The Importance of Obtaining Professional Advice in the Formation of a Business
This is a true story. The names have been changed for purposes of confidentiality.
I debated with myself about whether or not to write a newsletter piece on this transaction. However, the matter was of such a nature, and the consequences so dramatic, that the story needed to be shared. What was at stake was this: Either the principal shareholders started over from scratch, with years of toil and sacrifice being for nothing, or they would never have to work again. The transaction lasted longer than normal; for a period of 5 months, with hope and despair going from one extreme to another, like a roller coaster ride. Only a few hours before a closing deadline, did we really know how it would turn out.
Because I write this case study in SGR’s Israel newsletter, the natural assumption is that I am writing about an Israeli M&A exit transaction. That would generally be correct. The key principals were indeed very smart, very talented Israelis in their technical and creative abilities, who had opened a company in the U.S., which in this story I will call “KinneretTech.” However, this story could apply globally.
Our case study starts in the usual way, with a group of talented individuals forming a Delaware corporation to develop and market very innovative technology. They all knew and liked each other, decided that documents downloaded from the Internet would attend to the corporate formalities and there was no need to obtain professional advice in forming the company. Laboring tirelessly, the technology was developed and perfected. But without sufficient sales to generate cash, they did not have funds to pay their employees adequately. Thus, employment offer letters were issued offering the employees a percentage interest in the company once a stock option plan was developed. In other cases, oral statements were made about awarding a percentage interest in the company.
Increasingly desperate for cash, they sought contractual relationships with customers which would involve prepayments of a portion of the purchase price for their products. What mattered was getting cash in the door, and if the contact contained cash, little of the rest of the contract was critically evaluated. Once again KinneretTech did not seek professional advice on negotiating or entering into these contracts. This, in particular, was the case with a contract signed with a major global technology company, who in this story we will call “Goliath.”
A mutual acquaintance learned about KinneretTech and realizing they needed professional counsel, was kind enough to refer them to me. I was contacted in the mid-summer of 2016 after the CEO had made contact with another global company who was interested in KinneretTech’s technology. I will call them “BuyerGlobal.” If BuyerGlobal acquired KinneretTech, it would be very complimentary with BuyerGlobal’s own strategic plans and would provide them with a competitive advantage to acquire KinneretTech as opposed to developing the technology from the start. BuyerGlobal was prepared to pay; and pay handsomely for KinneretTech, although for a company the size of BuyerGlobal, this would be a small acquisition. They wanted a deal done quickly, and with no complications.
Salvation appeared to be at hand! Rather than wondering how they would meet the next payroll and office rent, the principal shareholders of KinneretTech might never have to work the rest of their lives. A letter of intent was negotiated on an expeditious basis and signed. Hopes were high.
And then the due diligence started.
We found that the actual existence of KinneretTech was not at all clear. The typical formation documents to select officers, approve the issuance of stock and attend to the customary formation formalities, were, as usual, styled “Unanimous Written Consent.” Except that they were not unanimously signed. Only the purported Secretary signed them. The bylaws they used were copied from an Internet source and were actually the bylaws for a publicly traded company formed in California (KinneretTech being a privately-held company formed in Delaware). “No big deal,” you ask? Not quite. In fact, not even close. Buyers in M&A transactions demand a comprehensive suite of representations and warranties. While they can vary a bit from one deal to the next, you can be assured that in any such document, the buyer wants a representation and warranty that that stock has been duly and validly issued, what the capital structure is, that the contracts the target has with third parties are valid; just to name a few. With the formation documents as they were, there could be no assurance that the stock had in fact been validly issued, that the officers were really officers, that there was a duly constituted board of directors, or that any of the contracts KinneretTech had were actually valid. But wait: Just get everyone to sign and verify everything. Is that not the easy thing to do? It would be, except all those fellows who used to like each other when KinneretTech was formed, were not so friendly any longer. There was a falling out and some had been fired from KinneretTech. One had even sued KinneretTech.
Remember those offer letters? They spoke to providing employees a percentage (specified for each employee) of KinneretTech’s capital subject to a stock option agreement being in place. But the offer letters did not say a percentage of what. Was it a percentage based on the issued shares at the time the offer letter was signed? Was it a percentage of authorized shares? Was it a percentage when the option plan was put in place? Would the percentage be guaranteed as additional shares were issued? Was it a percentage on an actual or fully diluted basis? What was the option exercise price? There was no way to tell. And to make it worse, no option plan had ever been put in place. One could say: well, then those employees were not entitled to anything. Really? The employees (some now former employees) certainly thought so, and if we closed a deal with many tens of millions of dollars being paid for KinneretTech, would any reasonable person expect them to just walk away? Hardly. And just how was KinneretTech supposed to give any accurate representation and warranty on the capital structure, and deal with the almost assured litigation that would ensue from those employees post-closing? In the States, such a case would be ideal for plaintiffs’ lawyers who work on a success-fee basis, with a real possibility of class action litigation. BuyerGlobal wanted a quick deal with no complications. This was not looking pretty.
Not looking pretty then turned into outright ugly. A diligence review of the contract which KinneretTech signed with Goliath revealed that (a) KinneretTech had granted very broad rights in its intellectual property to Goliath, (b) Goliath was not obligated to buy anything from KinneretTech, and (c) in certain key areas, Goliath and BuyerGlobal would be competitors in the marketplace. BuyerGlobal insisted that KinneretTech amend the contract with Goliath. But Goliath had no need to amend. It liked having broad IP rights and no obligation to make any purchases.
The transaction was now looking very questionable. BuyerGlobal was willing to pay a substantial amount of money for KinneretTech if the deal could be done cleanly. If not, they would walk away. Them walking away was looking very possible, and there was no “Plan B” to keep KinneretTech running for the longer term.
There were other serious problems we found in diligence, but due to space limitations in this newsletter, I won’t elaborate on them. The challenge we faced was that there were multiple and interlocking serious problems at KinneretTech. Courses of action that would tend to remedy one problem, triggered issues in other areas. And convincing BuyerGlobal that KinneretTech would remedy these problems, without cost or stress on them, was absolutely essential. So very creative strategies had to be developed and executed with great care. Even then, the amendment of the contract with Goliath was only obtained a few hours before the closing deadline. And, to the enormous relief of all concerned we closed.
I share this story as a cautionary tale. This story was a millimeter away from a very different ending. Regardless of which professional advisors a company wishes to use, the important thing, the critically important thing, is that professional advice must be obtained in running a business. One cannot assume that all will simply work out, that everything can be fixed, or that people will necessarily cooperate. The goal of almost every technology entrepreneur and their backers is to bring the technology to a point where a large company is willing to become an acquirer. But large companies have many opportunities for acquisitions, and often will do many each year. In general, they want them done expeditiously and cleanly. A potential target that due diligence reveals is a mess may simply be passed over in favor of another and easier acquisition opportunity.
Be sure that being passed-over is a story you tell once a year with your family about a great historical event and not a story about your company.
This client alert is intended to inform clients and other interested parties about legal matters of current interest and is not intended as legal advice. If you have any questions about these issues, please contact one of the above lawyers in the U.S.-Israel Practice Group at Smith, Gambrell & Russell, LLP.