transaction is where all of the cash is kept by the company (sometimes called a primary transaction), in a secondary, a material amount of cash is not staying with the company. This ends up with a lot more complexities to consider. These include:
Will this impact your 409a valuation? Often these transactions end up with a price per share for the common that is higher than the recent 409a price. Impact on your 409a should be understood before execution of the deal and communicated to the appropriate parties.
Tax implications on the company and the employees. Depending on the form of equity (stock, incentive stock option (ISO), or nonqualified option (NQO)), there are different tax requirements on the company and employee. For example, the company will likely need to have tax withholdings if a current employee is selling NQO options.
The regulatory requirements vary. Depending on the scale and number of people involved, it may trigger the transaction to be considered a tender offer, which has legal disclosures and a blackout period.
Waivers from preferred investors in the cases of right of first refusal and right of co‐sale restrictions.
Internal communications. In most cases, these transactions end up with some people being able to sell some shares and some who are not. You will want to be aware of employee morale and the importance of balancing transparency, privacy, and fairness.
Third‐party systems. With primary transactions, it is typically very straightforward. With secondaries, especially ones that trigger a tender offer, you will want to use third party marketplace software, which will greatly help with the required shareholder communication, flow of funds, and overall compliance.
Keep your partners informed early. Your outside counsel will be the primary partner involved in a transaction, but you will want to make sure that your audit partner and their valuation team are along for the ride and informed along the way so there are no surprises come audit time.
409a Valuations
409a valuations have become an important requirement for startups. Essentially, the minute you have an option grant or if you start the company with an investment on day one, you will need to have a third‐party 409a valuation. The 409a valuation establishes the fair market value of the common stock, taking into account a number of classic valuation variables such as recent fundraising, benchmarks, industry valuation multiples, etc. For most startups, the 409a will be valued using a recent financing as a base and then taking discounts for marketability. As a sanity check, there is usually a percent of the last preferred round that will seem reasonable to the valuation company (and the Board). This will change greatly depending on the stage and the type of preferred security, but roughly the range could go from 25% to well over 50%.
Once you have a valuation, you can grant options using that price as the strike price. You will want to have the valuation fairly close to the date when the Board approves the option grant. As you scale and build a quarterly heartbeat of Board meetings, you can simply do a 409a once a quarter to be effective close to the Board meeting.
Most of the time, the only valuation you'll need for operational purposes is a 409a. However, during an acquisition or when you are buying a company or assets, you will need to have a valuation done for accounting reasons. When you do, it is a good idea to build clear documentation and support as these valuations will be challenged much more by your financial audit firm during the annual audit.
Chapter 21 Mergers and Acquisitions (M&A)
Buy‐Side
Once a startup starts to find their product‐market fit and understand the clear drivers of revenue, acquisitions become a real possibility as a way to quickly grow the business. For a CFO, the main tactical efforts will include the financial merger model, the price, and how to pay for it, and managing due diligence. Primarily the CFO is the key partner (and sometimes voice of reason) for the CEO, who for startups, almost exclusively drives the buy‐side M&A efforts. As the company scales, you might hire someone to focus on M&A and the CFO becomes a key partner.
The Merger Model
The merger model is to help give your company a clear view of the before and after picture of the merger. The easiest way to do this is to compartmentalize the analysis. First, create a base model of the two standalone companies pre‐merger. This will include the actuals and forecasts. Then create another that merges the two, and some work that shows cost savings/synergies from the merger, and impacts on revenue, including the key drivers. Typically, that will include things like improved pricing, win rates, and client retention but could include a number of items. The key thing is to make sure the metrics that are driving the decision to make the merger are clear. At that point you can provide the CEO and Board some important financial metrics like payback period, total invested, and what certain metrics need to be for you to feel good about the decision. For example, when we looked at buying a new product (rather than building it), we thought that the two metrics that would improve were win rate and client retention. We were not going to change the price. So, by assuming a purchase price and cost synergies, we could illustrate how much those two metrics had to improve in order to justify the acquisition.
Figuring out the best way to pay for a purchase is an important means for the CFO to be an effective partner. You can use cash, stock, or even earn‐outs. Modeling the different scenarios and presenting the options to the CEO and board are critical skills. Many startup mergers are paid for by using company stock. Those are certainly the best use of cash flow, especially if the transition costs are not huge. But the more you use stock, the more you end up with a bunch of small stockholders that you don't know and have no idea how much of a hassle they will be. One way around that is, as part of buying a company, insist that the sellers create a single purpose vehicle with a managing partner that you know. That way you only have to deal with one person. If not, you may end up with 10s and maybe 100s of extra very small shareholders that will increase the amount of shareholder management you will need to do in the future.
If the acquisition results in increased free cash flow (after all of the cost synergies), you may be able to use credit financing to help minimize the amount of stock you need to put in the deal. This tactic is usually used for later stage companies that have established teams that can be leveraged in a merger.
Buy‐side acquisitions are also a time that the CFO can be a valuable partner for other parts of the company, helping build the transition plan and providing clear guidance and targets for things like new hiring, analyzing impact on new bookings and client retention, and other product, sales, and service plans.
Sell‐Side
Selling a company (or division) is usually one of the busiest times for a startup CFO. Not only do you have to be part of all of the many, many early meetings with possible buyers and bankers during the early courtship, but you are on every email, call, and planning meeting as the Board and management team decides whether or not to sell. You and your finance team are often working late trying to respond to the requests from possible buy‐side teams on historical numbers and financials. How you and your team react to an opportunity to sell the business is the culmination of your years of setting up scalable processes that lead to quick responses to diligence requests and modeling of scenarios. A prospective buyer will almost always want to see your financials and key corporate information in a different form and segmentation than you are used to. So how you can react to this surprise and still continue to operate the day‐to‐day business will be a true test of your team and your systems.
Key items before due diligence:
Investment bankers. If you are at a very early stage, it is unlikely you will be using an investment banker to help you with the process. As you get bigger, a banker can be helpful for you as a resource for some of the modeling, a coordinator for a lot of the diligence process, and most importantly, assisting you in navigating the industry landscape and