In This Issue

INDUSTRY NEWS
M&A Lawyers See Rise in Post-Closing Disputes
Expert panel at the 16th Annual Private Equity CFO Conference urges caution when VCs consider serving as a shareholder representative.

BEST PRACTICES
Avoiding and Fighting Disputes - An Easy and Powerful Tool
Nobody wants post-closing problems. We suggest one of the more powerful ways to avoid them and to handle them if they do come.

OPINION
Anyone Interested in a Penny? Two Cents Just Makes No Sense
Some things make no sense but are done anyway as industry practice. We identify one and propose a solution.

M&A Lawyers See Rise in Post-Closing Disputes

PricewaterhouseCoopers, Cooley Godward Kronish and Thomson Reuters recently hosted the 16th Annual Private Equity CFO Conference. During the morning session, Mike Rhodes, chair of Cooley's litigation practice, spoke about the macro trends in private equity M&A. He noted that Cooley is seeing a material increase in disputes between buyers and sellers following the closing of M&A deals, especially on escrows and earn-out consideration. According to Rhodes, more disputes means bigger headaches and a greater time commitment for whomever is appointed the shareholder representative.

In addition, Rhodes said, "The courts are applying greater scrutiny than ever to whether the parties have met their fiduciary obligations, including obligations the representative of the former shareholders has to other shareholders." Therefore, Cooley's litigators are "increasingly seeing problems when VCs act as shareholder representative of selling shareholders" and advise that "venture capitalists take on the role of shareholder representative sparingly."

Avoiding and Fighting Disputes - An Easy and Powerful Tool

Every merger agreement contemplates a process for the buyer to make claims and for the selling shareholders, through the shareholder representative, to review and react to the claim. We suggest that stockholders strongly consider establishing an expense fund in connection with that process.

An expense fund is a voluntary set-aside created by the shareholders at closing for third-party expenses incurred during the post-closing period. The fund should cover reasonably anticipated fees and expenses that occur when a claim is made and the parties are unable or unwilling to settle. Litigators say that the establishment of an expense fund is one of the best deterrents for minimizing buyer claims.

Many buyer claims are paid simply because the selling shareholders do not want to reach into their pockets after closing to fund dispute costs, even when a basis for a defense exists. Buyers sometimes count on this shareholder reluctance when deciding whether or not to make borderline claims. In contrast, if the buyer knows the shareholder representative has the resources available to mount a defense, they will more closely evaluate the merits of a claim and the amount of time and their own resources necessary to go through the dispute resolution processes of negotiation, mediation, arbitration and/or litigation.

An expense fund also gives the former shareholders more options when a claim is made. If there is no expense fund, the shareholder representative may not have the resources necessary to most effectively represent the selling shareholders. Shareholders can always "pass the hat," but the window to respond to disputes is typically limited. By the time funds become available, the response period may have lapsed.

Finally, an expense fund tends to result in a more fair and equitable allocation of dispute expenses to the former shareholders. If an expense fund is established at closing, then every shareholder contributes to it on a pro-rata basis with the unused balance returned to shareholders at the end of the post-closing period. Without an expense fund in place, it is more likely that the large shareholders will end up funding more than their pro-rata share of expenses in a dispute the shareholders elect to fight because collecting from the other shareholders tends to be difficult, if not impossible.

The right size expense fund depends on the deal. SRS recommends a minimum escrow expense fund of $50,000. If the escrow is larger or the earn-out potential is significant, an amount between $250,000 and $500,000 may be more appropriate. We've seen reserves as high as $1 million. It really depends on the magnitude of potential upside and the complexity of the company or merger terms. However, to be a good tool for the former stockholders, the expense fund needs to be a reasonable size compared to the amount of money at stake and the likelihood and complexity of the potential claims.

Regardless of the amount, SRS considers the establishment of an expense fund a best practice; having funds set aside ahead of time to quickly mount defenses against claims usually more than offsets any opportunity cost of the holdback.

EXPENSE FUND FAST FACTS In deals where SRS is the shareholder representative: • 2 out of 3 deals have expense funds •The average expense fund is over $268,000 •Expense funds range between $25,000 and $1M •The average expense fund is <1% of the sale price

Anyone Interested in a Penny? Two Cents Just Makes No Sense

In a recent M&A deal, all escrow funds were distributed to shareholders except for an amount that was related to an unresolved claim. Once the claim was resolved, the shareholders were left with an aggregate of a few thousand dollars which the escrow agent dutifully distributed based on each shareholder's pro-rata ownership. This resulted in some shareholders receiving payments for as little as one cent! The cost of sending checks for such miniscule amounts (administrative salaries, stamps, envelopes, printing, etc.) is many times greater than the face value of those checks.

No shareholder wants to receive a check in the amount of one cent. What are you going to do with it? They end up getting thrown away. The escrow bank sends them because they are required to do so under the terms of the escrow agreement.

We suggest a sensible alternative - give de minimus amounts to a charity. While the individual amounts are nominal, the aggregate over all transactions could be meaningful for charitable organizations. In addition to benefiting worthwhile causes, shareholders are spared the frustration of a ridiculous check and all parties to the deal save money in transaction expenses. In our view, no checks should go out for amounts less than $20.00. Anything under $20.00 should be consolidated and sent to a designated charity. If $20.00 is too much or too little, pick a number that feels right. Let's just stop sending checks in face amounts of pennies.

SRS In the News

7.21.09 | peHUB
Bringing Down the Fund: How One VC Almost Made the Multi-Million Dollar Mistake of a Lifetime
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7.6.09 | peHUB
Public-to-Public M&A Deals: Should There Be a Shareholder Rep?
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About SRS

Shareholder Representative Services (SRS) saves venture capitalists time and money by expertly managing the post-closing escrow or holdback period following the acquisition of one of their portfolio companies. Since 2007, SRS has represented more than 250 venture capital firms and managed the escrow period in more than 40 venture-backed M&A deals valued at over $5 billion.

For more information, visit: www.shareholderrep.com

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SRS | Shareholder Representative Services
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