Consequences of Complex Capital Structures – A Coda or a Bridge?

In earlier blog posts we discussed the potentially pernicious effect of a decline in the value of pre-public companies on equity compensation granted to employees.  As the junior-most securities in a startup capital stack, common shares (and options on common) granted to employees do not enjoy the rights and protections accorded to the more senior preferred shares.  The implicit leverage means that while preferred shareholders often favor risky moves to seek very high valuations, holders of common shares suffer disproportionately when such bets fail to pay off.  Certain tax provisions and choices – requiring or allowing early payment of taxes on economic benefits that have yet to materialize – can further compound the economic blow.  Consider further, the asymmetric risks borne by the various classes – the preferred investors’ interests are probably but a component of a diversified portfolio assembled by seasoned financial professionals, while employees’ ownership of common shares represents an outsized bet on a single name.  Unlike preferred investors, employees also depend on their employers for current income.

The 2015 sale of Good Technology, an enterprise mobile management and security company, to Blackberry provides an unfortunate illustration.

• After separating from Motorola in a spin-off/merger transaction in 2009, Good Technology raised a cumulative $300 million in VC funding over a number of years.
• An early 2014 funding round implied a (headline) valuation of more than $1 billion.
• The company filed to go public in May 2014.
• Good received an $825 million acquisition offer from CA Technologies in March 2015. The company did not act on the offer believing an IPO would value it at more than $1 billion.
• Prospects for the mobile management segment manifestly soured in April 2015 as the stock price of MobileIron, a competitor, fell following weak revenue announcement/guidance. Good, which had reported 2014 revenues of $212 million, also started to lower projections and postponed IPO plans.
• Thoma Bravo made a $650 million offer for Good in June 2015, but a transaction did not transpire.
• Amid a cash crunch, Good sold to Blackberry for $425 million in September 2015.

The transaction reportedly implied a value of $0.44 per common share, and more than $3.00 per preferred share.  Some employees had received secondary offers of approximately $3.00 per share earlier in the year.  Others had acquired and paid taxes on common stock at a value of up to $3.34 per share as late as August 2015.

In June 2017, directors on the Good board (including VC investors) settled a shareholder lawsuit for $17 million.  The shareholders also reached a settlement for an additional $35 million with JP Morgan, the company’s financial advisor on the Blackberry transaction.  The directors (six of whom represented total VC investments of $125 million in Good) were accused of focusing on the narrow interests of the preferred stock holders (to the detriment of common shareholders), and of failing to supervise JPM and control the sale process.  JPM was accused of conflicts of interest.

The settlement is undoubtedly a positive outcome for the common shareholders (primarily current and former employees) of Good Technology.  A broader governance question remains unsettled, nonetheless – to what extent should the board and management consider the interests of common shareholders when a set of (in)actions can result in dramatically different economic payoffs for the various classes of shares?  Also more generally, how much information should common shareholders have access to as they make decisions regarding equity transactions and related tax payments?¹  As a Financial Times article notes:

“Preferred stock was thought to be something that was privileged because it came with rights. That idea is now being trimmed back”, said Michael Kendall, a lawyer at the corporate law firm Goodwin. The heightened litigation risk he noted suddenly gives common shareholders new leverage in M&A negotiations. A better balance between the interests of elite VC/PE investors and common shareholders would bring more sanity and fairness to the private dealmaking marketplace.

As valuation analysts, we do not have authoritative views on these legal questions.  From our perspective, contractual (and/or customary) rights and preferences allocated among the various parties to a transaction define the parameters within which we operate while measuring fair value.  That being said, the extent to which differential shareholder rights can or cannot be (legally or normatively) enforced may inform the assumptions and expectations of market participants, be they VC investors or startup employees.  And those market participant perspectives will inform the valuation analysts’ assumptions and methods.

Related Links

• Consequences of Calcified Cap Charts: A Few Thoughts on Startup Equity-Based Compensation
• Look Before You Leap: Evaluating a Section 83(b) Election
• Unicorn Valuations: What’s Obvious Isn’t Real, and What’s Real Isn’t Obvious
• How to Value Venture Capital Portfolio Investments

End Note

¹ It emerged that even as common shares transacted at values in excess of $3.00 per share in August 2015, a third-party appraisal had valued Good at $434 million and the common stock at approximately $0.88 per share as of June 30, 2015.