ScaleView founder, Gabe Wilcox, sits down with Brian Alford from Optimal Counsel. Watch the video to learn more about Brian’s experience, Optimal Counsel, and tips on negotiating with an investor or buyer.
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Gabe Wilcox: Gabe Wilcox here from ScaleView Partners, the Austin investment bank for tech founders by tech founders, speaking today with Brian Alford from Optimal Counsel. Hey, Brian, how are you doing?
Brian Alford: Doing great. How are you this morning?
Gabe Wilcox: Very good. Well, to start, Brian, why don’t you tell us a little bit about yourself and your firm, because I know you’re relatively new in the market with Optimal, so we’d love to hear about the firm and your focus, and then we’ll kick it off from there.
Brian Alford: So Optimal Counsel is a corporate boutique firm that specializes in high growth companies. We represent a lot of tech and CPG startup companies and other high growth companies, most of them venture capital backed. So we do a lot of VC deals, but a lot of our clients aren’t venture capital backed. We kind of do deals in the early-stage 250K range all the way to the $500 million exit range and really represent the companies all the way in between on all their corporate transactions. And then we loop in other specialists as needed, whether it’s labor counsel or regulatory counsel, including in those deals if we need to loop them in. I’m one of the managing partners of Optimal Counsel and one of the founding partners of Optimal Counsel. We’re all over the country, all working remotely. Very efficient business model and very affordable rates compared to the big law firms. But we pay people the same or more per hour as they would make it in big law firms. So we attract the top talent we poach from the best big law firms to build our stack.
Gabe Wilcox: I think it’s really cool that you have that full cycle approach with companies from the early stages of even company formation all the way up to a big exit. Is that typical or is that something special to your practice? And I would imagine for the attorneys who join you, that’s a really cool thing to be a part of, too. That must be an attractive thing compared to maybe a big law machine.
Brian Alford: So a lot of companies, I think, form on Clerky or Stripe, Atlas or Gust Launch, those are fine platforms. Clerky in particular, I’d say, is probably the Y combinator backed company. So a lot of Y combinator companies start on Clerky as soon as you hit a financing. I think it’s really important to switch to a more sophisticated counsel than no counsel specifically. And so as a big law firm, you really can’t get involved until like, series A stage at the earliest. Sometimes companies will do it as a loss leader, but they’re not really prioritizing those companies. We specialize in those companies either at formation stage or at first financing stage, and it’s really fun to see them all the way to exit. And I think that is a limiter of some of the other boutiques is that they can’t scale up to the exit, and so a lot of those companies will switch to a different firm at the exit. We have an M and a group that specializes in representing companies selling to larger acquirers as well as buying smaller companies as well. They’re all pretty much private transactions, so we kind of specialize in private transactions. But in general, the fewer lawyers that touch your captain, the better. So I would recommend having corporate counsel as long as possible until you really need to make that switch and to get them involved, if you can, at the very first financing.
Forming an LLC vs. Basic Operating Agreement
Gabe Wilcox: Okay, that’s an interesting one that comes up. As a banker, we get that question sometimes from prospects or clients. I’ve had my company counsel forever. It may be the group who helped me from day one forming an LLC and getting a basic operating agreement. And now I have this big company, and specifically I’m looking at that transaction. Can I stay with the group I’ve worked with this whole time, or is there really specialized knowledge that comes into play? What’s your take on that?
Brian Alford: I can’t count the number of times for any particular company where we say, we’re putting this in place now so when you raise financing, the investor isn’t going to think it’s too strange, or we’re putting this in place now so that when you raise financing, it may be revised to this, but you’ll keep as much as you can in place. We’re going to address your goals in a way that’s most likely to stick around through the financing. In general, you want people with that longer term view, especially when it comes to LLCs and what you put in your LLC agreement. A lot of LLC agreements are not built for scalable companies. So if you want to be an LLC and you want to scale your company, I think it’s really important to not just pull something from LegalZoom. I love LegalZoom. They do have some good lawyers there, and one of my great friends is at LegalZoom. So try to find a lawyer there if you are scaling your company, and they may point you in the right direction as well.
There’s a pretty natural transition from a small company lawyer to a startup lawyer. And a startup lawyer implies high growth,and the small company lawyers are great. If you’re not trying to scale, as soon as you’re trying to scale, you need to be thinking long term and how is this going to impact my future financing? How are these going to impact Diligence? And would these be red flags in Diligence?
Gabe Wilcox: As a founder, I can appreciate the idea that it’s sort of scary to try to find the right attorney for your company. You want to find somebody you really click with and trust, and that relationship grows over time. And so the last thing you want to do and I get this I think the last thing founders often want to hear before a sale process is, well, we need to sort of find some new counsel who has specialized knowledge on M and A because your corporate attorney is probably great, but this is a different thing compared to sort of helping you with a little contract review and helping you with some HR stuff. They can continue to help on things like that,but we need someone who has experience in M and A. And so I think the way you describe your firm that you’ve built is that you’ve got both right. You’ve got the ability to be that long term partner to the company, but you also have a specialized M and A practice. So when it’s sort of time for dealstuff, you’ve got that resource in house too.
Brian Alford: Yeah, and we also are fine to work with your prior counsel, especially with respect to light contract review. If you want your prior counsel to still help with the commercial contracts, totally fine with us. By not being a big law firm. We don’t need to do everything. We do the stuff that we specialize in.
Tips for Negotiating with an Investor or Buyer
Gabe Wilcox: Since we started talking about deals via M and A or investment rounds for a company. Let’s talk about the kind of the negotiation and the deal dynamics because you’ve been a part of a lot of that. What are some tips for founders about negotiating with an investor or a buyer? Some tactics you’re likely to see from them? Some tactics you might employ yourself to get? And we always say this too, right to our clients. It’s to get the best deal that you can, but it’s also to get the deal done. So it’s kind of optimizing terms andalso optimizing for certainty of close. They both matter a lot. So with that frame, tell us a little bit about some things you’ve seen.
Brian Alford: I’m going to hear this comment is focused on the fundamental economics, not my lawyer thought we should do this and no one was thinking bout it off the wall kind of term that kind of digs into the weeds and it’s just kind of a 1% risk reduction mechanism, but more of the fundamental economics. And this is very common amongst founders, specifically the less experienced founders. They approach a deal, they see a big number, and they’re ready to sign on the dotted line. And so my high level point is I’ve never seen a deal die because a founder or a company asked for something, especially if it’s within the realm of reasonableness. And I can guarantee you whatever you’re asking for is not crazy relative to what that buyer or investor has seen. If we’re your counsel and we say this is something that people ask for, someone has asked for something wildly more ridiculous. And that buyer or investor has seen something wildly more ridiculous. And so when they come back and say, I can’t believe you asked for that. No one ever asked for that. They’re probably lying. I’ve never seen a deal die because of that. That doesn’t mean that you should die on that hill. But don’t be afraid to ask.
On the flip side, I cannot count the number of times that founders or companies have not asked for something because they thought it would upset the investor or the buyer. And the investor, the buyer is kind of giving them the impression that this is the best deal you’re going to get. Or I’m giving you better than the best deal you’re ever going to get. Those are standard tactics by an investor or a buyer. And they’re usually expecting you to ask for something. When they give you an offer, they’re expecting you to ask for something.
So thinking of it a different way, let’s say you’re a CEO and you have a larger company, and you go to a founder group of a smaller company and you say, listen, I think X is the greatest deal you’re going to get on the market for your company, and I’m going to beat it by 10%, or I’m going to beat it by 15%, because I love you so much and there’s so much synergy, and we’re going to build something great. And I’m so excited to get this deal done. And then the founders are like, okay, CEO, we love you. We love your business. We’re super excited. We can’t thank you. We can’t appreciate how much or like we can’t tell you how much we appreciate your interest, your offer, your level of excitement. And we’re going to go to our board and we’re going to go to some of our larger stockholders. We’re going to discuss this offer and we’re going to get back to you as soon as possible. If that CEO is disappointed in that response, then that CEO is effectively selecting for gullible inexperienced founders who are probably shirking their fiduciary duties as Directors and possibly hiding something. The founder who signs on the dotted line is either gullible because they believe this CEO that this offer is 15% above anything else they’re ever going to get in the market where they’re inexperienced and those usually correlate gullibleness and inexperience and sometimes people are experienced, yet still somehow gullible.
They’re not thinking about the fact that they have a duty to all stockholders to get the best deal. Or finally, there’s some issue at the company that only they know about and they just want to create deal momentum so that when that thing is found out, the deal will still hopefully close. I like the idea that this sort of low ball investor tactic might be a bad one, might actually even be a bad tactic for the investor because you get this adverse selection where you only get companies where there’s something extremely wrong under the hood. Sure, if you’re an investor and they sign on the dotted line immediately, that should be a red flag. What the CEO should want is for the founders to go back and evaluate the deal and ask for something reasonable in return, and they should be expecting it. And this goes a little bit into founders wearing different hats. You’re a stockholder, and you may see the dollars that you would make as a stockholder,and that may impact your thinking. You’re an executive, so maybe you want to close that VC deal and get back to building the company immediately because you’re tired of spending three months missing some sales because you’re chasing investment. But you’re also a director, and you could get sued as a director for not satisfying your fiduciary duty to stockholders. So you have to put that hat on as well. And I’ve got to go back to my board. It is a good way to take a beat. Take off your executive and stockholder hat, put on your director hat, and even if the board is you, at least that moment of taking a beat can help you evaluate the offer from a different perspective.
Gabe Wilcox: Really good stuff. And the different hats thing is tough, particularly in a closely held business where the founder might be the major shareholder but not the only shareholder, then it can be pretty tough to navigate that appropriately and understand that, yes, shareholders interest is a lot aligned with my interest, but not just right. It’s not totally just my show. We have other people on the captable, and so you have other responsibilities. We’ve seen that dynamic a lot.
When you talk about the negotiation side, where we often get hired as the investment banker. We often get hired when there is an offer on the table because for many founders, that’s the first time they’ve really thought about selling the company. They’re just execution machines. And then someone comes in with an unsolicited offer, and that’s the first time they really take a step back and say, whoa, maybe this is interesting, but there can still be a very impressive number to them. They’re like, all of a sudden, that’s right, what can I buy? With that, all of my problems could be solved for life. There’s a tendency right. There can be even among really sophisticated founders, there can be a tendency to want to be a little bit less aggressive and be very protective of what you think is the offer on the table. And even when it comes to hiring a bank, sometimes we hear a little, help me understand this. Will this sort of alienate the party that’s here today, what might we lose the offer? And so I think your advice is really important, which is that sophisticated buyers, by the way, we’ve seen more often than not, a sophisticated buyer tends to be actually happy with the idea that there are other professionals involved in the transaction who are in sort of the transaction business. It makes the likelihood of actually getting a deal done.
Brian Alford: I think it increases the odds to close. Another thing is when you get that offer, you’ve gotten a piece of information that you didn’t have before. And so going back to the example of the CEO who’s probably a strategic saying this is what I think you’re worth, I’m going to pay you this plus 15%. Well, you might be thinking, oh well, that company has some competitors. And I kind of believed that CEO before the conversation that we were worth X, but maybe we’re worth X plus 15% or more. And maybe we don’t know something about that CEO’s company and what business line they’re focusing and targeting on or what other companies they’re looking to buy or what their competitors are looking to buy. We just got a piece of information and we should use this new piece of information to motivate our future decision making. Maybe that means hiring a bank and maybe that means going out to other buyers.
Factors to Keep in Mind When Negotiating a Counter Offer
Gabe Wilcox: Absolutely. The other thing that occurred to me is when you talk about making a counter offer different terms, that to me is another good way to discover information. Because if you look at all the different and I want you to kind of expand on some of the important terms in an M and a deal or in a growth equity type deal. But there are a bunch of them. And headline price is one and it tends to be the one everybody focuses on. But there are a bunch of different terms in one of these agreements that matter and some are also economic in the end and some are not. But negotiating on one of the things we advise negotiating on sort of multiple terms is another way to discover more information about what’s most important to the buyer. Maybe they’re actually not super sensitive on price compared to what they want as an employment agreement with you. Or maybe they’re willing to offer more cash upfront or they’re pretty stuck on the cash amount, but they’re willing to offer more stock.
And so it is another process of discovery and if you don’t, if you don’t negotiate it, you kind of don’t learn. But what are some of those kinds of factors that a founder should be thinking about?
Brian Alford: Well, I think if there’s ever an earnout, then shifting what’s that initial closing versus what is that earn out is huge. And figuring out how you can shift and that itself, to your point will make you learn a ton about the buyer. But whenever you deal with earn outs. You also have to realize that once you get bought, the ability to achieve that earnout is largely outside your control. And it could be because the executive that championed the deal leaves the company after you get bought. And all the I’m not going to say promises,but all of their expectations that they set for you may be different after the acquisition.
Normally you get some sort of protection for termination without cause. You get some credit for hitting an earn out if you get terminated without cause for example. But there’s a thousand other things that could happen after the deal that impact your ability to hit the earn out and most of them are going to be outside of your control. So that’s one thing to just kind of keep in mind as an economic point that few people seem to really focus on, that your earn out should be discounted heavily. Even if you’re very confident that you’re going to blow away the earnout projections, you need to discount that cash pretty significantly and the buyers discounting it, you’re discounting it. Both parties are putting some sort of discount on that.
There’s the escrow, that’s the big probably second most important term, and a non earn out deal, which is is it 10% of the deal? Is it 15% of the deal put into a separate escrow account for twelve to 18 months. Usually that says buyer, I’m thinking I’m buying your company as you’ve told me it is. But to the extent something hits the fan after closing or I discover something that was in place before closing that I didn’t fully appreciate, or maybe you didn’t disclose, or I claim you didn’t disclose, then I want to potentially claw back some of those acquisition proceeds via that earn out fund. So you may think you’re selling your company for X, but 10% to 15% of that number may be subject to potential clawback from the buyer because of what’s called indemnification claims. The buyer wants indemnification ideally from all risk related to the business, relating to some kind of pre-closing period. But the buyer will draft the representation so broadly that they try to cover themselves from basically any risk that might occur over that twelve to 18 month period following closing to effectively just reduce your purchase price, reduce how much purchase price you get.
So that’s probably the majority of what the lawyers spend their time negotiating after the term sheet stage is just how do we make sure you get your money? You keep your money and anything that’s in earn out is smaller and you get it as quickly as possible. And as you know, the time value of money is important. So the more money you get upfront, the better and then the quicker you can get that remaining proceeds and the lower risk that is to purchase or claw back, the better.
There’s some terms that are kind of off the wall that you see in tech deals, which I think are a semi red flag for buyers like reverse vesting, founder stock. I’ve seen that pop up. I would be a little insulted as a founder if I saw a buyer say in most deals the founder stock, that’s unvested, is accelerated. So if you’re only vested in 70% of your stock, in most deals, you tell your investors and the board, hey, I’mnot doing a deal unless I get fully accelerated. And if the buyer wants to give me more to keep me incentivized, to keep working for the buyer, they can give me more equity in the buyer as an employee, just like a new hire that you’d give stock options to and that can keep me further incentivized. Or maybe there’s an earn out that keeps me incentivized, keeps me working for the buyer. But to A, not accelerate your vesting, that’s a tad aggressive by the buyer, but B, actually reversevest you and say, no, you’re not 70% vested, we’re going to bring you down to 40% vested. So we really put kind of, I don’t know if you’d call that golden handcuffs or what, but like spiky golden handcuffs.
But yeah, I’ve seen those in deals and so some of those off the wall economic terms, really important to talk to your banker, talk to your lawyer and say, is this standard, is this not? And push hard against your board too, because your investors don’t really care if you get reverse vested in the deal as long as they get paid. That’s what they care about. So just fight hard. Make sure you’re understanding what the market is.
There’s other big terms I’m trying to think of, like noncompete. You’re going to be likely bound by a noncompete that might stretch three years after the acquisition. So when you’re with the buyer and you realize that you have to stick around with the buyer for like two years and you’re working on a new idea, try to make it a noncompetitive idea.
Advice on Earn Out
Gabe Wilcox: Maybe we should come back to the reps and warranties it’s in the weeds. But then when you haven’t sort of been through the sale process before, but then after you’ve done the sale process, you realize, as you said, it’s a huge part of what you’re working through.
First though, I wanted on the earn out, we talked to, I think, good advice on an earnout. I would feel personally, I would feel similarly, which is that when you are kind of running your startup, you own a lot of risk, but you have a lot of control relatively about your outcome. And in a sale of the company for me, I would really only want to be sort of going one way with my risk. My idea would be selling risk taking some risk off the table. And so an earn out, unless it’s sort of icing on the cake. If you get your number and you’re happy with your number in cash up front and then there’s also an earn out, right, then you say, well, sure, give me the earn out. That’s just extra if it works. But if it’s not if it’s sort of something that you consider part of the price that you’re looking to get for the company, I don’t like that trade.
But I would agree with you, because now you have continued risk, but you’ve really limited your ability to control that outcome. And whether you can actually hit it or not, So I’m with you on that.
Brian Alford: And it’s a way for the buyer to hit a number that’s acceptable for the seller and take a percentage of that number and have almost no risk on that percentage to be like, hey, I’ll pay it to you. But you have to prove to me that this percentage of the acquisition value is worth it. So it’s like complete risk shifting of that portion of the purchase price from buyer to seller.
Gabe Wilcox: We talk to entrepreneurs all the time who don’t fully understand sort of the different components of deal compensation, I’ll say, which is that cash at close got it simple, easy to understand stock at close. Also, most people have an idea about it, although there’s some nuance for sure.
Brian Alford: Private company stock, you better I don’t know. So I’ve definitely seen deals where the private company stock is represented to be way more valuable than whatever their last round was, because it occurred maybe a year or two years after the last round. And just like the earn out, and maybe even more so than the earn out, you got to apply a huge discount to the value of that private company stock. They just did a preferred stock deal, fair enough. But then you have to dig into the liquidation preferences of all of their preferred stock and the economics of their preferred stock. Just to confirm they don’t have some highly preferential economic terms for their preferred stockholders, which could, if your preferred stock value is at $10 and they’re giving you common stock and saying, hey, this is $10, well, you got to apply a fairly hefty discount to internally establish a more appropriate market value of that common stock that you’re getting. So that’s like point number one.
Point number two is how long has it been since they’ve done a preferred stock deal? Has the value actually gone up or gone down? This is private company stock. Public company stock is much more straightforward, a lot easier to understand.
Preferred vs. Common Company Stock
Gabe Wilcox: So your point is, private company stock, what’s it worth? You can’t sort of go to Yahoo Finance and see what the market is valuing a share at. And more to the point, all shares aren’t created equal.
What is the negotiation there? You’re representing the company. Can the company be the buyer, that is, if they want to offer stock as part of the deal, are they free to represent whatever value they want on that stock? Do they need to go by a recent valuation and financing or something else? And then you mentioned kind of liquidation preference and other things like that. So you might have to look at what share class you’re in, and then what do you want? I think I know the answer to this,because I think it’s what you got me. But if you’re a founder, what do you want to hear about the stock that you’re getting?
Brian Alford: So I think maybe it’s possible to get preferred stock as a founder, maybe. But it’s likely that the buyers, investors are not going to be keen on the founders getting preferred stock. But if the buyer just raised the Series C round and at a specific price per share, and then they’re giving you that exact same Series C preferred stock at the exact same price per share, that’s fairly straightforward. You have to think about whether or not SoftBank was the Series C investor and whether or not that was an appropriate valuation.
Gabe Wilcox: So the price tag matters, right? Because you’re effective, you’re buying,you’re taking that price. So you do have to think, do I like the company at that price, or was this a crazy kind of number?
Brian Alford: But if it’s common stock, normally the buyer is going to be trying to treat the common stock as the same value as their preferred stock might be valued at. And so as a seller, you have to apply some sort of discount. There must be a discount, because preferred stock has favorable rights and preferences to common stocks. There must be some discount. It may not be that large. Maybe everyone can get on board with the buyer being such an amazing company that’s so likely to hit a home run that the discount isn’t that huge. But as a lawyer representing the seller, I would always try to argue to add a little bit more discount. You’re not running the buyer. You’re not on the board of directors of the buyer you don’t know. And then there’s always a little bit of a tension between there’s the preferred stock price, there’s maybe what you might apply as a market discount for the common stock.
And then there’s the four and nine, a common stock price. And so the legal documents may not be able to establish an exact price per share for the common stock, because that might make it harder. So 409 A is a tax value. I’m talking to Gabe, so I’m just assuming that Gabe understands everything I’m talking about. So the 409 A is a tax value of your common stock for the purposes of granting stock options. And you get financial advisors to third party financial advisors to say, if you were to sell your company. And look at competitive and look at all these different financial metrics, we think the common stock price is really here, and that allows you to grant stock options to people, and the options are more valuable the lower the exercise price is. If you can get a third party to say your common stock is worth this, then you can grant stock options to people at a lower exercise price and they’ll be happier.
Gabe Wilcox: What it is, your goal is to put a low number on it.You want to sort of look at all the ways that you might argue that the shares should be worth less. Liquid. And there’s a lot of risk in the business. That’s the game there. But right, so you’re saying then it might be problematic to have a deal document that says, well, but after the higher price, they’re worth a lot more.
Brian Alford: And Carta is a typical valuation firm. You might ask them how that impacts what the future for a 409 A price might be. They might be able to say, oh, it’s a one off transaction. We can still apply all this typical industry accepted analysis to determine a lower 409 A price. But that’s something to think about. I wouldn’t get too bogged down into what the legal documents need to say.
But more, what is the true discount between the preferred stock price and the common stock price? And to decide or determine what that discount is, you need to also understand what the terms of those preferred stock shares are. And the most basic term of a preferred stock share is in an exit, the preferred stockholders need to get at least 1X back. And so if you have a not great exit of the buyer, and all of the investors who hold preferred stock get at least 1X back, then that means a portion of the proceeds may be taken from the common stockholders and basically shifted over to the preferred stockholders. And so the common stock might be getting a lower price per share and the exit than the preferred stock price per share.
There are way more aggressive ones, like sometimes it’s 2X instead of 1X. Sometimes the preferred stock gets one X back first, and then they get their share of the remaining proceeds. So in every exit, the preferred stock may get a higher price per share.
So knowing those economic terms of the preferred stock can help you establish a more appropriate value of the common stock. And it’s incredibly complicated, hard to determine. I guess a banker might be in the best position to actually determine what that common stock might be worth because the lawyers can kind of help you, give you some guidelines. But we’re not financial advisors, right.
Should You Take Stock in a Deal
Gabe Wilcox: So you can explain the mechanism. Right here are sort of the rules, but then the banker no we certainly help the client look at that. The other thing that’s interesting about there are some gotchas with taking stock in the deal.
There are also some really good things about taking stock in an acquisition, I’ll say that. And that’s something that wasn’t fully apparent to me until I sold my SaaS business and had stock as a portion of that compensation. That turned out to be great, turned out tobe a home run return on that stock. And it was because we did pay attention to a bunch of the things you mentioned. What’s the price we’re getting in at? What are our rights compared to the financial sponsor and all that kind of thing? And so that’s important for it to work out well. But one of the things that we nowI share that experience with some of our clients today and it’s an interesting dynamic.
There’s a logic to taking a stock component of an acquisition deal that’s almost similar to why you would go raise growth equity, which is that you get the chance for two bites at the apple. And probably if it’s a strategic acquisition, it’s likely to be a company that’s the buyer is probably relevant to your company, right? That is almost to state the obvious. So it’s probably an industry pretty well. You’re kind of an insider. You have a view on probably you have a view on that acquirer and so you should think of it like an investment decision of any other kind.
But it can really be a way, again, I think to continue to bet on, to a certain extent bet on your company, because maybe your company is going to continue to perform really, really well after the acquisition and make that acquirer stock more valuable. But you can also bet on an acquirer, and it can be a way to sort of use the knowledge you’ve gained building a company in a specific industry to say, you know what? I’m going to take a lot. Of chips off the table today. But I’m very comfortable with taking stock as part of the deal because it’s a way to participate in the continued upside of this business.
Brian Alford: Yeah, I think that’s right. And that brings up to me at least an argument that you should try to get preferred stock in the deal. I think it’s unlikely that you will get preferred stock in a deal.
But to say, hey, if my company is worth X and I’m basically taking a portion of it and reinvesting it back into buyer, what’s the difference between what you’re proposing and you just paying me all cash, and then I just take some of that cash and put it back into your company? I was an investor of cash into your company, you’d give me preferred stock. So that’s at least an argument, right?
Gabe Wilcox: And this was now a few years ago, I think the structure was that perhaps everything was in common at the company, but we ended up paripasu with the backer and we ended up at a valuation that was also the same as what the most recent sponsor had done and said those were important, very important components to it working out well for us. And I would agree.
Look, if you’re effective, you’re saying my price for the company is $100 million. To the extent that you’re giving me some of that in stock, I’m basically an equity back investor. I’m an investor in the company now.
Brian Alford: Your deal was more of private equity backed. A lot of my examples are if the buyer is venture capital backed, and there’s preferred stock and common stock and maybe multiple tiers of preferred stock and then common stock.
If you’re getting bought by a private equity buyer too, that goes back to your point even stronger. Because almost always, if you’re bought by a private equity buyer, you want multiple bites at that apple. The private equity buyer is going to say, here, take 70% of the chips off the table, roll 30% over. So basically take 30% of your acquisition proceeds and roll it into stock in the surviving entity. And then we’re just going to sell this company again in three or four or five years and you may be able to get a much higher multiple on that same equity. And we’re also going to lever it up with a bunch of debt. So it will be high risk, high return equity.
Gabe Wilcox: And again, it goes back to evaluating it as an investment decision. You should look at the firm and try to understand their track record. But there are some very good private equity firms and they tend to be in the sort of 3X business. And so to the extent that there are scenarios where rolling some of that capital forward in stock is a pretty good bet for the founder.
Brian Alford: Can I just on that rollover real quick that both a secondary and venture capital deal as well as a rollover and a PE deal are a mechanism by many sophisticated investors to incentivize the founders to swing for the fences. Because they’ve de-risked themselves. Hopefully they’ve taken what is maybe 90 or more percent of their wealth and now can diversify it into other asset classes. And now the smaller piece of their wealth, they can now be much more risky with it.
Gabe Wilcox: Yeah, that’s a really good one. I was on the growth equity investment side of things earlier in my career and that’s a logic to kind of growth equity type minority investments that I think makes a ton of sense. It can be very hard to swing for the fences.
I would say that it’s really easy for founders to become too conservative with the way they run the business when they have 98% of their personal net worth tied up in the company. You take a lot of risk to start it and grow it. But to really keep the appropriate level of risk on can become harder and harder when you build something of value and you’re diversified out of it.
Brian Alford: Exactly.
Types of Compensation For a Deal
Gabe Wilcox: To go back to earn out quickly, we talked to a lot of people who don’t fully understand sort of the different types and timing and guaranteed versus non guaranteed, like just the different types of compensation for a deal. So maybe we can go through that. I’m sure you’ve seen it all.
The Escrow point was a good one because that’s sort of cash up front. That’s not really quite cash upfront. It’s cash a little bit later because there’s Escrow. But the difference, for example, between earnouts and just delayed payments. Do you see that in some of the acquisitions you work on, where there are payments that are guaranteed but delayed in some way?
Brian Alford: So let’s take the simplest deal would be all cash. Let’s say 85% to 90% of it at closing, initial closing, 10 to 15% of it in an Escrow that pays out twelve to 18 months later. And so the twelve to 18 month period is sort of the buyer being like, well, I hope I uncover all of the BS relating to this target company within that 12 to 18 month period. And at least I can address 95% of my risk by trying to flesh out all the issues during that twelve to 18 month period. So that’s sort of the basic, maybe simplest deal for selling your company.
Then you’ve got an earn out. And I guess I’ll avoid the topic of how does an Escrow relate to an earn out? Because if a buyer is asking for an Escrow and an earnout, then you can be like, hey, what are you doing? You’re already protecting your risk. If there’s an indemnification claim, if there’s an issue that you uncovered, just take it from the earn out. Like, you don’t need an Escrow and an earn out, or you can use the earn out to argue for a lower Escrow. So let’s just not get into those weeds yet.
The earn out is basically, let’s take a percentage of the acquisition and say a year later, two years later, three years later. I don’t have the deal data in front of me, but I’mpretty sure most earn outs are like a two year time period. If you have an earn out that’s beyond two years, I think that’s relatively uncommon. So I think most earn outs are kind of one to two years, and often it’s revenue targets. We see EBITDA targets. Sometimes we’ve seen founders sticking around milestones, sometimes we’ve seen tech integration milestones. So there’s milestones and there’s earnouts, but they’re kind of similar. You have to hit certain expectations to get certain payments.
Earn out usually can be different in that sometimes there’s no cap on the upside and that’s pretty interesting for sellers. You can continue to get acquisition proceeds to the extent your EBITDA keeps going up. And I think that’s usually EBITDA based because a buyer is going to be way more comfortable with an uncapped earn out if it’s profitable. If it’s just like revenue based or some other milestone, they probably are going to want to cap that earn out. But the high level point is that you’ve got some percentage of your purchase price that you have to earn through either milestones or financial metrics post closing. And it could be users if revenue and EBITDA is not as relevant. It could be based on user growth or maybe contracts. It could be based on monthly recurring revenue, annual recurring revenue. Think of every financial metric you can think of and that can play a part in an earnout.
Gabe Wilcox: Or non financial or there’s the sort of just show up, you got to show up, you’ve got to not get fired for cause. There’s that one too, right? Just kind of tenure based.
Brian Alford: And that’s kind of similar to my reverse vesting topic of just the founders having to stick around is basically like reverse vesting to say the acquisition proceeds that go to everyone are contingent upon the founders sticking around. And that’s a good way to get your investors aligned with you on pushing back on that term to say as founders we may agree to part of this, but we want everybody on the hook for it.
Those are the kind of the big deal buckets. One point that you mentioned was reps and warranties that kind of impact the Escrow, for example. And just so we don’t forget about it, for tech companies, there’s a concept of kind of standard representations and fundamental representations.
The standard representations are like all of the normal operations of the business and those usually survive for twelve to 18 months following the closing. And so when you make a representation about your business, it’s like we have these top customer contracts and we’re not aware of anything in writing that might jeopardize these customer contracts or something like that. That may be a representation that you might make that would be in the general representations bucket.
A fundamental representation might be we own the company, these are the people who own the company. And the buyer is like you cannot ever breach those fundamental representations. There’s no excuse for ever breaching those fundamental representations and those might survive for five years or six years after the closing. So that if we discover four years down the road that there was a 5% owner of the company that you didn’t disclose to us, we can actually even though we’ve released all the escrow money, we can still go and sue you for some of the money back because there’s an owner of the company that we didn’t realize. And so we’re going to take 5% of what we paid you and give it to this guy. And also we’re going to tell you, you got to cover our legal fees. So that’s fundamental versus your regular representations.
Your regular representations, hopefully after twelve to 18 months, you don’t have to worry about any breaches of those.
Gabe Wilcox: Right. Because that is survival. It means it’s sort of timed out. Like, if you have twelve months to make a claim for 18 months, and after that, that’s it, we’re done.Versus the longer period for something fundamental. Taxes tend to be like that, right?
Brian Alford: If you owe taxes are fundamental usually. What the buyers in tech deals try to do if they try to take intellectual property and move it from regular, which is where it is in most deals, and move it to fundamental or somewhere in between. And that can be an issue because the big one that gets negotiated in tech deals is like, okay, well, we’ve never had a patent troll, we’ve never had a patent infringement claim. But once we get bought by you “mega company”, and we’re blasted all over the internet as this deal closes and a patent troll pops up, that’s not our fault. That’s because you big buyer bought us.
Now, it kind of goes against my argument, because hopefully you’d imagine that would fall within the twelve to 18 month period post closing. But the point being that sticking IP into a fundamental rep that lasts for five or six years post closing can be a very material risk for the company.
So thinking about those survival periods is very important. And in tech deals, there’s different market terms and different things. People negotiate, and it’s good to get lawyers that are used to negotiating those things.
Current Market Insights
Gabe Wilcox: Let’s talk a little bit of current market commentary? 2022 was an interesting year. Tell me a little bit of some of the dynamics you’ve seen.
What’s different, if anything, from a year or two ago, and what are you expecting for next year if you want to predict?
Brian Alford: In the current market, I think valuations are lower, multiples are lower. In general, you’ve got public company valuations and then private company valuations. Track those or correlate to those to some extent, and those are usually private company exit valuations, not private company Series A valuation. So when you get to a Series A deal, especially if Series A valuations correlate lesswith how much revenue you have. And in large part, we’re talking about software companies here.
In an exit, it’s oftentimes a revenue multiple, and it’s oftentimes correlated to your public company competitors. If the public company valuations come down, the private company valuations come down as well. But if you were to compare that to Series A, there may be kind of an informal revenue multiple going on at Series A, but usually not. Usually Series A valuations fall in a certain valuation range and they’re not closely tied to revenue multiples. As you get to Series B and Series C, they start to become more correlated with revenue multiples. So because public company valuations have come down, all valuations have come down.
And I see a lot of companies trying to extend runway to hit a point where valuations come back. That’s probably the most common recurring theme is let’s extend runway. A lot of companies have paused hiring or reduced headcount to extend runway, and a huge part of that is risk reduction. But also, let’s get to a point where valuations are at a place where we’re happy because valuations are not super great right now, even though there’s tons of money out there trying to get into these lower valuations, trying to poach these lower valuations. So it’s a struggle between people trying to take advantage of the lower valuations and companies trying to not have to take a deal at a valuation they don’t want to take.
Gabe Wilcox: So why transact in a market like this? Because people do. What is the appeal we’re off the last couple of years, maybe crazy numbers, but not far off historical trend lines and so there are still fair deals to do? Is it maybe a growth equity type deal becomes a little more popular where you get a little bit now but maintain some upside for later when maybe things are frothier again?
What do you see driving deals getting done? And what do you see to the extent that deals are still getting done, where it’s disconnected from the public market a little bit? Why is that? Are there companies that are super strategic or the growth rate can be higher? Or are there reasons that people are still paying out?
Brian Alford: Well, I think a lot of it, even if a company is really hot and shouldn’t have any discount to their valuation a year ago because they’re just killing it, it has a lot to do with leverage, and investors and buyers still know that they’ve got more leverage than they did a year ago. So those hot companies still want to raise money and still want to grow.
I think that a lot of companies don’t want to really hit the pause button. So the really great companies still want to keep growing, still want to raise money, they want to have a good plan in place in case the market keeps turning down or in case their performance doesn’t meet expectations.
I think there are a lot of companies that have very enthusiastic existing investors and they might be inclined to do something like a bridge round where it’s maybe a discount to the next valuation as opposed to evaluation today. So I think a lot of companies are pursuing transactions like that, where they’re like, hey, if you get your money and now we’ll give you a good discount, and you’ll be protected, because if the next round isn’t great, you’ll still get that discount, or at least you’ll still get the highest you’ll go is at least that next round. And if things go really well, you have your discount to give you your value for investing early. So it’d be a convertible note or a safe that converts into the next round. And often it’s largely insider rounds for companies that are still very exciting, and it balances the concern of the existing stockholders to not take money at too low of a valuation with the interests of everyone to keep putting more money into the company and the investors to make sure that they still get a good return. So I’d say that’s fairly popular, and that’s one of the reasons why people want to raise money.
Other companies are saying six months, nine months is okay to kind of put the pause button on. And we don’t want to raise more money. We just want to extend our runway. So companies that it makes sense to them to press pause for six to nine months, that’s the route they’re going.
I think there’s always going to be companies that are super hot where the valuation isn’t going to be as correlated to public markets or anything. It’s purely a function of so many investors wanting to put money into their company.
Optimal Counsel's Optimal Client
Gabe Wilcox: Well, how about we wrap up with a quick sales pitch from you for Optimal, or at least let folks who are listening to what’s sort of the right type of client for you, when can you help? When should somebody get in touch with you?
Brian Alford: Certainly if you’re a high growth company, definitely reach out. Either you’re a high growth startup just forming, or you’re a company that’s looking at your first financing or you’re a company that has been jaded by big law and their slow response times and failure to prioritize you because you’re not worth $500 million yet. We’re a great fit for any of those companies as well as any company that’s exciting anywhere from probably $5 million to $500 million.
We kind of overlap really well with the companies that you’re working with in terms of exits. And if we’re not the right fit, I’ll try to help you find the right fit. And if you hit a billion dollar valuation at some point in your company’s life and you transition to big law, I’m okay with that. And maybe we can still help you buy other companies because we have a lot of larger companies, we will help them acquire other companies that are more in our deal size range.
You can learn more at www.optimalcounsel.com. You can also email me at brian@optimalcounsel.com. And you should find my LinkedIn and my bio.
Gabe Wilcox: Very good, Brian. Thank you for the time. Educational, entertaining as always.
Brian Alford: Thank you. It was really fun.
