Management and Common Stockholder Resistance to Acquisitions, and Using Carve-Outs to Overcome It
August 26, 2020
This past June, autonomous vehicle technology startup Zoox agreed to be acquired by Amazon for a whopping $1.3 billion. Time for the common stockholders to pop the champagne, right? Not exactly, according to a complaint filed in the Delaware Court of Chancery by two common stockholders. Although many details have been redacted from the public version of the complaint, it alleges that the common stockholders’ share of the $1.3 billion purchase price is dwarfed by the cash and stock bonuses payable to Zoox executives, let alone the liquidation preferences payable to the venture capital investors. The complaint also alleges that Zoox’s valuation was nearly $2 billion higher in 2018, and that a recent competing bid ignored by Zoox was more favorable to the common holders than the Amazon deal. The fact pattern of the Zoox case illustrates the friction that often exists between preferred and common stockholders of venture backed companies in the context of proposed acquisitions, as well as efforts made by such companies and their VC investors to neutralize common stockholder and management opposition.
Motivations to Resist
There are several factors that may motivate management and common stockholders of a venture backed company to resist a proposed acquisition, even one with a seemingly attractive purchase price.
First, some background on exits. VCs need to exit a portfolio company within a few years of making the investment in order to return proceeds to their limited partners before the expiration of the VC fund, which is typically ten years after fund formation. Unlike investors in public companies who can generally exit by selling their shares into a public market with ready buyers, VCs have no secondary market into which they can sell shares in most if not all of their portfolio companies and can only exit in an initial public offering, acquisition or liquidation of the company.
Of the three exit scenarios, IPOs are on balance the most favored by executives. They provides the greatest likelihood of job security and typically result in less oversight and scrutiny of management because the company is transitioning from being privately held by VC investors exercising contractual control rights to a more diffuse ownership. Also, in an IPO, preferred holders almost always are forced to convert into common under the terms negotiated in the certificate of incorporation; that usually guarantees the IPO terms to be favorable to the common holders because otherwise the preferred would not support proceeding with the offering.
By contrast, an acquisition has a tendency to present less job security to management than an IPO, particularly if the acquirer is a strategic buyer that has its own management team in place. Even if the management team survives the acquisition, it will likely face greater operational oversight than in an IPO because it will have only one owner – the acquirer – rather than diffuse ownership in an IPO.
As for the common stockholders, including founders, executives and employees who own restricted stock or options, an acquisition may not yield any return on their common shares if there have been large amounts of VC investment in the company and the aggregate dollar amount of liquidation preference exceeds the purchase price in the acquisition. In such a scenario, the preferred holders would be entitled to receive all of the acquisition proceeds and the common holders would receive nothing, leaving the common stock worthless. Such holders would also be forfeiting future upside in their equity, and may believe that the company is on an upward trajectory and could be sold down the road for a much higher price that would clear the liquidation preference stack and produce greater returns for the common.
Means to Resist
Management and common stockholders have several arrows in their respective acquisition resistance quivers. Management cooperation is critical to an acquisition process, and executives could choose not to cooperate. They may even exploit their position as gatekeepers by not informing the board or the VCs of acquisition inquiries. Many acquisitions, particularly by financial buyers, depend on executives continuing to manage the business post-closing and management could sabotage a deal by refusing to commit to stay on.
Common stockholders also have several means to resist an acquisition they disfavor. First, although few venture backed company boards are controlled by the common stockholders, the common often maintain significant influence on the board nonetheless. Under most voting agreements, the common are entitled to one or more board seats with at least one seat going to independent directors. Common stockholders could pressure their board designees to reject a proposal and to seek to influence independent directors to do so as well. Directors owe fiduciary obligations to all stockholders, and independent directors may be more reluctant to support a proposed acquisition opposed by the common holders. Further, many boards seek unanimity with respect to a vote on a significant transaction such as an acquisition because of the threat of litigation. Second, mergers and acquisitions almost always require some level of stockholder approval and common stockholder opposition could matter if the relevant state statute or the terms of the deal require a supermajority vote, in which case a minority group could block a deal if it constitutes a large enough percentage so as to prevent the company from securing the requisite vote threshold. Certain states such as California require that acquisitions be approved by each class of voting securities, giving the common a class veto irrespective of the percentage the common represents of the outstanding voting shares. Acquirers sometimes condition a deal on 90% or some other level of supermajority approval, thereby creating a veto opportunity for the common. Finally, common stockholders could threaten litigation, although this tactic does involve reputational risk associated with opposing a deal favored by the investors; founders and executives following an exit often recycle themselves in another startup, in which case they could likely find themselves seeking either VC funding or employment from a VC backed company.
Carve-out Plans to Overcome Resistance
Companies and VCs could try to overcome management and common stockholder resistance through a carve-out plan. Executives could be offered bonuses under a carve-out plan linked to completion of an acquisition. Whether or not such a bonus would be economically dilutive to VCs depends on whether and to what extent the acquisition proceeds exceed the liquidation preference stack. If it does, aggregate bonuses within such excess would not come out of the VCs’ pocket. By way of example, if the acquisition price is $100 million, the liquidation preference stack is $95 million and the aggregate bonuses are $4 million, the company will pay out (i) $4 million to the executives in bonuses, $95 million to the VCs and $1 to the common stockholders. Such bonuses would not cost the VCs anything but rather would come out of the common stockholder payout. It appears the foregoing scenario is what happened in the Zoox deal, causing the common holders to assert that the payout to them is dwarfed by the bonuses payable to executives.
A management carve-out plan typically designates either a percentage of acquisition proceeds or a fixed amount to be paid to plan participants. The typical size pool is around 10% of acquisition consideration, but may vary with the number of participants in the plan or shift on a sliding scale depending on the amount of consideration. For example, the pool could be 8% if the consideration exceeds $80 million, 10% if it exceeds $100 million and 12% if it exceeds $120 million. “Consideration” for the purpose of calculating the pool typically assumes no carve-out plan and excludes transaction expenses. The portion of a pool attributable to an earn-out or escrow would be payable to participants only if and when it’s paid to stockholders. Participation could be broad-based, although it’s typically limited to senior executives whose retention is crucial to the acquisition process. Allocation of value within the pool could be extremely flexible and could be linked to factors such as rank, tenure and base pay. Rights in the plan typically don’t vest until the acquisition closes so that anyone who leaves beforehand would forfeit his or her benefit. Adoption of a plan often necessitates a charter amendment to designate the preference of the carve-out plan over the capital stock.
Similarly, to overcome common stockholder opposition, a carve-out plan could be adopted so that some agreed upon amount is carved out of the preferred holders’ liquidation preference and paid to the common. Obviously, the preferred holders would need to agree. Common stock carve-outs are more likely to occur when the VCs don’t control the board (and need to sway one or more independent or common stockholder designee directors), when the common stockholders get a class vote and/or when the common would otherwise get wiped out. Occasionally, carve-outs are conditioned upon common stockholders signing liability waivers and/or upon representative directors voting in favor of the acquisition.
Board Duties and Liability
When a board is asked to approve a management carve-out plan, it must consider its fiduciary obligations to maximize value for all stockholders. On a very basic level, a management carve-out reduces the amount that would otherwise go to the stockholders. As mentioned above, whether the proceeds of the plan get carved out of the preferred’s share or the common’s share depends on whether the acquisition proceeds exceed the aggregate liquidation preference amount. Accordingly, in considering the adoption of a carve-out plan, the board risks being the target of litigation for breach of fiduciary duty or corporate waste if the plan is not carefully structured so that it fairly allocates financial burden between the common and preferred.
Because of the inherent conflicts that result from the presence on the board of preferred stockholder designees, director conduct may not receive the benefit of the deferential standard of the business judgment rule, and instead may be judged by the stricter standard of entire fairness under which both price and process must be proved to be fair to avoid liability. Risk could be mitigated by having the process run by a special committee of disinterested directors, and further mitigated through stockholder approval (which would be generally required if the plan is carved out from the preferred holders’ liquidation preference).
The controlling case here is the 2013 Delaware case of In Re Trados, where the acquisition of a VC-backed company resulted in senior management receiving payments under a carve-out plan, and the common stockholders receiving nothing and sued the directors for breach of fiduciary duties. In applying the entire fairness standard, the court held that although the directors failed to execute a fair process there was no liability because the common stock was worthless even without the carve-out plan. In other words, the aggregate liquidation preference exceeded the acquisition consideration which meant the plan proceeds were carved out of the preferred holders’ payout.