Monday, October 29, 2007

Selling the Startup:Who Runs the Process?

In a startup, selling the business tends to be an opportunistic thing, rather than part of a planned corporate strategy. Which means that, the question of who should manage the process of selling the business, is often not addressed until a serious expression of interest has been received from a potential acquiror. What next?

In a public company, the path is set: designate a special committee of the board, composed almost exclusively of independent directors, and hire an advisor to shepherd the process and ultimately render an opinion as to the fairness of the transaction.

In an emerging company, the course is less clear. For one thing, "independent" directors often are not truly independent; many are past investees of VCs brought on because of their industry/channel/technical expertise. They often lack the acquisition experience that would make this an effective delegation of the process.

By default, then, CEOs are often tempted to allow their VCs to spearhead the effort while they focus on operations. After all, they reason, a director owes a general duty to act in the best interests of all shareholders. Right? Not necessarily.

Before we go further, my usual disclaimer: as a general rule, I love VCs. Put a little ketchup on them, and they taste just like chicken. But they don’t necessarily have the skills to act as your quasi-investment banker. This is particularly true outside of Silicon Valley, where most funds have a limited track record of successful exits. Negotiating a financing or a term sheet with a portfolio company is NOT the same thing as negotiating a sale with a large acquiror. For one thing, the leverage is reversed for what VC used to, and some VCs find it hard to be the supplicant.

In addition, many VCs are not hard-wired to negotiate aggressive terms outside of the investing context. VCs are in the business of cultivating deal flow. Deal flow comes from relationships. This does not make them predisposed to be aggressive when you are in discussions with, say, a Cisco or an IBM.

More importantly, your VCs may not owe you any obligation to consider your best interests in shaping an acquisition. Consider your company’s structure; in most VC-backed companies, it is VCs who control the board and the corporation, thanks to a combination of protective provisions and preferred stock rights. As a recent article by two Berkeley law professors points out, this level of control may entitle VCs to do as they please when selling the business, without regard for the common shareholders. The authors point to the Delaware court ruling in Orban V. Field that "when the preferred control the board, directors do not owe a fiduciary duty specifically to the common shareholders and have wide discretion to benefit the preferred shareholders instead."

Don't overlook another tactical issue: time with the acquirer allows management to size up the opportunities available for you post transition, and even shape compensation in a way that allows you to recoup some of the sale proceeds that might otherwise be lost. Don't give that tactical advantage away too quickly.

The solution? For many, the board as a group might oversee the sale, without a special committee. An outside advisor can also be effective, if cash permits (and yes, I know some of you have very jaded views on this). But whatever else, management should not disengage from the frontlines. Time to suit up.

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