Capitalizing on the success of entrepreneurship: IPOs, private sales, tax aspects, residual interest of entrepreneurs after sales of IPOs.

• Position: Canada-United States Law Institute Annual Conference on Comparative Legal Aspects of Entrepreneurship in Canada and the United States - Discussion

INTRODUCTION

Richard Gordon

PROFESSOR GORDON: Henry isn't here, and I may be the person who will start things off. I am Professor Richard Gordon, Those of you out there who are--and I guess down here as well--who are lawyers and not yourselves entrepreneurs, I don't know if you have had the same sort of reaction that I've had the past couple of days, hearing so many successful entrepreneurs speaking. I haven't even thought of myself as a lawyer, but as one of those other "L" words--"loser," because I haven't made a gazillion dollars and lost it and made it. And I am hearing constantly the descriptions about how special entrepreneurs are, and I have been feeling increasingly, well, diminished, I guess would be the best way to put it.

I was a tax lawyer when I was in practice, and I am very pleased--I was actually pleased to hear the previous panel as well because there are--we are hearing about the value added lawyers can bring to the process, specifics, and that made me feel a little bit better as a lawyer, talking about some tax issues, and that made me feel even better as we turn to what lawyers really do.

We are also getting to the fun part, which is capitalizing on success. That's always a good thing. So I am not going to actually make the introductions because I don't know either one of our distinguished panelists, although I know they are distinguished.

UNITED STATES SPEAKER

Elizabeth Dellinger *

&

CANADIAN SPEAKER

Anthony Penhale **

MS. DELLINGER: Great. Well, my name is Betsy Dellinger. I am a partner at a law firm here in Cleveland by the name of Baker Hostetler. I chair our private capital practice. What that really means is my practice involves representing venture funds, representing startup businesses, representing what I often call emerging growth companies, privately held companies and basically working all sorts of capital formation. You look at a business, look at their capital needs, match up the two, do the legal work, do a lot of strategic counseling and let the companies grow but stay out of their way and then helping them exit and realize on to other potential businesses.

Anthony will introduce himself, and then we will give a presentation where we sort of lead off, go back and forth between us and feel free to jump in with questions as we go.

MR. PENHALE: My name is Anthony Penhale and I am a partner in the Montreal office of Stikeman and Elliott. I principally deal ultimately with the tail end process of what we are talking about, once the company has been taken public or bought or sold, typically bought by somebody bigger or private equity in this context.

Our offices are throughout Canada, mainly in Toronto, Montreal, Vancouver, Ottawa, Calgary; we deal with a number of different capital raising functions and obviously a lot of tax planning for which I must put a disclaimer right away--I am not capable of explaining anything correctly when it comes to taxes.

MS. DELLINGER: We have a number of slides here, and I will loosely follow them. I will start with this one, "Capitalizing on Successful Entrepreneurship: When and How." On the "when," there are two times when you, as an entrepreneur, will not capitalize on your success. The first is when VC (venture capitalist) money comes in to fund the growth of the company.

Venture capitalists put a lot of money into the company, but they don't want to see it spent on the management. They want management and the founders of the company to be tied in closely with them as co-investors in the growth of the business. (1)

The second instance in which you will not be able to capitalize on the success of your entrepreneurship is when some form of cash compensation is being drawn from the company during the growth stages of the business. I think entrepreneurs are uniquely the hardest working people out there for the lowest relative compensation, because their opportunities to realize success come closer to the back end of their activities than at the front end during the course of the entrepreneurship.

That said, in this presentation we really want to address when an entrepreneur will experience success and how best to achieve it. There are three basic categories of exits from a company. A liquidity event is really the definition of how the entrepreneur realizes the success of the business. As I say this, bear in mind that there could be two types of entrepreneurs growing the business coming in to a liquidity event. One is the person who started the company, a family-owned business that is now looking for an exit. The other is a venture capital funded business. When venture money comes in, the control shifts in a variety of ways and timelines are sometimes more predetermined by the fund's particular commitments to its investors and when the fund plans to withdraw from its investment. (2) So these factors can have a bearing on what the exits are and how they happen.

Liquidity events can occur first in the form of a private sale. Such a sale could be to a strategic buyer, to someone else in the industry, or to a more mature equity fund or second state venture fund. Second, they can occur in the form of public sales, typically called "initial public offerings," or IPOs. A third type of liquidity event is a recapitalization event. We will drill down on each of these a bit, but recapitalizations are basically a way of selling part of the business and holding on to another part as the business continues to grow.

MR. PENHALE: All right. Just before you move on, there is perhaps a distinction we can make between what I think is a reality in the Canadian market in contrast to the U.S. market. In the Canadian market, at least in Quebec, if you look at the 50 largest companies, you would not be surprised to find that two thirds of them are either controlled by a group of shareholders--public and private--or controlled by the family that actually founded them. (3)

I remember a number of years ago we were involved in a cross-border IPO-related transaction. Our firm had been retained by counsel for the underwriters, and we had the U.S. counterpart. We were looking at a structure involving dual classes of shares, and you had half of the table literally scratching their heads trying to figure out why there would be one class of shares with more votes than the other class. How could you possibly take this to market and what had you been smoking to think that you could? And that's a reality. Increasing the market of people investing results in investors' recognition of all sorts of governance issues to do with a class. Still, even in an established public company in Canada, it would not be rare to find that there is a controlling shareholder, group of shareholders or family, who play a key role in decisions pertaining to liquidity. (4)

MS. DELLINGER: I will also add, and this ties into what Anthony said, that it seems to me after having practiced law for 20 years, that over that period of time, the exits for privately held companies, whether by private sale, public sale or otherwise, have almost become commoditized somewhat. (5) Nowadays, someone declares, "Well, I am thinking about selling my business," and all of a sudden someone else jumps out in front of them and says, "Here are the three ways you can do it. Here are the valuation models and the agreements you are going to need, and this is how you are going to sell your company, and we also have a list of the 50 best candidates to sell your company to, and we are going to narrow that list at auction."

There are virtues to that because, in some respects, that makes the market more efficient and some of the auction processes that have been created by investment banks, large or small, tend to increase valuation. On the other hand, when something is commoditized, there may be something lost in that process, too.

There is one thing that I always encourage an entrepreneur to do: look at the whole package of options, listen to what the professionals have to say, and pay close attention for the option that sounds prepackaged. They might be selling to the company you can compete with versus what is really, really important to your business that may look for the particular value proposition your business offers and really help promote that piece of it and actually got lost in the process.

The first method of exit that we will focus on is the private sale. There are two types of potential buyers out there when dealing in private sales. First, there are "strategic" buyers, who are people in the industry or companies looking to buy companies and equity funds. (6) Second, there are equity-fund buyers. (7)

It used to be that you had venture capital, and then you had traditional equity funds and it was somewhat uncommon to have an equity fund sell to an equity fund. The opposite is true today. Now this is one of the most common types of transactions being made. (8)

The other word you see flying around in the media is "hedge funds," but from the entrepreneurial company standpoint, an equity fund and a hedge fund are really the same thing. An equity fund is a pile of money that is funded, either by individuals or institutions or pension funds, that is looking for a place to make money outside of the traditional public market series of private investments. (9) They are looking for businesses that can run themselves and make money on their money, versus the strategic buyer who is really looking to have innovative business with its current operations. (10)

MR. PENHALE: There can also be some confusion between strategic and financial buyers because they can strap onto one of their foreign acquisitions, causing a party that is seemingly a financial buyer to behave like a strategic buyer.

MS. DELLINGER: Certainly, and I have another slide that will address that very issue. At this point, I would like to discuss the valuation of a business. It used to that a strategic buyer would almost invariably pay more than an equity...