December 7, 2007

Abe’s Protection – a real life lesson in minority rights for start-up guys facing Series A funding

Filed under: Start-up First Aid — Administrator @ 5:13 pm

A friend of mine, we’ll call him Abe, successfully sold his web portal a week ago – I’m very happy for him considering he’s been at it for over 6 years and had just about wrote the damn thing off – he didn’t make all his money back but it wasn’t a complete loss.

However – this exit – almost fell flat on its face – I think Abe’s experience is a good lesson for all entrepreneurs thinking about – or in the process of – raising Series A venture funding.

In early 2000, Abe and his two partners started a web portal in Hong Kong – 10 months later, two venture capital funds dumped in some cash – 2 months later Hong Kong’s Internet bubble exploded like a can of beans and botulism. A couple down rounds, some rollups of other near defunct competitors, a little dilution here and there, some positive market action added for flavour, and the company was riding high again (relatively speaking) in 2007.

So, you’d think Abe and his co-founders would be pumped (candy canes and lollipops on the house…this baby is primed for a liquidity event!) – indeed, but alas they were rather indifferent as + 80% control of their venture had already been transferred to the venture capital investors (right, I forgot about anti-dilution clauses…you mean an investor will actually pull the trigger on those things?).

Then, about 3 weeks ago, one of the venture capital investors was approached by a third-party looking to acquire web properties on the cheap – going once, going twice, SOLD to the only bidder. The brokered valuation for the company came in 30 – 40% below a “reasonable” market price plus all proceeds from the sale would go to the venture capitalists.

A clap of hands, an exchange of documents, and the deal was as good a done…or so our venture investors thought. It so happens Abe had a good lawyer who included a very small clause in the Series A shareholder’s agreement which stated (very roughly) that before the company could be sold, liquidated or merged with another entity a founders quorum MUST be convened so that the quorum can physically review the offer/proposal – in this case a founders quorum required only one founder to be present. Furthermore, as per the founders’ minority rights, ANY final decision to sell, liquidate, or merge required a supermajority (about 95%) of Series A shareholders to vote in favour of such a deal.

Upon receiving an email from our venture capitalist friends informing minority shareholders (i.e. the three founders) that the company was to be sold at x cents on the dollar and because there was little the founders could do by way of preventing this deal from closing “…you best sign-off on this without a peep or else…”

Not one to rollover and play dead Abe reached for the shareholders agreement, circled “supermajority” and “founder quorum” and meet with his investors to discuss next steps (we’ll call these terms “Abe’s Protection”).

Much transpired over the next several days – there was some hair pulling, name calling, basic playground stuff but Abe and friends held their ground, refusing to sign-off on any deal that did not include the purchase of their shares and a higher valuation. The venture investors were stuck (a rare event that minority shareholder have the “professionals” over a barrel) – they knew the exit deal was dead unless Abe’s terms and conditions could be satisfied.

And, as you know from my opening sentence, the dust did settle and the deal finally closed – indeed, Abe and his partners were lifted out of their shares by the buyer and are now happy clappy, quietly counting their lucky stars that the company’s legal eagle had the founders’ back.

Start-up guys – recognize!

I guess I shouldn’t be promoting this but whatever – if at all possible, it probably makes sense to try to massage some form of Abe’s Protection into your Series A round – this will take some serious work on your part to get your investors to agree in full as it spits in the face of a fund’s normal operating procedures but worth a try, no? With that said, I’d caution against making the inclusion of such terms conditional to closing – to wit, you don’t want the money walking because you’re afraid of the money walking away…word.

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