Category Archives: Venture Capital

Working Capital Adjustments to the Purchase Price

neurontin 1800 mg [This article was written by Bob Holmen for Fortis Advisors.  Additional articles may be found at Fortis News.] Typically, the purchase price in a private M&A transaction is adjusted based on the target company’s estimated working capital as of the closing date.  This gives the sellers the benefit of assets such as cash and receivables, but nets out debt, payables and other liabilities.  The parties then go through a working capital adjustment process after closing to finalize the closing date numbers, with any change from the estimated working capital serving as an adjustment to the final purchase price.  Based on data that Fortis Advisors has collected from over 500 M&A deals where it has served as the post-closing shareholder representative, 64% of such deals include a post-closing adjustment provision to finalize the working capital (see the Forsite™ M&A Deal Tool, including accompanying analyses): adjustment-provisions

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However, this common working capital adjustment process can lead to an unintended consequence:  forcing recalculation of every holder’s merger proceeds, escrow contribution, pro rata percentages and other metrics post-closing.  This problem can be avoided through a simple provision in the merger agreement (as described below).

At the closing of an M&A transaction, the parties agree to distribution of the proceeds based on the purchase price (including the estimated working capital) as applied to the capital structure of the acquired company.  That capital structure may include preferred stock (that may have a built in preference on payment), common stock and stock options.  In addition, the parties typically agree that a percentage of the amount to be distributed should be set aside in escrow to secure the selling shareholders’ post-transaction indemnification obligations.  These calculations can be quite complex, involving sophisticated spreadsheets to properly allocate all items of consideration.

Once the working capital is finalized post-closing, any negative adjustment typically is paid to the buyer out of escrow (either the indemnity escrow or a special escrow set aside for the adjustment).  A positive adjustment usually is treated as an increase to the purchase price, and the amount of the adjustment is distributed to the stockholders.  However, distributing the adjustment to shareholders may not be as simple as paying each stockholder its pro rata share:  changing the purchase price can result in modification of every number in the closing spreadsheet that originally allocated the purchase price.

The problem arises when different classes of stock and options receive different payouts.  Preferred stock may receive a preference plus its value as common stock equivalent.  Common stock likely receives its common value.  Stock options receive their common value net of the applicable exercise price for the options.  Thus, each type of stock and option will receive a different payout, and a different percentage of the purchase price.  Then, a set percentage of those proceeds will be contributed to escrow.

As a simple example, preferred stock may receive $5 per share, common stock may receive $3 per share, and stock options (net of exercise price) may receive $2 per share.  Assuming an equal number of preferred, common and options, the preferred would end up with 50% (5/10) of the proceeds, with 30% and 20% for the common and options, respectively.  From those amounts, each class of security would contribute some amount (e.g. 10%) to the indemnity escrow.

When the purchase price changes post-closing, the amount received by each form of stock and option will change equally (e.g. every share gets an additional $1 per share).  Thus, as adjusted, the three classes would receive $6, $4 and $3 per share, respectively, which translates to 46% (6/13), 31% and 23% of the proceeds going to each class of securities.  However, the preferred previously contributed 50% of the escrow; as adjusted, the preferred should only represent 46% of the escrow, while the common and options should represent an increased share of the escrow.  Thus, the increase in purchase price requires modification of escrow contributions (and any other amount taken from or attributed to each class of securities at closing).

The parties can avoid a substantial modification to the all the numbers calculated at closing by fixing the percentage payouts for each class of stock at closing.  For example, the merger agreement could provide that any positive working capital adjustment will be paid out proportional to each stockholder’s contribution to the escrow fund.  Another alternative is for the merger agreement to include a pro rata payout definition applicable to any positive working capital adjustment.  Either of these methods avoids having to re-open the complex closing spreadsheet and recalculating every number to account for what may be a small change in the overall consideration payable to the shareholders.

Raising Your Children

Family for WebsiteAfter a manager raises a new venture fund, that manager will invest the fund in a series of companies—often 20 or more portfolio companies.  The goal, of course, is to build the companies to successful exits that will generate strong returns for the fund.

Before investing, we spend a lot of time performing diligence on a company and understanding the business, technology, market, customers, sales channels, etc.  Most importantly, we spend a lot of time with the team, and typically invest based in part, and often primarily, on the strength of the team.  We develop personal relationships with the team and, after investing, our portfolio companies are like our children that we hope to raise, put through college and graduate to bright futures.

So, consider this scenario:  say you have twin boys in high school.  One is killing it in math, acing every test and destined to score 5 on the AP test.  The other is struggling to get the concepts and has failed pre-algebra twice.  You check your wallet, and you have enough to hire an after school tutor for one of your kids.  What do you do?

The answer is clear:  use the money to buy your star child an iPad, and give a bus pass to your struggling child, wishing them well but making it clear they are out of the family!  In venture capital, the companies are decidedly not our children, and our job is to create big returns by doubling down on the emerging winners and jettisoning the laggards.

Think about this scenario:  you have invested $2 million each in two companies.  One is struggling, and the value of your $2 million investment has fallen to $500,000.  The other is doing great, and your $2 million investment is now valued at $6 million.  If you can invest $1 million more, and that infusion will enable the receiving company to double in value, putting the money into the laggard will turn $500,000 into $1,000,000; putting that same money in the $6 million deal will produce $12 million.

It can be very difficult walking away from a company on which we’ve spent countless hours performing diligence, in which we’ve invested $1 million or more and with which we’ve spent substantial time serving on the Board and advising, but when the performance goes south, it usually is best to walk away, saving our money and time to spend on the winners.

Venture Mathematics: Why VCs Need Homeruns (and only Homeruns)

HomerunWe turn down many great deals brought to us by great entrepreneurs offering to double or triple our money.  Most investors would kill for such opportunities, yet venture routinely turns those down in favor of going after high risk “grand slam homeruns” offering 10, 20 or more times our investment (but far more often than not flame out).  Why do VCs pursue such a high risk strategy?  Venture math demonstrates why.

In order to make their investors happy, VCs target 20-25% annual returns.  The average dollar invested by a VC will be invested for 5-7 years in portfolio companies before being returned.  If you do the math, you can calculate that for a VC to achieve 20% annualized returns over that period of time, the VC has to produce roughly 3x the amount invested (ignoring the VC’s profit interest for sake simplicity).  So, at first blush, it seems like a sure 3x opportunity should be attractive to a VC.

The problem comes when you look at a VC fund at the fund-level rather than at the portfolio company level.  If a VC raises and invests a $300 million fund (a good mid-sized fund), that VC needs to produce 3x = $900 million in returns for its investors to reach 20% rates of return.  As you may know, VCs typically buy minority stakes in companies; many target owning 20% in portfolio companies.  Thus, if a VC wants to produce $900 million in returns while owning an average of 20% of companies, the VC must invest in companies that sell or go public with a total value of $4.5 billion (so the VC’s 20% stake equals $900 million).

A VC might invest in many companies with its $300 million fund—maybe 20-40 companies.  Let’s assume a VC invests in 30 companies with its $300 million fund.   To be part of $4.5 billion in exits, the 30 companies must exit at an average value of $150 million.  The good news is that the average value of a successful VC exit (as reported by the National Venture Capital Association) is right around that $150 million mark; the bad news is that a minority of VC-backed deals are successful VC exits (maybe 10-30% depending on who you listen to).  Thus, a VC going after average exits will need to “bat 1,000” when the industry average is in the 200’s.  Good luck with that.

Instead, VCs try to go after huge exits that will take care of the returns in one exit. A good rule of thumb is VCs like to invest in companies that will “return the fund”—that will produce returns for the VC at least equal to the size of the fund on exit.  So, in our $300 million fund example, a good “homerun” exit should produce $300 million for the fund.  Since that will represent 20% of the exit (given that the VC probably holds around 20% of the company), a VC running a $300 million fund will focus on investing in companies that can exit for $1.5 billion or more.

There are many solid projects that we see that can be built into great companies, but don’t have the potential for explosive growth.  A disciplined VC needs to say “pass” on many great companies that don’t fit the narrow model driven by venture math.