Acquihires 101: Tips for Founders

by Scott Edward Walker on December 13th, 2018

We had a busy 2018, including closing several significant M&A transactions and financings.  We have also recently handled a few “acquihires” (or “acqui-hires”) — which is a somewhat unique transaction, with a host of unusual issues.  The purpose of this post is briefly (i) to provide an overview of acquihires and (ii) to discuss the significant legal issues that founders must address.

What is an Acquihire?

An acquihire is essentially the acquisition of a startup for its talent/team, rather than for its products or services.  The acquirer is typically a large successful company, and the target is typically a failing early-stage startup.  The appeal from the acquirer’s perspective is that – in one fell swoop – it acquires a team of engineers.  The appeal from the startup’s perspective is a “soft landing.”

How is the Deal Structured?

The deal is typically structured as an asset purchase (as opposed to a stock purchase or merger) — though the acquirer often does not actually want the startup’s IP and/or other assets.  Accordingly, the deal may be a mere fiction designed to get funds into the startup to be distributed to its investors.  An acquihire “home run” would be a 2x return to its investors; in many cases, however, the investors will end-up losing money because the bulk of the acquirer’s funds will be allocated to the employment packages.  Following the closing of the acquisition, the startup will be dissolved, and all of its assets (including the purchase price proceeds) will be distributed to its investors and stockholders, as discussed below.  (Note: a stock purchase or merger is obviously a cleaner transaction from the startup’s perspective, but few acquirers will agree to that structure — which would require the acquirer to handle the dissolution post-closing and otherwise expose it to far more potential liability.)

What Legal Documents are Utilized?

Acquihires will typically entail the same process and the same documentation as any other acquisition: a letter of intent, a confidentiality agreement, a purchase agreement, etc.  Sometimes, however, an acquirer will try to convince the founders to skip the purchase agreement and only execute a release agreement, permitting the acquirer to hire all of the startup’s founders and key employees and releasing the acquirer from any liability in connection therewith.  As discussed below, this structure exposes the founders to potential legal liability resulting from their breach of fiduciary duties as directors and/or executive officers.  Moreover, like in any M&A transaction, the founders’ goal is to negotiate all of the material terms in the LOI so that they know whether they have a deal or not.  (Note: the acquirer’s goal is to lock-up the seller, with a “no-shop” provision, to prevent the founders from negotiating with any other parties and to then negotiate the material terms in the purchase agreement.  I discuss this issue in #2 of my post: “Selling Your Company: The 5 Biggest Legal Mistakes”.)

Will the Founders Receive any Purchase Price Proceeds?

The purchase price proceeds (together with all of the startup’s other assets) must be distributed in accordance with applicable prioritization laws: (i) first, the secured creditors must be paid-off (though most startups do not have secured creditors, such as a bank); (ii) second, all unsecured creditors (including the holders of convertible notes) must be paid-off; (iii) any remaining amount is then used to pay-off any preferred stockholders in accordance with their liquidation preference; (iv) holders of any SAFEs would then typically be paid; and (v) finally, any remaining amount would be distributed ratably to the common stockholders, including the founders.  Based on the foregoing, the founders rarely receive any distribution from the purchase price proceeds.

Why Then Do Founders Do Acquihires?

From a business perspective, the appeal for the founders is two-fold: (i) they are typically given generous employment packages; and (ii) the startup itself is given a soft landing – i.e., investors will get some money back and the team will join the acquirer.  From a legal perspective, the founders are typically Board members and thus have significant fiduciary obligations to (i) the stockholders and (ii) the creditors, if the startup is in the “zone of insolvency” (which is often the case).  Accordingly, the founders may not simply cut their own personal deals directly with the acquirer.  Instead, they must ensure that any deals relating to the startup are entered into in good faith, are fair and reasonable, and without self-dealing.

What Should Founders Be Worried About?

As noted above, in any acquihire founders should be worried about their fiduciary obligations as Board members and executive officers because they have an inherent conflict of interest with respect to the money that the acquirer is putting on the table.  Indeed, founders obviously want to negotiate the best possible employment package for themselves, and the acquirer typically wants most (if not all) of its money to go to the founders and the key employees (particularly where it has no interest in the startup’s IP and/or other assets).  Founders thus must be very careful and should rely on experienced legal counsel to help sort through these tricky conflict-of-interest issues.  Moreover, there are certain legal steps that must be taken in connection with any “interested party” transaction in order to comply with applicable law.

Are There Any Other Issues Founders Should Worry About?

Yes, the startup should not be dissolved unless (i) all of the creditors, including noteholders, are paid-off in full or (ii) each of them has executed a settlement and release agreement, agreeing to partial payment and releasing the startup (and its directors and officers) from any liability.  Indeed, there is a quite a bit of legal work in connection with most dissolutions, including (i) obtaining the approval of the startup’s Board of Directors and stockholders, (ii) drafting and negotiating settlement and release agreements, and (iii) drafting a Plan of Liquidation and Dissolution.  Moreover, there are tax issues that must be addressed, including the payment of franchise taxes in all applicable states and the filing of applicable income tax returns.  Finally, if not all of the startup’s employees will be joining the acquirer, the founders must ensure that they are complying with applicable employment laws in connection with the termination of employees and the payment of any compensation that is due and owing (including vacation pay).

Are There Any Other Suggestions In Connection with Acquihires?

This may sound self-serving, but founders should get their lawyers involved as early as possible.  Indeed, significant legal planning and strategizing must take place prior to negotiations with any potential acquirers.  The fact that the deal is relatively small does not mean it is not complicated and fraught with potential legal pitfalls.  As a senior partner at a major New York firm advised me when I was a first-year associate there: “The difference between a $100 million transaction and a $10 million transaction is one zero.”

Comments are closed.

Secured By miniOrange