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Note on No Shop/No Solicit - The Issuer and the VC

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


The surge of capital into funds styling themselves as venture funds, and the fact that a number of erstwhile venture funds now are closer, in their appetites for deals, to buyout funds (in the sense that they seek to invest larger sums at a time when a probable liquidity event is a good deal closer than an investment in a seed round) means that the VCs are seeking ways to mimic the buyout/M&A protective provisions: "no shop, no solicitation" clauses with teeth in them. There is, however, one quite prominent distinction. The typical venture issuer does not have enough cash, and more important, the typical venture round is not large enough to give much meaning to a 3 percent break-up or topping fee. Three percent of $3 million is only $90,000. If a VC is looking at a fast moving e-commerce company and offering to invest $3 million, a topping fee of $90,000 is not a huge deterrent. Accordingly, break-up and topping fees have not yet become popular in emerging growth finance. The typical provision in a VC term sheet requires the issuer not to solicit alternative offers for a period of, say, 30 to 60 days and then does not say much more than that. This language, incomplete as it is, gives rise to a host of questions that remain to be analyzed and answered.

Assume, hypothetically, an early stage company is looking for $3 million. Assume that VC #1 offers $3 million at a pre-money valuation of $10 million. The term sheet, prepared by counsel for VC #1 and extended to the entrepreneur and his or her company, is explicitly styled as nonbinding except for the confidentiality provision and a laconic "no shop, no solicitation" clause providing effect.

Assume further that there is no overt solicitation during the exclusivity period, but a competing investor appears on the scene and engages the chief financial officer in conversation. The competing investor is not given a placement memorandum, but the issuer had earlier presented at a conference (where in fact it had caught the attention of VC #1, the initial investor) and a placement memorandum was available from that source. The intruder makes an offer at a pre-money valuation of $15 million, subject to due diligence and the expiration of the "drop dead" date, meaning the date in the initial investor's term sheet when exclusivity expires. The chief financial officer listens with enthusiasm, agreeing to discuss the investment if the initial investment does not close by the "drop dead" date.

The initial investor's due diligence proceeds at a pace slower than anticipated, and counsel for the issuer negotiates long and hard, indeed, past the "drop dead" date, on a variety of provisions in the definitive agreement prepared by the initial investor's counsel. VC #1, initial investor, is not aware of the competing bid until after the "drop dead" date has expired. The term sheet does not have language, as indicated above, that "time is of the essence" and there is no parol evidence to the effect that the "drop dead" date was a vital date; indeed, it was picked by the initial investor and his counsel rather than the issuer.

After the "drop dead" date, the issuer's counsel notifies VC #1 counsel that the bid is inadequate and the issuer is going forward with VC #2. Angry and feeling ill-used, the jilted investor sues both the issuer and VC, alleging bad faith. The issuer offers to pay the jilted investor its costs but the offer is refused; the initial investor is looking for some benefit of bargain damages. What is the result? [1] The answer is that no one quite knows at this point. If counsel were to draft a memo of law, the almost certain result of that effort would be a typical "on the one hand, on the other hand" document, suggesting that the outcome of the dispute is likely to depend on state law and will be highly fact specific.

Certain lessons can, however, be distilled from the current state of play. First, a seemingly innocuous "no shop" provision in a term sheet is a binding legal agreement and, if deemed to have been breached, can entail damages. Whether those damages will be significant or simply equate to out-of-pocket costs (roughly speaking, either tort or contract damages) is an open point. Most financial partners do not sue in such circumstances, aware that other attractive deals will not come their way if they are deemed to be litigious soreheads. However, as deals become scarcer vis-à-vis the amount of money available and more pressure is put on the "no shop" provision, then the mood may be different. Second, it is apparent that a good deal more care should be put into drafting the term sheets and tailoring an appropriate remedy for breach of a no-shop provision.

From the VC side there are a number of "fixes." First, if the penalty for breach is simply recovery of costs, the sum being the equivalent of a break-up fee, then the term sheet should say so (as some term sheets do). Alternatively, the "no shop" provision should be considerably expanded. It may provide, as the model form suggests, that the issuer is under a duty to notify VC #1 whenever an unsolicited offer comes in over the transom. It may be that the "no shop" provision can contain such strong and aggressive positions as the following: During the period of negotiations, VC #1 will have the opportunity to have a representative at all board and committee meetings of the issuer called to discuss the instant or a similar transaction.

Further, the measure of damages can be specifically stated, either costs [2] or lost profits. Indeed, it may be that specific performance could be required. In addition, the duty to bargain in good faith should be explicitly addressed. Obviously, given the history of the National Labor Relations Act, for example, it is hard to quantify that duty precisely. However, it may be that if the definitive agreements have not been prepared and executed by the "drop dead" date through no one's fault, then the "drop dead" date is automatically extended.

From the issuer's side, once it is a fait accompli that a term sheet will contain a no-shop provision, the goal is to limit the duration and scope of the provision to the greatest extent possible. The issuer should strive for limiting the period of time afforded to the VC in which to perform legal due diligence and to present a set of definitive agreements as a modicum of protection against a "fishing expedition" by an investor - namely, the possibility that an investor is looking to buy time to conduct its business due diligence before committing itself to the investment opportunity.

In addition, if the definitive documentation deviates significantly from the term sheet, then the issuer should have an "out." Thus, in most instances, it would be in the issuer's interest to have a detailed and comprehensive term sheet when a no-shop is in the picture, in order to minimize the risk of unpleasant surprises in the definitive documentation. Moreover, the issuer wants to limit the damages, of course, to costs, however established, versus an evanescent notion of lost profits or benefit of the bargain. It should be clear that specific performance is not in the cards. From the issuer's point of view, investments at the seed or first venture round stage entail partnership, if the company is to be successful at all. It is unlikely that a partnership will develop between an angry VC #1, compelled to wedge its way in by going to court, and the issuer, which would enable the issuer to spread its wings and fly.

Even if the "no shop" provision entails an explicitly expressed concept of specific performance, that remedy does not appear to be realistic. A forced marriage between two antagonists is not likely to be productive of the kind of relationship that will yield value for all concerned. To be sure, if an equitable remedy (i.e. specific performance) behind the "no shop" provision was enforceable, it would provide a deterrent, constraining any issuer attracted to sharp practices such as going through the motions until the "drop dead" date expires or surreptitiously soliciting alternative offers without leaving a trail. However, it will not solve the problem if a third party, without sub rosa encouragement from the issuer, legitimately appears upon the scene and makes an offer. Moreover, it is difficult to figure out what the damages in the nature of lost profits would be and how they would realistically be assessed. Litigation between the issuer and the VC is unlikely to result, even if it were pursued at warp speed by both parties, in a happy resolution for either side. The issuer could be left in tatters and the plaintiff VC with a judgment it could not collect.

Accordingly, some practitioners suggest that the fairest resolution is to specify the damages for breach of the "no shop" provision as costs and, perhaps, a warrant to purchase X percent of the issuer at a favorable price, the analogy in my mind being that VC #1 is paid as if it were the placement agent securing the existence of VC #2: two percent, for example, of the amount invested or actual costs, whichever is greater, plus a warrant to purchase, say five percent of the issuer at a nominal exercise price. The provision would also make it plain that any uninvited solicitation would have to be made known to VC #1 [and that the "drop dead" date for negotiating with VC #1 would be extended, say, for another thirty days if the due diligence or negotiations are proceeding according to plan]. If at the end of that period, whether through the issuer's obstinacy or not, no definitive agreement is executed, then VC #1 extracts its pound of flesh.

Finally, the agreement can frustrate issuers watching the clock by automatically extending the drop-dead date if, through no one's fault, the definitive agreements have not been prepared and executed by that date.


[1] There is no significant authority precisely on point in the public company context. However, there is some support or the notion that this section of the term sheet is a contract and that, therefore, contractual damages are appropriate. For example, in a case in which a corporation breached a no-shop clause signed as part of a letter of intent agreeing to sell the business, the Eighth Circuit awarded benefit-of-the-bargain damages. American Family Services Corp. v. Michelfelder, 968 F.2d 667 (8th Cir. 1992). There was no mention of a breakup or termination fee in the no-shop agreement in that case.

The Third Circuit also was willing to consider a benefit-of-the-bargain measure of damages as a remedy for a defendant's breach of a no-shop agreement. STV Engineers, Inc. v. Greiner Engineering Inc., 861 F.2d 784 (3d Cir. 1988). However, in that case, the court later found that the plaintiff would not have been able to complete the merger, and limited the plaintiff's damages to reliance damages. Moreover, the court later vacated its decision due to a finding that the defendant had not breached the no-shop agreement.

In light of these precedents, a court probably would award contractual damages. However, much likely would depend on how the court construes murky facts and circumstances in attempting to extrude the parties' intentions. In the venture capital space, the courts will not be considering whether the board has a fiduciary duty to consider all potential bidders. The hypothetical assumes that the board represents all or most of the shareholders and that there is no need for the court to act in loco parentis.

[2] It is recommended to define what those costs include and how they are to be established - for example, out-of-pocket costs may be an appropriate measure.


Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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