Monday, November 12, 2007

Selling the Startup: The "No-Shop" Clause

As in an equity financing, a term sheet for the acquisition of your startup will contain a "no-shop" clause that restricts you from seeking other purchasers for the business, or other avenues of liquidity, for an extended period of time. Many entrepreneurs spend little time debating the terms, taking an "in for a penny, in for a pound" approach to the no-shop clause. After all, they reason, once they've started towards closing and their customers begin to catch wind of the deal, it will be very hard to change horses.

I appreciate the logic, but the reality is, once the term sheet is signed, the power shifts away from the startup to the purchaser. The typical term sheet will give the purchaser the discretion to step away from the deal if due diligence is unsatisfactory, or if the necessary internal approvals are not obtained. We can often narrow this discretion quite substantially for our clients, but our ability to do so in part depends on how deal-hungry you, the entrepreneur, are. For example, if you sign a term sheet early in discussions with a potential purchaser, it's harder to pare back.

Here are my notes from the front on no-shop clauses:

1. There is no "standard" no-shop for an acquisition. The length of the no-shop period, the seller's obligations during that period, and the penalty for breaching the clause vary widely. You can, and should, have a reasoned debate about each aspect.

2. No-shop clauses are rarely mutual, but maybe they should be. The most common drivers of an acquisition of a high tech startup are: (a) consolidation of a maturing market, (b) the purchaser's desire to expand into new verticals, and (c) the purchaser's desire to shift from selling one or more point solutions to a single platform offering. These drivers favour multiple acquisition strategies. Why should a purchaser be allowed to pursue alternate acquisitions of competing or overlapping technology while you are shut out of the market?

3. The larger the purchaser, the more likely it is that the deal will take more than a year to complete.
Depending on where your products (and your industry) are in the technology life cycle, a non compete that could keep you out of the market for that long may be unacceptable.

4. Go-Shop Clauses: Some purchasers try to alleviate your concerns about (1) - (3) above by adding a "go-shop" clause, which allows your startup to continue to look for a more favourable price for a limited period of time after the term sheet is signed. This notion was concocted by public company boards as a means of satisfying their fiduciary obligations to shareholders. A number of rulings criticizing these provisions have since been made, but go-shop clauses are now making their way into private company financings and acquisition term sheets. "Go-shop" clauses are challenging: typically certain competitors are carved out and other provisions inserted so that they don't allow a startup to try and meaningfully shop around. The best approach, in my view, is to focus on creating a no-shop that allows you and your startup relief if, for example, progress is not made in a short time frame, or if deal terms are altered, and which will ensure that, as a tactical matter, you don't sign the term sheet too soon in the process.

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