Start-Up Exits – How much Investor support do the Founders need to get for key M&A terms?

For founders, a successful M&A exit can be a great reward for years of entrepreneurial growth. It can be an opportunity to move on to the next idea or to guide the original business in the context of a large institutional backer. In a start-up that has seen several financing rounds, there may be a good-sized number of investors, which will frequently make a merger transaction the most efficient way to accomplish the sale. The advantage of a merger is that unanimous support for the sale, at the very least in terms of closing signatures and votes, is not required; all that is needed are enough votes to get over the legal (i.e., Delaware General Corporation Law) and contractual hurdles (investor protective provisions/drag-along) to sell the company.

But recent cases indicate that some provisions that crop up in merger transactions may not be binding on stockholders who don’t sign on for them, which can put the weight of that burden on the founders.

Stockholder Representative: Frequently thought of as more an issue of administrative convenience than a key economic term, where the merger involves more than a few target stockholders, the buyer will require a stockholder representative to be appointed effective at the closing to negotiate and administer post-closing matters, such as price adjustments and earn-outs, indemnity obligations/escrows and tax returns. Buyers do not want to deal a large number of stockholders, and if there is an escrow backing up post-closing protection for the buyer, both buyers and sellers want to have a clear path to determine who gets what escrow funds and when, which would be extremely uncertain if there is more than one seller whose sign off is needed. Thus, the seller representative usually takes on these functions on behalf of the target stockholders.

How can the Stockholder Representative be an issue? In a few circumstances, courts have taken the view that the stockholder rep is an agent of the target stockholders, and, thus the stockholders can revoke the authority of the representative. If that were only an issue of selecting a new stockholder rep, it may not be a huge issue. But in one case, the court concluded that a group of dissident stockholders who had not voted for the merger could revoke the stockholder rep’s authority (at least as to that group of stockholders), which left the dissident stockholders free to negotiate their own resolution of a dispute with the buyer. 

In this case, the buyer brought indemnity claims based on a breach of reps and blocked release of the entire escrow fund, which put the escrow in limbo until the parties worked it out or someone sued. The stockholder rep sued. Then, the buyer counterclaimed and brought in all the former target stockholders as co-defendants (including the dissident stockholders); as costs mounted and concern grew that the loss for them would be large, the dissident stockholders bypassed the stockholder rep and settled with the buyer with respect to what would otherwise have been “their” portion of the escrow fund. 

In theory, this could mean that the other stockholders, especially the ones who supported the deal (i.e., founders) could be left to shoulder all the remaining indemnity risk on their own, disproportionately. 

Can this be addressed? First, Delaware merger law has usually been of the view that if properly done, the stockholder rep’s functions and powers are part of the terms of the merger itself and, thus binding on all the stockholders. So if you are a Delaware corporation, you can successfully build a proper stockholder representative role into the merger. Second, even in states where this “agency” concept may apply, the wording of the merger agreement can be done in such a way as to improve its durability against attack. Third, if at all practical, there is always the possibility of selling the company through a stock purchase agreement, where each stockholder has to sign up to all the contract provisions, including the seller rep provision.

Indemnity: A case still on appeal in Delaware got a lot of attention recently because of the impact on the indemnity obligations on a tranche of preferred stockholders who did not vote for the merger and because of the court’s treatment of the letter of transmittal requirement. The Cigna case involved an acquisition of a private venture backed target, with post-closing indemnification for breaches of representations and warranties, some of which were “fundamental” (i.e., to survive indefinitely).  Somewhat unusually, the deal did not have an escrow; the target stockholders were at risk on a “claw back” basis for losses (but not above their pro rata share of the merger consideration). So in theory, a stockholder may have had to pay back all the deal price they received. The merger agreement also required a letter of transmittal (LOT) be submitted to receive the merger consideration but did not specifically say what would be in the LOT.  Cigna, a holder of preferred stock, refused to submit an LOT, and the buyer refused to pay them the merger consideration.

LOTs are pretty frequent in merger transactions because they help track the submission of cancelled stock to make sure the correct stockholders get the correct merger consideration.  The LOT in Cigna included a release of the target and buyer and an agreement to be bound by the terms of the merger agreement, including the indemnification provisions relating to representations and warranties (and language around the appointment of the stockholder representative).

LOT/Release:   The argument against submitting the LOT was that when the merger actually became effective under law, it was improper to put additional requirements on the stockholders to get what the merger agreement said they would get. A release of historic claims by stockholders is certainly beneficial to buyers but can be indirectly useful to a target stockholder because it reduces the risk of claims that would just come back on the rest of the stockholders under the indemnity. But at the end of the day, the court invalidated the release because it only showed up in the LOT, wasn’t part of the approved merger terms, and wasn’t supported by consideration.

Indemnity Obligations: In the most sweeping part of the opinion, the Court invalidated Cigna’s indemnity obligations (again, Cigna had not voted for the merger) because with the complete claw-back possibility, the target stockholders would be “unable to determine what they are receiving as merger consideration,” which violated the merger statute. Thus, stockholders who voted for the merger were stuck with the claw-back indemnity, while the stockholders who did not vote for the merger were not.

Can this be addressed? First, as noted, this case is still under appeal to the Delaware high court so the outcome may change. Second, the case notes that it is very fact-specific and hints that more ordinary course escrow type arrangements are still okay.

Ultimately, the lessons from these and similar cases is that founders need to make sure they are getting the right legal approach to implement key deal terms and to align all the stockholders.