next preferred
stock equity financing could be more favorably positioned than the holder of senior preferred stock without any enhanced preferred
rights.Negotiating for better stock
With a framework for understanding what better stock means, below are several strategies sellers can employ in M-A negotiations to obtain
better stock than that initially offered by the buyer.Avoiding dire situations and preserving leverage. Leverage matters in every
negotiation and any strategy that ignores this reality is doomed to fail
To state the obvious, the first strategy to negotiate for better stock in an equity-funded acquisition is the first strategy in preparing
for any M-A event: companies should do all they can to avoid being in a dire fire sale situation when a buyer comes knocking on their door
If the seller is a failing company seeking a sale as a last ditch effort to avoid shutting its doors, even the best strategies may be
useless in negotiation since as soon as the buyer says “no”, the seller will likely fold its hand and agree to the deal offered.
