Vcr 2012 final


Published on

  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Vcr 2012 final

  1. 1. VENTURE CAPITAL REVIEW Issue 28 • 2012 produced by the National Venture Capital Association and Ernst & Young llp
  2. 2. 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 National Venture Capital Association 1655 Fort Myer Drive Suite 850 Arlington, VA 22209 Phone: 703.524.2549 Fax: 703.524.3940 Web site:
  3. 3. 3 Venture-Capital-Backed IPOs: Outperforming the Market and Creating Market Leaders By Jacqueline A. Kelley and Bryan Pearce, Partners of Ernst & Young LLP 11 Midstream Shareholder Liquidity Alternatives: Structuring Shareholder Take-Outs in Growth Equity Financings By 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 Success By 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 Funds By 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 Issue By 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
  4. 4. 2
  5. 5. Venture-Capital-Backed IPOs: Outperforming the Market and Creating Market Leaders By Jacqueline A. Kelley and Bryan Pearce, Partners of Ernst & Young LLP Confirming the invigorating effect venture capitalists have on entrepreneurship in the US, IPOs of venturecapital-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 oneyear post-IPO return of a number of venture-capitalbacked 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%. 3
  6. 6. Average IPO Proceeds ($mm) 2007 2009 2010 2011 2012 YTD 2007 to June 2012 134.6 VC backed IPOs 2008 128.0 145.1 110.7 201.7 101.0 138.6 PI backed IPOs* 195.7 232.9 287.7 160.8 382.8 168.4 227.6 Non PI-backed IPOs 295.3 175.6 322.8 146.0 190.4 215.4 232.5 All IPOs 222.0 184.2 278.7 143.2 272.4 157.9 208.2 All IPOs without exclusion 222.0 581.4 371.5 220.5 272.4 304.7 271.9 Total IPO volume Total IPO Proceeds ($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 both Source: Dealogic, Thomson Financial, Ernst & Young US exchanges IPOs Door number 1, 2 or 3? Which is the best exit? (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 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-capitalbacked 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%. 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 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 2 Emily Chasen, “Confidential IPO Filings Outpacing Public Ones,” Wall Street Journal’s CFO Journal, May 30, 2012, confidential-ipo-filings-outpacing-public-ones, accessed July 19, 2012. 3 Exit Poll Report, National Venture Capital Association/Thomson Reuters, July 2, 2012. 1 VentureSource, Q1 2012 data. 4
  7. 7. Average post IPO performance - 1 day (%) Average post IPO performance - 1 month (%) 2007 to June 2012 2007 2008 2009 2010 2011 2012 YTD 2007 to June 2012 2007 2008 2009 2010 2011 2012 YTD 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 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 Non PI-backed IPOs Average post IPO performance - 6 months (%) Average post IPO performance - 1 year (%) 2007 to June 2012 2007 2008 2009 2010 2011 2012 YTD 2007 to June 2012 2007 2008 2009 2010 2011 2012 YTD 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 Top Sectors (# of Deals) 2012 YTD Top Sectors (capital raised $mm) 2011 Top Sectors (capital raised $mm) 2012 YTD High Technology 34 High Technology 20 High Technology 8,902 Oil & gas 3,006 Financial 22 Financial 10 Health care 5,879 High technology 2,320 Oil & gas 21 Oil & gas 8 Oil & gas 5,720 Financial 2,077 Health care 16 Health care 6 Financial 4,200 Retail Real estate 9 Retail 5 Power & utilities 3,372 The venture capital effect initially unprofitable but highly innovative companies Academic studies suggest why venture-backed IPOs perform better than the market. that could not possibly fund their own growth the 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 876 venture capitalists’ preference for scalability meets chance to gestate and mature. At the same time, 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 venturebacked firms are associated with higher management 4 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of VentureCapital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance,, accessed July 19, 2012. quality, as measured by factors that include management team size, education, prior experience 5
  8. 8. Operate like a public company long before your firm becomes one 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. At 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. 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, venturecapital-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 Keep an open mind Every 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. Intensifying the venture capital effect: 10 steps to IPO readiness At 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. 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: 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. • sale to a private equity firm A • sale to a strategic buyer A • artnerships, joint ventures and strategic alliances P Are your companies ready for the IPO Value Journey®? Here are the steps we recommend at Ernst Young. • lternative liquidity options, such as Rule 144A A 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. 5 Thomas J. Chemmanur, Hassan Tehranian and Karen Simonyan, “Management Quality, Venture Capital Backing, and Initial Public Offerings,” Social Science Research Network, id=2021578, accessed June 17, 2012. 6 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of VentureCapital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance,, accessed July 19, 2012. 6
  9. 9. Develop a brilliant sense of timing 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. Timing 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. 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. 7
  10. 10. Company leadership must strike the right balance between managerial focus on the IPO transaction and the day-to-day operation of the company. Convene a superb team 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. Clearly, the market looks for companies with highquality 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. Establish excellent corporate governance With 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. 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. Inform and communicate to potential investors Assemble a solid infrastructure A 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. Because 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. 8
  11. 11. Orchestrate a successful road show 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. For 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 welldesigned 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. 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 dayto-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. Attract the right investors and analysts Conclusion: great public companies, a great contribution In 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. Clearly, 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. Companies should develop a plan for outreach to equity analysts and shareholders — and actively cultivate a dialogue with them, attend conferences and initiate nondeal marketing visits. Early engagement of investors and analysts prior to the road show can help drive value and avoid surprises. Preparing for the IPO Value Journey® 1. Operate like a public company 2. Keep an open mind 3. Develop a brilliant sense of timing Prepare to prove that you are true to your word 4. Convene a superb team 5. Assemble a solid infrastructure Once 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. 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 1 Prepare to prove that you are true 0. to your word 9
  12. 12. 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 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. 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 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.  7 Manju Puri and Rebecca E. Zarutskie, “On the Lifecycle Dynamics of VentureCapital- and Non-Venture-Capital-Financed Firms,” The Journal of Finance,, accessed July 19, 2012. About the Authors Jacqueline A. Kelley (, Partner, is the Americas IPO Leader, Ernst Young LLP. Bryan Pearce (, 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. 10
  13. 13. Midstream Shareholder Liquidity Alternatives: Structuring Shareholder Take-Outs in Growth Equity Financings By Dan Meehan and Alfred L. Browne of Cooley LLP I. Introduction The 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. 11
  14. 14. 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. II. Structuring Alternatives Numerous 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 newlyissued (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 newlyissued 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. reference, we will employ the same capitalized names and terms throughout the text. • ompany is a corporation with 40 million shares C of stock outstanding: o 0 million shares of Common Stock owned by 2 Founder, a U.S. individual who has owned his shares for more than 1 year; and B. Target Participants o 0 million shares of Series A Preferred Stock 2 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. 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 takeout and how to allocate take-out dollars. These include: • ompany has issued employee options on 10 C million shares of Common Stock with a strike price of $.50 per share. • he Series A Preferred Stock has a per share T liquidation preference of $1.00. • ew Investor’s ownership requirements N (e.g., majority vs minority stake) • ew Investor will invest $100 million to acquire N shares of Company stock. • urrent owner willingness to relinquish a C controlling stake in Company • ew Investor expects to own a majority of the N fully-diluted Company stock. • emands for liquidity by Founder and D Original Investor • ew Investor is willing to allow up to $80 million N 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. • illingness of both New Investor and company W management to allow employee participation, taking into account the motivational pros and cons of employee liquidity • ompany’s operational funding requirements C 12
  15. 15. C. The Participant Transaction predetermined by agreement of Company’s board, management and/or New Investor. Participation of Company stakeholders in the take-out can take any one or more of the following forms: After the redemption is complete, New Investor will own its desired percentage of Company, and the takeout participants will have achieved some measure of liquidity with respect to their ownership stakes in Company. • ompany redeems outstanding stock by paying C cash to selling stakeholders • Existing stockholders sell their outstanding Company stock to the new investor for cash (a “secondary” sale) 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: • statutory cash-out merger with a “rollover” of A equity by continuing stakeholders • ompany distributes cash (as a “dividend”) to C some or all holders • Compensation paid to company employees • s described above, in certain situations, the A tax consequences of a redemption can be more favorable for one or more selling shareholders. • loan from the company, sometimes coupled A 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. • 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 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 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. 13
  16. 16. 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. • ergerSub merges with and into Company. M Company is the surviving entity in the merger. • ew Investor may prefer to deal with only one N entity (the corporation), rather than numerous individual sellers. • ewco acquires all of Company’s remaining N shares in the merger in exchange for cash paid to Company’s stockholders. 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. 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. 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. 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. 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): 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. • ew Investor organizes a new entity to be the N acquirer (“Newco”) in the merger and makes its investment into Newco in exchange for newlyissued Newco preferred stock. • ertain Company stockholders contribute their C existing Company stock to Newco in exchange for newly-issued Newco stock having (usually) the same rights as the contributed Company stock. 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 • ewco forms a wholly-owned “shell” subsidiary N (“MergerSub”). 14
  17. 17. 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. 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. 7. Treatment of Stock Option Holders III. Tax Considerations Company may also want to provide liquidity to its option holders in a take-out. There are a few different ways to do this: 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: • ermit option holders to exercise all or a portion P 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 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: • ermit option holders to surrender all or a P 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. • 5 million shares of Series A Preferred Stock redeemed at a 1 $3.37 per share price ($50.5 million total); • 0 million shares of Common Stock redeemed at a $2.00 1 per share price ($20 million total); and 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: • ptions on 3 million shares, netting $1.50 per option share O 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: • ew Investor or Company might loan money to N Founder. Typically, the loan would be secured by Founder’s Common Stock. The loan may be fully recourse, fully nonrecourse, or partial recourse. • loan coupled with a call option on Founder’s A 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. • or U.S. individuals (including U.S. individual F 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. • or non-U.S. shareholders (including non-U.S. F partners of an investment fund), whether U.S. withholding tax will be imposed in connection with the transaction. Other variations are also possible, including a “prepaid forward” sale of the stock. Each variation (and each component choice within each variation) involves • or U.S. corporate shareholders, whether a F “dividends received deduction” is available to reduce tax from the transaction. 15
  18. 18. 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 distribution for Original Investor, then its actual tax consequences are determined based on a threetiered filter. First, if Company has current or accumulated “earnings and profits” (or “EP”) 4 then the distribution would result in dividend income for Original Investor up to Original Investor’s allocable share of the EP.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 EP, the next redemption dollars are treated as a taxfree 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 EP, 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. 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. Third, if Original Investor’s redemption proceeds exceed both its share of Company’s EP 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 EP, Original Investor would have $30.5 million of capital gain under distribution treatment, as compared to $35.5 million under sale treatment. 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. 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 EP 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 EP, or EP for all prior years combined. Thus, dividend treatment may apply even if Company has no accumulated EP (for all prior years combined), if Company has EP for the current year viewed in isolation. 5 Each shareholder of a corporation will be allocated a certain portion of the corporation’s EP based on the relative ownership and distribution rights inherent in their stock. 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. 16
  19. 19. 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 commonequivalent 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 commonequivalent 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. 17
  20. 20. In contrast to redemptions, the tax consequences of a direct sale of stock by existing stockholders to New Investor are often straightforward. practitioners identify as relevant in determining whether redemption proceeds may be characterized in whole or in part as compensation. These include: • ll available information about the valuation of the A Common Stock. • he expected financial accounting treatment of T the redemption price paid to employee-sellers. • hether the redemption price for the Common W Stock is viewed as an arm’s-length, negotiated price. • hether any portion of the Common Stock is W 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). 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. • hether dividend treatment might be a more W 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. 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 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. 18
  21. 21. 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. • 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. 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. 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. 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. • reatment of the Purchase of Founder’s Common Stock: T 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: 7 This assumes that Founder’s other compensation exceeds the wage base limit for Social Security taxes. 19 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 he other $2.5 million paid to Company in exchange T for a primary issuance of Company stock (most likely the Series B preferred stock described in the Base Example, rather than additional common stock).
  22. 22. 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. 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. 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. 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. 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’slength 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 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 cashout 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 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). 20
  23. 23. F. Tax treatment of payments to stock option holders taxing authorities. On the other hand, if dividend tax treatment would result in wholly or mostly tax-free proceeds (because the company has no EP 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. 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. 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 EP and no accumulated EP. 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.” Founder Common Stock Treatment: Even though Company may have no accumulated EP, the $20 million of current year EP will render a portion of Founder’s distribution taxable as dividend income for tax purposes. Assume 25% of the current year EP 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 taxefficient liquidity alternative. 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. Old Investor Series A Preferred Stock Tax Treatment: Assume Company’s remaining EP ($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%; nonU.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. 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 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. 9 ISOs are employee stock options that meet certain requirements and qualify for special tax treatment under the Internal Revenue Code. 21
  24. 24. IV. Other Considerations 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. 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. 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. 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 oversubscribed. 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. 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. 22
  25. 25. 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. 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. In summary, when approving a “take-out” transaction structured as a redemption, a board should carefully consider each of the following: • hat is the corporate or business rationale for the W redemption/liquidity transaction? • ho will benefit from the liquidity? W • re there any conflicts of interest around the A board table? Will any board members receive significant proceeds in the transaction? • s there a class or group of stockholders who are I not being offered the chance to sell their shares? • t what price should Company repurchase A shares? How does this affect option pricing? • ill Company have adequate capital to operate W 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: its business after the transaction? Does the transaction satisfy state law limitations on share repurchases and dividends? • re there restrictions in Company’s contracts A • hether the board may, in the proper exercise of W its fiduciary duties, approve the exchange and/or grant New Investor additional stockholder rights. (including investor documentation and/or debt documentation) that limit Company’s ability to repurchase shares? • hat the terms of the Series B Preferred Stock W should be. • as Company satisfied its disclosure obligations H • hat the exchange ratio should be. W in connection with the repurchase? • hether there is an effect on the valuation of W Company’s Common Stock and correspondingly on the pricing of Company’s stock options. • re there any compensatory payments being A made (or any deemed compensatory payments being made)? Is Company satisfying its tax • hether the exchange triggers any preexisting W rights held by Original Investor, such as rights of co-sale, or rights of first refusal. withholding obligations? 23
  26. 26. • he tax consequences of the exchange (both for T New Investor and possibly for Original Investor and Founder). Conclusion A 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 Authors Dan 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 MA 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. 24
  27. 27. Contingent Consideration: Does it Have Value? 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 25
  28. 28. Viewing contractual rights as a contingency and not reporting fair value is inconsistent with investment company accounting principles. to a philosophical paradox such as that presented by Schrödinger’s cat or Morton’s Fork. Contingent Consideration—Missing the Forest Because of the Trees 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. Deal 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 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. 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. 26
  29. 29. Contractual Rights: a Modern-Day Morton’s Fork 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. As 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, costeffective, basis. 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). 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. 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. Practical Solutions to Valuing Contractual Rights Our 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 LPs generally ignored the If a contractual right is fair value of contractual not recorded at fair value rights, if any 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. 27
  30. 30. 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. • mportance of the contingent payment(s) to I the deal, fund IRR calculations or the potential value in relation to the original investment 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. • omplexity of the terms affecting the visibility C of likely outcomes • ength of time expected for the contingency L to resolve itself • he nature of the contingency; certainty of T payment or performance • ange of potential outcomes (variance of R payments) • nformation usefulness for an investor; would I 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? 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: 28
  31. 31. 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. 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. Monitoring Care 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. 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. 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. Conclusion Because 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 Given an estimate of the cash flow associated with a contractual right, the present value must 29
  32. 32. Contractual rights are difficult to value, but arguably no more difficult to value than an option, warrant, or any early stage enterprise. • 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. • contractual right is not contingent; the cash A flows it describes may be subject to future events, but the right itself is not contingent. • Ps need their GP to provide fair-value-derived L NAV based on the fair value of all assets including contractual rights. a consistent basis across all the asset classes in • ontractual rights are difficult to value, but C arguably no more difficult to value than an option, warrant or any early stage enterprise. 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 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.  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: About the Authors David 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. 30