Some Investors May Request Protection From Acqui-Hires

Inside baseball warning, but I like writing about the things being discussed that the press never really picks up on.

Acqui-hires, if you aren’t aware, are the acquisitions of startups by large companies (usually Facebook, Google and Twitter) that are made primarily for the teams, not the products.

Every few weeks there’s a press report of an acquisition of some startup or another along with a rumored acquisition price that’s quite low, sometimes less than the amount of venture capital invested in the company. Those deals usually, but not always, have equity grants to key founders and employees that are often a multiple of the acquision price. Example – a recent deal had a rumored acquisition price of around $2 million plus stock grants to a few key employees of $15 million.

I’ve been fascinated with acqui-hires for years now. The first one in recent history I know about was Parakey, acquired by Facebook in 2007 (I talked about that deal here). But they’ve proliferated fast since then. Google, Twitter and Facebook all have dedicated “corporate development” executives who work closely with human resources and exclusively look for these deals.

Huffington Post has a summary of some of the acqui-hires over the years. Additional thoughts from me over the years here and here.

Lots of people (me included) think acqui-hires are just fine. It can be a last refuge of a dying startup with a star team, for example. And since these startups have few other options, investors are usually not in a worse position than they’d be if the company simply went out of business.

Other VCs aren’t as thrilled. Their counter argument (from a previous post):

Investors see themselves as being taken advantage of, providing capital for founders to essentially buff up their resume to get their dream job. When a company is acquired, they say, the value of stock grants should be considered acquisition value and divided up among all stockholders. If a founder leaves stockholders behind to take a lucrative side deal, they’re not acting ethically.

They haven’t been thrilled for years now, but something’s starting to change. There have been Bin 38-like whispers of some investors acting to fight back on these deals. A lawyer I spoke with says there are a variety of causes of action in an acqui-hire deal, all centered around the notion that there’s a lot of money going to some shareholders (founders/employees) but not others (investors). Specifically, the long standing notion of equal treatment of shareholders codified in California, Delaware and most other state corporations codes.

If deals are specifically being architected to give key employees very large payouts and investors very little, there are probably fraud, breach of fiduciary duty and other causes of action available to shareholders.

The cause of action is relatively straightforward – the deal as a whole would be considered fraudulent based on the fact that the team’s value is based largely on the fact that it has become a cohesive whole on the shareholder’s dime, and is worth far more as a group than the aggregate of the individuals.

No investor in her right mind would bring such an action, of course, because of the reputational fallout from doing so. I have heard of a couple of threatened and settled lawsuits, though, that never became public.

What’s really pissing off investors are the stories that get back to them. Statements made by high level executives like “fuck the investors, there’s nothing they can do” sound fine in a closed door meeting with an entrepreneur. It sounds less defensible in a deposition that becomes public.

I doubt we’ll see much of that, though, given the reputational issues I brought up above as well as the fact that most investors honestly aren’t angered by these deals.

But what I do believe we’ll start to see are clauses being added to investment contracts that are designed to change these deals. Specifically these clauses would force all deal consideration around a deal – including stock options and stock grants to employees – to be pooled and distributed pro rata among all shareholders.

This would likely kill many of these acqui-hire deals, since the stock grant portion of the deal is a compensation expense to companies. That means the government is paying for a sizable chunk of these acquisitions. Any attempt to pool the consideration and distribute away from employees would not only suck for employees, it would no longer be a tax expense for companies. That would make these deals some 50% more expensive to the buyers. Obviously employees wouldn’t be thrilled to lose most of that compensation to investors, either.

Ultimately the market will decide if these clauses stick, but when there’s a downturn (and there’s always a downturn around the corner) onerous clauses often find their way into deals, and can eventually become “standard.”

We would never ask for a clause like this at CrunchFund, and would counsel our companies only to consider it as a last resort. Additionally we would often counsel companies we’ve invested to take these types of acqui-hire deals when offered, if it’s in their best interest.

But in the meantime, it would probably be a good idea for the buyers out there – specifically Facebook, Google and Twitter – to consider toning down the anti-investor rhetoric in these meetings. They’re injecting a lot of emotion into a difficult issue, and that doesn’t help anyone in the long run.

27 thoughts on “Some Investors May Request Protection From Acqui-Hires

  1. jamesjor02 says:

    the Instagram aquisition by facebook should also be talked about! It’s fun to read about in the media, but I think there’s more to it!

  2. Raj says:

    Parakey was acquired by Facebook not Google btw.

  3. If you invest in the right entrepreneurs, you will not run into these issues – I have been on the investor side in 3 acqui-hires and every single time the entrepreneurs took a very fair approach to “sharing the wealth”. Reputation considerations are valid for both sides.

    • Dave McClure says:

      not completely true. many times, the entrepreneurs don’t have complete control over terms, and/or under pressure will accept less investor-favorable terms from acquirers. while I agree that treating people fairly / choosing to work with good people does make it less likely, it doesn’t eliminate it by any means.

  4. Mark Thomas says:

    Great article, and I certainly see both sides of the argument as to why investors should or should not be pissed about this. On one hand, if the product is flailing through no fault of the star team (and that CAN happen), then the investor is at least getting something back from their initial investment when it otherwise would not have. Plus, they’re building goodwill among the entrepreneurs and within the industry for their understanding. On the other hand, most star teams would not have even gotten to the point where the dedicated corporate development executives at the top companies would have heard about them, had it not been for the funding dollars from the investors in the first place (maybe, maybe not — tough to tell on that one).

    Overall, I think the last part of your post is what’s important — the market will dictate whether these clauses are included all the time, excluded all the time, or included/excluded based on the economy.

  5. Hi Mike,

    Putting your corporate lawyer hat on for a moment (yes … I know it’s been a long time), I suspect that you would agree that it would be difficult to narrowly craft a provision that includes options or RSUs granted to target company employees as a “distribution” that would be subject to a liquidation preference. I suppose one could say these the target company employee grants are only “distributions” to the extent the return to the preferred is below X – in order to differentiate from deals where the investors are happy versus deals where the investors are not happy.

    In any event, I think that the typical protective protections that Series A investors have on a sale of company should be sufficient for them to exert displeasure with a deal. And I suspect that convertible debt investors might start wondering why they don’t have protective provisions in typical deal docs that would give them leverage if they are not happy with the terms of an acqui-hire.

    Yokum

    • Dave McClure says:

      definitely more likely to occur in convertible note situations. probably the biggest argument for doing priced rounds over notes, IMHO… way more important than several other issues people bring up about weaknesses of notes.

  6. Bob Specht says:

    What about something along the lines of investors requesting the acquisition price be a certain % of stock grants? Say 50%, your $2m and $15m example wouldn’t work, but something like $6m and $11m would. No genius on the subject, just a thought.

  7. nullflux says:

    Parakey was acquired by Facebook in 2007, not Google, as your TC article states.

  8. Fly Catcher says:

    Well, then instead of going through acquisition hassle of worthless startup the luring entity could just offer a sexy options+signup bonuses to key people and be done with that?

  9. James Hong says:

    Why can’t this risk just be priced into the seed round’s valuation? Just increase awareness of this issue, and then presume that the market will figure out how to deal with it..

  10. Jimmy says:

    Meh. If I had a quarter for every time investors screwed over employees, I’d be a rich, rich man. Even more so when it’s founders+investors. I can’t get all indignant about a little payback

  11. Alechemist says:

    That’s crap. Are investors “sharing the wealth” of their warrant kickers or liquidation preferences? You only hear sharing when the investors are shut out.

  12. SOR says:

    Eh, an investor might be miffed, but an acquirer isn’t going to move forward with closing a deal without shareholder consents. An investor can try and put something in contract but it won’t matter. You just structure around it. In general it is very transparent to investors who is getting what, and they can block a deal (or go along with the economics proposed by the acquirer). Much of the focus of the corp dev team is spent figuring out how little they can pay an investor (leakage) and put dollars into the hands of employees coming on-board, while minimizing total $s while also considering tax consequences & risk profile of deal (e.g. SPA, vs APA vs some other structure). An investor might try to go after an employees post-closing equity incentives or other consideration via a side letter, but then you just make them rep that there are no side letters or similar arrangements.

  13. You’re saying : “We would never ask for a clause like this at CrunchFund”

    Can you explain why ?

    • Michael Arrington says:

      Lots of reasons. One of them is that it’s too much like a prenuptial agreement where you’re assuming things are going to go badly right from the start. We focus on maximizing the win, not minimizing the loss.

      • In that case, don’t sign a shareholder agreement at all…
        Are you not putting any bad leaver clause in your agreements? Exclusivity ? Non compete ?

        I think it’s really a better thing to be clear from the beginning. It’s completely normal to act like that.

        I’m currently managing exactly that kind of problem with 2 big companies trying to screw us as investors. It’s just a nightmare…

        From now, will add this clause in all our future shareholders agreements.

        Jeremie Berrebi
        Kima Ventures

        • Adding that in our cases, this companies are targeting a very successful and profitable startup!
          In that case, we are not talking about minimizing the loss, they are just trying to buy it at lower price that the real one.

      • Chris Kelly says:

        If everyone thought like this, there would probably be more successes. When an investor focuses on minimizing risk, they also tend to restrict opportunity.

  14. I don’t think you can put a general rule of thumb over all these cases. It’s really different in each one.
    In my last startup we got an acquisition offer where we were told very bluntly, that they prefer to lower the price and give it to us (the founders) directly as bonuses. We said no thanks. I believed that our investors took a risk on us and we should stand behind them. I do think it’s the ethical and right thing to do.

    That said, if a startup is getting to the end and its real value is very low, it’s perfectly ok that the founders and employees gets a better deal. In such a case, their bonuses are not because of what they did so far but for what they will do in the future.
    Their bonuses will be vested and are there to compensate them and motivate them for their future work and make sure they will stay for the long term.

  15. Jay Hollenkamp says:

    Is there anything preventing employees of a dying startup simply leaving en masse and jumping aboard the acquirer company? Couldn’t the acquiring company simply make an offer of employment conditional on all members accepting? And if so, why would investors want to scuttle the acqui-hires? At least with acquit-hires, there is some return to investors. My point is that I suspect game theory would suggest that these acquit-hires are not such a bad thing for investors.

  16. Even putting aside the reputational disaster, investors have no leverage. The employees could just resign en masse and start working for FB/Goog right after that, without the fig leaf of an ‘acquisition’.

  17. Hell of a post. Refreshing to see some relevant writing on the industry. This is what makes Uncrunched special. The thought process goes deeper than, “is this pretty” or “how many people have downloaded it”

  18. Martin Wells says:

    Great post, and well considered on both sides.

    It’s an interesting problem that at first glance can appear like fraud, or at best minority shareholder disadvantage. Having been on the investor side of one of these deals, I found frank, open discussion with the founders helped a lot. A negotiated settlement that balances the result worked out pretty well, also considering that the equi-incentive stock being offered typically requires founder employment lock-in (or at least earn out) — something investors don’t have to pay.

  19. Kralik says:

    How would an anti-acqui-hire clause be legally written? What should we be on the look out for?

  20. Dave McClure says:

    there are probably two very different scenarios to consider re: these types of acquisitions: 1) company doing well (or at least ok), has money / revenues, has alternative financing available perhaps, and 2) company running out of money, limited alternatives, looking to get acquired vs shut down.

    in scenario #2, most times the acquirer will control terms, and investors will get little if any return. and probably appropriate that not much money going to investors, unless perhaps there are multiple acquirers bidding and there actually is value on the table.

    in scenario #1, there is likely value being acquired that should be split between founders and investors, however it’s likely in acquirer or founder economic interest to provide more value to founders in retention incentives vs terms of sale. this is difficult to negotiate, and often since investors are not always at the negotiation table for the deal, their interests may be less well represented.

    obviously not all such deals are black or white, and many will fall in between. but I think mike is right to raise the issue at least in the scenario where the company has value & alternatives available. what is unclear is how or whether to negotiate contracts or relationships to preserve investor interests.

    treating people fairly and setting up aligned incentives helps, but won’t solve everything.

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