Beach Money Exits.

• Author: Wansley, Matthew

1. Introduction 152 II. The Structure of VC Markets 157 A. The VC Business Model 158 B. The Mechanisms of VC Contracts 160 1. Strong Equity Incentives 160 2. Convertible Preferred Stock 162 3. Staged Investments 162 4. Syndication 163 C. Incentive Misalignment and Exit 164 III. The Beach Money Problem 166 A. Founder Incentive to Exit 167 1. Nondiversifiable Risk 167 2. Diminishing Marginal Utility 169 B. Founder Power to Exit 171 1. Information Asymmetry 172 2. Founders' Contribution to Enterprise Value 173 3. The Revenge of the One-Shotter 174 IV. The Limits of Contract 175 A. VC Screening and Monitoring 176 B. Blocking Rights 177 C. Independent Directors 178 D. Secondary Capital 180 E. Other Contractual Solutions 182 V. The Law of Exits 183 A. The Duty of Loyalty in Trados 184 B. The Elusiveness of Beach Money Disloyalty 187 1. No Benefit Outside Deal Consideration 187 2. No Divergence in Price Per Share 188 3. No Higher EV Alternative Without Founders 190 C. The Duty of Care Revisited 191 D. Appraisal Rights 192 VI. How Acquirers Can Destroy Value 193 A. Weakening Incentives Prematurely 195 B. Directing Assets Towards Exiting Customers 198 C. Buying Off Competition 200 VII. Conclusion 202 I. INTRODUCTION

   Venture capital (VC) markets fund the development of high-risk, high-growth technology startups. VCs must overcome acute information asymmetries when they invest. (1) Early-stage startups may lack the metrics--earnings, revenue, or even customers--that investors use to value mature businesses. There is generally no liquid market for a startup's shares. (2) Startup founders (3) know more about their technology, team, skill, and work ethic than their VC investors can learn. (4) VCs also face an agency cost (5) or moral hazard (6) problem. They cannot easily observe a startup's progress towards commercialization, so they need a mechanism to ensure that the founders are putting their cash to good use rather than just extracting private benefits from ownership.

   The primary mechanism VCs use to motivate founders is the equity that founders hold in their startups. (7) Founders take below-market salaries. (8) As Ronald Gilson explains, "the overwhelming percentage of management's compensation is dependent on the [startup's] success. Low salaries are offset by the potential for a large increase in the value of the entrepreneur's stock ownership ...." (9) In most cases, founders' equity will be worth zero. (10) But founders know that, if their startup successfully "exits" through an initial public offering (IPO) or acquisition, they will receive an extremely lucrative payout for their shares. The equity incentives push founders to manage the business in a way that maximizes shareholder value. (11)

   But the strong equity incentives of VC-backed startups make them vulnerable to value-destroying opportunism. When a successful startup receives an acquisition offer that is below the expected value (EV) of the business, founders with a large equity stake may be motivated to accept it. Founders cannot diversify their financial risks like VCs can, because their equity is concentrated in one company, rather than spread across a portfolio of companies. (12) An acquisition that is not EV-maximizing for shareholders could give founders more risk-adjusted value than remaining independent would.

   Additionally, founders deciding whether to accept an acquisition offer may face a diminishing marginal utility of wealth. (13) An offer below the EV of the business may give the founders "beach money"--financial security for life. (14) The payout to founders can be high enough that VCs cannot persuade them to forgo it for the prospect of even greater wealth later. I call a startup acquisition that is not EV-maximizing for the business but is in the founders' private financial interest, given nondiversifiable risk and diminishing marginal utility, a "beach money exit."

   Founders often have the power to force a beach money exit over the objections of VCs. In a minority of cases, founders will control the board outright or effectively control it with a friendly independent director. (15) But even when founders do not control the board or the VCs have a contractual right to block an acquisition, founders may still have the power to force the exit. In many early-stage startups, the founders' reputation in the market, their expertise with the startup's technology, and the loyalty of their hand-picked team are the main sources of enterprise value. (16) When founders in successful startups push for an exit, VCs have no attractive options. They cannot force the founders to manage the business against their will. They cannot replace the founders without destroying value and risking mass employee defections. They cannot sue without risking their reputation among prospective founders. (17) From a VC's perspective, a 2-5x return is underwhelming. (18) But to almost everyone else, founders who deliver 2-5x growth look successful.

   Because VCs know that their options after a beach money exit offer are limited, VCs anticipate and try to prevent them. (19) They screen prospective founders to make sure their expectations about exit are aligned with the VCs' expectations. Then they monitor founders to ensure they are building long-term value for the business, rather than courting prospective acquirers. VC investment contracts usually include "blocking rights"--negative covenants that give VC directors the right to veto a sale, even when they lack a board majority. (20) VCs' insistence on blocking rights is notable because VCs also have liquidation preferences, which entitle them to a return of 1x before common shareholders are paid out in an acquisition. (21) The combination of blocking rights and liquidation preferences suggests that VCs worry about founders forcing sales even in moderately successful startups. (22) Tellingly, sometimes blocking rights only allow VCs to veto exits below a certain value. (23) This suggests that there is a range of returns--likely somewhere in the 2-5x range--where VCs will sometimes support and sometimes oppose an acquisition, depending on their assessment of the startup's EV.

   In some cases, VCs can turn to an independent director to arbitrate the exit dispute. (24) In other cases, VCs can defuse pressure for a beach money exit by facilitating the purchase of founder equity on the secondary capital markets. (25) Secondary capital provides founders with liquidity and sometimes helps them resist attractive acquisition offers. (26) But the more that founders cash out on the secondary capital markets, the more that prospective investors in later rounds will worry that founders' forward-going incentives are weak.

   Delaware fiduciary law likely would not provide redress either. (27) At first glance, a founder-director pursuing her own financial interest at the expense of the interest of the shareholders appears to be violating her fiduciary duty of loyalty to the corporation. But beach money exits do not fit well with existing doctrine. Founders do not receive any benefit outside the deal consideration. They receive the same payout per share as all other shareholders, since the VCs' preferred shares will convert, or be paid out as if converted, to common shares in the acquisition. The VCs' case that the acquisition is not in the shareholders' interest may rely on the value that could be created if founders continued to manage the firm. But founders' fiduciary obligations do not require them to continue managing the business. VCs would face similar obstacles to exercising their appraisal rights, given Delaware's increasing deference to deal prices. (28)

   Beach money exits matter. The difference between a startup board's estimate of the startup's EV as an independent company and the lower EV implied in the acquirer's offer indicates that the acquirer may put the startup's assets and employees to a less productive use. An acquirer can destroy value by weakening the strong equity incentives of former startup employees prematurely. (29) It may also direct the former startup's efforts to serve its existing customers, rather than new, potentially larger markets. It may not plan to use the startups' assets at all--the acquisition may be designed simply to buy off a potential competitor. If IPOs continue to decline and acquisitions become the dominant startup exit strategy, (30) founders will have an even greater incentive to push for early sales.

   Researchers have acknowledged that VCs investing in startups worry about forced exits. (31) They have noted that founders may support early sales because their personal rate of return on their equity will be higher than the VCs' rate of return. (32) But researchers have not addressed beach money exits, their causes, or their effects. There is a rich and illuminating law and economics literature on startup exits, but it largely focuses on cases in which the nominal payout per share of preferred shareholders--i.e., VCs--and common shareholders--i.e., founders and employees--diverges. (33) These divergences happen on the "moderate downside," when a startup is not growing rapidly but has not burned all of its cash. (34) In those situations, the VCs' liquidation preference entitles them to a greater pershare payout from an acquisition than common shareholders would receive. (35) Founders might seek to resist an exit in the hope that the startup's fortunes improve enough to generate a return for common shareholders, while VCs just want to cut their losses. (36) Jesse Fried and Mira Ganor, for example, argue that VCs are biased towards exit (37)--and on the moderate downside, their case is compelling. (38)

   Beach money exits happen on the largely uncharted "moderate upside," where VCs will convert, or be paid out as if converted, to common shares in an exit. On the surface, the financial interests of VCs and founders should be aligned in such a case: seek the highest EV exit for all common...