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Key Issues for a Venture Capitalist to Consider When Selling a Portfolio Company

Patrick Roundeau and David Westenberg, Hale & Dorr, LLP


Given today's economic environment and capital markets conditions, sales of venture-backed companies are becoming increasingly frequent. This article provides a brief overview of some of the key points a venture capitalist - particularly one serving on the company's board of directors - should keep in mind when considering an acquisition proposal for a portfolio company.[1]

Understand how the aggregate deal consideration is to be allocated among all equity holders of the target company. Acquiring companies often propose an acquisition price without specifying how this will be allocated among the various classes of equityholders of the target company. This allocation is generally determined by a combination of the acquiring company's intent in this regard, the desire of the board and stockholders of the target company, and the terms of the target company's governing documents (such as its charter and its option plan). Among the issues that you should understand and consider are:

Will the deal consideration be allocated strictly in accordance with the liquidation preferences of the outstanding preferred stock set forth in the target company's charter? If either the acquiring company or the target company desires that the allocation vary from that mandated by the charter - such as providing more to the holders of common stock than they would otherwise be entitled - it will generally be necessary to amend the charter or obtain a waiver of rights under it. This raises issues with respect to: The stockholder vote required to approve such an amendment or waiver. Depending on the type of amendment or waiver involved and the terms of the target company's charter, the amendment or waiver may require the consent of only the holders of the affected class or series of stock, the holders of all preferred stock voting as a single class, the holders of all outstanding stock, or a combination of these consents. In addition, the consent required may be a simple majority, or a super-majority (e.g., two-thirds or 75%). The fiduciary duties of the target company's board of directors. Each director of the target company owes a fiduciary duty to all stockholders of the company, and not just the holders of a certain class of stock (even if that director was elected solely by the holders of a particular class of stock). If the board recommends that stockholders approve a charter amendment or waiver that would result in a certain class of stockholders obtaining a smaller portion of the acquisition price than they would otherwise be entitled to under the charter, or if the board approves an acquisition agreement which is contingent upon such an amendment or waiver, the board may be subject to claims by the affected class of stockholders unless it can assert a valid business justification for such amendment or waiver. How do outstanding stock options and restricted stock affect this allocation? For example: In a stock-for-stock merger, the outstanding stock options of the target company generally roll-over into options for stock of the acquiring company. Does the acquisition price proposed by the acquiring company (whether expressed in a number of shares or a dollar value) include the number or value of the acquirer shares that will be subject to these assumed options (thus reducing the shares available to stockholders of the target company), or will any shares subject to assumed options be additive to the number or value of the shares comprising the proposed purchase price? A significant portion of the restricted stock and stock options of the target company will likely be unvested (and thus subject to forfeiture) if the holder's employment with the acquiring company terminates following the closing (even after taking into account any acceleration-of-vesting provisions). In addition, some of the outstanding options may be out-of-the-money at the proposed acquisition price. You should consider whether unvested stock and options and out-of-the-money options should be taken into account in converting the aggregate purchase price to be paid by the acquiring company into the price per share of target company stock. For example, the restricted stock held by target company employees whose employment is likely to be terminated following the closing should generally be excluded when determining the purchase price per share, since all shares of the acquiring company issued in exchange for unvested restricted stock held by terminated employees will be subject to repurchase (often for nominal consideration) by the acquiring company.

Consider whether you would prefer to receive shares of the acquiring company which will be registered on a resale Form S-3 following the closing, or shares which are registered on a Form S-4 prior to the closing. If the acquiring company pays the purchase price for the acquisition in the form of its own common stock, the target company stockholders generally cannot sell the shares received in the acquisition unless those shares are first registered under the Securities Act of 1933. This registration typically occurs in one of two ways:

  • the acquiring company issues unregistered shares to the target company stockholders, but agrees to register them (usually on a resale Form S-3 registration statement) within a short period of time following the closing of the deal; or
  • the acquiring company registers the shares on a Form S-4 registration statement before issuing them to the target company stockholders at the closing.

The former alternative is generally possible only if the number of target company stockholders that do not qualify as "accredited investors" is 35 or less. If this approach is possible, you should consider which alternative your fund (and the other target company stockholders) would prefer. There are advantages and disadvantages to each approach, and the preferred approach is likely to depend upon the facts of the transaction.

The primary advantages of receiving unregistered shares accompanied by resale registration rights are as follows:

The transaction can be closed more quickly, since no pre-closing SEC filings are required. Registering the acquiring company's shares on a Form S-4 prior to closing can delay the closing of the deal by up to a couple of months. The amount of time saved will be greater if the transaction does not involve a Hart-Scott-Rodino filing or other closing conditions that might otherwise result in a significant delay between signing and closing. If your fund is an affiliate of the target company - which will usually be the case if it has a representative on the board - the fund may publicly sell acquiring company shares which have been registered on a Form S-4 only in compliance with the restrictions imposed by Rule 145 under the Securities Act. Among those restrictions is a prohibition on selling, in any three-month period, a number of shares in excess of the greater of (a) 1% of the outstanding acquiring company shares or (b) the average weekly trading volume of the acquiring company shares during the preceding four weeks. [2] These restrictions are not applicable if the fund (or its partners) is selling the shares pursuant to a resale Form S-3 registration statement. [3]

The primary disadvantages of receiving unregistered shares accompanied by resale registration rights - and thus the primary advantages of receiving shares registered on a Form S-4 prior to closing - are as follows:

The former stockholders of the target company cannot sell the acquiring company shares in the public market until the Form S-3 registration statement has been filed with, and declared effective by, the SEC. The Form S-3 can typically be prepared and filed within a couple of days following the closing, and is often declared effective by the SEC within a few business days of filing. However, there are a number of factors that could delay the filing or effectiveness of the Form S-3, including (a) a requirement that the acquiring company file audited financial statements of the target company and pro forma financial statements (although this requirement is only applicable in the case of significant acquisitions) and (b) a decision by the SEC to review and comment on the resale Form S-3 registration statement (although such registration statements are typically not reviewed). The resale registration rights negotiated as part of the acquisition agreement may not require the acquiring company to register all of the shares issued in the acquisition immediately, or may permit the acquiring company to terminate or suspend such registration under certain circumstances. For example, the acquiring company may negotiate to register only 50% of the acquisition shares immediately following the closing, with the other 50% to be registered six months later. Similarly, acquiring companies often negotiate for a right to temporarily suspend sales by the target company stockholders under the Form S-3 if the acquiring company is in possession of material nonpublic information (such as a pending earnings shortfall, or a pending acquisition) that has not yet been publicly disclosed or incorporated into the Form S-3. If the Form S-3 contains a material misstatement or omission, a former target company stockholder that sells shares under the Form S-3 could have liability, under Section 12 of the Securities Act, to the purchaser of those shares. This risk of liability is not applicable to the sale of shares that had been registered on a Form S-4.

If you serve as a director of the target company, understand what your fiduciary duties are and ensure they are properly discharged. The actions of directors in connection with a sale of the target company are often, though not always, subject to enhanced legal scrutiny. The legal standard against which the directors' actions will be judged, and thus their risk of liability, depends upon a number of factors, such as whether the consideration paid consists of cash or stock, and whether any of the directors have affiliations with the acquiring company or are receiving benefits from the transaction that differ from those received by target company stockholders generally. It is important for directors to consult with counsel to understand the standard applicable to a particular transaction and the steps they must take to fulfill their fiduciary duties under that standard. This is particularly true if the target company is publicly held; although these same duties apply to directors of a private company, the scrutiny and thus the risks are generally greater for directors of a public company.

Regardless of the legal standard that applies, the following recommendations for directors are always applicable:

You should disclose to the other members of the board of directors any potential conflicts of interest you or your fund may have with respect to the transaction, such as an investment in or affiliation with the acquiring company. You should consider the advisability of engaging an investment banker. A banker can assist the target company and its board in soliciting other acquisition proposals (or gauging the level of interest from other potential bidders), and in valuing the securities of the acquiring company to be issued in payment of the purchase price. In addition, an investment banker can provide a "fairness opinion" on the transaction, which is especially important when the vote of public company stockholders must be solicited. You should stay informed regarding transaction discussions and provide input on the negotiation of key deal terms. [4]

Be careful about approving a deal which involves commitments from target company stockholders to vote a majority of the outstanding target company shares in favor of the transaction. The fiduciary duties of a target company's board of directors generally require it to take reasonable steps (or ensure it has a reasonable opportunity) to ascertain whether a better value for stockholders of the target company could be obtained from another acquirer before committing to sell the company. This duty is typically discharged in one of two ways:

  • by contacting potential acquirers before signing an acquisition agreement; or
  • by preserving in the acquisition agreement the ability of the target company to accept a superior proposal from another bidder, either by permitting the target company to terminate the agreement or by ensuring that the target company's stockholders have the capability of voting against the first transaction (although the target company is typically required to pay "break-up fees" in those circumstances).

If the acquiring company has obtained voting commitments from stockholders of the target company holding a sufficient number of shares to guarantee stockholder approval of the acquisition (without a right of the target company to terminate the agreement to accept a better offer), the approval of that transaction by the target company's board may be a violation of the board's fiduciary duties, unless the target company has conducted some type of "market check" before signing the acquisition agreement. [5] While, as a practical matter, the risk of approving such a transaction is greater for the board of a public company than a private company, board members should be attentive to this issue even in private company sales.

Consider Section 280G issues. Section 280G of the Internal Revenue Code imposes on senior executives a 20% excise tax (in addition to normal income or capital gains tax) on compensation - including the value of accelerated stock options or restricted stock - paid to them that is contingent upon a change in control of the company if such compensation is in excess of a specified level. In addition, the compensation subject to that excise tax is nondeductible by the company. While the details of these tax provisions are beyond the scope of this article, there may be - depending upon the facts and circumstances involved - ways for the target company to avoid the imposition of these tax provisions. You can help out both the acquiring company (which will assume responsibility for the tax obligations of the target company) and the executives by ensuring that the target company assesses whether the provisions of Section 280G are applicable to the benefits payable to its executives in connection with the acquisition and considers ways to avoid the applicability of those provisions.

Make sure that the acquisition agreement includes certain provisions necessary to protect your interests. [6] The negotiation of the details of the acquisition agreement is generally best left to company management and counsel. However, there are a few provisions that are either sufficiently important to your interests as a stockholder, or affect you individually as a director, that you should ensure are included in the agreement if at all possible. They are as follows:

The indemnification obligations of the target company stockholders to the acquiring company should generally be limited to the portion of the purchase price placed in escrow. The acquiring company should agree to one or more of the following terms regarding indemnification of the persons serving as directors of the target company before the acquisition: An agreement to continue the existing indemnification provisions in the target company's charter or by-laws without modification for a period of several (generally six) years following the closing. An agreement of the acquiring company to honor the indemnification provisions in the target company's charter or by-laws. Such a provision would be important if the acquiring company has significantly greater financial resources than the target company. If the target company has D&O insurance, an agreement to continue the existing D&O insurance in effect for a period of several (generally six) years following the closing (possibly subject to a cap on the premiums the acquiring company would have to continue to pay). This provision is customary in an acquisition of a public company, and is sometimes (though less typically) included in an acquisition of a private company.

Make sure the resale Form S-3 (if one is used) properly handles sales of shares by your fund's partners. As a general rule, a resale Form S-3 registration statement - which is typically used if the acquiring company issues unregistered stock in the acquisition - must name each of the stockholders whose shares are covered by the Form S-3. This raises some disclosure issues if your fund intends to distribute the acquirer shares to its partners (rather than selling the shares itself and distributing the cash proceeds). If the total number of acquirer shares received by your fund in the acquisition is less than 1% of the outstanding acquirer shares, your fund and/or its partners can be listed in the Form S-3 on a group rather than an individual basis - e.g., "Venture Capital Partners I and its general and limited partners." However, if your fund's holdings exceed this amount, the required disclosure becomes more complicated. If your fund distributes its shares prior to the time the Form S-3 is declared effective, the fund partners holding the shares must be named in the Form S-3. If the distribution is made after the effectiveness of the Form S-3, a Prospectus Supplement naming the partners receiving the shares must be prepared, filed with the SEC and distributed to the stockholders selling under the Form S-3 before those partners can sell their shares under the Form S-3. [7] These disclosure requirements are typically not difficult to comply with, but it is important that someone is responsible for ensuring that they are handled properly.


[1] Structuring and negotiating an acquisition of a company clearly involves numerous business, legal, tax and accounting issues. The extent to which a venture capitalist becomes involved in the structuring and negotiation process will vary, based on factors such as your fund's ownership position and your role in the company. This article does not attempt to review all of the important issues in a typical acquisition, but instead raises a number of fundamental points that you should consider even if you are not playing a lead role in this process.

[2] If your fund distributes its shares to its limited partners, these same restrictions would apply to the limited partners, and all sales by the limited partners would have to be aggregated for purposes of determining compliance with these volume limitations.

[3] One means of addressing the volume limitation would be to require the acquiring company to file a resale Form S-3 registration statement following the closing - in addition to the Form S-4 filed before the closing - for the benefit of those holders affected by the volume limitation.

[4] This principle may not be applicable if you or your fund has a conflict of interest with respect to the acquisition.

[5] Whether a court will conclude that approval of such a transaction is a breach of the Board's fiduciary duties is heavily dependent upon the facts and circumstances of the transaction, and Delaware courts have reached different results in some recent cases involving somewhat similar fact patterns. While the law in this area is uncertain and still evolving, there is sufficient risk involved that a director should not approve such a "locked up" deal without at least receiving advice from counsel on this specific issue.

[6] If you are a director of the target company, your fiduciary duties obligate you to act, in your capacity as a director of the company, in the best interests of all stockholders of the company, and not just the interests of your fund. However, those duties do not prevent you from communicating to the company, on behalf of your fund (in its capacity as a stockholder of the company) that there are certain provisions your fund would like included in the transaction in order for it to support the transaction as a stockholder. In addition, seeking to obtain reasonable protection for yourself as a director of the company is not inappropriate, so long as this is not obtained at the expense of any benefits to the stockholders of the company.

[7] A Prospectus Supplement would not be required for any partner receiving less than 500 shares, provided certain required language was included in the Form S-3.

Patrick Rondeau's practice concentrates on public offerings, mergers and acquisitions, venture capital work and general corporate and securities work. He is a 1981 summa cum laude graduate of Williams College and a 1984 cum laude graduate of Harvard Law School. He joined Hale and Dorr in 1984 and has been a senior partner since 1992. Mr. Rondeau is the former co-chair of the Securities Law Committee of the Boston Bar Association, and frequently speaks at seminars on securities law and related topics.

David Westenberg represents technology companies in their formation and initial funding, venture capital investments, merger and acquisition transactions and public offerings. Mr. Westenberg is active in various technology councils and has represented the Massachusetts Telecommunications Council since its formation. He also chairs Hale and Dorr's Internet and E-Commerce Group and co-founded its Telecom and Wireless Group. Mr. Westenberg received a J.D. degree from Harvard Law School and an S.B. degree from the Massachusetts Institute of Technology. He serves as Co-Chair of the Corporate Law Committee of the Boston Bar Association.