VENTURE CAPITAL REVIEWIssue 28 • 2012

produced by the NatioNal VeNture capital associatioN aNd erNst & youNg llp

National Venture Capital Association (NVCA)As the voice of the U.S. venture capital community, the National Venture Capital Association (NVCA) empowers its members and the entrepreneurs they fund by advocating for policies that encourage innovation and reward long-term investment. As the venture community’s preeminent trade association, NVCA serves as the definitive resource for venture capital data and unites its 400 plus members through a full range of professional services. Learn more at www.nvca.org.

National Venture Capital Association1655 Fort Myer Drive Phone: 703.524.2549 Suite 850 Fax: 703.524.3940 Arlington, VA 22209 Web site: www.nvca.org

3 Venture-Capital-Backed IPOs: Outperforming the Market and Creating Market LeadersBy Jacqueline A. Kelley and Bryan Pearce, Partners of Ernst & Young LLP

11 Midstream Shareholder Liquidity Alternatives: Structuring Shareholder Take-Outs in Growth Equity FinancingsBy Dan Meehan and Alfred L. Browne of Cooley LLP

25 Contingent Consideration: Does it Have Value?By Steven Nebb, CFA and David L. Larsen, CPA, Managing Directors of Duff & Phelps LLC

31 Acqui-Hires for Growth: Planning for SuccessBy Marita Makinen, David Haber and Anthony Raymundo of Lowenstein Sandler PC

43 Anticipating Inflection Points: The Necessity of Managing Uncertainty in the Law in the Formation and Operation of Private Investment FundsBy Timothy W. Mungovan and Joel Cavanaugh of Proskauer Rose LLP

51 The Emergence of the SecondMarket By Adam Oliveri, Managing Director and Head of the Private Company Market at SecondMarket

55 Culture is a Business IssueBy Liz Brashears, Director, Human Capital Consulting at TriNet

Please send comments about articles in this issue or suggestions regarding

topics you would like to see covered in future issues to Jeanne Metzger,

NVCA’s Chief Marketing Officer, at jmetzger@nvca.org.

2

3

Confirming the invigorating effect venture capitalists have on entrepreneurship in the US, IPOs of venture-capital-backed companies on US exchanges outperform the IPO market in general.

These findings are revealed in a recent Ernst & Young analysis of data provided by Dealogic. [see table]. In this article, we will explore how, in doing much more than providing capital to entrepreneurs, venture capitalists have a significant impact on the market performance of their investees.

The market performance of venture-backed companies that go public is notable. Even in the volatile equities market of the last five years, the average one-day post-IPO return of venture-backed companies between early 2007 and June 2012 was 18.8%, more than three times the return of companies that did not accept venture capital investment. At six months, these same companies still outperformed their counterparts. While the one-year post-IPO performance of all companies was affected by the 2007-08 financial crisis, and more recently by the Eurozone crisis, it is important to note that there have been enormous successes even in a difficult market. In recent years, the one-year post-IPO return of a number of venture-capital-backed companies has exceeded 25%. The standouts include information technology security firm Fortinet, whose one-year post-IPO return topped 150%; the professional social networking site LinkedIn, whose one-year return topped 120%; and the restaurant reservation site OpenTable, whose one-year return topped 105%.

By Jacqueline A. Kelley and Bryan Pearce, Partners of Ernst & Young LLP

Venture-Capital-Backed IPOs: Outperforming the Market and Creating Market Leaders

4

door number 1, 2 or 3? Which is the best exit?The data suggests that given the excellent performance of their portfolio company IPOs in recent years, venture capitalists should give closer consideration to an IPO as an exit strategy for more of their portfolio companies. Currently, venture-capital-backed IPOs are just 8% of the total exit pool,1 in part because the ongoing Eurozone crisis and US election year uncertainty continue to dampen enthusiasm for IPOs among all players. However, in recent years, the percentage of venture-backed companies exiting via an IPO has been as high as 14%.

There are other reasons for optimism about the venture-backed IPO market, as indicated by the fact that two American exchanges, the New York Stock Exchange as well as the NASDAQ, are currently actively competing for venture-backed offerings. In addition, the new Jumpstart Our Business Start-Ups

1 VentureSource, Q1 2012 data.

(JOBS) Act has eased the regulations associated with an IPO for emerging-growth companies — those with under $1 billion in revenue (among other tests) — and may be bringing new companies into the IPO pipeline. Under the JOBS Act, emerging-growth companies are now able to file confidential IPO registration statements with the Securities and Exchange Commission (SEC). In just the brief period between April 5 of this year, when the JOBS Act took effect, and late May, about 30 companies took advantage of this and filed confidentially, according to the SEC’s Paula Dubberly.2

Finally, venture-backed companies continue to perform superbly after their IPOs. The National Venture Capital Association/Thomson Reuters Exit Poll Report for the second quarter of 2012 found that 9 out of the 11 venture-backed IPOs brought to market in the quarter were trading above their offering price.3

2 Emily Chasen, “Confidential IPO Filings Outpacing Public Ones,” Wall Street Journal’s CFO Journal, May 30, 2012, http://blogs.wsj.com/cfo/2012/05/30/confidential-ipo-filings-outpacing-public-ones, accessed July 19, 2012.

3 Exit Poll Report, National Venture Capital Association/Thomson Reuters, July 2, 2012.

Average IPO Proceeds ($mm)

2007 2008 2009 2010 2011 2012 YTD2007 to

June 2012

VC backed IPOs 134.6 128.0 145.1 110.7 201.7 101.0 138.6

PI backed IPOs* 195.7 232.9 287.7 160.8 382.8 168.4 227.6

Non PI-backed IPOs 295.3 175.6 322.8 146.0 190.4 215.4 232.5

All IPOs 222.0 184.2 278.7 143.2 272.4 157.9 208.2

All IPOs without exclusion 222.0 581.4 371.5 220.5 272.4 304.7 271.9

Total IPO volume Total IPO Proceeds ($mm)

2007 2008 2009 2010 2011 2012 YTD

2007 to

June 2012

2007 2008 2009 2010 2011 2012 YTD

2007 to

June 2012

VC backed IPOs 57 7 12 64 51 32 223 7,670 896 1,742 7,087 10,288 3,231 30,913

PI backed IPOs* 123 13 36 109 78 53 412 24,069 3,027 10,357 17,527 29,855 8,927 93,763

Non PI-backed IPOs 112 28 29 59 61 22 311 33,074 4,916 9,362 8,614 11,612 4,739 72,317

All IPOs 292 48 77 232 190 107 946 64,813 8,840 21,461 33,228 51,754 16,897 196,993

All IPOs without exclusion 292 49 78 233 190 108 950 64,813 28,490 28,978 51,368 51,754 32,904 258.308

Note: Exclude IPO of Visa Inc; General Motors Co; Banco Santander Brasil SA; Facebook to eliminate skewness of averages* Private-investment-backed IPO refers to backing by PE firm or by VC firm or by bothSource: Dealogic, Thomson Financial, Ernst & YoungUS exchanges IPOs

5

the venture capital effectAcademic studies suggest why venture-backed IPOs perform better than the market.

First, venture capitalists take a long-term view when selecting companies for funding. A forthcoming Journal of Finance article considered 25 years of U.S. Census Bureau data that tracks firms from their birth and found that venture capitalists choose their portfolio companies based on their scalability, rather than short-term profitability.4 Clearly, venture capitalists perform an important function in an economy that depends on groundbreaking technologies. They give

4 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of Venture-Capital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance, http://www.afajof.org/journal/forth_abstract.asp?ref=708, accessed July 19, 2012.

initially unprofitable but highly innovative companies

that could not possibly fund their own growth the

chance to gestate and mature. At the same time,

venture capitalists’ preference for scalability meets

the demands of today’s capital markets, which expect

companies to have long-term growth potential.

Second, venture capitalists set the stage for further

growth by actively professionalizing the young

companies in which they invest. Another recent study,

which looked at 3,200 entrepreneurial firms that went

public between 1993 and 2004, found that venture-

backed firms are associated with higher management

quality, as measured by factors that include

management team size, education, prior experience

Average post IPO performance - 1 day (%) Average post IPO performance - 1 month (%)

2007 2008 2009 2010 2011 2012 YTD

2007 to

June 2012

2007 2008 2009 2010 2011 2012 YTD

2007 to

June 2012

VC backed IPOs 18.3 6.7 16.7 16.8 20.5 24.6 18.8 15.4 12.4 12.5 19.1 15.7 30.5 18.3

PI backed IPOs* 17.3 7.3 11.0 12.6 16.5 20.6 15.5 16.5 11.7 11.0 14.3 12.9 22.5 15.3

Non PI-backed IPOs 8.9 11.1 5.9 4.4 0.9 2.7 6.0 6.4 (2.9) 16.6 2.5 (2.7) 4.2 3.9

Average post IPO performance - 6 months (%) Average post IPO performance - 1 year (%)

2007 2008 2009 2010 2011 2012 YTD

2007 to

June 2012

2007 2008 2009 2010 2011 2012 YTD

2007 to

June 2012

VC backed IPOs 11.5 1.8 10.8 28.0 (4.8) - 10.5 (17.2) (0.4) 27.4 13.3 (11.4) - (1.1)

PI backed IPOs* 5.2 (17.4) 13.7 27.8 (0.3) - 9.5 (19.0) (17.9) 27.4 16.0 (2.8) - 0.0

Non PI-backed IPOs 2.3 (24.4) 17.2 2.3 (4.9) - (0.3) (20.8) (31.9) 5.3 (12.4) (12.9) - (16.2)

Note: Exclude IPO of Visa Inc; General Motors Co; Banco Santander Brasil SA; Facebook to eliminate skewness of averages * Private-investment-backed IPO refers to backing by PE firm or by VC firm or by both Source: Dealogic, Thomson Financial, Ernst & Young US exchanges IPOs

Top Sectors (# of Deals) 2011

High Technology 34

Financial 22

Oil & gas 21

Health care 16

Real estate 9

Top Sectors (# of Deals)

2012 YTD

High Technology 20

Financial 10

Oil & gas 8

Health care 6

Retail 5

Top Sectors (capital raised $mm) 2011

High Technology 8,902

Health care 5,879

Oil & gas 5,720

Financial 4,200

Power & utilities 3,372

Top Sectors (capital raised $mm)

2012 YTD

Oil & gas 3,006

High technology 2,320

Financial 2,077

Retail 876

6

and core functional expertise.5 Management quality and venture-backing, in turn, certify the firm’s value to the IPO markets and have a number of positive effects on venture-backed IPOs, including increasing firm valuations both in the IPO market and in the immediate secondary market.

Finally, since venture capital tends to specialize and concentrate in a few high-growth sectors of the economy — including information technology, life sciences and cleantech — venture capitalists not only understand their portfolio companies’ businesses and markets particularly well, but also can offer the management of these companies valuable guidance at every juncture.

This “venture capital effect” can be enormous. Over the period of a typical venture capital investment, venture-capital-financed companies are half as likely to fail as non-venture-capital-financed companies, 32 times more likely to be acquired and 805 times more likely to go public.6

intensifying the venture capital effect: 10 steps to ipo readinessAt Ernst & Young, our experience with these young, high-growth venture-backed companies, supported by substantial research, suggests that companies beginning the process of preparation for an anticipated IPO 12 to 24 months in advance will typically outperform the market when they eventually complete their offerings.

Even when an IPO is not on the immediate agenda, early preparation will allow a company to take advantage of an IPO window should one open unexpectedly — and enhance the company’s value should a merger or acquisition be the ultimate outcome.

Are your companies ready for the IPO Value Journey®? Here are the steps we recommend at Ernst & Young.

5 Thomas J. Chemmanur, Hassan Tehranian and Karen Simonyan, “Management Quality, Venture Capital Backing, and Initial Public Offerings,” Social Science Research Network, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2021578, accessed June 17, 2012.

6 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of Venture-Capital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance, http://www.afajof.org/journal/forth_abstract.asp?ref=708, accessed July 19, 2012.

operate like a public company long before your firm becomes oneAt successful companies, an IPO is not a single event, but a transformational process. Long before the company engages in the four phases of the IPO ramp-up — due diligence, drafting, SEC review and marketing — time should be spent on planning and processes. Businesses intending to go public in the next year or two should develop a formal, comprehensive written plan and timeline. They should develop an integrated transaction strategy that formalizes policies, procedures, reporting and communications. They should work on the legal, financial, technological and risk management infrastructure required of a public company. And they should address key financial and reporting issues, including accounting for stock option issuance and revenue recognition.

Keep an open mindEvery year, venture capitalists achieve an exit for significantly more of their portfolio companies through an M&A transaction rather than an IPO. Though such private M&A exits may lack some of the prestige of a stock market listing, they can be an effective and less costly vehicle for raising funds and realizing an optimal company valuation.

Private buyers often appear soon after a company strengthens its infrastructure and signals its intentions to go public. A multitrack approach during the IPO preparation process can therefore help a company improve its chances of raising capital and achieving the highest possible valuation. Multitrack options include:

• A sale to a private equity firm

• A sale to a strategic buyer

• Partnerships, joint ventures and strategic alliances

• Alternative liquidity options, such as Rule 144A placements or private exchanges and cross-border listings

We recommend taking into account all attractive alternatives. It should be noted that the ability to conduct confidential filings under the JOBS Act may impact the multitrack process, as the intentions of companies choosing the confidential filing alternative may not be as well understood in the public markets until later in the public offering process.

7

develop a brilliant sense of timingTiming is crucial to the success of IPOs. Instead of asking whether the stock market is ready for it, a company first needs to ask whether it is ready for the stock market. Input from a variety of external advisors, including investment bankers, attorneys and auditors, can help board members and management develop a realistic timeline for an IPO. It is important to communicate this expected timeline to key stakeholders throughout the process.

Even when the company is ready, it might be necessary to delay the IPO if the markets are unfavorable or there is a glitch in the offering process.

On the other hand, when an IPO is timed perfectly, the company can price its shares to yield an optimal valuation and the highest possible returns for its investors. Every IPO-bound company should be prepared to quickly enter into the registration process when a window of opportunity appears.

8

convene a superb teamClearly, the market looks for companies with high-quality management teams, and strong IPO performers typically begin the process of strengthening their management team a full one to two years in advance of an offering. It is crucial that venture capitalists work with the board as a whole and the CEO to determine whether key players have the skill sets necessary to run a public company.

A company considering an IPO also needs a strong set of external advisors with significant experience in taking companies public. The selection of a well-regarded team of financial and tax advisors, auditors, attorneys and underwriters carries significant weight with investors. These experienced professionals can help the company anticipate bumps in the road and resolve difficult issues before they are raised externally.

Finally, the CEO and CFO are very important to investors. The CFO must be able to communicate the company’s financial results effectively to the investor audience. And the CEO must be able to articulate the company’s vision and strategy, as well as execute the business plan and forge good relationships with all external stakeholders.

assemble a solid infrastructureBecause of the risks and regulations associated with life as a public company, a financial, technological and risk management infrastructure must be built, and the right systems, procedures and controls put into place well before an IPO.

Often, newly public companies find it a challenge to produce quarterly financial statements. We recommend that companies prepare their financial statements as if they were already public for several quarters prior to the IPO.

Information systems need to be aligned both with the company’s business objectives and critical reporting requirements. Management should have the information tools that allow it to make good decisions and answer analysts’ questions quickly.

establish excellent corporate governanceWith heightened corporate governance standards for public companies and increased liability exposure, the board of an IPO-bound company should include a mix of audit, governance, compensation and compliance specialists, as well as experienced executives. Typically, small-cap company boards should aim for five to six outside directors with a minimum of three independent committees (audit, compensation and governance/nominating). Directors must be able to meet a substantial time commitment of 200 hours or more per year, and companies must be able to draw a definitive line between directors’ duties and the responsibilities of executive management. Finally, the company should develop a deep executive bench and an appropriate succession plan.

inform and communicate to potential investorsA highly skilled investor-relations professional — whether in house or on retainer — is essential to help guide a company’s strategic communication plan in preparation for an IPO. He or she should be able to draw the market’s interest and attract sell-side coverage and potential investors. The investor-relations professional should also be able to manage the risks associated with the external messaging. Once the company has gone public, he or she will have to continually retell the company’s story and fine-tune the investment value proposition, as well as provide the appropriate guidance on milestones and financial performance.

Company leadership must strike the right balance between managerial focus on the IPO transaction and the day-to-day

operation of the company.

9

orchestrate a successful road showFor the CEO and CFO, the most exhausting part of going public is the pre-IPO road show, during which they present the company to large investors. The road show typically requires between 8 and 10 long days in the US and an additional few days in Europe or Asia, often with visits to multiple cities in a single day. It is extremely important that despite this grueling schedule, the company’s messaging remains consistent. A well-designed road-show presentation with an “elevator pitch” and talking points is essential. Management’s presentation coaching and practice are crucial to road show preparedness. Pre-IPO companies often consult professional presentation training specialists to prepare CEOs and CFOs for the unique requirements and rigors of IPO road shows. The presentation team should plan to rehearse formally a number of times before the first day of meetings.

attract the right investors and analystsIn order to drive a strong post-offering performance, the company’s message must continue to resonate, even as the investor pool expands to include thousands of new investors. At first, many newly public companies enjoy high share prices fueled in part by investors’ interest in IPOs and by the press coverage for such companies. However, unless this interest is carefully maintained after the IPO, the initial euphoria will quickly fade.

Companies should develop a plan for outreach to equity analysts and shareholders — and actively cultivate a dialogue with them, attend conferences and initiate non-deal marketing visits. Early engagement of investors and analysts prior to the road show can help drive value and avoid surprises.

prepare to prove that you are true to your wordOnce a company goes public, the real work begins: keeping the promises made on the road show. Management has to prove its credibility to investors by using the proceeds of the public offering effectively and executing the business plan. Companies that are about to go public should clearly define the parameters and metrics that analysts and investors can use in tracking the progress of the business. Strong financial planning, analysis and reporting are key.

There will always be factors outside of the company’s control — including volatile behavior on the part of the stock market, consumers and the larger economy — that affect operating performance. It is doubly important, therefore, that a company about to go public focuses on the factors it can control, such as managing the business well, meeting revenue numbers and creating value.

Preparing for an IPO is an intense and arduous process, and it’s easy for management and employees to become distracted by the enormity of the task. Company leadership must strike the right balance between managerial focus on the IPO transaction and the day-to-day operation of the company. They must remember that preparedness can help lead to a successful IPO outcome, but all of the best financial engineering will not create business prosperity — only robust planning, accurate expectations setting and strong operational execution will forge the path to long-term success.

conclusion: great public companies, a great contributionClearly, venture capitalists play an outsized role in the American economy. They fund innovation and improve productivity. Venture capitalists invest in the cutting edge, in companies with revolutionary ideas that have the potential to spawn whole new industries.

preparing for the ipo Value Journey®

1. Operate like a public company

2. Keep an open mind

3. Develop a brilliant sense of timing

4. Convene a superb team

5. Assemble a solid infrastructure

6. Establish excellent corporate governance

7. Inform and communicate to potential investors

8. Orchestrate a successful road show

9. Attract the right investors and analysts

10. Prepare to prove that you are true to your word

10

It is no accident that although venture capitalists’ portfolio companies represent only a tiny fraction of all new American firms, those companies create a disproportionate share of the country’s employment.7

Arguably, however, venture capitalists make their greatest contribution by helping to shape great public companies. A well-managed IPO not only represents the best possible outcome for venture capitalists and their limited partners, but also may well represent the

7 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of Venture-Capital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance, http://www.afajof.org/journal/forth_abstract.asp?ref=708, accessed July 19, 2012.

best possible outcome for entrepreneurs and for the economy as a whole. Through an IPO, a promising company can finance its growth while retaining independence and a unique personality that might be lost in an acquisition or other form of private purchase.

By so successfully launching their portfolio companies into the public markets, venture capitalists regularly add new iconic enterprises to our market landscape — many companies with such strong identities and transformative products they change the world for the better.

About the AuthorsJacqueline A. Kelley (jacqueline.kelly@ey.com), Partner, is the Americas IPO Leader, Ernst & Young LLP.

Bryan Pearce (bryan.pearce@ey.com), Partner, is the Americas Director, Entrepreneur Of The Year® and Venture Capital Advisory Group, Ernst & Young LLP. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity.

Ernst & Young Global Limited does not provide services to clients. Ernst & Young LLP is a client-serving member firm operating in the US. The views expressed herein are those of the authors and do not necessarily reflect the views of Ernst & Young LLP.

11

Midstream Shareholder Liquidity Alternatives: Structuring Shareholder Take-Outs in Growth Equity Financings

i. introductionThe recent increase in private financing transactions with a dividend, redemption, secondary sale, or other “take-out” component is well documented. Once the province of a relatively limited subset of sponsors and targets, the so-called “recap” financing has gone mainstream. Reliable data tracking the number of such transactions is somewhat scarce. But over the past three years, the percentage of financing transactions handled by our firm with a liquidity component has increased dramatically. With potential increases to capital gains tax rates on the horizon, we expect an even greater focus on liquidity for transactions closing through the end of 2012.

Take-out transactions take many forms. We focus here on transactions in which the target company is a corporation1 and remains intact as a legal entity, the new investor acquires between 20% and 70% of the company’s fully-diluted ownership, and a significant portion of the investment dollars end up in the hands of the company’s existing stakeholders. This article will explain the typical structuring alternatives for these transactions, the key tax considerations for the various potential participants, and certain other important considerations.

For purposes of illustration, several examples are provided. Unless otherwise indicated, the examples assume the facts below. For brevity and ease of

1 Although the basic structuring alternatives for a non-corporate transaction are the same, the tax consequences of a transaction involving a partnership or limited liability company can differ dramatically for both existing owners and the new investor.

By Dan Meehan and Alfred L. Browne of Cooley LLP

11

12

reference, we will employ the same capitalized names and terms throughout the text.

• Company is a corporation with 40 million shares of stock outstanding:

o 20 million shares of Common stock owned by Founder, a U.S. individual who has owned his shares for more than 1 year; and

o 20 million shares of series A Preferred stock purchased for $1.00 per share by Original Investor, a U.S. investment fund organized as a limited partnership with various types of partners including U.S. individuals, non-U.S. persons and U.S. pension funds.

• Company has issued employee options on 10 million shares of Common Stock with a strike price of $.50 per share.

• The series A Preferred stock has a per share liquidation preference of $1.00.

• New Investor will invest $100 million to acquire shares of Company stock.

• New Investor expects to own a majority of the fully-diluted Company stock.

• New Investor is willing to allow up to $80 million of its investment to be paid to existing Company owners and option holders, with up to $20 million payable to Founder and up to $4.5 million payable to option holders.

ii. structuring alternativesNumerous structuring permutations are available for financings with a liquidity component. This section describes the most typical alternatives.

A. The Investor Transaction

New Investor’s transaction may take the form of an investment in Company (or in some cases, a new entity formed to acquire Company) in exchange for newly-issued (typically) preferred stock (a “primary” issuance) or a direct purchase of outstanding stock from selling stockholders (a “secondary” purchase). Occasionally, a secondary purchase will be followed by New Investor’s surrender of the acquired stock in exchange for newly-issued preferred or common stock.

In a primary issuance scenario, Company would distribute a significant portion of the new money to existing stockholders, as described in more detail below. In a secondary transaction, the existing stockholders will of course receive New Investor’s money directly.

B. Target Participants

Recipients of the take-out dollars may include Original Investor, Founder, Company option holders and other Company employees. Sometimes all groups will participate, sometimes only one. Historically, recap transactions were most often a liquidity opportunity for founders. More recently, the primary objective of the take-out is often replacement of existing investor ownership with new investor ownership.

Numerous considerations inform the decision about which Company stakeholders participate in the take-out and how to allocate take-out dollars. These include:

• New Investor’s ownership requirements (e.g., majority vs minority stake)

• Current owner willingness to relinquish a controlling stake in Company

• Demands for liquidity by Founder and Original Investor

• Willingness of both New Investor and company management to allow employee participation, taking into account the motivational pros and cons of employee liquidity

• Company’s operational funding requirements

Historically, recap transactions were most

often a liquidity opportunity for founders. More recently,

the primary objective of the take-out is often

replacement of existing investor ownership with new investor

ownership.

13

C. The Participant Transaction

Participation of Company stakeholders in the take-out can take any one or more of the following forms:

• Company redeems outstanding stock by paying cash to selling stakeholders

• existing stockholders sell their outstanding Company stock to the new investor for cash (a “secondary” sale)

• A statutory cash-out merger with a “rollover” of equity by continuing stakeholders

• Company distributes cash (as a “dividend”) to some or all holders

• Compensation paid to company employees

• A loan from the company, sometimes coupled with one or more options to acquire or sell stock

The transaction may also involve a recapitalization of existing Company stock. For example, Company’s Series A Preferred Stock might be reconstituted as Common Stock, or existing Common Stock might be subject to a reverse stock split.

1. Redemption

In a take-out structured as a redemption, New Investor typically will invest money directly into Company, generally in exchange for the Series B Preferred Stock, and Company will use some or all of the investment dollars to redeem existing Company shares. Existing stockholders may be given the option to elect to participate in the take-out, or the participants may be

predetermined by agreement of Company’s board, management and/or New Investor.

After the redemption is complete, New Investor will own its desired percentage of Company, and the take-out participants will have achieved some measure of liquidity with respect to their ownership stakes in Company.

2. Secondary Sale of Outstanding Stock to New Investor

Although sellers often prefer the tax consequences of selling their shares directly to a new investor, recapitalization transactions are frequently structured as a purchase by New Investor of newly-issued shares from Company, followed by a redemption of Company stock. There are a few key reasons for this:

• As described above, in certain situations, the tax consequences of a redemption can be more favorable for one or more selling shareholders.

• Typically, the business deal is that the new investors will acquire a series of preferred stock that has different terms from the existing preferred stock.2

2 This sometimes can be achieved by first purchasing outstanding shares directly from the sellers and then exchanging the purchased shares for the new series of preferred stock. It can also be accomplished by reconstituting the purchased shares as a new series of preferred stock. However, a primary purchase from Company followed by a redemption typically is a more direct and straightforward route from a corporate law, mechanical and tax perspective, whereas the mechanics of exchanging or reconstituting shares often involves numerous steps, more nuanced fiduciary considerations and the involvement of more stakeholders. These considerations are discussed in Part IV.

14

• New Investor may prefer to deal with only one entity (the corporation), rather than numerous individual sellers.

However, a secondary sale sometimes is used – either because it is most tax-efficient for the selling stockholders, or because New Investor does not demand a new series of stock, or simply because New Investor and the sellers prefer to negotiate the terms of their transaction with minimal interference from Company.

Sometimes, a secondary purchase will be followed by an exchange. For example, if New Investor purchases Common Stock and Series A Preferred Stock, New Investor might immediately exchange that stock for newly-issued Series B Preferred Stock.

3. Cash-Out Merger

A statutory cash-out merger may be utilized in cases where it is not possible to easily obtain signatures from all of the participating Company stockholders (as would be required in a more straightforward sale transaction), either due to the number of existing Company stockholders or because certain stockholders may be unwilling to sign. Such a merger transaction is often structured in the following manner (or some variation thereof):

• New Investor organizes a new entity to be the acquirer (“Newco”) in the merger and makes its investment into Newco in exchange for newly-issued Newco preferred stock.

• Certain Company stockholders contribute their existing Company stock to Newco in exchange for newly-issued Newco stock having (usually) the same rights as the contributed Company stock.

• Newco forms a wholly-owned “shell” subsidiary (“MergerSub”).

• Mergersub merges with and into Company. Company is the surviving entity in the merger.

• Newco acquires all of Company’s remaining shares in the merger in exchange for cash paid to Company’s stockholders.

4. Dividend

Instead of using New Investor’s funds to redeem Company’s existing shares, Company could use those funds to declare and pay a dividend on existing shares. Depending on Company’s charter or articles of organization, a dividend could be paid on Company’s existing common stock, preferred stock or both.

By declaring a dividend, Company can provide a certain amount of liquidity to everyone owning the classes of share receiving the dividend. While this solution can mitigate some issues involved in picking participants for an oversubscribed take-out, it also can end up providing liquidity to investors that may not otherwise demand it.

5. Compensation Paid to Company Employees

Company could use New Investor’s funds to pay bonuses to certain Company employees. If only employee shareholders are seeking liquidity, a bonus can put cash in their hands without going through the process of declaring and paying a dividend or redeeming stock. The bonuses would be run through Company’s payroll procedures and could be made disproportionately without any effect on Company’s ownership structure.

6. Combination

Sometimes Company might choose to use a combination of compensation and redemption to achieve all of the stakeholder’s goals. With this option, Company can reorganize its capital structure through

A key issue in any redemption transaction is whether stockholders’ surrender of outstanding shares

in exchange for cash will be treated as a “distribution” with respect to their remaining stock of Company, or will instead

be treated as a sale or exchange of the redeemed stock.

15

the redemption portion of the take-out and also issue compensation to the extent it wants to reward certain employees beyond the value of those employees’ redeemed shares.

7. Treatment of stock Option Holders

Company may also want to provide liquidity to its option holders in a take-out. There are a few different ways to do this:

• Permit option holders to exercise all or a portion of their options (either through payment of the exercise price or through a “cashless” exercise), allowing them to participate as stockholders in the liquidity transaction; or

• Permit option holders to surrender all or a portion of their unexercised options in exchange for liquidity proceeds calculated based on the difference between the option exercise price and the fair market value of the underlying stock.

8. Other Liquidity Options

Of course, the alternatives for structuring cash transfers to existing Company owners are not limited to those described in this article. For Founder and key employees, in particular, numerous alternative approaches (from the simple to the very creative) have been utilized over the years. For example:

• New Investor or Company might loan money to Founder. Typically, the loan would be secured by Founder’s Common Stock. The loan may be fully recourse, fully nonrecourse, or partial recourse.

• A loan coupled with a call option on Founder’s company stock. In this variation, New Investor is typically the lender and holds the call option. Often, the call option cannot be exercised for some period of years, and the strike price of the option may be significantly higher than the current value of the Common Stock, reflecting the parties’ expectations (or at least hopes) about the future value of that stock. Typically, the loan in this approach would be fully (or mostly) nonrecourse. In some cases, Founder may also have a put option, effectively creating a “collar” on the Common Stock.

Other variations are also possible, including a “prepaid forward” sale of the stock. Each variation (and each component choice within each variation) involves

different – and sometimes very sophisticated – tax considerations. Those considerations are beyond the scope of this article, but should be addressed with a tax advisor before any of these variations are implemented.

iii. tax considerations

A. Redemption

The key tax issues that may arise as a result of a redemption transaction in connection with a recap financing are discussed below. To aid in the explanation, we will refer to the following sample facts:

Example 1

New Investor will pay its investment dollars to Company in exchange for newly-issued Series B Preferred Stock. Company will use $75 million of New Investor’s invested capital to redeem a portion of its outstanding equity, as follows:

• 15 million shares of series A Preferred stock redeemed at a $3.37 per share price ($50.5 million total);

• 10 million shares of Common stock redeemed at a $2.00 per share price ($20 million total); and

• Options on 3 million shares, netting $1.50 per option share after deduction of strike prices ($4.5 million total).

1. Distribution vs sale Treatment – Why it Matters

A key issue in any redemption transaction is whether stockholders’ surrender of outstanding shares in exchange for cash will be treated as a “distribution” with respect to their remaining stock of Company, or will instead be treated as a sale or exchange of the redeemed stock. The determination of sale or distribution treatment is explained below. But first, it is important to understand the stakes involved in this question. They include:

• For u.s. individuals (including u.s. individual partners of an investment fund), whether (or at least when) basis in Company’s stock can be used to reduce taxable income from the transaction, as well as the tax rate applicable to the transaction.

• For non-u.s. shareholders (including non-u.s. partners of an investment fund), whether U.S. withholding tax will be imposed in connection with the transaction.

• For u.s. corporate shareholders, whether a “dividends received deduction” is available to reduce tax from the transaction.

16

In example 1, Original Investor may have limited partners comprising all three of the above categories (U.S. individuals, U.S. corporations and non-U.S. persons). While U.S. corporate partners of Original Investor may have a preference for distribution treatment because of the possible dividends received deduction, non-U.S. partners often will prefer sale treatment because sale treatment generally will avoid U.S. withholding tax for their share of the redemption proceeds. If distribution treatment applies and if some or all of the “distribution” is treated as a dividend for tax purposes (as explained further below), Original Investor typically would be required to withhold U.S. withholding tax with respect to its non-U.S. partners’ share of the dividend income at rates up to 30%.3

U.S. individuals often prefer sale treatment because of the ability to use their basis in the redeemed shares to offset taxable income from the transaction. In Example 1, Founder has no basis in his shares of Common Stock, having received those shares for future services upon Company’s inception when they had no value. In addition, Founder is eligible for the 15% federal tax rate on “qualified dividends,” the same rate that would apply to long-term capital gain he would recognize on a sale of his shares. Accordingly, Founder is likely to be indifferent as between dividend and sale treatment for his redemption. On the other hand, Founder may prefer sale treatment if he lives in a state with a reduced tax rate on capital gains or if federal income tax rates on dividend income increase.

In contrast to Founder, U.S. individual partners of Original Investor likely will not be indifferent as between sale and distribution treatment. Original Investor has an aggregate basis of $15 million in its redeemed shares. If sale treatment applies, Original Investor will recognize a tax gain on the sale of $35.5 million – that is, its $50.5 million of “sale” proceeds less its $15 million basis in the redeemed shares. Because of Original Investor’s ability to utilize its $15 million basis to reduce its gain under sale treatment, Original Investor’s U.S. individual partners may well prefer sale treatment to distribution treatment.

However, in some situations, U.S. individuals may prefer distribution treatment. If the redemption is treated as a

3 The actual withholding tax rate for a given partner of Original Investor will depend on the partner’s home country residence and on whether that country has a tax treaty with the U.S. that reduces the regular withholding tax rate on dividends.

distribution for Original Investor, then its actual tax consequences are determined based on a three-tiered filter.

First, if Company has current or accumulated “earnings and profits” (or “E&P”)4 then the distribution would result in dividend income for Original Investor up to Original Investor’s allocable share of the E&P.5 Original Investor may not use its basis in the shares to offset the dividend income.

Second, if Original Investor’s redemption proceeds exceed its share of Company’s current and accumulated E&P, the next redemption dollars are treated as a tax-free return of basis up to Original Investor’s basis in its Company shares. In some cases, this may cause Original Investor and its partners to prefer distribution treatment. Under this second tier of the analysis, Original Investor may use its basis in both the redeemed shares and its retained shares. As compared to sale treatment, this potentially allows Original Investor to receive an additional $5 million of redemption proceeds free of tax. For example, if Company has no current or accumulated E&P, Original Investor would presumably prefer distribution treatment, which would allow Original Investor to receive $20 million of its redemption proceeds free of federal income tax. Under sale treatment, Original Investor may use only its $15 million basis in the redeemed shares as an offset.

Third, if Original Investor’s redemption proceeds exceed both its share of Company’s e&P and its entire $20 million tax basis in the Series A Preferred Stock, then any remaining redemption proceeds will be treated as capital gain. If Company has no current or accumulated e&P, Original Investor would have $30.5 million of capital gain under distribution treatment, as compared to $35.5 million under sale treatment.

2. Determining Distribution vs Sale Treatment

Determining whether a redemption should be classified as a distribution or a sale is equally complex, and not entirely objective in every case. However, certain

4 There is no clear definition of E&P in the tax code. It is not synonymous with either taxable income or GAAP retained earnings. However, it is often relatively close to the corporation’s net taxable income (or loss), as reduced by previous dividends distributed by the corporation. Dividend treatment may apply if Company has either current-year E&P, or E&P for all prior years combined. Thus, dividend treatment may apply even if Company has no accumulated E&P (for all prior years combined), if Company has E&P for the current year viewed in isolation.

5 Each shareholder of a corporation will be allocated a certain portion of the corporation’s E&P based on the relative ownership and distribution rights inherent in their stock.

17

objective safe harbors are available. A complete redemption of a shareholder’s interest in a corporation is one safe harbor (although even this test is not as simple as it sounds, due to the potential application of certain share ownership “attribution” rules). The “substantially disproportionate” redemption is another safe harbor. Under this test, the shareholder’s percentage ownership of both outstanding common stock and outstanding voting stock after the redemption must be less than 80% of its percentage ownership prior to the redemption. Various other nuances apply, including certain stock ownership attribution rules and a requirement that, immediately after the redemption, the stockholder must own less than 50% of the corporation’s total voting power.

In example 1, Original Investor’s initial common-equivalent and voting percentage of the outstanding stock is 50%. To qualify for the substantially disproportionate test, Original Investor’s ownership after the redemption must be less than 40% (i.e., less than 80% of 50%). In the above example, Original Investor’s percentage of the outstanding common-equivalent and voting power after the redemption is approximately 14% and therefore satisfies the substantially disproportionate test, meaning Original Investor’s redemption should be treated as a sale of shares for income tax purposes, rather than a distribution.

Similarly, Founder’s percentage ownership of the outstanding stock decreases from 50% to approximately 29% after the redemption and should also qualify as substantially disproportionate. As noted above, Founder may be indifferent as to whether the redemption is treated as a sale or redemption for tax purposes.

If neither the “substantially disproportionate” nor the “complete redemption” safe harbors are available, a redemption may in some cases still be classified as a sale for income tax purposes if it is “not essentially equivalent to a dividend.” However, this analysis is based on the facts and circumstances of each case rather than on objective criteria. The case law generally requires a “meaningful” reduction in the stockholder’s interest in the corporation, but the courts and the IRS have varied interpretations of what qualifies as “meaningful.” Accordingly, tax practitioners prefer not to rely on this category in advising on the tax consequences of redemptions.

18

3. Possible Recharacterization

In addition to determining the general tax treatment of a redemption as either a sale or distribution, in some cases a redemption transaction may raise other tax characterization questions. In particular, if Company redeems shares held by employees, there may be a question about whether some or all of the redemption price could be characterized as compensation for tax purposes. This is usually a somewhat subjective analysis and can be a very sensitive and important issue for both the selling employees and the company.

For Company, one key question is whether a tax withholding obligation may exist with respect to some or all of the payments to employee sellers. The tax deductibility of such payments will also be a consideration for Company. A payment of compensation is deductible by Company, whereas the redemption price for stock is not. For the selling employees, compensation treatment usually will result in a significantly higher tax burden for the transaction proceeds, given that compensation is taxed at federal income tax rates up to 35% (possibly increasing in the future) and is subject to employment taxes as well.

The compensation question often arises in situations where the redemption price to be paid for – in our examples – Company Common Stock is equal to (or very close to) the price being paid by New Investor for Series B Preferred Stock. This situation highlights the question because the Series B Preferred Stock has economic features (such as a liquidation preference and dividend rights) and other rights that seemingly make it far more valuable than the Common Stock. On the other hand, in many cases, all the parties to the transaction believe that the agreed redemption price for the Common Stock does represent its true fair market value. There are several factors that tax

practitioners identify as relevant in determining whether redemption proceeds may be characterized in whole or in part as compensation. These include:

• All available information about the valuation of the Common Stock.

• The expected financial accounting treatment of the redemption price paid to employee-sellers.

• Whether the redemption price for the Common Stock is viewed as an arm’s-length, negotiated price.

• Whether any portion of the Common stock is being sold by persons who provide no services to Company (for example, if Original Investor also held Common Stock and was selling it to New Investor at the same price as Founder).

• Whether dividend treatment might be a more appropriate recharacterization than compensation.

The tax analysis should take into account all of the foregoing factors.6

In cases where some or all of the redemption price payable to employee-sellers is determined to be compensation, the redemption payment mechanics should be revised for the compensation portion of the payments. The compensation portion should be run through Company’s payroll processing procedures (internal or external). Income tax withholding and employment taxes should be withheld from that portion of the payment. The resulting amount (net of withholding) can then be paid to the employee sellers. Of course, any portion of the amounts payable to employee-sellers that is determined to be equal to the true fair market value of Company’s Common Stock can be paid outside those compensation procedures.

Example 2

Assume Company’s board of directors determines (by commissioning an independent appraisal) that the fair market value of Company’s Common stock is $1.75 per share, rather than the $2 per share Company will pay to redeem that stock. Company’s board determines based on consultations with tax counsel that the excess portion of the payment for Founder’s Common Stock will be treated as compensation to Founder. Founder is being paid $2 per share, so $0.25 per share will be considered compensation.

6 Tax practitioners may occasionally consider the relative incentive of a taxing authority to characterize the common stock redemption price as compensation. Sometimes, the overall tax revenue generated by the transaction would be lower with compensation treatment because of the resulting corporate tax deduction.

In contrast to redemptions, the tax consequences of a direct sale of stock by existing stockholders to New Investor are often

straightforward.

19

• Redemption: Since the fair market value of the stock is $1.75 per share, that portion of the payment will be treated as a sale of Founder’s shares (assuming Founder’s satisfaction of the “substantially disproportionate” redemption test described above) and will be taxed at the 15% federal long-term capital gains tax rate, plus state and local taxes. For purposes of this example, assume a 10% state and local tax rate on both capital gains and ordinary income. Thus, in this example, Founder will pay $4.375 million in taxes on the “purchase” portion of his proceeds. Since no withholding would occur for this tax liability, Founder would be well advised to set aside funds for payment of these taxes, either through estimated tax payments during the remainder of the year or by the due date for his tax return, at the latest.

• Compensation: As noted above, $2.5 million of the total consideration payable to Founder is determined to be compensation. Company will run this amount through its payroll provider, deduct applicable income and employment taxes, and remit the balance to Founder. Assuming federal income tax is withheld at a 35% tax rate and all other taxes (Medicare, state, and local)7 total an additional 12%, approximately 47% (or $1.175 million) of the amount treated as compensation will be withheld and remitted to the applicable taxing authorities by Company. Also, Company will be entitled to a tax deduction equal to the $2.5 million of compensation. This deduction is often a significant windfall to Company (assuming Company has net taxable income against which to use the deduction) that was not anticipated at the outset of the transaction and was created with no net cash outflow from the Company. In some cases, the parties may have originally expected that all of Founder’s payment would be taxed as capital gain. In such cases, the board of Company may consider paying Founder a “gross-up” amount to cover the difference between compensation taxes and capital gains taxes.

B. Secondary Sale to New Investor

In contrast to redemptions, the tax consequences of a direct sale of stock by existing stockholders to New Investor are often straightforward. In our example, if Original Investor sells 15 million shares to New Investor for $50.5 million, Original Investor will recognize a capital gain of $35.5 million, which is the difference between the $50.5 million purchase price and Original Investor’s $15 million tax basis in the 15 million shares sold. As noted above, this typically will be Original Investor’s preferred tax outcome (as compared to distribution treatment). Similarly, if Founder sells 10 million shares directly to New Investor for $20 million, Founder likely will recognize a capital gain of $20 million.

7 This assumes that Founder’s other compensation exceeds the wage base limit for Social Security taxes.

However, secondary sale transactions are not entirely free from tax uncertainty. There still can be a question about whether some of the purchase price payable to employee-sellers represents compensation. This often surprises transaction participants. Intuitively, it would seem that if no payments are made by Company to its employees, then no portion of the sale price could be treated as compensation. Moreover, participants often note that a price negotiated by unrelated buyers and sellers should be respected as fair market value. On the other hand, where the facts indicate that there is some compensatory element to the agreed price (based on the various factors described previously), most tax practitioners believe that a taxing authority would not be swayed merely by the “form” of the transaction as a secondary sale. And certain tax regulations support this belief.

In cases where it is determined that some portion of the secondary sale price does represent compensation, it is usually easiest to restructure that portion of the payment. Typically, this takes the form of a payment by New Investor to Company, followed by Company’s payment to the employee-sellers after deduction of applicable withholding taxes. Often, New Investor’s payment to Company is restructured as the purchase price for newly-issued preferred stock. In some cases, the parties may find it easier to restructure the entire transaction as a primary issuance of stock by Company, followed by a redemption payment to selling shareholders.

Example 3

Instead of purchasing newly-issued stock from Company, New Investor purchases already outstanding shares from Founder. Assume also that Company Common Stock has an objectively determined fair market value of $1.75 per share and that the parties, including Company’s board of directors, determine that the excess $.25 per share payable to Founder represents compensation due to Founder’s status as a key employee.

• Treatment of the Purchase of Founder’s Common Stock: In this situation, rather than having New Investor pay the entire $2 per share directly to Founder, a better approach is typically to bifurcate the investment as follows:

o $17.5 million paid directly to Founder in exchange for 10 million shares of Founder’s common stock at $1.75 per share; and

o The other $2.5 million paid to Company in exchange for a primary issuance of Company stock (most likely the Series B preferred stock described in the Base Example, rather than additional common stock).

20

Company would then process the $2.5 million through payroll as a compensatory bonus to Founder in the same manner discussed in Example 2 above. The ultimate tax results of this approach for Founder and Company would be equivalent to those described in Example 2. However, New Investor may be unwilling to hold the common stock purchased from Founder and may require that the common stock be exchanged for new Series B Preferred Stock.

As noted in Part III.A.1 above, a secondary sale might facilitate a better (or worse) tax result for Original Investor or Founder, depending on various factors.

Example 4

Assume now that Original Investor agrees to sell fewer shares – only 2.5 million shares of Series A Preferred Stock – in the transaction. If the transaction is structured as a primary issuance to New Investor followed by a redemption from Original Investor, Original Investor’s percentage of outstanding voting stock and common equivalents after the transaction would be approximately 44%. This reduction in Original Investor’s percentage from 50% to 44% would not satisfy the “substantially disproportionate” test explained in Part III.A.2 above. Accordingly, some or all of Original Investor’s redemption may be characterized as a dividend, meaning Original Investor is reducing its tax liability on that portion of its proceeds by offseting those proceeds with a portion of its tax basis in the Series A Preferred Stock. However, if the transaction were structured as a secondary sale of Series A Preferred Stock directly to New Investor, Original Investor could use a portion of its tax basis to reduce the taxable amount. This may create tension between Original Investor’s desire for a better tax outcome by selling Series A Preferred Stock to New Investors, and New Investor’s preference for purchasing Series B Preferred Stock with different rights and privileges. Alternatively, New Investor may be able to exchange Series A Preferred Stock with Company for newly-issued series B Preferred stock; or New Investor may be indifferent to the type of stock purchased because of its expectations about Company’s current value and future prospects.

C. Cash-Out Merger

The tax issues arising in a cash-out merger transaction are particularly complex, and a full discussion of those issues is beyond the scope of this article. Depending on the precise structure used, the cash paid in a cash-out merger may be treated as “sale” proceeds for tax purposes, or as “redemption” proceeds (which in turn may result in dividend income, recovery of basis or capital gain), or as so-called “boot” in a stock rollover transaction, each with their own unique tax results.

Perhaps the most critical question in such a transaction is whether the “rollover” component will be tax-free to the rollover participants. Because this component involves the exchange of Company stock for illiquid stock of Newco, it is typically important to the participants that the rollover be nontaxable. The

tax analysis of a rollover depends in part on whether Newco is a corporation or an entity classified as a partnership for income tax purposes (typically a limited liability company, or “LLC”). If Newco is an LLC, the rollover usually can be structured as a nontaxable transaction.

If Newco is a corporation, the rollover participants and New Investor together must own at least 80% of Newco’s voting power and total stock value in order for the rollover to be eligible for nontaxable treatment. However, “nontaxable” treatment for a rollover to corporate Newco is not necessarily what it seems. Depending on various factors, a rollover participant who also receives some cash in the merger may end up with approximately the same overall tax liability as if the rollover were a fully-taxable transaction, even if the rollover itself satisfies the 80% test. Again, a full explanation of this phenomenon is beyond the scope of this article.

D. Dividend

Most of the tax considerations applicable to a dividend payment are addressed above in Part III.A. As noted above, Company’s dividend of cash may represent a nontaxable return of stockholder basis in Company stock or may be taxable as dividend income. A special low federal income tax rate (15% under current law) applies to “qualified” dividend income received by individuals.8

As with redemptions and secondary sales, a dividend may raise the question of compensation treatment for employee-stockholders. However, the tax analysis is somewhat different because a dividend does not involve a sale of shares – either in form or in substance. Accordingly, the question of valuation is less relevant in this context. Rather, the tax analysis focuses on the rights of the parties to dividend under the corporate charter, relative shareholdings, arm’s-length compensation and other factors. Arguably, a dividend structure renders the already subjective compensation analysis even less clear. Depending on the circumstances, there may be less inclination to recharacterize a dividend as compensation than in other contexts both on the part of tax advisors and

8 In order to qualify, the stock on which the dividend is declared must be held by the stockholder for more than 60 days during the 121-day period beginning on the “ex-dividend” date (generally, the last date on which one must have owned the stock in order to become eligible for a declared dividend).

21

taxing authorities. On the other hand, if dividend tax treatment would result in wholly or mostly tax-free proceeds (because the company has no E&P and the dividend recipients have tax basis in excess of the dividend amount), one should take into account the increased incentive of a taxing authority to challenge dividend treatment in such circumstances.

Example 5

Assume now that Company will not redeem any shares of its stock, but will pay out $40 million of New Investor’s investment as a dividend to Founder and Original Investor. Assume $30 million of this amount is distributed to Original Investor and $10 million is distributed to Founder. Also assume that Company has $20 million of current year e&P and no accumulated E&P.

Founder Common Stock Treatment: Even though Company may have no accumulated e&P, the $20 million of current year E&P will render a portion of Founder’s distribution taxable as dividend income for tax purposes. Assume 25% of the current year E&P is allocable to Founder (i.e., $5 million) and therefore that $5 million of Founder’s distribution will be taxed as a dividend. If Founder had tax basis in his shares, the other $5 million would first reduce Founder’s basis before being treated as capital gain. In this case, because Founder’s basis in his shares is $0, the other $5 million will be taxed as long-term capital gain. Because dividends and long-term capital gains are currently taxed at the same 15% federal tax rate, and assuming 10% state and local tax, Founder’s dividend will be subject to aggregate tax of $2.5 million. Again, since this tax is not withheld by the Company, Founder should consider setting aside a portion of the distribution to cover taxes when they become due. In future years, if the federal dividend rate and capital gains rate vary, Founder may find this dividend approach to be a less tax-efficient liquidity alternative.

Old Investor Series A Preferred Stock Tax Treatment: Assume Company’s remaining e&P ($15 million) is allocated to Old Investor and therefore $15 million of Old Investor’s $30 million distribution will be treated as a dividend for income tax purposes. Old Investor’s partners will be subject to the disparate tax treatment for dividends discussed in Part III.A.1. above (u.s. individuals subject to federal tax of 15%; non-U.S. persons subject to US tax withholding at rates up to 30%; and u.s. corporations may be able to benefit from a “dividends received deduction”). The other $15 million of Old Investor’s dividend will be treated as a tax-free recovery of Old Investor’s basis in its Series A Preferred Stock (reducing that basis from $20 million to $5 million.

E. Compensation paid to company employees

The tax implications of a payment intentionally structured as compensation to Company employees are addressed elsewhere in this article. The payment generally should be run through the company’s payroll procedures and applicable taxes should be withheld.

F. Tax treatment of payments to stock option holders

If Company option holders do participate in the proceeds of a take-out transaction, it is often most convenient to simply pay them in exchange for their agreement to cancel a portion of their unexercised stock options. This approach does not require the employee to write a check for the option exercise price, or the issuance of stock certificates.

Payments to employee option holders for unexercised stock options will always be characterized as compensation for tax purposes, and tax withholding will apply whether the options in question are so-called “incentive stock options” (commonly referred to as “ISOs”)9 or “nonstatutory stock options.”

On the other hand, employees who hold ISOs should at least consider whether tax savings can be achieved by first exercising their ISOs and then participating in the liquidity transaction as a stockholder. For example, if the liquidity transaction is structured as a secondary sale directly to the new investor or as a redemption of shares qualifying as a “sale” for tax purposes, the exercise of an ISO followed shortly thereafter by a sale of the underlying shares will be treated as a so-called “disqualifying disposition.” Although this approach results in the same federal income tax rate as the net “cash-out” approach described above for unexercised options, the exercise of an ISO and sale of the ISO shares allows the employee to avoid income tax withholding and employment taxes. Employees who use this approach will need to plan appropriately for payment of the income tax by the time they file their income tax returns for the year of the payment (at the latest), and in some cases may need to make interim estimated tax payments in order to avoid interest penalties.

However, in some cases, exercising an ISO may not be the optimal approach. ISOs generally must be exercised with a cash payment (rather than through a cashless exercise). And, if the liquidity transaction is structured as a distribution taxed as a dividend, the option holder may end up triggering alternative

9 ISOs are employee stock options that meet certain requirements and qualify for special tax treatment under the Internal Revenue Code.

22

minimum tax (“AMT”) by exercising the ISO10 and may be taxed at the same time on the dividend income. Thus, exercising an ISO may result in 3 layers of cash cost for the employee – the exercise price, AMT and the dividend tax. The liquidity amount may or may not cover the entire cash outlay. Accordingly, the decision to exercise an ISO as part of such a transaction should be made only with the help of a tax advisor.

Example 6

Company will allow option holders to participate in liquidity proceeds (for options on up to 2 million shares) by either surrendering unexercised options for their net “spread” value or exercising their options and participating in the transaction as stockholders. All the options are ISOs. The ISOs have an exercise price of $0.50 per share, so $1.50 will be paid for each unexercised option surrendered.

Certain option holders wish to avoid employment taxes on their proceeds for 1 million option shares). Those employees pay $500,000 to Company a few days in advance of the liquidity transaction. In the transaction, their 1 million shares are redeemed by Company for a total of $2 million. Assume the redemption qualifies as a sale for tax purposes.

Their sale of the ISO shares is a so-called “disqualifying disposition.” The employees will owe ordinary income taxes on the spread between their exercise price and the sale price. Assuming a 35% federal income tax rate and a 10% state tax rate, that would equate to approximately $675,000 of income tax on the $1.5 million of compensation income the options holders recognize. However, assuming the option holders’ wages are already above the Social Security wage limit, the employees will avoid the Medicare tax.11 No tax would be withheld from the payments to these holders. Rather, they should consider setting aside $675,000 for payment of the tax when it becomes due.

The employees who accept $1.5 million in exchange for cancelling unexercised options on 1 million shares will owe the same amount of income tax (assuming the same income tax rates), plus Medicare tax (and Social Security tax, if applicable), which would be withheld from the $1.5 million.

10 The alternative minimum tax may ultimately be offset against capital gains taxes in a future sale of the shares, but if the future sale is a loss for tax purposes, the AMT may never be fully recovered.

11 At the current 1.45% Medicare rate, the employees would save $21,750, and the Company would save an equal amount. The Medicare rate is scheduled to rise for some taxpayers, beginning in 2013.

iV. other considerations Although this article focuses primarily on structure and tax considerations, additional issues must be considered. In a “take-out” transaction structured as a redemption, Company’s board of directors must consider the advisability of issuing the Series B Preferred Stock in the first instance, and then the advisability of using the proceeds to repurchase existing shares. Often, there are several legitimate reasons for approving these transactions, including the need to align Original Investor (and possibly Founder) with the strategic plan adopted by the board and management. Stockholders who are no longer interested in Company as an investment, who require very near-term liquidity, or who simply do not “buy-in” to management’s strategy will often disrupt or otherwise negatively impact the management team’s efforts. A prudent board will seriously consider a liquidity transaction to minimize these disruptions and negative effects.

While there are often several legitimate reasons for approving a “take-out” transaction, during the approval process a board must also be mindful of self-interested motivations and/or the appearance of impropriety. Failure to do so may raise questions (and in some cases, legal claims) from Company stockholders.

When the transaction is structured as a redemption of shares held by insiders (including investment funds affiliated with board members), courts will often scrutinize these transactions more carefully. If liquidity is available only to a select group of stockholders, Company’s board should be prepared to justify the rationale for the limitation. Often, in order to avoid the appearance of impropriety, a board will require that the redemption be made available to all holders of capital stock on a pro rata basis, with a nondiscriminatory “cut-back” mechanism if participation is over-subscribed. However, by making the redemption available to a broader number of individuals or entities, the securities law rules for tender offers may be implicated – adding an additional level of complexity to the transaction.

23

In summary, when approving a “take-out” transaction

structured as a redemption, a board should carefully

consider each of the following:

• What is the corporate or business rationale for the

redemption/liquidity transaction?

• Who will benefit from the liquidity?

• Are there any conflicts of interest around the

board table? Will any board members receive

significant proceeds in the transaction?

• Is there a class or group of stockholders who are

not being offered the chance to sell their shares?

• At what price should Company repurchase

shares? How does this affect option pricing?

• Will Company have adequate capital to operate

its business after the transaction? Does the

transaction satisfy state law limitations on share

repurchases and dividends?

• Are there restrictions in Company’s contracts

(including investor documentation and/or debt

documentation) that limit Company’s ability to

repurchase shares?

• Has Company satisfied its disclosure obligations

in connection with the repurchase?

• Are there any compensatory payments being

made (or any deemed compensatory payments

being made)? Is Company satisfying its tax

withholding obligations?

The considerations applicable to a take-out transaction structured as a secondary sale are similar, but not entirely the same. In many cases, Company will not be involved in the decision to sell or set the sale price, and Company may try to avoid becoming involved in the process. The board’s actions are less likely to be scrutinized if Company is only minimally involved. Company’s involvement may be limited to approval of an exchange of Series A Preferred Stock or Common Stock purchased by New Investor for newly-issued Series B Preferred Stock, and the authorization and issuance of the Series B Preferred Stock. Company may be required to disclose more extensive information if there are several selling stockholders and/or if the tender offer rules apply. Company may determine that it is appropriate to prepare a disclosure document. However, in many cases the board’s fiduciary obligations will require a full analysis of the factors listed above.

If New Investor’s purchase of Series A Preferred Stock or Common Stock is followed by an exchange for newly-issued Series B Preferred Stock, other issues arise, such as:

• Whether the board may, in the proper exercise of its fiduciary duties, approve the exchange and/or grant New Investor additional stockholder rights.

• What the terms of the series B Preferred stock should be.

• What the exchange ratio should be.

• Whether there is an effect on the valuation of Company’s Common Stock and correspondingly on the pricing of Company’s stock options.

• Whether the exchange triggers any preexisting rights held by Original Investor, such as rights of co-sale, or rights of first refusal.

While there are often several legitimate reasons for approving a “take-out” transaction, during the approval process

a board must also be mindful of self-interested motivations and/or the appearance of impropriety. Failure to do so may raise questions (and in some cases, legal claims)

from Company stockholders.

24

• The tax consequences of the exchange (both for New Investor and possibly for Original Investor and Founder).

conclusionA financing transaction with a stockholder liquidity component generates opportunities to rationalize a company’s capital structure; bring in new investors with fresh ideas, energy and capital to move the company forward; provide liquidity for founders and other stakeholders; take advantage of various tax benefits; and eliminate or diminish the presence of distractive stakeholders. These transactions also involve potential costs and complexities – both tax and nontax. Accordingly, such transactions must be carefully planned, and counsel should be consulted early in the process to identify and work through the potential opportunities and traps.

About the AuthorsDan Meehan is a partner with Cooley LLP. He is based in New York and is Chair of the firm’s Tax Group. His practice focuses on structuring and tax counseling for private equity, leveraged buyout and M&A transactions. He regularly advises financial investors, strategic buyers and target companies, with an emphasis on the software, technology, government services and life sciences sectors. He also helps businesses optimize their operational tax structure and plan for the tax aspects of future financing and exit transactions.

Al Browne is the partner in charge of Cooley LLP’s Boston office and Chair of the firm’s growth equity practice group. Al specializes in mergers and acquisitions; late-stage venture capital and growth equity transactions; cross-border transactions; and complex intellectual property transactions, particularly in the software industry. His clients include strategic and financial buyers and sellers in public and private acquisitions, among them private-equity-sponsored leveraged buyouts and take-private transactions. Al also has significant experience in counseling boards of directors in connection with mergers and acquisitions and related governance and anti-takeover matters.

The authors appreciate the assistance of Jonathan Rivinus, an associate in Cooley’s Tax Group.

25

By Steven Nebb, CFA and David L. Larsen, CPA, Managing Directors of Duff & Phelps LLC

In an environment of greater regulation and increasing transparency, most venture capital managers have come to grips with the accounting requirement to report all investments at fair value. They may not like the requirement, but generally they understand that most LPs must have fair value information to monitor investments, allocate capital and prepare their own financial statements.

A phenomenon of the current economic and technological environment is the increasing use of consideration dependent upon future events, as a strategy for exiting an investment. The contractual right to future consideration can be very beneficial, especially for deals encircled with uncertainty; where significant potential value of a business lies in the outcome of future events. The contractual right to future consideration is often described as “contingent consideration.”

Negotiating a contract for future consideration allows sellers to close a deal with the ability to realize a price they think is fair, taking into account future performance they deem both valuable and likely, but that has not yet been achieved. For buyers, the ability to contractually delay paying for value before it fully crystallizes protects their investment.

Without the ability to contractually defer payment until future events are more certain, many deals would not be consummated. Yet for financial and tax reporting purposes, the contractual right to future consideration often presents a dilemma that is less savory. Accounting questions surrounding contingent consideration are mired in historical bias and may lead

Contingent Consideration:Does it Have Value?

26

to a philosophical paradox such as that presented by Schrödinger’s cat or Morton’s Fork.

Morton’s Fork is a logical dilemma in which people are faced with a decision whereby no matter which approach they choose, there are distasteful results for both options. You could think of it as being “between the devil and the deep blue sea,” as the saying goes. Unless the victim of the dilemma manages to find an exception, the outcome of the situation will most probably be undesirable. Morton’s Fork got its name from Lord Chancellor John Morton, who worked in England under Henry VII. According to Morton’s logic, wealthy subjects of the Crown obviously had money to be spared for taxes, and poor subjects were clearly sitting on savings, so they could also bear high taxes. Rich and poor alike found themselves at the points of “Morton’s Fork,” paying high taxes. Clearly this logic could be applied to the debate on the taxation of carried interest, but that’s a discussion for another article.

When faced with Morton’s Fork, the temptation may be to do nothing, but sometimes this is also a bad alternative. A more thoughtful consideration of the options either reveals an additional choice, or a choice in the array of existing options which is less repugnant. It may also be possible to subvert Morton’s Fork by finding or creating an exception to the rule. Being between a rock and a hard place is sometimes solvable if one is willing to develop a hammer to smash the rock out of the way. Morton’s Fork, in the context of “contingent consideration,” is the somewhat equally unpleasant situation of a historical practice of not reporting the fair value of such arrangements and the new paradigm of LPs, who use net asset value (NAV) to estimate the fair value of an interest in a venture capital fund, being required to have all underlying investments reported by the manager at fair value. The hammer in this situation may indeed be a thoughtful approach to estimating the fair value of contingent consideration in situations where it is warranted.

contingent consideration—Missing the Forest because of the treesDeal professionals are well versed in structuring contracts to take into account various outcomes. Often these contractual rights are termed “contingencies.” Historically, when accountants heard the word “contingency” they immediately thought of FASB statement 5 (now known as AsC Topic 450). FAsB statement 5 became effective in 1975, at a time when all accountants were well schooled in the principles of conservatism. Statement 5 did not allow “gain contingencies”1 to be recorded in the financial statements.

Because of this historically indoctrinated conservative bias, many accountants believe that it is inappropriate to record in the financial statements the value of contingent consideration. Some have used a discussion by the Emerging Issues Task Force that was considering the question of contingent consideration by the seller in a business combination, but that was unrelated to venture capital or investment company accounting (AsC 946), as support for not reporting the fair value of future consideration.2 Yet, the application of FASB Statement 5 and the EITF non-decision is misguided. In the context of a venture capital exit that includes potential future consideration, the right to the future consideration is contractual. Said differently, a contractual right exists. The right itself is not contingent; the future consideration is variable depending on future events and outcomes. In many ways this is no different than the ownership in an underlying portfolio company; an ownership right exists; the future cash flows that will result from that ownership right are dependent (contingent) upon future events. The same concept applies to warrants or options. The ultimate value is contingent upon

1 FASB Statement 5, Paragraph 17—Contingencies that might result in gains usually are not reflected in the accounts since to do so might be to recognize revenue prior to its realization.

2 EITF 09-4—The EITF did not reach a consensus decision on the sellers accounting for contingent consideration in a business combination.

Viewing contractual rights as a contingency and not reporting fair value is inconsistent

with investment company accounting principles.

27

future events. To avoid confusion and misapplication of Generally Accepted Accounting Principles, it is more appropriate to describe “contingent consideration” in its legal form, that being a “contractual right” to future consideration.

Now we move to 2006 when FAsB issued statement 157 (now known as AsC Topic 820) Fair Value Measurements. While statement 157 did not require any asset or liability to be reported at fair value (Under US Generally Accepted Accounting Principles, investment companies have been required to use fair value since at least 1940), it did re-highlight issues surrounding the application of fair value principles. Further, in 2009, FAsB clarified that limited partners are allowed to use reported NAV in certain circumstances to estimate the fair value of a limited partnership interest. Those circumstances include that the underlying assets from which NAV is comprised are reported at fair value and are in-phase (as of the same measurement date).

All of this history and background has resulted in a clash of paradigms:

old paradigm New paradigm

Conservatism is good! Conservatism means purposefully understating

Contingent gains are not recorded

All assets are reported at fair value

LPs could blindly accept reported NAV

LPs must satisfy themselves that NAV is derived from the fair value of all underlying investments.

LPs generally ignored the fair value of contractual rights, if any

If a contractual right is not recorded at fair value the LP either cannot use NAV as their FV estimate or must adjust reported NAV to include the FV of contractual rights, if significant.

All investment company assets, including investments in debt, equity, options, warrants and contractual rights are required by GAAP (FAsB AsC Topic 946) to be reported at fair value. However, practice continues to vary.

contractual rights: a Modern-day Morton’s ForkAs noted above, historical practice, training and bias drive many accountants to find the notion of estimating the fair value of future, unknown, cash flows associated with a contractual right to be distasteful. Some believe estimating the fair value of contractual rights is not possible, while others believe that such estimations are not cost beneficial. However, uniformly, when VC managers are asked if they will sell their “contractual rights” for $100, they respond “absolutely not, they have much greater value than that.” Therefore, it should be clear that contractual rights do have value. The difficulty then is estimating the fair value of contractual rights on a consistent, cost-effective, basis.

US GAAP requires corporations who purchase a company in a purchase business combination to record as a liability the fair value of earn-outs or other future payments dependent upon future events. The fair value of such liabilities are adjusted at future measurement dates. If the fair value of the liability side of a contractual right arrangement can be estimated, it should be clear that the fair value of the asset side of a contractual right arrangement can also be estimated. Depending on the size and complexity of the agreement, the tax impacts and future variability, some managers use the services of a third-party valuation expert to assist in determining fair value. However, generally, such fair value estimates can be made by the manager themselves.

practical solutions to Valuing contractual rightsOur experience working with investment managers shows that many managers are reluctant to estimate the fair value of future payments contingent upon future events, because they are concerned that such estimates potentially open a Pandora’s Box that would expose them to more audit/regulatory scrutiny and volatility of returns. However, as stated above, viewing these types of arrangements as a contingency and not reporting any value until payment is received is not consistent with either investment company accounting rules or fair value accounting principles. Investment company accounting guidance requires all contractual rights be recognized in a fund’s financial statements at fair value. More importantly, LPs are not allowed to use

28

NAV to estimate the fair value of a fund interest if all underlying assets are not reported at fair value.

Since of the components of contractual rights can vary significantly in form and complexity, the level of effort (or cost) to estimate fair value will also vary. It is not practical to value every contractual right using the same process or model. Venture Capital investment managers must use a pragmatic approach valuing contractual rights by selecting a policy which is dependent upon the nature of the contractual right. Just like the valuation of other venture investments requires judgment, the estimation of the fair value of a contractual right requires judgment.

Ultimately the decision of what qualifies as appropriate procedures for estimating the fair value of each contractual right will come down to discussions with an investment manager’s auditors, valuation provider, and/or investors. These discussions should be centered on the following factors that may help frame overall policy and procedures:

• Importance of the contingent payment(s) to the deal, fund IRR calculations or the potential value in relation to the original investment

• Complexity of the terms affecting the visibility of likely outcomes

• Length of time expected for the contingency to resolve itself

• The nature of the contingency; certainty of payment or performance

• Range of potential outcomes (variance of payments)

• Information usefulness for an investor; would investors find the results of the analysis useful in making decisions about their investment or exposure to the asset class or sector in making transaction, future investment decisions (return/track record) or asset allocation decisions or in assessing the usability of NAV as the investors’ fair value estimate?

LPs are not allowed to use NAV to estimate the fair value of their fund interest if all underlying assets are

not reported at fair value.

29

So how do you value a contingent payment, contractual right?

Due to the unique aspects of these types of rights, it is likely that an income approach (discounted cash flow) will be the best tool to estimate fair value. This requires the development of expected cash flows and an appropriately chosen discount rate. Estimated cash flows in their simplest form are determined by assessing the probability of payment at various points in time.

Cash flow assumptions should include the estimation of the likelihood and timing of various possible outcomes for achievement of the specified contingency and/or consider scenario-based projections relevant to the specified contingencies. The key starting point is to decompose the factors that would lead to a contingency being met (or not being met). The manager must identify sources of data to be used to support assumptions. It is possible to keep the analysis relatively simple while still incorporating the material complexities of the contractual right.

Typically, contingent payments are structured based on reaching a particular technical or functional milestone, or on revenue, gross profit or EBITDA targets. For milestone contingencies the likely value will be a function of the likelihood of meeting the milestone requirements and the associated payment.

For nonlinear targets like revenue or various profit targets, a natural starting point is to consider the company’s forecasted financial metrics and compare them to the contingent target(s), while considering various potential scenarios that would lead to a meaningful range of outcomes (full payment, partial payment(s), and no payment of the contingency). Since the payoff of contingent consideration based on financial performance is typically nonlinear, in order to calculate the expected cash flow arising from the contractual right, it is appropriate to consider the payment associated with each point on a distribution of possible outcomes, which can be estimated by probability-weighting meaningful scenarios or by employing other valuation techniques such as option pricing models (binomial) and simulations (Monte Carlo), which can be particularly helpful when dealing with more complex contingent payment structures.

Given an estimate of the cash flow associated with a contractual right, the present value must

be estimated by applying an appropriate discount rate. In determining the right discount rate to use, the following risks factors should be considered: 1. Risk associated with the related outcome (assumed payment level of the contingency) and the assumptions used to determine that outcome (i.e., business risk as estimated by the company’s WACC or deal implied IRR), 2. How the probabilities or the weighting of various scenarios affects the overall risk of payment, 3. The counterparty risk associated with the acquirer, and 4. The degree of confidence surrounding the probability-weighted estimated cash flows. While this process sounds complex, it can be accomplished in most cases with limited additional effort because deal professionals have assessed the probability of future cash flows in negotiating the terms of the contractual right.

MonitoringCare should be taken in selecting a model that relies on supportable and easily understood assumptions/probabilities/scenarios since the fair value of a contractual right will need to be updated regularly. These assets will need to be revalued each reporting period until the contingency is resolved. If a model is not robust enough to handle changing company and market conditions, and if the inputs to the model are not easily supported or are difficult to estimate, the measurement and reporting of contractual rights may become difficult and a source of debate between interested parties. However, with careful consideration of the probability-weighted cash flows and discount rate, the reporting of the fair value of contractual rights can be meaningful for the investment manager as well as the investors in the fund.

It should also be noted that in many cases, the fair value of a contractual right will be relatively small at inception. As time passes, the visibility and confidence in future cash flows, if any, will increase. Generally this means that the discount rate will decrease as the clarity of estimated future cash flows improves.

conclusionBecause of regulation, transparency, globalization, economic conditions and investor needs, the venture capital industry finds itself today firmly in a fair value reporting regime. LPs find themselves under increasing scrutiny as they attempt to report performance on

30

a consistent basis across all the asset classes in

which they invest. The purpose of this article is not to

describe all factors associated with estimating the fair

value of contractual rights. The paradox of Morton’s

Fork seems to indicate that neither the GP nor the LP

really want to be full fair value reporters. However, if

the paradigm is shifted, and after smashing the fair

value boulders that seem to be insurmountable, the

following key points remain:

• us GAAP requires investment companies to report all assets at fair value.

• so-called “contingent consideration” is a legal contractual right to future cash flows depending upon future events.

• A contractual right is not contingent; the cash flows it describes may be subject to future events, but the right itself is not contingent.

• LPs need their GP to provide fair-value-derived NAV based on the fair value of all assets including contractual rights.

• Contractual rights are difficult to value, but arguably no more difficult to value than an option, warrant or any early stage enterprise.

Estimating the fair value of all assets, including contractual rights, while imperfect and subject to judgment, continues to be the best basis for reporting the value of investments on a periodic basis.

About the AuthorsDavid L. Larsen is a Member of FASB’s Valuation Resource Group, a Board Member of the International Private Equity and Venture Capital Valuations Board (IPEV), leads the team that drafted the US PEIGG Valuation Guidelines, and is a Member of the AICPA Net Asset Value (NAV) Task Force. Mr. Larsen serves a wide variety of alternative asset investors and managers in resolving valuation and governance related issues.

Steven Nebb serves as the project lead for numerous Alternative Asset managers and investors including large global private equity, venture capital and Business Development Companies. He provides advisory support to many limited partnerships and corporate pension plans regarding fund management, financial reporting requirements and general valuation of investments, and has over 14 years of experience in performing valuations of intellectual property, private equity, illiquid debt and complex derivatives for a variety of purposes including fairness opinions and transaction advisory, financial reporting, tax, litigation, and strategic planning.

Contractual rights are difficult to value, but

arguably no more difficult to value than an option,

warrant, or any early stage enterprise.

31

By Marita Makinen, David Haber and Anthony Raymundo of Lowenstein Sandler PC

Acqui-Hires for Growth: Planning for Success

A new M&A buzzword, the “acqui-hire,” reflects competition for talent through acquisitions in today’s hot technology market. In an “acqui-hire” the buyer is motivated primarily by the talent of the seller’s employees rather than by its operating business or technology — which may still be under development.

Facebook CEO Mark Zuckerberg, in an often-repeated quote, told a 2010 audience that “Facebook has not once bought a company for the company itself. We buy companies to get excellent people.”1 During the past three years, which have been characterized by rapid change in the technology industry and the explosive growth of new household names in social media and cloud computing, large-cap public companies and venture-backed companies alike have competed to amass critical talent. Recent examples of talent-driven transactions include Twitter’s acquisitions of summify in January 2012 and Posterous in March 2012,2 Google’s acquisitions of Milk in March 2012 and Restengine in May 2012,

3 Zynga’s acquisitions of

1 Nathaniel Cahners Hindman, Mark Zuckerberg : ‘We Buy Companies To Get Excellent People’, THE HUFFINGTON POST, October 19, 2010 http://www.huffingtonpost.com/2010/10/19/mark-zuckerberg-we-buy-co_n_767338.html. Commenting on the Instagram acquisition, Mr. Zuckerberg posted “This is an important milestone for Facebook because it’s the first time we’ve acquired a product and company with so many users”.

2 Mike Issac, Twitter Acquires Social-Aggregation Startup Summify, WIRED, January 19, 2012 http://www.wired.com/business/2012/01/twitter-summify-acquisition/; Laurie Segall, Why Twitter bought Tumblr’s biggest rival, Posterous, CNN MONEY, March 14, 2012, http://money.cnn.com/2012/03/14/technol-ogy/posterous_twitter/index.htm.

3 Alexia Tsotsis, Winning a Bidding War With Facebook, Google Picks Up the Milk Product Team, TECHCRUNCH, March 15, 2012, http://techcrunch.com/2012/03/15/winning-a-bidding-war-with-facebook-google-picks-up-the-entire-milk-team/; Josh Constine, Twitter Buys Personalized Email Marketer RestEngine To Deliver Best Tweet Digests, TECHCRUNCH, May 10, 2012, http://techcrunch.com/2012/05/10/twitter-acquires-restengine/.

32

area/code in January 2011 and Buzz Monkey in June 2012,4 Groupon’s acquisition of ditto.me in April 2012,5 LinkedIn’s acquisition of IndexTank in October 2011,6 and Facebook’s acquisitions of Lightbox and Glancee, both in May 2012.7

The term “acqui-hire” has been applied generously to describe acquisitions of companies with pre-existing businesses ranging from scant to significant. Facebook’s acquisitions of Drop.io in October 2009 and Gowalla in December 2011 each made a splash in part due to the established user bases of the targets, which did not appear to impact the decision to terminate the services offered by the targets.8 Perhaps weary of the disappearance of services and applications over the years, the community of early adopters has grumbled about the propensity of larger technology companies to buy and then discontinue innovative new offerings.9 Time will tell whether acqui-hires will continue to be announced at a breakneck

4 Dean Takahashi, Zynga dials Area/Code game studio for an acquisition, VENTUREBEAT, January 21, 2011, http://venturebeat.com/2011/01/21/zynga-dials-areacode-game-studio-for-an-acquisition/; Kim Mai Cutler, Zynga Adds 50 People Through Talent Acquisition of Video Game Marker Buzz Monkey, TECHCRUNCH, June 4, 2012, http://techcrunch.com/2012/06/04/zynga-acquires-buzz-monkey/.

5 Colleen Taylor, Groupon Acquires Recommendation App Ditto.me, TECHCRUNCH, April 16, 2012, http://techcrunch.com/2012/04/16/groupon-acquires-ditto-me-the-social-recommendation-and-planning-app/.

6 Colleen Taylor, LinkedIn acquires search engine startup IndexTank, GIGAOM, October 11, 2011, http://gigaom.com/2011/10/11/linkedin-acquires-search-engine-startup-indextank/.

7 Josh Constine, Facebook Hires Team From Android Photosharing App Dev Light-box To Quiet Mobile Fears, TECHCRUNCH, May 15, 2012, http://techcrunch.com/2012/05/15/facebook-lightbox/; Mike Isaac, Ramping Up Mobile Discov-ery, Facebook Acquires Glancee, ALLTHINGSD, May 4, 2012, http://allthingsd.com/20120504/ramping-up-mobile-discovery-facebook-acqhires-glancee/.

8 Anthony Ha, Facebook hires Drop.io’s Sam Lessin, calls it an acquisition, VENTUREBEAT, October 29, 2010, http://venturebeat.com/2010/10/29/face-book-drop-io-sam-lessin/; Laurie Segall, Facebook buys Gowalla, CNNMONEY, December 2, 2011, http://money.cnn.com/2011/12/02/technology/gowalla_facebook/index.htm.

9 Dana Raam, The Acqui-Hire: Rethinking the Trust We Place in Start-Ups, SOCIALMEDIATODAY, May 8, 2012, http://socialmediatoday.com/danaraam/ 479653 /acqui-hire-should-we-be-rethink ing-trust-we-place-star t-ups; Sarah Perez, Insta-Backlash: Twitterverse Overreacts To Facebook’s Instagram Acquisition, Users Delete Accounts, TECHCRUNCH, April 9, 2012, http://techcrunch.com/2012/04/09/insta-backlash-twitterverse-overreacts-to-facebooks-instagram-acquisition-users-delete-accounts/

pace or if the maturity of several of the most prolific acquirors and slower market growth will slow this trend.

Acqui-hires present challenges for venture capital investors, who invest in start-up companies based on longer-term investment goals. Acqui-hires often represent a truncated company life, coupled with the promise of a payout and incentive rewards for the management team under a different umbrella. This situation can create conflicts between the interests of investors and the founder team. In our experience while an acqui-hire is generally a good result for all constituencies in failed or stalled venture-backed companies, investor experiences have been mixed in the case of acqui-hires for very early stage companies or successful post-financing companies.

This article will explore acqui-hires from a legal perspective. Motivations and concerns for key transaction constituencies, including buyers, venture capital firms and founders will be examined. Common legal issues in these talent-driven acquisitions, including the satisfaction of fiduciary duties, the negotiation of post-closing indemnification provisions and the evaluation of tax issues will be explored. Finally, we will include a practical checklist for venture capital investors who may find their portfolio company engaged in an acqui-hire.

Motivations and concerns for Key constituenciesA buyer uses an acqui-hire to grow technical staff in a more meaningful way than traditional hiring methods afford. The buyer might have a specific project or task in mind to be accomplished by the acquired team, which may or may not relate to the target’s activities before closing. In any event, the buyer is looking for a cohesive group that has proven its ability to work together, combined with technical prowess and a good culture fit. In a pure acqui-hire, the business success of the target is secondary at best. A lack of revenue, market traction or other typical barometers of success

32

In an “acqui-hire” the buyer is motivated primarily by the talent of the seller’s employees rather than by its operating business or technology — which may

still be under development.

33

do not necessarily equate to a lack of creativity, intelligence or ability to design and build a product. The buyer’s primary concerns are post-closing employee retention and the potential for contingent liabilities of the corporate entity that would have been avoided by simply hiring the target’s employees.

For target company investors, the primary concerns in an acqui-hire are reputational and economic. The acquisition cuts short the expected life of the investment and might dramatically diminish the expected return to preferred stockholders if the deal consideration is cash or stock in a slower-growth public company. However, home runs for investors in acqui-hires can happen, particularly if the buyer is a hot private company paying in stock. Venture investors will not be disappointed with stock consideration issued by a rapidly growing company heading for a rich exit or IPO. For example, Facebook’s August 2009 acquisition of venture-backed FriendFeed purportedly involved a significant stock component, which would now be worth several multiples of the deal value.

10

Investors holding convertible venture debt will have special economic concerns, discussed in more detail below.

On some occasions, the acqui-hire will result in less than a full return of invested capital. In these downside scenarios, investors will need to assess the likelihood that the target has a viable future and the potential for greater value realization at a later date. Difficult cases occur when the target may have a viable although less than certain future, while a current acqui-hire transaction would result in a disappointing return to investors. In these cases, board members are placed in a challenging situation and must carefully consider fiduciary duties to common stockholders, who may receive no consideration or only nominal consideration in an acqui-hire transaction. From the perspective of the target’s board, a deal without any consideration to common stockholders may be a risky option in light of recent Delaware case law.

Reputational concerns of venture capital investors, including maintaining relationships with repeat founders and avoiding generating an impression

10 Alyson Shontell, If You Think The Word Acqui-Hire Really Means Failure, Take A Look At FriendFeed’s ~ $330 Million Exit, BUSINESS INSIDER SAI, February 5, 2012, http://articles.businessinsider.com/2012-02-05/tech/31026289_1_friendfeed-paul-buchheit-jim-norris.

of being difficult in the venture capital community generally, might create hurdles to blocking a founder’s interest in pursuing an acqui-hire. We believe (and our experience over hundreds of venture deals has made clear) that most investors will agree that having a veto over an exit transaction does not easily, if ever, lead to exercising that veto.

The mindset of the founders being wooed in an acqui-hire is the most challenging to assess. The founders may be truly torn between continuing their entrepreneurial path and folding into a much larger organization with greater resources and presumed stability. Our friend Josh Kopelman, founder of First Round Capital, has explained this, metaphorically, by using the distinction between taking the train and deciding whether to ride local or express – venture investors like to take the express and lock in for the big outcome, while founders (especially younger, first-time founders) might want the optionality of riding local and exiting early. Founders also must balance their own self-interest against the interests of others who have placed their trust in them, including investors, company personnel, and customers. Often, as an acqui-hire progresses, this key tension receives a great deal of attention by venture capital investors and their attorneys.

common legal issues in acqui-hire transactions

Duty of Care

A board of directors that considers an acqui-hire must be ever-mindful of its fiduciary duties to stockholders. Duties of care and loyalty apply to all board decisions, including in connection with a sale process. Under Delaware law, once a board has made a decision to pursue an exit transaction, fiduciary duties, commonly referred to as “Revlon” duties in this context, require the board to follow a reasonable process to achieve the best value reasonably attainable for stockholders.11 Boards of private companies, large and small, are not

11 See Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986), Paramount Communications, Inc. v. QVC Network, Inc., 637 A.2d 34, 37 (Del. Supr. 1994) and their progeny. We note that certain mergers involving public companies in which a substantial portion of the consideration consists of stock in the buyer will not implicate Revlon duties. See In Re Smurfit-Stone Container Corp. Shareholder Litigation, 2011 Del. Ch. LEXIS 79, 2011 WL 2028076.

34

exempt from these requirements.12 California courts have not expressly adopted Revlon-type requirements in connection with exit transactions involving California corporations. However, directors of California corporations would be served well by understanding Delaware case law, which is based on the same basic duties of care and loyalty as clearly apply to California corporations.

The duty of care requires directors “to act in an informed and deliberate manner in determining whether to approve an agreement of merger before submitting the proposal to the stockholders.”13 The duty of care, in the context of an acquisition, requires a board to become well-informed regarding transaction terms and process, consider viable alternatives, retain and consider the advice of outside experts and advisors, consider the views of management, and engage in meaningful discussions with advisors and management. The Delaware courts have stated repeatedly that “There is no single path that a Board must follow in order to maximize stockholder value, but directors must follow a path of reasonableness which leads toward that end.”14 However, the Delaware courts have cautioned that “if a Board fails to employ any traditional value maximization tool, such as an auction, a broad market check, or a go-shop provision, that Board must possess an impeccable knowledge of the company’s business for the court to determine it acted reasonably.”

15

In most acqui-hires, an auction process is not conducted before approval of a sale. In addition, private company exit agreements rarely include a “fiduciary out” or go-shop provision that would allow a market check post-signing. These factors can place stress on the board’s exercise of the duty of care in the context of approving an acqui-hire. Case law interpreting fiduciary duties in connection with a sale process is very fact-specific and almost always involves public companies. The In re OPENLANE, Inc. case, which involved a small-cap bulletin board company, may be instructive. In OPENLANE, the Court stated that “The fact that a company is small…

12 See Cirrus Holding Co. Ltd. v. Cirrus Industries, Inc., 794 A.2d 1191 (Del. Ch. 2001).

13 Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985).14 In re OPENLANE, Inc. Shareholders Litigation, 2011 Del. Ch. LEXIS 156, at

*17-18 (Del. Ch. 2011) (quoting In Re Smurfit-Stone Container Corp., at *16, which was citing QVC Network Inc., 637 A.2d at 45).

15 In re OPENLANE, Inc. at *18.

does not modify core fiduciary duties… In other words, small companies do not get a pass just for being small. Where, however, a small company is managed by a board with an impeccable knowledge of the company’s business, the Court may consider the size of the company in determining what is reasonable and appropriate.”16 The OPENLANE court found that the company’s board, consisting of founders and key investors who had an active role in the company’s business for years, was one of the “few boards that possess an impeccable knowledge of the company’s business” and accordingly could reasonably approve a sale of the company without a broad market check, a financial advisor’s fairness opinion or a “fiduciary out” termination right.17 Despite the potential for deference to a board consisting of founders and hands-on professional investors, and the lower risk of stockholder claims involving closely-held companies, boards involved in the consideration of acqui-hires must strive to fulfill their duties of care in evaluating and approving such transactions. Even without the benefit of a full market check process, the board should carefully review potential alternative buyers, market and competitive factors, and company projections and financing prospects. The transaction process and board deliberations should be carefully documented with the assistance of counsel familiar with exit transactions in order to support a finding that the board has satisfied its duty of care.

The OPENLANE case underscores one of the core difficulties small venture-backed corporations have when trying to follow Delaware law – the courts in Delaware interpret law as it is made on the backs of larger, better-capitalized corporations. In other words, Delaware case law is replete with well-funded companies hiring seasoned financial advisors to hold banker-run auctions and provide fairness opinions under conditions that more clearly check the boxes needed for a determination that the board has satisfied its fiduciary duties. Hiring well-connected and attentive bankers is much easier when selling a company for $500 million or more, and an exit in that price range would easily allow a board to fund separate advisors for a special committee. Acqui-hires inhabit precisely the opposite universe. Bankers rarely undertake engagements to sell a start-up for $9 million, which

16 Id at *24.17 Id at *21-22.

35

may well be the deal size for an acqui-hire. Further, because acqui-hire consideration may consist largely of illiquid stock (for tax, employee incentive and other reasons), and cash consideration will usually be reduced by transaction expenses, it is difficult for investors to rally behind paying advisors what appears to be a disproportionate fee on a small deal. Unfortunately, boards facing an acqui-hire are left to grapple with a set of laws written by and for an entirely different class of businesses.

Duty of Loyalty

Boards considering acqui-hires must be familiar with the duty of loyalty. The duty of loyalty requires that each director make decisions based on the best interests of the corporation, without regard for personal interest. Both management and representatives of venture capital investors must fully disclose and carefully evaluate any conflicts of interest in connection with acqui-hires, particularly when transactions involve substantial management carve-out plans and/or result in a disappointing amount of consideration (if any) to common stockholders. As described below, in reaction to the Trados decision, common stock carve-outs may be prudent in transactions in which the common stockholders would otherwise receive no consideration.

What had been the most controversial aspect of acqui-hires in the minds of investors – the presence of management carve-out plans which at times appear

disproportionate to payments for the target’s equity securities – has become commonplace. Management carve-outs were heavily used during the nuclear winter of the dot com bust when companies were sold, if at all, below the liquidation preference and both sellers and buyers needed to create incentives for continuing management. As the market thawed, and some would say overheated, buyers sought to win the hearts and minds of the management team by overriding the capitalization table and providing hefty incentive or retention pools for management. In the acqui-hire context, the need to create incentives and relatively modest transaction sizes conspire to shift the capitalization so that 40% or even half the deal consideration may consist of incentive pool payments and equity grant rolls overs, each of which are contingent on key employees staying with the buyer post-closing. The constituencies who do not partake in retention incentive packages will certainly ponder the fairness of this shift, particularly if they are being paid pennies on the dollar relative to original investments.

Management carve-out plans created by a target’s disinterested board of directors differ from buyer-created management carve-out plans. The former often signal that a company has become ripe for an exit transaction and are frequently created when a target’s preferred stock liquidation preference has overtaken the value of common equity held by continuing management. These plans may consist of cash bonuses or retention plans to provide employees

36

with equity if they stay through a sale and for some period post-sale and are intended to create conditions which will lead to the highest exit price possible for all stockholders. Buyer-created management carve-out plans typically take the form of retention plans or equity grants that vest over time based on continued employment with the buyer. These plans can become significant in size as the buyer attempts to shift value to its desired pool of employees (in the view of buyer, the true value of the business may in fact be attributable to these employees rather than the company itself). In either case, larger carve-out plans may heighten the risk of fiduciary duty claims against the board and increase the likelihood that stockholders will vote against the transaction with the intent of bringing a State law appraisal rights suit thereafter.

Nowhere is that risk higher than when the “management has hijacked the process” – in other words, a carve-out is created by a management team in cooperation with a buyer and forced upon the company due to the management’s control of the process. Involving the board – not just management – is key in even the early stages of negotiations surrounding an exit, especially if there will be a disproportionate stay pool or carve-out for management. The law requires that management prioritize the interests of the stockholders above and beyond those of the employees. The process is at least as important as the outcome in determining fairness, so a process in which independent board members provide input that affects the outcome of the negotiations is desirable. Filling the unfilled “independent” board seat can become virtually impossible as a company moves into a transaction, especially if the exit is valued flat to or below the last financing. Accordingly, ensuring that as the company moves into potential exit or financing scenarios the board is full and engaged is very helpful, although often overlooked.

If a management board member will benefit from accelerated incentive award vesting, a post-closing employment arrangement, buyer stock incentives or other retention programs, these additional financial interests will lead to enhanced scrutiny of the transaction process in the event of any stockholder dispute. The value of compensation or other benefits above the per share deal price to be received by a management board member should be specifically disclosed to the board and stockholders in advance

of soliciting a vote on an acqui-hire. Depending on the situation and the nature of the conflicts, the board and its legal advisors may also consider whether the founder board member should recuse himself or herself from all or a portion of board deliberations relating to a transaction. If possible, the board members should be in the habit of having any member whose compensation is discussed exit the room for that discussion, whether in the financing or at any other point in the life of the company. Too often, we have seen board members state “I’m comfortable speaking in front of” the conflicted board member so she or he “need not leave the room.” We believe that doing this sets the wrong culture for the boardroom and characterizes any desire to have someone step out as a negative. Boards are better served by being in the habit of having someone exit the discussion to avoid stigmatizing a discussion without the interested party and to pave the way for a clean process. In cases where several board members hold special interests in a transaction, the board may choose to form a special committee of disinterested directors to approve the transaction.

Duty of loyalty concerns in approving an acqui-hire also exist for directors designated by preferred stockholders, particularly when the consideration flowing to equity is not sufficient to result in a payment to common stockholders after satisfying the liquidation

Both management and representatives of venture capital

investors must fully disclose and carefully evaluate any

conflicts of interest in connection with acqui-hires, particularly when transactions involve substantial management

carve-out plans and/or result in a disappointing amount of consideration (if any) to

common stockholders.

37

preference. Many venture capital lawyers are aware of the 2009 Delaware Chancery Court decision in In re Trados Inc. Stockholder Litigation.18 Trados involved the sale of a venture-backed company for $60 million, of which preferred stockholders received approximately $52 million (on a liquidation preference of $57.9 million), management received $8 million under a management carve-out plan and the holders of common stock received no payments in respect of their common shares. A common stockholder alleged that the directors breached their fiduciary duties in approving the transaction because at least a majority of the directors were unable to exercise disinterested business judgment and favored the interests of the preferred stockholders at the expense of the common stockholders. The seven-member board included four designees of the preferred stockholders and two members of management. The plaintiff alleged that the preferred stockholders were eager to pursue an exit transaction, despite the fact that the company was well-financed and showing improved financial performance, and that the members of management had an interest in the transaction through their participation in a seller-created carve-out plan.

The Trados Court noted that “in circumstances where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders.”19 In denying defendant’s motion to dismiss the fiduciary duty claims, the Court found it reasonable to infer that the common stockholders would have been able to receive some consideration for their shares in the future had the merger not occurred, and accordingly the interests of the preferred and common stockholders may have diverged as to the decision of whether to pursue the merger.

The Trados issue should be explored in each acqui-hire involving a loss on investment at any level of the capital structure. The Trados risk may diminish if the only common stockholders who do not receive deal proceeds are management team members who otherwise receive post-closing employment incentives, but those are rarely the facts. When a group of common stockholders not connected to the current venture

18 In re Trados Incorporation Shareholder Litigation, 2009 Del. Ch. LEXIS 128 (Del. Ch. 2009).

19 Id at *28 (emphasis in original).

capital investors or management of the company receives no deal proceeds, the risks increase. In such cases, a common stock carve-out may be needed in order to obtain requisite votes and to mitigate the risk of breach of duty claims and state law appraisal actions. Other areas of conflict between stockholders may arise and should be addressed in connection with acqui-hire transactions, including when some investors have a special need for liquidity not shared by other stockholders.20

In addition to exposing directors to potential breach of fiduciary duty claims, a transaction in which directors or officers of a corporation have personal interests could be voidable under state common law. Both Delaware and California provide statutory safe harbors under which no transaction will be voidable solely for the reason that directors or officers have a financial interest. The safe harbors require the interested directors to fully disclose their interests and either the corporation must receive the affirmative approval of the transaction from a majority of the disinterested directors or of the disinterested stockholders, or the corporation must show that the transaction satisfies an entire fairness standard when it is approved by the board.21 Entire fairness means that the transaction was arrived at through fair dealing and resulted in a fair price.22 To avoid the burden of proof that a transaction meets the exacting standards of “entire fairness” review, informed approvals from the disinterested constituencies should be obtained when possible. In other words, having at least a majority of disinterested directors or a “majority of the minority” stockholders vote to approve (on an informed basis) the transaction helps insulate it from challenge. In our experience, with earlier stage acqui-hire targets, disinterested directors are often lacking. In addition, obtaining the consent of a majority of the disinterested stockholders can be difficult as there may be few disinterested stockholders. Nonetheless, parties should assess the landscape to understand in advance whether there will be a disinterested group and, if so, whether consent is likely obtainable.

20 See In re Answers Corp. Shareholder Litigation, 2011 Del. Ch. LEXIS 57 (Del. Ch. 2011).

21 8 DEL. C. § 144 (Lexis 2012); CAL CORP CODE §§ 310(a)(1)-(3) (Lexis 2012). California also requires the transaction must be just and reasonable to the corporation if board rather than stockholder approval is relied on.

22 See, e.g., Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983). Entire fairness review can also apply to the evaluation of fiduciary duty claims in the absence of an independent process that passes muster under applicable state law.

37

38

Non-stockholder Constituencies

Delaware law has established that fiduciary duties run only to those presently holding stock rather than to holders of options, warrants and, except in special cases including insolvency, convertible notes.23 Without the benefit of fiduciary duties in most cases, investors in convertible notes must be very aware of the potential treatment of their securities in the event of an early-stage acqui-hire transaction.

In the last five years, we’ve seen an uptick in convertible notes as the mechanism for first funding in early-stage tech companies. These convertible notes typically convert into preferred stock in connection with the first true equity financing of the company. Customarily, the principal and accrued interest of the debt will purchase shares of preferred stock in that first financing at a discount of 15% or 20% below the issuance price to other investors. To illustrate, a note holder, upon converting her or his note, will typically pay about $0.80 for a $1 share of preferred stock (and will pay even less when interest is factored in, though in our experience, interest rates in these note deals are low), which means an automatic up-round for note holders when the company gets equity financing. To further enhance the return of the convertible note investor, the valuation in the equity financing round is typically subject to a negotiated cap, meaning that the note investor may buy at a lower valuation than other investors in the equity round (if the conversion price obtained by applying the cap is lower than the conversion price obtained by applying the discount). Because an acqui-hire might precede a company’s first equity financing, care should be taken to document what becomes of the convertible note in a change of control event.

Absent an expressly negotiated contractual right, the consent of a debt holder would not be required to consummate an acqui-hire. The consummation of a transaction will almost certainly accelerate required payments of indebtedness incurred under a convertible note. However, unlike a bank lender, the holder of convertible note issued by a venture-backed company typically is more interested in the conversion feature than the repayment terms — and the structure of the conversion feature may dramatically affect the economic result in an acqui-hire scenario. The

23 See Simons v. Cogan, 549 A. 2d 300, 304 (Del. 1988).

39

payment of principal and interest under the note offers no upside to the note holder, and the typical interest rate would not be risk adjusted. In our experience, contractual veto rights as alluded to above are rare. Rather, a premium on the repayment of the debt is a more common form of protection. For example, the principal and interest could become repayable at a multiplier (e.g., 2x outstanding indebtedness), which offers some upside to the note holder.24 The note could be convertible into equity upon a change in control at a prescribed valuation, which offers upside protection to the note holder but might be viewed by the founders as a windfall depending on the exit transaction price. Finally, the note could have a combination of the last two methods, giving the holder the best of both worlds, depending on which method provides a greater payout at a given exit size.

Indemnification and Escrow Issues Common to Acqui-hire Transactions

While post-closing indemnification obligations remain a key issue for venture investors, buyer concerns are heightened in acqui-hires where the immediate return on investment is often near the amount invested and where the transaction price rarely supports the cost of full diligence and risk assessment. Venture investors, rather than acting as the “deep pocket” for the indemnity escrow, have incentives to make sure that all transaction constituencies receiving consideration in an M&A transaction share the risk of escrow and indemnification on a pro rata basis.

Once the economics of equity incentive roll-overs or new grants and retention packages are known, investors should seek to align their post-closing interests with those of management. One mechanism for investors to consider is subjecting roll-over options and the retention package to the escrow and indemnification provisions of the acquisition document. Treating the incentive and retention package the same as the proceeds otherwise payable to the common and preferred stock properly allocates the risk of post-closing purchase price adjustments

24 Note, however, that the parties ought to consider (preferably, before signing the note deal) the governing State’s usury laws to determine if the conversion discount, exit premium or other features might be considered additional interest. Usury laws vary significantly from state to state and often are subject to any number of specific exceptions that must be carefully navigated. A “savings clause”, whereby the rate is said to be the specified amount unless the maximum lawful rate is lower, in which case such lawful rate applies, is prudent to include as a backstop in jurisdictions that may respect such a clause.

among the investors who took the capital risk and the management team who operated the business and are in a better position to make representations, warranties and disclosures regarding the company. In the 2011 sRs M&A Deal Terms study, sRs noted that use of management carve-out plans has increased in recent years, raising issues of how they participate in escrows and earn-outs. We have not seen published reporting regarding the frequency or method of that participation. Companies adopting seller-sponsored carve-out plans should consider whether to expressly provide that those plans will participate in future indemnity and escrow obligations on a pro rata basis. In our experience, obtaining indemnity and escrow participation from buyer-created carve-out plans is difficult, as the buyer will not wish to have its retention incentives diluted by the prospect of indemnity claim claw-backs.25

tax issuesAcqui-hires require careful review of the tax treatment of different categories of transaction and employee incentive consideration. If the parties structured the deal as a shutdown of the target’s business followed by the buyer’s hiring of the target’s stockholder/employees, those stockholder/employees would be taxed on any payments they receive as ordinary compensation income. Currently, ordinary compensation income is subject to a federal income tax rate as high as 35%. By contrast, to the extent that any payments to stockholder/employees constitute purchase price in exchange for target company stock, a long-term capital gain rate (currently 15%) would apply for stockholders who have held their shares for at least one year. In addition, if the buyer’s stock will be the predominant form of consideration, the transaction, if structured as a purchase, might be eligible for treatment as a “tax-free reorganization,” which would mean no immediate taxation with respect to stock of the buyer received and capital gain treatment when that stock is later sold.

If the transaction is structured as a purchase of the target company, but the business of the target is not continued after the transaction, a risk exists that

25 Moreover, placing compensatory options in escrow may raise deferred com-pensation issues under Section 409A of the Internal Revenue Code. Careful consideration should be made of the facts and circumstances before any options are subject to escrow.

40

the Internal Revenue Service might not respect the transaction structure as a purchase (whether or not structured to qualify as a tax-free reorganization). In this event, the consideration received by the stockholder/employee would be recharacterized as ordinary compensation income. Analysis of these structures is nuanced and will require involving tax lawyers early in the deal. While we understand that parties may perceive tax counsel as a disproportionate expense in the case of smaller deals, we have found all too often that parties suggest and even agree upon tax inefficient structures only to realize that halfway through the deal and have to start from scratch, wasting more time and money.

While management carve-out payments in the form of a buyer retention plan are clearly intended as compensation and taxable at ordinary income rates, contingent deal consideration for equity needs close tax scrutiny. Consideration payable after the transaction that is tied to performance of the company might be treated as compensation rather than purchase price if the right to receive payment hinges upon an individual’s continued employment with the buyer. Those arrangements may also implicate the deferred compensation penalty rules of section 409A of the Internal Revenue Code. In practice, many acqui-hire deals are structured so that retention milestone goals are measured by group rather than individual retention in order to mitigate the risk of payments for equity being characterized as compensation. However, a buyer might want to characterize the payments as compensation because compensation payments are generally deductible to the buyer (though from an accounting perspective, compensation is an expense, and some buyers might not want the earnings charge). Whether any payments should be characterized as compensation rather than as purchase price is based on all the relevant facts and circumstances, and a tax expert should be involved to advise in these situations.

Venture capital investors should note that indemnification for tax matters is frequently not capped by the indemnification escrow. The 2011 SRS M&A Deal Terms Survey provided that tax matters are subject to a stand-alone indemnity in 69% of the reported transactions. In addition, sRs reports that 77% of reported transactions exclude tax representations from the cap on indemnification and general survival periods. The 2011 ABA Private Target Mergers & Acquisitions Deal Points Study

indicated that tax matters are subject to a stand-alone indemnity in 61% of the reported transactions and are carved out of the indemnification cap in 53% of the reported transactions. The SRS survey included more recent data, so a trend of increased incidence of stand-alone tax indemnity and carve-out of tax from caps may be developing. In any event, we believe that the SRS survey is more heavily weighted toward transactions involving venture-backed companies and, thus, is more instructive in the acqui-hire context. The prevalence of indemnification above the escrow for tax issues, coupled with the special structuring issues in acqui-hire transactions, which could give rise to post-closing liability for improper withholding, call for careful attention to be focused on who bears the post-closing risk of “getting it wrong.”

Another consideration is the potential applicability of section 280G of the Internal Revenue Code, which imposes a 20% excise tax (and disallows deductions) for so-called “golden parachute” payments made to executives on a change of control of a company. Any compensatory payment, which can include acceleration of vesting, should be examined early on to determine whether stockholder approval needs to be obtained to eliminate the application of the excise tax.26

the Viability of prophylactic provisionsWhat can be done to better align the interests of founders and investors in connection with acqui-hires? Although the acqui-hire phenomenon has been growing over the past several years, the market has not answered by placing specific protections in investment financing documents. The board already has the ability to adopt, or decline to adopt, seller-created management carve-out plans. From an investor’s perspective, the acqui-hire outcome focuses attention on the consent rights of investor-designated directors and brings new issues to bear on often utilized provisions. For example, investors often require the company to have a compensation committee and for the investor-designated director to serve on that committee. Taking it one step further, investors may

26 Stockholder approval will not suffice to eliminate the 280G excise tax in the case of companies with equity securities that are publicly traded. See Edward M. Zimmerman, Jason Mendelson and Brian A. Silikovitz, Golden Parachute Tax Rules In A Venture Capital Context: Early Stage Structures Can Create Tax Hits Upon Exit, MEALEY’S LITIGATION REPORT, July 2006.

41

desire to expressly require any management carve-out or other change in control plan be approved by the compensation committee, including the affirmative consent of the investor-designated director. Also, the affirmative consent of the investor-designated director is commonly required to approve the compensation of executive officers — and this right can be used to influence the outcome of a seller-created management carve-out plan.

Nevertheless, target-side protective provisions cannot shield against an aggressive management carve-out plan contained in a buyer term sheet. A more aggressive option would be to deem any buyer retention package part of the proceeds to be split among all parties pursuant to the charter allocation provisions. The lack of a trend concerning investor protections to address the acqui-hire scenario could be indicative of entrepreneurs holding enough leverage in a hot market to resist them but could also be indicative of the fact that developing “new” protective provisions in the standard venture investment documents may not be meaningful.

We believe the best protective mechanisms are planning and communication. Investors should level-set with their portfolio companies ahead of time. The first step in this process is often at the investment term sheet stage when investor-designated director consent requirements are negotiated. Specific discussions should occur concerning expectations if a buy-out term sheet were to arrive, including that the investors should be made aware of the possibility of a term sheet early in the process. Once a buy-out term sheet arrives, what steps can be taken to protect the investors’ interests and anticipate conflict issues? The directors and investors should determine whether a retention package is being offered to the founders or other key personnel and, if so, whether there is enough detail to understand its impact relative to the rest of the deal package. A full understanding of the

entire economics of the transaction is essential to the process of fiduciary duty compliance.

acqui-hire transactions – an investor’s checklistBelow is a suggested checklist of items that all venture capital investors should consider when their portfolio company is engaged in an acqui-hire. We do not predict that acqui-hires will warrant wholesale changes to the way venture financing transactions are structured or give rise to a new playbook for the acquisition transactions themselves. However, these transactions do have sweeping ramifications to the relationships between investors and founders, if for no other reason than the vastly different objectives they may have in any given acqui-hire.

pre-term sheet• When investing in convertible notes, expressly

provide for a conversion feature of notes (not just payment of principal plus interest) upon an exit transaction prior to conversion. Be aware of the applicable State usury laws and build in a “savings clause” to protect repayment of the loan at a premium.

• Consider the viability of, and current market for, express protections for preferred stock in organizational documents.

• When adopting any seller-side management carve-out plan, openly discuss and address indemnification, escrow and earn-out issues with management.

• Have a periodic M&A “rules of the road” discussion with management to encourage early investor involvement prior to initiating sale discussions with potential buyers.

Venture investors, rather than acting as the “deep pocket” for the indemnity escrow, have incentives to make sure that all

transaction constituencies receiving consideration in an M&A transaction share the risk of escrow and

indemnification on a pro rata basis.

42

term sheet stage• Before moving into exclusivity, consider whether

the company has identified and adequately considered other M&A or financing alternatives that might be attainable.

• Consider whether a financial advisor should be retained (and ensure that any retention is approved by the board).

• Consider whether the board is receiving advice from experienced M&A counsel and make sure there’s a seasoned tax lawyer involved…early!

• Confirm that all potential interests of management and board representatives in the potential transaction have been expressly disclosed and that board minutes reflect that disclosure.

• Involve counsel in determining who is and is not an “interested director” as the determination is very nuanced under Delaware law.

• Have recusals been considered for directors who may be considered “interested” in a transaction? Ensure that a director leaves the room when his or her compensation is discussed.

• Has the board discussed the need for an independent committee with counsel, and is an independent committee practical under the circumstances?

• Consider forming a negotiating committee including representatives of investors to participate in deal negotiations or to receive more frequent updates from management.

• Carefully review the term sheet’s provisions relating to treatment of unvested seller incentive awards, creation of management carve-out plans, post-transaction equity awards or other bonuses or compensation, and participation of equity incentive holders and management carve-out plans in escrow and indemnity. If the term sheet is silent as to any of these items, ask questions now to avoid surprises later.

definitive agreements stage• In most cases the board should meet to consider

approval of the transaction, more than once, rather than act by written consent, to create a record of discussion and deliberation. That record should be roughly contemporaneous as courts have frowned upon minutes done months after the facts.

• Confirm that the board process is sufficiently documented through minutes and preservation of presentation materials to show that the board has fulfilled its duty of care.

• Confirm that all final post-closing management arrangements have been disclosed.

• Confirm that the tax treatment of compensatory payments as opposed to payments for equity is clear and properly structured.

• Know your Trados profile and consider whether a disinterested stockholder approval is feasible and could be prudent. Also under Trados, consider creating a common stock carve-out to provide more value to the common holders.

About the AuthorsMarita A. Makinen is the Chair of Lowenstein Sandler’s M&A Group and a Member of the Tech Group. She advises public and growth-stage private companies, particularly in the areas of mergers and acquisitions, finance, governance and securities law requirements.

David B. Haber, Member of the firm at Lowenstein Sandler, practices in the firm’s Tech Group. He focuses on mergers and acquisitions of venture and private-equity-backed companies, private equity and venture capital transactions, and angel investments.

Anthony W. Raymundo is Counsel in Lowenstein Sandler’s Tech Group. He specializes in private equity, venture capital and angel investments, as well as mergers and acquisitions involving venture-backed companies.

The authors would also like to give special thanks to Brian Silikovitz and Carl Hessler for their help on this article.

4343

One of the defining characteristics of the American legal system is that the law evolves to reflect changes in society and business practices. Just as a particular technology can become obsolete, accepted legal practices can become outmoded as the law changes over time. The challenge for lawyers lies in anticipating inflection points in the law and assisting clients to adapt and thrive in the new environment.

The venture capital industry is by no means immune from this evolutionary process. Indeed, as the industry continues to mature and competition increases, the legal environment is poised to undergo material changes as well. In addition to a generally heightened regulatory environment, there are several potential legal developments that could impact the duties and responsibilities of fund sponsors in both forming and operating funds.

Anticipating and managing these nascent changes is particularly important in the venture capital industry, given the relatively lengthy periods for capital commitments. While it is always theoretically possible to amend an agreement to reflect changes in the law, the parties’ negotiating positions and bargaining power may well have changed from when they first executed an agreement. An altered legal landscape may benefit one party over the other, and once the law is changed or clarified, the other party may be perfectly content with the status quo and refuse to amend the agreement. It may be easier, therefore, to negotiate for a particular provision that anticipates a change in the law during the initial agreement negotiation, either because the other side is unaware of the potential change or discounts the likelihood or importance of the change.

Anticipating Inflection Points:The Necessity of Managing Uncertainty in the Law in the Formation and Operation of Private Investment FundsBy Timothy W. Mungovan and Joel Cavanaugh of Proskauer Rose LLP

44

This article will focus on three potential changes in the law, each with a different degree of immediacy, that may have an impact on the venture capital industry: (1) whether managers of a Delaware LLC owe default fiduciary duties to other members; (2) whether the general partner and/or investment adviser is responsible for the statements in the offering documents; and (3) whether an investment in a private investment fund constitutes a “public offering” for purposes of Section 12(a)(2) of the securities Act of 1933.

do managers of a delaware llc owe default fiduciary duties to members in the absence of an exclusionary clause? One of the more challenging issues for transactional attorneys right now is whether managers of a Delaware limited liability company (LLC) owe “default” fiduciary duties of loyalty and care to the members. Delaware LLCs are very common organizational structures that have a variety of applications in the venture capital industry, from general partner entities to transactional vehicles.

In January 2012, in Auriga Capital Corporation v. Gatz Properties, LLC, Chancellor Strine of the Delaware Chancery Court held for the first time that a manager of a Delaware manager-managed LLC owed “default” fiduciary duties of loyalty and care to the members of the LLC, where the manager qualified as a fiduciary under traditional equitable principles, and where the LLC agreement lacked an express provision excluding those duties.1

The Auriga decision is now on appeal to the Delaware Supreme Court, and there is some question whether the Supreme Court will affirm the decision. For example, Ann Conaway, Professor of Law at Widener Law School, has criticized the holding and the reasoning of what she calls “Chancellor Strine’s unfortunate opinion in Auriga v. Gatz.”2

In addition, Myron T. Steele, Chief Justice of the Delaware supreme Court, writing in a 2007 law review article (published prior to Auriga), expressed some

1 See Auriga Capital Corporation v. Gatz Properties, LLC, et. al., Del. Chanc. C.A. 4390-CS (Jan. 27, 2012).

2 See Ann Conaway, Professor Conaway on Auriga, THE INST. OF DELAWARE CORPORATE & BUS. LAW, (Jan. 31, 2012), http://blogs.law.widener.edu/delcorp/2012/01/31/professor-conaway-on-auriga/.

discomfort with the imposition of default fiduciary duties in an LLC context. In Chief Justice Steele’s view, “Delaware courts have continued to focus on the status relationships of the parties, rather than upon a contractual relationship when resolving governance disputes. The ‘gap filler’ found most comfortable where . . . LLC agreements do not expressly resolve the dispute will, rightly or wrongly, continue to be traditional common law fiduciary duty principles accompanied by, when breached, common law equitable relief, rather than by contractual terms, statutory ambiguities, breaches of implied contractual covenant of good faith and fair dealing.”3

Nevertheless, Chief Justice Steele went on to state that “the common law duties of loyalty, with its arguable subsets of disclosure and candor, and of care, with its gross negligence standard of conduct, although reasonably clear and often litigated, are not appropriate in most governance disputes involving . . . LLCs.” Instead, Chief Justice Steele recommended that the Delaware courts “refocus on contractual relationships” and give effect to the principles of freedom of contract (which the Delaware legislative branch seems to support).4

The outcome of the Auriga appeal on the question of whether default fiduciary duties exist in a Delaware LLC is likely binary: either they exist or they do not. This present uncertainty (pending a decision from the Delaware Supreme Court) creates challenges for practitioners in the venture capital industry, who frequently utilize the LLC structure. Practitioners need to understand that this uncertainty exists, not only for drafting documents in a manner that is consistent with the clients’ intent, but also to ensure that clients are informed of the inherent risks of any negotiated document that fails to take account of the uncertainty in the law.

Put differently, knowing that there is uncertainty in the law on whether default fiduciary duties exist in a Delaware LLC is necessary, but by itself not sufficient, for the informed transactional lawyer. The harder questions, and perhaps more important questions, are whether and how those default duties are restricted or eliminated. Having an informed view of the answers

3 Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 Del. J. Corp. L. 1, 28 (2007).

4 Id. at 29-32.

44

45

to these questions is necessary both to negotiate an agreement that is consistent with the client’s intent and to inform clients of the risks.

The facile solution is to assume that default fiduciary duties of loyalty and care exist in an LLC context and that the only way to avoid such default duties is to expressly exclude them. Following this logic, if they are not expressly excluded, then the default fiduciaries duties exist. This “facile answer,” however, may not be entirely accurate.

The Delaware LLC Act provides in relevant part that: “to the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a[n] [LLC] agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by the provisions in the [LLC] agreement . . . .”5

What happens if the LLC agreement “restricts” the manager’s duties but does not expressly exclude or restrict the so-called default fiduciary duties? The

5 6 Del. C. § 18-1101(c) (emphasis added).

answer is unclear. In Auriga, Chancellor Strine focused first on the absence of an exclusionary provision that would eliminate default fiduciary duties, observing that “the [operative] LLC Agreement contains no general provision stating that the only duties owed by the manager to the LLC and its investors are set forth in the agreement itself. Thus, before taking into account the existence of an exculpatory provision, the LLC agreement does not displace the traditional fiduciary duties of loyalty and care owed to the company and its members by [the manager] . . . .” Chancellor Strine then analyzed the exculpatory provision in the LLC agreement and concluded that it too did not eliminate the manager’s default fiduciary duties.6 What remains unclear is whether Chancellor Strine would find that an exculpatory provision could restrict or eliminate the default fiduciary duties in the absence of an express exclusionary provision.

Chief Justice Steele’s commentary does not provide any clarity on this issue. On the one hand, he has opined that “when the parties specify duties and liabilities in their agreement, the courts should resist the temptation to superimpose upon those contractual

6 Auriga Capital Corporation v. Gatz Properties, LLC, et. al., Del. Chanc. C.A. 4390-CS (January 27, 2012).

duties common law fiduciary duty principles analogized from the law of corporate governance.”7 On perhaps a more practical level, Chief Justice Steele has conceded that “it is understandable that, in circumstances where the parties have not clearly expressed the intention to expand, restrict, or eliminate traditional common law fiduciary duties, the Delaware courts will retreat to familiar territory by analogy.”8 Nevertheless, rather than looking to default fiduciary

7 Steele, Myron T., Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited Liability Companies, 32 Del. J. Corp. L. at 25.

8 Id. at 32.

duties, Chief Justice Steele suggests that the courts look to the contractual covenant of good faith and fair dealing to “gap fill.”9

What should practitioners do in the face of this uncertainty? Both Auriga and Chief Justice Steele seem to agree on at least one key point: the parties to an LLC agreement should affirmatively and expressly state in the LLC agreement the duties and responsibilities of the manager and members. If the parties agree that default fiduciary duties do not

9 Id.

46

47

apply, then they should say so in the LLC agreement. If the parties cannot agree on what those duties and responsibilities are – and the limits on those duties – they run the risk that default fiduciary duties of loyalty and care may (or may not) be imposed.

The more challenging scenario is where the LLC agreement lacks an exclusionary provision (as in Auriga) but the parties do affirmatively address the duties of the members and managers in the LLC agreement. Do these affirmative statements constitute the “expansion or restriction or elimination” of duties and, if so, do they eliminate the default fiduciary duties of care and loyalty? The answer would seem to be highly dependent on the precise language in the agreement. In this instance, the greater the uncertainty in the terms of the LLC agreement, combined with uncertainty in the law, creates a greater risk of conflict and disputes over the operation and governance of the LLC.

If the Delaware Supreme Court decides that there are no default fiduciary duties, using an LLC may be more, or less, attractive depending on the circumstances and the parties’ relative positions. If a party does not want the manager to have default fiduciary duties, it may be easier to start the negotiations with the LLC form. If, however, a party wants the manager to have default fiduciary duties, then it may make sense to start with a limited partnership instead of an LLC, because the Delaware Supreme Court has already held that default fiduciary duties do exist in a limited partnership context.10 Of course, it is important to recognize that parties are permitted to eliminate expressly those fiduciary duties in both the limited partnership agreement and the LLC agreement.11

If the Delaware Supreme Court decides that there are default fiduciary duties in an LLC context, there will be no advantage in terms of “default duties” between a limited partnership and an LLC. The challenge will be agreeing upon – and expressing clearly – the duties that the manager/GP owes to the other parties.

10 See Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 168 (Del. 2002).

11 74 Del. Laws ch. 265, section 15 (2004); 74 Del. Laws ch. 275, section 13 (2004).

is the general partner/managing member of an investment fund or its investment adviser the “maker” of the statements in the partnership agreement and offering materials under rule 10b-5?The answer to this question is important to whether a general partner12 or investment adviser can be held liable in a private action under section 10(b) of the securities exchange Act of 1934 (the ’34 Act) and the accompanying seC Rule 10b-5 for false statements included in the investment fund’s offering materials and partnership agreement. In Janus Capital Group,

Inc. v. First Derivatives Traders, the Supreme Court of the United States held that the investment adviser and administrator (Investment Adviser) to certain mutual funds (the Funds) was not the “maker” of the allegedly false statements in the Funds’ prospectuses and therefore the Investment Adviser could not be liable under Rule 10b-5.

13 In deciding whether the

Investment Adviser was the “maker” of the statements, the Supreme Court declared that “for purposes of Rule 10b-5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”14

The Court’s reasoning in determining that the Funds, not the Investment Adviser, had the “ultimate authority” to “make” the statements in the prospectuses is critical to understanding the extent to which Janus can apply in the venture capital context. In Janus, the Court rejected the suggestion “that an investment adviser should generally be understood to be the ‘maker’ of statements by its client mutual fund, like a playwright whose lines are delivered by an actor.” Instead, the Court focused on the fact that “corporate formalities were observed” between the Funds and the Investment Adviser and that the Funds had a “board of trustees more independent than the statute requires.”

12 For the purposes of this analysis, the term “general partner” (of a limited partnership) is interchangeable with the term “managing member” (of a limited liability company).

13 Janus Capital, Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2301 (2011).14 Id. at 2302.

48

The Court analogized the Investment Adviser to a “speechwriter” that “may have assisted” the Funds with “crafting what [the Funds] said in the prospectuses” but that ultimately did not “make” those statements.15

Janus, which to our knowledge has yet to be applied in the private funds context, is still relevant to the venture capital industry – despite the many differences between venture capital funds and mutual funds – because of the application of Rule 10b-5. For example, in the event that an investor brings a claim under Rule 10b-5 against the general partner of a limited partnership venture fund and/or the investment adviser (to the fund) based on allegedly false or misleading statements in the offering documents, the general partner and the investment adviser may assert that they are not the “makers” of the statements under Janus.16

If the investment adviser and the general partner are separate legal entities, then the investment adviser to the VC fund would likely be able to draw the strongest parallels to the investment adviser in Janus. The general partner, as a distinct legal entity from the limited partnership itself, may also try to raise a Janus defense. Of course, the general partner of a limited partnership would likely be deemed to have more control over the actions of the limited partnership than an investment adviser to a mutual fund. To avoid confusion on this precise issue, the entity that is responsible for drafting the offering documents – whether that is the general partner or some other entity controlled by the sponsor – should consider expressly stating that it is the “maker” of the statements in the offering documents.

In addition, in order for this defense to have any viability, it is critically important for the general partner and the investment adviser to respect and observe corporate formalities. For example, where the general partner of a limited partnership (the investment fund) is itself a limited partnership, no single individual should be “acting” for the GP. Rather, the general partner of the GP should be acting for the GP, which in turn

15 Id. at 2305.16 Of course, the applicability of this argument is highly dependent on the precise

facts in question, including the terms of the offering documents and any side letters.

is acting for the limited partnership/fund. Wherever

possible, formal decisions and written communications

should be consistent with this type of structure.

is the purchase and sale of interests in a private investment fund a “private offering” for the purposes of section 12(a)(2) of the securities act of 1933?When investors believe that they have been duped

or misled into investing in a fund, they often assert

claims for misrepresentation and fraud, both under the

common law and under section 10(b) of the ’34 Act

and Rule 10b-5. Pleading and proving a claim of fraud

or misrepresentation is difficult, but it is particularly so

under section 10(b) because the plaintiffs must plead

fraud with particularity, and they must plead and prove,

among other things, causation, reliance and scienter.

Given the challenges of bringing a claim under section

10(b), investors in private investment funds are eager

to identify different legal theories to establish liability,

including claims under section 12(a)(2) of the securities

Act of 1933 (the ’33 Act).17 section 12(a)(2) offers a

theoretically attractive alternative to investor plaintiffs in

comparison to a claim under section 10(b)/Rule 10b-

5. First, section 12(a)(2) permits rescission, whereas

Rule 10b-5 permits recovery of actual damages only.18

second, claimants under section 12(a)(2) do not have

to show causation, reliance or scienter.19

Instead, they

must show that, in connection with a sale of securities,

the seller made material misstatements or omissions.

Investors, however, face a significant challenge

because claims under section 12(a)(2) have been

limited to public offerings of securities by means of

17 As an example, an institutional investor in a private investment fund recently filed a putative class action in the United States District Court for the District of Massachusetts against a private investment fund (a limited partnership), its general partner, its investment adviser and other affiliates and related parties, seeking rescission of the limited partners’ investment under section 12(a)(2) of the Securities Act of 1933.

18 Rescission may be useful in a context where the investment fund’s assets are illiquid or hard to value, making it difficult to calculate actual damages.

19 Stephen M. Bainbridge, Securities Act Section 12(2) After the Gustafson Debacle, 50 Bus. Law. 1231, 1233-1234 (1994-1995).

49

prospectus for the better part of two decades.20 In 1995, the supreme Court of the united states held in Gustafson v. Alloyd Co., Inc. that the sale of securities in a private transaction was outside the scope of section 12(a)(2) because the purchase agreement was not a “prospectus” under section 10 of the ’33 Act.21 According to Gustafson, “a prospectus under section 10 is confined to documents related to public offerings by an issuer or its controlling shareholder.” “[W]hatever else ‘prospectus’ may mean, the term is confined to a document that, absent an overriding exemption, must include the ‘information contained in the registration statement.’”22

In 1998, the united states Court of Appeals for the First Circuit decided Maldonado v. Dominguez.23 While the court in Maldonado ultimately held that the plaintiffs did not have a claim under section 12(a)(2), the Court’s analysis and reasoning seems to suggest that a broader class of investors/claimants may be entitled to protection under section 12(a)(2) than is apparent under Gustafson. After initially acknowledging that “the Supreme Court conclusively decided that [section 12(a)(2)] applies exclusively to ‘initial public offerings,’” the First Circuit then articulated an analytical approach that suggested that it defined broadly the term “initial public offering.” In evaluating whether the transaction at issue in Maldonado was public or private, the First Circuit focused on the relationship between the purchasers and the seller, and the purchasers’ access to information, rather

20 Section 12(a) provides in relevant part:

Any person who--

1. offers or sells a security in violation of section 5, or

2. offers or sells a security (whether or not exempted by the provisions of section 3, other than paragraphs (2) and (14) of subsection (a) of said section), by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,

shall be liable, subject to subsection (b), to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.

21 Gustafson v. Alloyd Co., Inc., 513 U.S. 561, 569 (1995).22 Id.23 Maldonado v. Dominguez, 137 F.3d 1 (1st Cir. 1998).

than whether the offering involved a “prospectus” – as the Supreme Court had done in Gustafson. The Maldonado court explained that:

“[A] placement of stock is private if it is offered only to a few sophisticated purchasers who each have a relationship with the issuer, enabling them to command access to information that would otherwise be contained in a registration statement. The determination of whether an offer is not public has not been relegated to a simple numerical test. Instead, courts are required to weigh the facts of each case carefully to assess whether the offerees need to be protected under the 1933 Act.”24

In concluding that the transaction was “private” and therefore outside of section 12(a)(2), the First Circuit focused on the following facts:

• The seller sent investment invitations to only twelve investors.

• The seller personally knew each of the investors and had managed accounts for them in the past.

• each investor purchased a 5.5% interest in the new corporation and a seat on the board of directors.

• The board of directors “had full control and direction of the corporation’s affairs and business.”

In short, the First Circuit focused on the facts that established that “the Plaintiffs were not merely asked passively to invest in an existing entity, but to partner in starting a new corporation.”25

Based on Maldonado – which arguably represents the broadest interpretation of Gustafson and 12(a)(2) among the Circuit Courts – investors in venture funds and other private investment funds may argue that the First Circuit “left the door open” for them to claim that they invested in a “public offering” and, as such, they qualify for protection under section 12(a)(2). As part of their argument, investors in private funds will no doubt distinguish the facts of Maldonado from their own investment. Unlike Maldonado, the typical venture fund certainly has more than a dozen investors, and the solicitation of investors typically involves substantially

24 Id. at 8.25 Id. at 8.

50

more than a dozen prospective investors. In addition, the LPs may or may not have had a previous relationship with the GP/fund sponsor. Furthermore, LPs in a venture fund typically have no control over the fund’s affairs and business.

In response, GP/fund sponsors will certainly argue that offerings of interests in private funds are – indeed – private offerings. These offerings are typically excused from section 5 registration requirements, as such offerings are considered a section 4(b) private offering transaction through a safe harbor provision (most often Rule 506 of Regulation D). Historically, an issuer could generally be assured that it was within this safe harbor if it limited its offering to accredited investors and did not publicly advertise the transaction.

At the same time that plaintiff investors seem interested in section 12(a)(2) claims, the law on solicitation and advertising for private funds is shifting markedly. The Jumpstart Our Business Startups Act (JOBS Act) expressly provides for an amendment to section 4 of the ’33 Act that allows for broader solicitation and advertising for certain private offerings, as follows:

“(b) Offers and sales exempt under section 230.506 of title 17, Code of Federal Regulations (as revised pursuant to section 201 of the Jumpstart Our Business Startups Act) shall not be deemed public offerings under the Federal securities laws as a result of general advertising or general solicitation.”

In addition, section 201 of the JOBs Act requires the SEC to revise its rules “to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules

shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” At the time that this article was submitted for publication, those revised rules had not yet been released.

The precise interplay between the JOBS Act, the exemption under section 230.506 of title 17, section 12(a)(2) and Gustafson remains unclear. For example, does an exemption from registration automatically make the offering “private” for purposes of 12(a)(2)? Under Gustafson, the answer should be yes, given the Supreme Court’s emphasis on the uniform application of the securities law. Under Maldonado, the answer is less certain, given the First Circuit’s focus on the parties’ relationships to one another and relative access to information, in assessing whether those investors are “in need of protection.”26

To reduce the risk that the offering of interests in a venture fund or other private investment fund is deemed a “public offering” under section 12(a)(2), private fund sponsors should closely monitor the changing regulatory landscape, particularly with respect to general advertising and general solicitation, and ensure that their offerings stay within the guidelines of private offerings as dictated not only by statute, but by the courts, as well.

26 It is important to acknowledge that, in focusing on these factors, Maldonado was relying on the Supreme Court’s pre-Gustafson decision in Securities Exchange Commission v. Ralston Purina Co., 73 S. Ct. 981 (1953). In Ralston Purina, the Supreme Court reversed the dismissal of the SEC’s action against the issuer, after holding that an offering of treasury stock to the issuer’s key employees was not necessarily exempt from registration under section 5 of the ’33 Act because the employees “were not shown to have access to the kind of information which registration would disclose.”

About the AuthorsTimothy W. Mungovan is a partner in the Litigation Department of Proskauer Rose LLP and co-head of the firm’s Private Investment Funds Disputes Group. Tim focuses his practice on representing fund sponsors and institutional investors in avoiding and resolving disputes on a variety of matters that are specific to private investments funds. Tim has extensive experience litigating claims of fraud and breach of fiduciary duty on the part of fund sponsors and investment advisers. Tim also has substantial experience defending claims of securities fraud, brought by the Department of Justice, the SEC and private plaintiffs.

Joel Cavanaugh is an associate in the litigation department of Proskauer Rose LLP and a member of the Private Investment Funds Disputes Group. Joel’s practice focuses on litigation involving private investment funds. He also has experience in a broad range of complex disputes, including intellectual property, antitrust, securities, and mergers and acquisitions litigation.

The authors would like to thank Andrew C. Fink, a summer associate in the Boston office of Proskauer Rose LLP, for his valuable contributions to this article.

51

The Emergence of the SecondMarket

“A Second Market is emerging,” declared the New York Times on April 23, 2009. The article was referring to the proliferation of private company stock sales, and the author detailed multiple reasons for the trend: “typically, venture-backed start-ups are sold or go public within five to seven years, but lately it is taking longer. As the exits are delayed, venture capitalists who are unable to cash out cannot return money to their investors or devote time and money to new companies. Some employees inside the start-ups, being paid low salaries, get impatient for a payday.” The article expressed wariness towards the secondary markets, and stated that “the creation of a vibrant market in unregistered securities of private companies...has its doubters.”

a New Kind of ipo As the Times article alluded, the capital formation process in the United States historically has seen startups receive seed or angel funding, a few rounds of venture capital financing and, a few years later, register to go public. However, in recent years, numerous systemic changes have caused the US public stock market listing to evolve in such a way that it is not a great fit for growth-stage companies. Therefore, some of the country’s most dynamic startups have started taking nearly twice as long go public or are not wishing to go public at all. According to the NVCA, from 1991 to 2000, there was an average of 520 IPOs per year, with a peak of 756 IPOs in 1996. since 2001, the united states has averaged only 126 IPOs per year, with 38 in 2008, 61 in 2009, 71 in 2010 and 52 in 2011. Moreover, the profile of companies going public has changed and only the largest companies receive the sales and research support to be successful public companies.

By Adam Oliveri, Managing Director and Head of the Private Company Market at SecondMarket

52

This lackluster IPO market cannot provide sufficient liquidity to investors and early employees of private companies, a clear signal that a new growth market needs to emerge. Companies go public to efficiently raise large amounts of capital, provide shareholders with liquidity, and create a potential acquisition currency for their equity. If the private markets continue to evolve to serve these needs, the lines between public and private companies will continue to blur, and the private markets could provide certain companies with a better way to accomplish the traditional objectives associated with a public market listing.

Market evolution Over the past couple of years, it became increasingly obvious that private “over-the-counter” trading without a company’s endorsement was not an ideal solution for startups. Companies do not want “24/7” trading and prefer an organized, controlled process. SecondMarket, for example, has fully transformed its model to offering the ability for companies to enable an organized, controlled secondary market process. Companies partnering with SecondMarket are able to control the universe of eligible participants, define limitations on the level of seller or buyer participation, determine the timing and frequency of transactions, as well as the appropriate pricing mechanism.

Why secondary liquidity? Companies choose to enable secondary liquidity in their shares for a variety of reasons, but perhaps

the most important one is to provide key employees with partial liquidity. A controlled secondary liquidity program provides companies with a critical employee retention tool by rewarding loyalty while keeping employee interests aligned with the long-term goals of the company. Recurring shareholder liquidity programs can also make it easier for private companies to attract and hire new employees by giving real value to employee equity compensation.

Public companies have a critical asset that is generally not available to private companies: they can use their equity to make strategic acquisitions. With a more liquid equity, private companies potentially have a valuable acquisition currency to fuel growth without using balance sheet or raising additional capital. Controlled liquidity programs can provide companies with greater leverage when evaluating potential acquisitions and a demonstrated path to liquidity for shareholders of acquired companies.

A more liquid market for private company stock also provides an alternate liquidity path for early investors. Liquidity allows a company to replace early angels, former employees and other “dead equity” with new, value-add investors who are aligned with the company’s long-term vision.

a New investment FrontierAs the markets continue to evolve, a recent development in the secondary market investor ecosystem is the increased level of participation by traditional public equity investors. Investing in growth-stage private companies has traditionally been dominated by venture capital firms. However, as the secondary markets mature, public equity investors are eager to capture growth and access long-term gains in the fastest-growing private companies.

The majority of public equity investors who are transacting on the secondary markets are buy-and-hold investors looking for companies with high growth prospects and a strategy for achieving that growth. In 2011, institutional investors accounted for 73% of the buyers of private company shares on SecondMarket. These institutions ranged from asset managers and hedge funds to mutual funds, family offices and corporations.

The diversity of this buy-side demand indicates a substantial shift, where investors looking for growth

Companies partnering with SecondMarket are

able to control the universe of eligible participants, define

limitations on the level of seller or buyer participation,

determine the timing and frequency of transactions, as well as the appropriate

pricing mechanism.

53

are utilizing the secondary markets to invest in pre-IPO companies. Prominent funds such as T. Rowe Price’s New Horizon Fund target common stocks of small, rapidly growing companies, and have become much more active in the secondary markets. In turn, private companies are benefiting from this influx of new buyers as they gain access to new, long-term capital.

the dawn of integrated FinancingAnother recent shift in the market has been the large number of growth-stage startups incorporating secondary liquidity with primary rounds of financings in their pre-IPO strategies. Companies are increasingly utilizing this type of integrated financing by closing a traditional round of funding with the inclusion of a

secondary component to allow their shareholders to gain some liquidity.

As board members, venture partners and investors of growth-stage startups contemplate the futures of their portfolio companies, a number of elements must be taken into consideration. First, the public markets have irrevocably changed and the IPO market for small-cap companies is not likely to return (although importantly, the JOBS Act may help to improve the pipeline). Next, companies will continue to stay private longer (also aided by the JOBS Act), making way for a growth market to replace what the small- and mid-cap-sized IPO accomplished for companies in prior decades. Additionally, the private markets are no longer exclusively tied to venture capital and other

Liquidity allows a company to replace early angels, former employees and other “dead equity” with new, value-add investors

who are aligned with the company’s long-term vision.

54

private equity funds to generate growth capital. Public equity investors will continue to become a larger part of the capital formation process for private companies, and it will become standard for companies to raise larger amounts of capital while staying private longer. Integrated financing, by incorporating a secondary liquidity round into primary fundraising, will also continue to gain momentum as companies increasingly embrace the concept of controlled shareholder liquidity, causing the line between the public and private markets to continue to blur.

The secondary market for private companies may initially have been met with wariness, but it has proven to be an essential partner to thousands of innovative, exciting startups and their investors. While best practices will evolve and continue to be established, the secondary market has in fact emerged, and it is here to stay.

About the AuthorAdam Oliveri is currently the Managing Director and Head of SecondMarket’s Private Company Market. One of the first three employees hired by SecondMarket, Adam Oliveri has played a critical role in the growth and development of the company.

If the private markets continue to evolve to serve

these needs, the lines between public and private companies will continue to blur, and the

private markets could provide certain companies with a better way to accomplish the traditional objectives associated with a public

market listing.

5555

Culture is a Business IssueBy Liz Brashears, Director, Human Capital Consulting at TriNet

Corporate culture is often thought of as that touchy-feely stuff that is difficult to define and should be left up to Human Resources to manage. For some it conjures images of toys scattered through the office and Segways running up and down the corridors, while some young pierced tech guy sits at his cube jamming out to music while he works. The reality is that culture is a business issue that has significant impact on a venture’s ability to generate a return on investment and should be prioritized and measured just like other business objectives such as financial growth, product development, sales, marketing and the like. Culture is defined as the identity and personality of an organization. It consists of the shared thoughts, assumptions, behaviors, and values of the employees and stakeholders. Culture is dynamic, ever-changing, and evolves with time and new experiences. Many factors help drive and define the culture, including leadership styles, policies and procedures (or sometimes lack thereof), titles, hierarchy, as well as the overall demographics and workspace. Culture is not just about having Nerf guns and scooters in the hallway. Culture exists in every organization, whether it is by design or by default.

Venture-backed companies understand the key importance of financial performance. They often live and die by it. The board will generally have stated goals around spending control, revenue generation and/or revenue growth. Culture, on the other hand, is rarely a metric that is monitored or viewed at an organizational level or by the ventvure companies that back the organization.

56

An organization’s culture may be one of its strongest assets or it can be its biggest liability. The reason culture is so important is that its impact goes far beyond the talent in the organization; it has significant influence on the organization’s goals. Culture drives or impedes the success of an organization. With culture impacting the talent, the product, the clients as well as the revenue, why would a company not measure, review and intentionally nurture something so important and critical to its success?

You don’t have to have a name like Google to understand how culture can drive a business strategy. Invodo is a venture-backed company in Austin, Texas, that helps other businesses increase sales through the power of video. Invodo takes pride in its culture, and it intentionally drives and promotes that culture with its new employees. One of the ways it does this is with a scavenger hunt for new employees that they have 30 days to complete. Items on the list include introducing yourself to the five executives of the company and scheduling a lunch with each one of them. Other items on the scavenger hunt include finding out how the company got started, identifying who was the first employee of the company, sitting in on a call with an Enterprise Sales Representative and finding out where the co-founders’ favorite coffee spot is located. Also as part of the hunt, new employees have to memorize the Invodo code (company values) and the mission statement. They then recite it at the next quarterly meeting. It is an incredible way to quickly integrate new employees into the organization’s cultures and to energize them about the company’s mission, vision and values.

In addition to the scavenger hunt, Invodo actively celebrates success by awarding two high-performing employees with the Samurai Sword and the Warrior Spear quarterly. The Samurai Sword is awarded to the Enterprise Sales Representative who closes the most deals in the quarter. The Warrior Spear goes to the Market Developer who earns the most points in a given quarter for setting sales appointments. Both are coveted awards that employees work hard to achieve and other employees rally around to celebrate.

To help promote its culture, Invodo has a Fun Committee. The Fun Committee is a small group of employees who plan everything from the Wet Your Whistle Wednesdays (a themed happy hour event that takes place in the office every other Wednesday) to the annual holiday event.

It’s not just fun and games at Invodo. It works hard to deliver great results for its clients and shareholders. As a result it was recently nominated as one of Austin’s Best Places to Work, an acknowledgment of its thriving culture, team atmosphere, great benefits and, most importantly, engaged employees. Even more importantly, its revenue and client base are continuing to expand.

For many venture-backed companies, the elements of their culture originated with the founder or other leaders who were instrumental in the early stages of the organization. Sometimes that culture developed through default, while in other companies there was intentional execution to drive and promote the culture. As new leaders come into an organization they often are encouraged to adopt and follow existing practices. Cultures are perpetuated as stories of people and events illustrating the company’s core values are retold and celebrated. The benefits of a strong culture can be endless. A strong and thriving culture will:

• establish a foundation for success

• Attract and retain top talent for the organization

• Promote the brand of an organization

• Increase employee engagement

• Drive productivity

• Distinguish a company from competitors

The organization’s culture is the foundation that can promote growth and hinder complacency. For start-up companies, driving the culture in the early stages is important. One of the easiest places to do this is in the hiring practices. Cultural fit has been known to be the biggest reason around employee turnover and management distraction. If an organization hires talent to fit the culture and the desired company values then it has a win-win situation for both the employee and the organization. You can’t change who people are at their core. Of course, skills are important; however, if necessary, skill gaps can be closed through training and development.

Hiring decisions are one of the most important decisions that managers are going to make for the organization. For young venture-backed companies, there is often an absence of a hiring process and skills. It is critical that managers receive the appropriate training on interviewing and hiring techniques that will improve their opportunity for success. Additionally,

57

The reality is that culture is a business issue that has significant impact on a venture’s ability to generate

a return on investment and should be prioritized and measured just like other business objectives such as

financial growth, product development, sales, marketing and the like.

a consistent hiring process partnered with trained managers will minimize the organization’s risk as well as help drive the culture. A strong hiring practice will also help in retaining the top talent in the organization. Top talent will quickly become frustrated if they see a pattern of bad hiring.

While people drive the culture, the culture drives the brand…or is it that brand drives the culture? The truth is they are too intimately tied together to discern which comes first. Great companies leverage their culture to promote their brand. Companies such as Zappo’s, Southwest Airlines, Disney and Google take pride in their culture and use it to promote who they are as an organization. Every interaction with an employee, a client, or a stakeholder is an opportunity to brand the organization. These very interactions are the ones that over time define and reinforce the organization and the culture that permeates it.

Culture has a tangible impact on employee engagement. Employee engagement is a measure of an employee’s commitment to his or her job, team, manager and organization, which results in increased discretionary effort or willingness to go “above and beyond” normal job responsibilities. This level of commitment is critical in the success of early stage companies and also results in the employee’s intent to stay with the organization. The primary factor that seems to separate an engaged employee from just a satisfied employee is that the engaged worker consciously puts forth additional effort in a manner that promotes the organization’s best interests. Not only does engagement have the potential to significantly affect employee retention, productivity and loyalty, it is also a key link to customer satisfaction, company reputation and overall stakeholder value.

Employee engagement drives workforce productivity. Multiple studies demonstrate how a strong and thriving culture with high employee engagement leads to greater employee productivity. Innovation and creativity are often key to the growth of early stage companies. In a great culture where new ideas are respected, and mistakes are viewed as opportunities for learning, employees can actually enjoy their work and be energized by the environment around them. They are naturally more productive because they are eager to be part of a company where they feel valued and their contribution matters. It is a simple concept, but happy employees make for happy, successful companies.

Company culture is unique and provides arguably the most sustainable competitive advantage an organization can have in the marketplace for distinguishing itself against the competition. Competitors may attempt to poach employees, steal customers and duplicate the product or service an organization has worked hard to develop. Culture, like the brand, becomes the fabric of an organization. The stronger the culture and the brand, the more difficult it is for competitors to pose a threat to the organization.

Treehouse Island, Inc. is a venture-backed company based in Orlando, Florida, that believes that education can be fun and entertaining. It hopes to change the world by delivering high-quality skills that are in demand right now, such as web design, development and iOS, all at an affordable price. It may not have a Wet Your Whistle Wednesday like Invodo, but it does have Thirsty Thursdays, which it refers to as a “Chill the Heck Out” event. This offsite happy hour is but one opportunity for employees to get together and socialize. These and other company events are posted on a Culture Calendar, or for a more interactive experience, colleagues can connect virtually in the campfire chat room. Other items on the Culture

58

Calendar include Improv night, group gatherings, potlucks and even contests. Recently it held a challenge for the employees to design a nemesis for its company mascot, Mike the Frog.

At Treehouse, you will find Nerf guns, Legos, flying miniature helicopters and some strange decorative art. Aside from the rich benefit package and a free lunch every day, Treehouse pays a full salary for a four-day workweek. They don’t work Fridays…ever. Currently Treehouse has around 40 employees but is adding one or two new employees each week. With rapid growth, it is easy for the culture to shift if someone isn’t intentionally driving it. Treehouse acknowledges that its founder, Ryan Carson, is the principal driver of the culture, but it has also empowered other team members. It has colleagues charged with driving internal culture and the external culture and social branding of the organization. In light of its rapid growth,

one of the ways it manages its culture is through a comprehensive on-boarding process that places special emphasis on integrating and engaging remote employees. It leverages the campfire chat room and other avenues of social media to connect with colleagues that aren’t located in the same physical space. Treehouse has put significant and intentional effort into developing its people and culture. As a result, Treehouse continues to grow and be a place that attracts fresh talent. In the last six months, its revenue has grown by 150%.

Both Invodo and Treehouse have established a strong foundation to become enduring companies over the long term by leveraging their culture as a key competitive advantage and strategy. However, culture alone, will not guarantee success.

Emotional Canine, whose name has been changed to protect the guilty, was one of those not so happy

59

endings. Emotional Canine was a startup company that thought it had the next greatest idea. It too believed in the value of a thriving corporate culture. It hadn’t even run its first payroll and it hired a Cultural Officer for the organization. It strategized about its culture, hiring practices and the vision of the organization for weeks on end. It worked hard to mold the culture and drive others to embrace the values it had espoused. In the end, Emotional Canine probably spent too much time focusing on its culture and not near enough on its actual business plan. A great culture can only get you so far; it doesn’t ensure the success of a business strategy that doesn’t make any sense.

Like Emotional Canine, there are plenty of venture-backed companies that think they are the next big thing with a cool new product. Many of these companies are focused on the short-term results but don’t stand for anything meaningful for the long-term. If they want to create a successful and enduring company then their culture has to be part of the focus. If it is not then it will evolve on its own, and that may not always lead to a successful outcome.

If an organization finds that it has not proactively established its culture or that the culture is not aligned with the organization’s values, there is hope. Culture is deeply rooted and doesn’t change easily, but leaders can manage and influence it. If a venture-backed company wants to focus on creating a strong culture within its organization, the best place to start that journey is with the leadership. Leaders should personally examine how they can exemplify the importance of building a strong culture that supports the business’s initiatives and personally commit to

promoting a workplace that supports top talent. Here are a few simple ideas to get started:

P Culture starts with the organization’s leaders. Employees model the behaviors of leaders. It is important to keep in mind that leadership and management are two different things. Leadership has to do with the character and behavior of the individual and how they influence the behavior of others and may not have any relationship with positional authority or the reporting structure. True leaders lead their peers, their subordinates and can also lead those above them. Management has more to do with positional authority and job responsibilities. The way people and teams are managed says a lot about the organization. When focusing on culture, focus on the company’s leaders as well as managers in order to have the most influence.

P Create alignment between values and behavior. Successful cultures assimilate the mission, vision and core values of the organization. Companies with successful cultures are clear about their purpose, what they stand for, what they believe in, whom their customers are and whom they want to become. Additionally, it is critical that the products, policies and behaviors of the organization align with the stated values. A company’s values should do more than just live inside a PowerPoint. They should be brought to life in the people, events, products, space and the stories that are told. They should be used in selecting the right talent and in managing and developing that talent.

P Alignment between business goals and individual objectives is critical to success. Business goals should be clearly communicated at every level within the organization. Regardless of the position, all employees should understand how their own individual goals and expectations align with the company’s strategic goals. It is important that employees can articulate what the organization is trying to achieve and how they fit into that picture. Employees want to be part of an organization that is moving forward, and they appreciate knowing how their efforts should be directed and how they have an impact.

P Heroes and superstars should be encouraged and celebrated. Celebrating and rewarding achievement will drive others to success. Invodo

With culture impacting the talent, the product, the clients

as well as the revenue, why would a company

not measure, review and intentionally nurture something

so important and critical to its success?

60

recognized this with its Samurai Sword and Warrior Spear. Recognizing heroes isn’t just about having an employee of the month program, however; it is about making a practice of finding what people are doing right and celebrating those who live out the company’s values even when no one is looking.

P Focus on learning and development within all levels of the organization. Learning should be a continuous process for each individual and should demonstrate value and ROI over time. It is important to invest in employees for further growth and development in their career in order to grow the talent pool and capabilities of the organization. Significant shifts in the economic, technological and social fronts over the past years have forced talent to confront new challenges and opportunities. Organizations that foster a learning environment and train their people to properly address those challenges develop a competitive advantage. Creating a culture where learning is valued can be seen as a strategic advantage for the organization.

P Incentivize culture alignment. For example, if customer service is a core value, implement mechanisms to measure such service and reward employees for exceptional results. Likewise, if innovation and creativity are a priority, reward employee contributions to development of new products, improvement to existing processes or other key areas of focus for the organization. Incentive compensation should drive employee behavior and results that align with the company’s

core values. If it doesn’t then the organization is wasting its money.

P Strive to promote trust by operating with honesty and transparency. A transparent organization is one where the company takes proactive measures to ensure that employees know what is going on and it welcomes employee feedback. It does not require that the company act on every recommendation but rather that the company is open to dialogue. Town hall meetings, company newsletters and informal fireside chats are some of the simple ways that small companies can promote transparency and trust.

Is the culture a product of design or default? Traditionally, venture capital firms have not focused on identifying or measuring the culture of their portfolio companies. As culture drives the financial performance of the firm, there should be specific, measurable goals around culture, just like other key performance indicators. Each new venture has a set of values and a culture, whether or not it was intentionally engineered. Organizations should endeavor to create a business strategy to communicate, cultivate and measure the culture to drive business performance. The growth and productivity of a venture is dependent on having an aligned workforce that can innovate, execute, and meet designated targets. A thriving culture that engages the workforce will generate a return on investment through the success of the organization’s product, people, customers and brand.

Company culture is unique and provides arguably the most sustainable competitive advantage an organization

can have in the marketplace for distinguishing itself against the competition.

61

Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit www.ey.com.

About Ernst & Young’s Strategic Growth Markets NetworkErnst & Young’s worldwide Strategic Growth Markets Network is dedicated to serving the changing needs of rapid-growth companies. For more than 30 years, we’ve helped many of the world’s most dynamic and ambitious companies grow into market leaders. Whether working with international mid-cap companies or early-stage venture-backed businesses, our professionals draw upon their extensive experience, insight and global resources to help your business achieve its potential. It’s how Ernst & Young makes a difference.

Cooley represents private equity sponsors in middle-market buyout, take-private and growth equity transactions involving companies in the technology, life sciences, software, clean energy, government contracts and new media industries. The firm also represents numerous venture capital sponsors and companies across a broad array of dynamic industry sectors, from small companies with big ideas to international enterprises with diverse legal needs, including mergers and acquisitions, intellectual property protection, litigation and general corporate representation. For more information on Cooley, visit: www.cooley.com.

As a leading global financial advisory and investment banking firm, Duff & Phelps balances analytical skills, deep market insight and independence to help clients make sound decisions. The firm provides expertise in the areas of valuation, transactions, financial restructuring, alternative assets, disputes and taxation, with more than 1,000 employees serving clients from offices in North America, europe and Asia. For more information, visit www.duffandphelps.com. (NYSE: DUF)

Lowenstein sandler PC is a top-ranked business law firm with approximately 270 attorneys providing a full range of legal services. The firm’s commitment to its clients is demonstrated through its client-centered, service-oriented culture. Lowenstein Sandler attorneys are regularly recognized for excellence by clients and peers in national publications, including The Best Lawyers in America, Chambers USA: America’s Leading Lawyers for Business and The Legal 500.

Prosakuer (www.proskauer.com) is a leading international law firm with over 700 lawyers that provide a range of legal services to clients worldwide. Our lawyers are established leaders in the venture capital and private equity sectors and practice in strategic business centers that allow us to represent fund sponsors and institutional investors globally in a range of activities including fund structuring, investments transactions, internal governance and succession planning, acquisitions and sales of interests on the secondary market, liquidity events, distributions, tax planning, regulatory compliance, portfolio company dispositions, management buyouts and leveraged recapitalizations, risk management and compensation and estate planning for partners.

Headquartered in New York since 1875, the firm has offices in Beijing, Boca Raton, Boston, Chicago, Hong Kong, London, Los Angeles, New Orleans, Newark, Paris, São Paulo and Washington, D.C.

secondMarket is the trusted global platform for alternative investments. since its founding in 2004, the company has developed the largest centralized community of qualified institutional and individual investors, and facilitated billions of dollars of transactions in a variety of unique asset classes. SecondMarket also provides customized capital solutions and innovative tools for fund managers and private companies, enabling them to engage with their stakeholders and the SecondMarket investor community.

SecondMarket is backed by premier long-term investors, including: FirstMark Capital, The Social+Capital Partnership, Li Ka-shing Foundation, Temasek Holdings, New Enterprise Associates (NEA) and Silicon Valley Bank. SecondMarket is a registered broker-dealer and member of FINRA, MSRB and SIPC and a registered alternative trading system (ATS) for private company stock.

TriNet is the cloud-based HR partner for startups. TriNet mitigates employer-related HR risks and relieves HR administrative burdens. From employee benefits services and payroll processing to high-level human capital consulting, TriNet’s all-in-one solution is integrated with every facet of a client’s business. TriNet specializes in serving high-growth companies who recognize top talent is the most critical asset. For more information, visit http://www.trinet.com.

© 2012 ernst & Young LLP and the National Venture Capital Association. sCORe no. Be0205All rights reserved.

i