GUIDE

tech M&A: factors to consider when receiving shares as consideration

Payments behemoth Square recently announced its intention to acquire buy-now-pay-later player Afterpay in a USD30million deal. In the ultimate buy-now-pay-later acquisition, the terms of the all-share deal mean shareholders in Afterpay will need to wait a little longer to cash out. Square of course is publicly listed so its shares are liquid. Investors can therefore cash out in due course, subject to applicable lock in periods. But what about if a private or non-listed tech company offers to acquire your company? And instead of cash, they fully or partially offer shares as consideration? This scenario is increasingly common as even well-backed startups do not typically have large cash resources to fund acquisitions. What should sellers in these circumstances be thinking about? In this guide we unpack some key factors to consider.

who’s the buyer?

Before getting into negotiation of the key commercial and legal terms of the deal, the first question is – who is the buyer? And what are its plans? Is it already listed or looking to IPO, or even seeking a listing of the enlarged group via a SPAC process? If the answer is none of the above, then the buyer is likely to remain a private company up to an exit. Therefore your shareholders are in effect exchanging illiquid shares in the target for a smaller shareholding in a larger buyer entity, whilst losing control of the business at the same time. This means that the prospects and plans of the buyer should be key to your decision to sell. The ability to cash out via a successful exit will be dependent on the prospects of the larger combined business. And all the key strategic decisions, including whether and when to sell, will of course be made by others going forwards.

part cash / share consideration

One factor to consider is how the consideration (the purchase price) will be split between cash and shares, and whether all shareholders in the target company will receive the same deal. Your investors may prefer to cash out as part of sale of the company rather than receive shares in another private company. Part of their decision making will be based on how well they consider the prospects of the buyer. Further, if the buyer is based in a foreign jurisdiction, investors sometimes can have issues with receiving consideration shares if the buyer’s place of domicile is outside of the scope of their fund mandate.

valuation

A key aspect you need to agree at the term sheet stage is of course the valuation of the consideration shares to be issued to the sellers. This, along with the valuation of the target company being sold, determines what percentage of equity sellers will own in the buyer. If your potential buyer is a private company, this might be based on the valuation of their most recent financing, or any more recent valuation they have obtained independently. Or it might just the view of the board of the buyer. Either way, you should undertake financial due diligence and challenge this valuation where necessary. Between the timing of signing the non-binding term sheet and closing of the transaction there should be scope for the valuation to be adjusted subject to material due diligence findings. Finally, unlike with an all-cash sale, shareholders of the acquired target will be partners in the post-acquisition business and will therefore have as much interest in ensuring that there are synergies between the two businesses as the current shareholders of the buyer.

class of shares

Valuation is one thing. The class of shares that sellers receive as consideration is just as important. If the buyer has raised several rounds of venture financing, it will inevitably have a liquidation preference stack. This is important for sellers to understand early in their diligence process. The class of shares is often a key negotiation point. If you receive ordinary shares in the buyer as consideration for the sale proceeds, those ordinary shares will sit behind any preferred shares that are in issue. This is particularly relevant for your investors who may be reluctant to in effect exchange their existing preference shares for ordinary shares in the buyer.

due diligence

On any M&A deal, a buyer will carry out financial, legal and commercial due diligence on the target company. In the same way, sellers will want to do the same thing on the buyer in circumstances where shares are offered as consideration. As mentioned above, this would cover the financial due diligence (to validate the buyer’s valuation). We also recommend legal due diligence on key aspects such as the buyer share structure, its governance arrangements, whether there is any debt or key liabilities, and any material contractual matters, amongst other things. For example, if there are any convertible securities which would further dilute shareholders in the buyer.

warranties from the buyer

To support any due diligence on the buyer, sellers should also insist on the buyer providing certain warranties. If the buyer fails to disclose an issue which represent a breach of warranty, sellers will want to be compensated in the same way as a buyer would be if they were in breach. Ideally these buyer warranties would be equivalent to the warranties being provided by the sellers. However sometimes buyers will only offer basic warranties around the shares to be issued as consideration. Ultimately, this is an issue for negotiation in the sale and purchase agreement.

warranties, liability and price adjustment

As with any M&A deal, your investors may be reluctant to stand behind business warranties and liability for breach of such warranties. With all-cash deals, often the liability gap between buyer expectation and sellers wanting to minimise their potential liability is resolved by way of an escrow account, from which claims can be met pro-rata from all sellers. With all-share deals, sellers are unlikely to want to reimburse a buyer for breaches in cash. To deal with this, typically some consideration shares will be held back (or escrowed) by the buyer for a period to meet any claims, or alternatively the buyer may have an ability to claw back shares from sellers if there is determined claim (or a combination of both of these).

approval rights in the buyer

In all-share deals, sellers transition from full owners who exercise control over their business to minority owners of the combined business. In these types of acquisitions, shareholders in the selling company might end up with around 15-20% of the equity in the buyer once all the consideration shares are issued. This means that realistically, investors cannot expect to retain the kind of control in the buyer as they might have had previously in the target company. Founders of the target are the same. They might get a single board seat but will not be making material decisions. In terms of approval rights, most likely the sellers will simply be able be vote alongside all other shareholders in the buyer, but nothing much more than this.

restrictions on shares transfers

Your investors may have limited or even no restrictions on their ability to sell shares in your company. That may not be the case in respect of their shares in the buyer. Again, this requires some due diligence on the governance documents of the buyer. Practically, it is unlikely that material changes will be made to the buyer’s governance documents as this will require agreement from all its shareholders. In addition, as part of any warranty period, there may be a restriction on selling shares for some time. Selling shares to a listed buyer is very different as lock-ins period are typically required by law or under the applicable stock exchange rules. Even for private company buyers, there may be contractual restrictions on selling shares for a period.

round up

If you are selling your company to a listed company like Square and being issued shares as consideration, it is fair to say that things are somewhat easier. As a listed company, the buyer will have a fixed valuation at any time. Financial information is publicly available which is likely to require less due diligence. Consideration shares issued by a listed buyer should be the same class as the listed shares and they will be capable of being sold easily in the market subject to any lock-in periods. For a sale to a private company, all-shares deals bring more issues to think about, and due diligence on the buyer is essential. Otherwise, it will not simply be a case of buy-now-pay-later — the expected pay day may not come at all.

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explore other guides

how to issue equity to your advisors (shares vs options)

Advisors help startups by offering expertise or perspectives that the core founder team may not have. Since most startups don’t have the cash to compensate these advisors, a common way to pay for their guidance is to offer equity.

We are often asked how companies should best go about this. In this guide we cover the types of advisor equity (shares versus options), how vesting can be incorporated, what else to cover, and other common questions.

types of advisor equity

When offering equity to advisors, there are two common roads to take: either giving shares, or granting options. The fundamental difference between shares and options is that if someone owns shares, they are immediately a shareholder in the company. If someone owns options, they have the right to purchase shares in the future.

share issue

Shares are a straightforward way to compensate an advisor. In most cases, advisors prefer shares rather than receiving options under the company’s option scheme. Like any share issue, the company will need to pass board and shareholder resolutions, as well as receiving necessary waivers and consents under the constitution and shareholders’ agreement in place. For that reason, a company intending to issue shares to advisors in the future usually carves this out under the constitution and shareholders’ agreement in the same way as they would an ESOP.

granting options

Options are an alternative way to compensate an advisor, and can be granted easily if a pool of options (such as an ESOP) has already been established. However, often advisors can come on board before the ESOP is formally set up.

If options are issued to an advisor, in the event that the advisor wants to exercise their options and convert them into shares, they will need to pay the ‘exercise price’, which may be around the price that the investors paid in the last funding round. This means that they will need to come up with cash to exercise their options.

how much to give?

There are different models to decide how much equity to offer. The Founders Institute gives a useful framework based on the stage of the company (idea, startup, or growth) and based on the various levels of engagement. This is really just a guide however.

	Idea Stage	Startup Stage	Growth Stage
Standard: Monthly Meetings	0.25%	0.20%	0.15%
Strategic: Add Recruiting	0.50%	0.40%	0.30%
Expert: Add Contacts & Projects	1.00%	0.80%	0.60%

https://fi.co/insight/the-founder-institute-s-standard-advisor-agreement-for-startups-fast

vesting schedule

Advisor agreements typically have a vesting schedule of around 12-24 months, i.e. they are shorter than vesting schedules for founders and employees under an ESOP. This is because advisors generally bring greater value over a short term. As your startups grow, it cycles through different advisors that fit their applicable stage of growth.

Some advisor agreements also contain some measure of ‘claw back’ if the advisor does not perform make the expected contributions over the agreed period. An alternative to a provision like this would be using a cliff of 3-6 months to provide for a ‘test run’ to see if the relationship is beneficial.

other provisions

The advisor should agree that all intellectual property and other business, technical and financial information that the advisor obtains from the company or learns in connection with his or her services is appropriately assigned to the company.

As a minimum, the advisor should be subject to confidentiality provisions. You may want to add a no-conflict provision, and also a provision that the advisor complies with certain company policies.

Finally, there is usually a termination right for both parties and sometimes automatic termination if the company has not requested that the advisor render any services for a lengthy period.

tax implications

Options and shares are treated differently with regards to how they are treated in a tax sense. Generally speaking if you are issued shares for services, you would expect to have an income tax liability whereas options do not trigger a liability until exercised. We recommend obtaining tax and accounting advice before putting in place any advisor agreement.

advisor agreement template

We have produced a simple template agreement that a startup can use when bringing an investor on board. The template is drafted on the basis that the advisor receives shares, and that no cash compensation will be paid. It also provides that some of the shares may be clawed back by the company if the advisor fails to make the expected contributions over the agreed period, which is usually one or two years.

You can download our advisor share agreement template here. If you have any questions regarding the template or want to work with us to draft your advisor agreement, get in touch.

a primer on venture debt in southeast asia

Traditionally, growth stage technology companies in Southeast Asia have raised venture capital via convertible debt or equity rounds. However, venture debt is fast becoming an alternative or complementary path for startups looking to get capital to accelerate their growth. In this guide we cover the basics of venture debt. For more detail, download our latest free e-book, The Startup Guide to Venture Debt in Southeast Asia.

what is venture debt?

Venture debt is a form of debt financing, similar to bank loans but with a few key commercial differences. Venture debt is typically used by VC-backed, fast-growing tech startups that may not have positive cash flow or significant assets to use as collateral. These companies are typically not eligible to receive traditional debt financing from banks or other institutional lenders (or would only be able to borrow at prohibitive interest rates).

is my company a good candidate for venture debt?

The typical profile of a company taking on venture debt is a venture backed, fast-growing startup at series A or later. By the time a company is ready to explore venture debt, it will already have cashflow and an established customer base. Venture debt lenders also prefer venture-backed companies (i.e. those who have received funding from VCs / institutional investors). Institutional investors will have ‘vetted’ the company, and can be a future funding source should the company need help in paying back the venture debt.

why go for venture debt instead of an equity round or convertible debt?

There are a few reasons why a company may use venture debt as an alternative, or supplement, to equity financing:

less dilution: founders retain more of their shareholding
board control: venture debt lenders typically do not require a director seat
transaction time: the process is generally faster than an equity round, since lenders ‘piggy-back’ off the due diligence of the institutional investors.

learn more about venture debt and the process

If you’re looking for more information about types of venture debt, key terms to negotiate in your venture debt term sheet, and details of venture debt providers in Singapore, download our free PDF guide.

You can access the guide by filling out your details below:

how to calculate your ESOP pool shares

This short guide demonstrates how founders should calculate the number of options to include in their ESOP pool.

For the purposes of this example we have assumed that the founders are setting up a customary 10% ESOP pool (check out our guide 5 key questions when setting up an ESOP for a more detailed discussion on the appropriate size of your ESOP).

example

In almost all cases you should calculate the size of your ESOP pool on a fully diluted basis. i.e. the ESOP should be equal to 10% of all shares and options on issue (including the ESOP). Looking at a company with 1,000,000 shares on issue:

tool

If you are experiencing some arithmetic fatigue, we have you covered. Available for free download here is a spreadsheet tool that incorporates the above formula. All you need to do is plug in your total number of shares and options on issue, your ESOP pool size as a percentage, and the tool will generate the relevant number of ESOP pool shares.

Excel version