Fiduciary Duty. This paper describes how the Board of Directors of a technology company can exercise its fiduciary duty to supervise the work of management and its M&A advisors without becoming entangled in the process. This follows the ideal separation of responsibilities for a well-governed company as detailed throughout this manual.
Over-riding Principle. Superseding any other consideration, Boards of Directors have a primary fiduciary duty to act on behalf of the shareholders of the company to supervise management’s actions. There are slight differences in the way that fiduciary duty is interpreted among states in the US and between the US and Canada. The differences can be quite nuanced and not very helpful in guiding directors as to their exercise of fiduciary duty. The prudent approach in any matter coming before the Board, including deliberating on a potential exit opportunity, is for directors to exercise their best judgement. As a general statement, directors must inform themselves of the matter at hand, act in good faith, with no conflict, in the best interest of the company and its stakeholders, to the best of their abilities. This is termed the “business judgment rule” and is effective both in the US and Canada. In simple terms, directors must make the best decisions given their experience and information, and cannot be held liable for any outcome, provided they acted according to these rules.
Alignment. Selecting the optimum offer is only the last in a series of decisions the Board must make in an M&A process. Let us examine the M&A process and note where the Board has a role. First, the Board must determine that the optimum plan for the stakeholders is to sell the company. The company may have several options to pursue, such as a financing, a partial exit or a complete exit. The challenge is that it may be difficult to engage acquirers and M&A advisors in an exit process if the company is not fully committed. To maximize the probability of closing, the exit must be the only option the company is considering. In committing to an exit, the Board may stipulate several conditions, such as a minimum price, certain terms, restrictions on the domicile of the acquiror, and other conditions to shape the offer in the company’s favour.
M&A Advisor. Next, The Board must empower management to choose an M&A advisor. The Board should resist the temptation to have the CEO or Board to take on this responsibility while also running the business, it is likely that they will do a poor job at both. This may result in a sub-optimal or failed exit, and may also crater the company’s business in the process.
As part of its instructions to management, the Board must determine the process by which the M&A advisor is to be selected. This will likely include written submissions from a short list of candidates and an interview with the Board in making the final selection. The Board may consider the track record with companies of a similar size, industry experience, and the advisor’s process, among other things. Many investment bankers are agnostic to industry and technology and follow the same process whether they are selling an oil & gas company, consumer goods or a tech company.
This “one size fits all” approach may not be successful for all technology companies. There are more early exits occurring in the tech industry. Many tech companies at an early age of development may have achieved one of the four drivers which enable them to exit before they have generated large and sustainable revenues and earnings. Until recently, acquirors were not interested in a company which had not scaled to significant size. However, a survey of 1500 early exits demonstrated that tech companies can generate significant value by development of one of four pillars of successful early exits:
- Intellectual Property,
- core competencies in a narrow but attractive niche,
- early validation by industry leaders, and
- market traction in a narrow but attractive niche
Tech companies embarking on an early exit based on success in one of these pillars need to have an M&A advisor which is familiar with their industry and technology as it requires a depth of understanding both to discover and engage potential acquirors.
The candidate M&A advisors may have their own stipulations. Typically, experienced advisors focus on transactions in a particular valuation tier, and will take a pass on potential engagements outside their sweet spot. Importantly, the advisor may seek to ensure that there is alignment among all of the stakeholders about the exit before accepting the engagement. M&A advisors are paid mostly on the value of the successful exit. As noted above, the advisor may seek confirmation that the company is committed to an exit before investing several person-years of effort at their risk.
In addition, in the tech industry, many companies are organized such that each venture capital investor has its own class of preferred shares which have a veto on an exit. The VC fund may have stipulations that require its representative to veto any acquisition which does not generate a minimum return (often 10x the investment made). The situation could arise where after months of work, an offer may be presented which is acceptable to the majority of shareholders, but a minority VC investor could block the sale. The Board of Directors must explore this situation thoroughly with all stakeholders and not approve commencement of the exit process until firm alignment is achieved. The M&A advisor may seek confirmation of alignment before accepting the engagement.
Exit Process. Once the Board has approved the selection of the M&A advisor, it can oversee the process while management and the M&A advisor execute the exit. The Board may request regular status report on important milestones:
- Agreement on the company’s business strategy: This is needed for all exiting companies and is particularly important for tech companies seeking an early exit. There may be many possible strategies for the business at an early stage. Developing the optimum strategy is key to maximizing the potential and value of the exit.
- Confidential Information Presentation: A deck of about 10 slides which explains:
- the company,
- value proposition,
- for early exits, success on the pillars,
- for companies with sales traction, financial performance and projections
- One-page company summary
- Market segments to be approached
- Lists of potential acquirors in each segment
- Number of potential acquirors with contact info determined
- Status of the virtual data room
- Exit sales funnel
- Total companies
- Companies contacted – summary sent
- Companies responded – first interview by bankers
- Companies received presentation of CIP
- Companies received presentation by CEO
- Companies conducting Due Diligence
- Companies presented Letter of Intent (LoI)
Letters of Intent. Once a potential acquiror presents a Letter of Intent (LoI) to acquire the company, the advisors will review and negotiate the terms until they are optimized. Ideally, there will be several prospective acquirers presenting LoIs. Competition should increase the exit price and other terms. The advisors will then present the LoI representing the best value for money to the Board for its review and approval. In consultation with the advisors, the Board may elect to withhold approval until the advisors can solicit and negotiate other offers.
Once the Board approves the best offer, it must then seek approval of all of the shareholders who have a class veto. For transparency and openness, the Board may wish to seek and allow all the shareholders to approve the offer.
Formal Documents. At this point, under supervision of the exit advisors, the selected acquirors will complete their due diligence and begin drafting of the formal Purchase Agreement documentation. The DD and Documentation are typically very time consuming and often difficult. The longer they take, the greater the potential for the exit to fail. The Board, in consultation with the M&A advisors, often stipulate that the selected acquiror has a limited time period in which to complete the paperwork (typically 45 – 60 days).
Once the final documents have been prepared, the Board will review them with the advisers for accuracy and completeness, then approve the final documents for signature by all the relevant parties. Money and other consideration changes hands, and the acquisition is complete.
CEO Compensation. Finally, there is one feature of the M&A process which needs attentive governance: the inherent conflict of the CEO in negotiating with the acquirer both the exit terms and their own employment terms. The CEO and other officers and directors owe a fiduciary duty to the company and selling shareholders, as described above. If the acquiring company requires key employees to enter into new employment arrangements as a condition of proceeding with the acquisition, the identified key employees can end up trying to serve three masters during the period of negotiations – their current employer, their prospective employer, and their own personal interests. The better the new compensation package, the more the CEO may be seen to favour the acquiring company or themselves, over the sellers. The acquiring company could increase the CEO comp and reduce the overall purchase price, thus giving the CEO an advantage over the other exiting shareholders. Alternately, if the CEO is asked by the acquiror to agree to employment terms that they feel are personally disadvantageous, the CEO who doesn’t capitulate personally could be seen to be putting their personal interests ahead of the other sellers’ interests.
While these conflicts may in some cases be more theoretical than real, proper governance dictates that they should be addressed in advance. To mitigate the inherent conflicts, the CEO’s personal employment terms should be negotiated by the CEO with the advice of the M&A advisors, and with the acquiring company, with oversight by and guidance from Board. The Board should approve the CEO’s new compensation package to eliminate any appearance that the CEO took advantage of the selling shareholders. Finally, in some cases, although not necessary, the selling shareholders might approve the CEO’s compensation to confirm that the process and outcome were transparent. In that event, unanimity would not be required; only the approval of a group of shareholders holding a simple majority of the shares.