Ask an Investor: How do I maximize optionality around an M&A offer?

Welcome to a new BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors Roger Chabra and Katherine Hague tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.


We’ve talked before in this column about the importance of constantly building optionality into your startup. As a founder, you should be always working to have as many options as possible for your business, on both the strategic and financing side.

Companies that have multiple options available to them (e.g. a range of available funding sources, a broad assortment of potential acquirers who have they have warmed up to) and/or are profitable (or can become profitable relatively quickly) have the best chance to survive and thrive. The best entrepreneurs I know are always thinking hard about optionality for their businesses.

This week we saw AppDynamics, which was in IPO registration (they actually priced the offering!), culminate a sale to Cisco for $3.7 billion USD mere days before said IPO. This is optionality in action. No doubt, the company’s executives and their board were following a dual track here. IPO windows are fleeting; they come and go. The company knew that the best time to maximize outcome was when they were running their public offering process. From here, they would be in the driver’s seat with a number of options available to them. We will never know if they should have gone public or not, but, for now, the outcome seems pretty favourable for the team and investors.

Appdynamics founder and Executive Chairman Jyoti Bansal

One of the main scenarios where founders have their optionality compromised is when they sign a term sheet to be acquired by another company. As we know, term sheets are non-binding, and can be cancelled by both parties at any time. Of course, good citizens go into term sheets with the stated objective to get a deal done. However, ask any smart entrepreneur who has been around and they will tell you that term sheets get cancelled, for good and bad reasons, all the time.

So, as a founder, how do you maximize optionality in this scenario?

If you are entering into an M&A term sheet with little cash in the bank, an unprofitable cash-flow position, and little prospects of additional financing, you are in a very precarious position. Your backup options, if the term sheet falls through or you decide not to take the deal, are limited. M&A transactions take many months to finalize, and experience has taught me that you can count on your potential acquirer introducing some surprising terms throughout — sometimes at the 11th hour, right before closing.

The best time to enter into an M&A term sheet is when you have a cash cushion, can turn a profit with some adjustments, have other interested acquirers, and have options for financing with new or existing investors. This is what is commonly known as BATNA (Best Alternative to a Negotiated Agreement). Having BATNAs is having leverage. Leverage is your friend. Leverage keeps acquirers focused and keeps them working quickly, and on favourable terms to you. In the case where your M&A term sheet gets cancelled, your company will be just fine, because you have BATNAs.

Leverage is your friend. Leverage keeps acquirers focused and keeps them working quickly, and on favourable terms to you.

However, BATNAs or not, recognize that a cancelled term sheet will seriously taint your company. Other potential acquirers or investors will perceive weakness on your side, and will take advantage of that. If you are taking a term sheet, the best option available to you is to ensure that your term sheet moves quickly to a close with this specific acquirer.
 

Yet, how do you get leverage or a BATNA when you are post-term sheet, and in exclusivity with one potential acquirer? You have no doubt communicated to any other potential acquirers or investors that you are “going with XYZ’s term sheet.” This innately compromises your position and “single-threads” you to the company whose term sheet you signed. Not a great position to achieve leverage.

In larger deals, we often hear about a clause known as a “break fee.” Simply put, a break fee is a cash penalty that a potential acquirer pays to the potential acquiree when a deal is not consummated (e.g. a term sheet is cancelled). In startup land, these are relatively uncommon, but it is important to recognize that this option does exist. I have seen break fee clauses in startup deals, albeit very rarely these days.

The problem with break fee clauses is that, by the time a deal is actually cancelled, the damage to the acquiree company is severe. You may have spent months negotiating a term sheet, communicating to your other acquirers, investors, and staff that you were in an M&A process with so and so.

Optionality is among the best weapons an entrepreneur can have. Make sure to always have it and use it.

The damage to your business (and your personal well being!) is never properly compensated by a relatively small cash injection as a result of a break fee clause being triggered. Also, you will receive no cash penalty if you decide not to take the deal; only if the acquirer decides not to finalize the deal. This is a grey area which is up for interpretation, and beyond the scope of today’s post (ask your lawyer!).

Silicon Valley

So if a break fee isn’t an option, what is? One important tactic that I have seen used with increasing success is to negotiate a financing from your potential acquirer alongside the M&A transaction. Essentially, if the M&A deal doesn’t close, you get access to some financing cash from the potential acquirer instead.

Now, this isn’t a perfect solution either. You will still have exerted considerable physical and mental effort under the M&A option, and be in danger of being “damaged goods” to others. Furthermore, you may end up with an investor that you don’t particularly want on your cap table, especially if they cancel an M&A deal on you, or they try to change terms in the M&A deal, and you decide to cancel!

A better scenario would be to have your internal investors “backstop” you. Meaning they step up and commit to funding you if the M&A deal falls through. Sounds good in theory, right? Well, I’ve been a VC for more than a dozen years and I can tell you that it doesn’t play out this way in practice. For better or for worse, and for various reasons, some good, some bad, internals are resistant to provide backstop financings.

However, having a backstop financing from a potential acquirer in place before you sign a term sheet can be much better than being in a position of having little money left in your bank account, an unprofitable business and having to go back to your internal investors (or try a find new ones) once an M&A deal falls through.

Your peak point of leverage is when you have a potential acquirer ready to offer you a term sheet — hopefully, multiple potential acquirers ready to offer a term sheet. Here you are in the driver seat, because you have optionality. Take advantage of this.

Once you sign one of the term sheets, you will be in exclusivity and will be prevented from talking to other potential acquirers or investors. Your best bet is to negotiate a financing from your potential acquirer just before you sign the M&A term sheet. If the acquirer is truly serious about buying you, you will be in a good position to demand a financing, and on some relatively favourable terms.

I have seen these financings structured as equity, convertible debentures, and even straight debt. Again, because of leverage, you can often call the shots on deal structure and terms. Often, you will get favourable terms and may not have to give a board seat, liquidation preference, or conversion discount under these structures.

Importantly, you should negotiate to have the financing money put into an escrow account with your lawyer at the time of the M&A term sheet signing. If the M&A deal falls through, then you won’t have to go back to the acquirer to get the money. It will simply be released into your corporate bank account from your lawyer.

It can be a bit awkward to ask a potential acquirer for a financing on top of an M&A offer. After all, they are committing millions (billions!) of dollars to buying your company already right? Well, it’s not a legal commitment, it’s a promise — and promises are broken all the time. Your company’s life is potentially at stake here. A good acquirer will see your ask as a signal you are a good negotiator and leader. This will bode well for you, regardless of what scenario actually plays out.

Optionality is among the best weapons an entrepreneur can have. Make sure to always have it and use it.


Katherine’s take:

Katherine Hague

Roger offers some great advice in this post. Optionality is everything in a negotiation. That said, I want to touch for a second on the emotional toll this has on founders. When nothing is working and you don’t, in fact, have any alternatives on the table, there is an incredible pressure to create the illusion that everything is awesome, never been better, that you have all of the options in the world! Meanwhile, you scramble to try to create those opportunities in the background.

Having been there myself, I can tell you it’s a very lonely existence. Often, you can’t tell your existing investors (some of whom are on your board) or your potential acquirers what’s going on for fear it may kill any chance of a financing or M&A deal. You don’t want to tell your employees how unstable things are because it would be a distraction to the team, and could lead to decreased confidence in the company. Worse yet, someone might leak the situation to someone else in the industry. You don’t want to tell your family, because either they won’t get it — or it will cause worry and instability. And finally, you don’t feel comfortable opening up to people in the broader tech community because it’s a very, very small world. It’s a crushing burden, which can and all too often leads to depression.

So what do you do? There is no simple answer. My first piece of advice would be to nourish the relationships you have with your Board of Directors, employees, and family so that they can ultimately become people you feel safe sharing the honest state of the business with. Realize that people can be motivated by this type of transparency, and that whatever you are going through has happened before. You are not broken and there is nothing to be ashamed of.

Beyond just these relationships however, you have other options. The most powerful source of support I have found over the years has been a close network of other founders.

Having a co-founder is a great way to share not only the workload, but the emotional burden of a startup. My co-founder Andrew Louis and I went through all of the highs and lows together. Having someone by your side that you can confide in that is as invested as you and who gets every part of the situation you’re is, I think, is one of the greatest benefits of having co-founders.

Silicon Valley

If you don’t have a co-founder, you can create your own trusted network of founders, who have been there and that get what you’re going through. When I was starting out, I was lucky enough to be starting out at the same time as some other incredible women in the Toronto startup community. We would get together for dinners every few months. We’d share stories, drink a bit too much Prosecco, inspire each other, and pick each other up when things weren’t going well. There’s nothing like another founder you respect telling you an equally shitty story when you’re going through a rough patch to help you know you’re not alone!

We became friends and confidants, and our businesses grew together. To name just a few of the success stories out of this small network: Michele Romanow went on to sell Buytopia to Groupon and become a Dragon on CBC’s Dragon’s Den. Lauren Haw and Alyssa Richards took over the real estate world, growing RateHub exponentially and recently re-launching Zoocasa. Nicole Verkindt launched OMX and became a Dragon on Next Gen Den. Diana Goodwin went on to win the Globe and Mail Small Business Challenge with AquaMobile. Lauren Friese sold TalentEgg to Charity Village. And Heather Payne launched HackerYou and grew it into Canada’s first career college coding bootcamp! We went through a lot together and are still in each other’s corners to this day, investing in each other’s companies and always opening doors for each other. They were people I knew I could go to on the darkest day, with no judgement.

If you’re looking for a more formal way to build a support network, you should consider joining a forum group like Ben Baldwin’s new Founder City Project TO or EO (Entrepreneur’s organization) which is available outside of Toronto. Forum groups are made up of approximately eight founders, who meet periodically throughout the year to speak confidentially to act as each other’s’ sounding board, to share experiences, and help each other grow and succeed personally and professionally. I recently joined Founder City myself and am excited to have this as a new resource as I go through the continued ups and downs of founder life.

Even with an amazing support system, there can be dark days. Just know you aren’t alone. There are other founders out there that get it and want to help.

And if you ever need to talk, I’m hello [at] kaherinehague.com!

Got a question for the investors? Email them here.

Roger Chabra

Roger Chabra

Roger Chabra is a General Partner at Rho Canada Ventures, an early stage Venture Capital investment firm, based in Montreal. You can follow Roger on Twitter at @rchabra.