Every employee’s dream: The Complete Guide to a Successful ExitWho decides whether to make an exit, which clauses does one need to be careful about in the agreement, what kinds of exit are there, and how is payment to be made? Following the acquisition of Israeli company Datorama, we examined how to conduct an exit in the best and most correct manner
17.07.18 | Adv. Yaron Sobol
“Exit” – issuing company shares to the public or the company’s sale of its activity – is a magical word that does wonders for entrepreneurs, investors, employees and managers. An exit is the wish of everyone involved in a company: the entrepreneurs who had the dream and realized it; the investors who believed in the entrepreneurs and risked their money; the employees who came on board for the journey; and the managers who analyzed the market, set company targets and took pains to achieve them, building activity that created value.
An exit results from from a mixture of a number of factors in the right place and at the right time. The company’s technology has ripened into a product; an IPO or a merger with another company, and above all – proper management of the company. Good and proper management is very often the magic key to the exit door. An exceptional product or technology are not enough because, without proper management, the exit will fade into nothing.
Following the huge transaction reported yesterday (Monday), according to which giant global company Salesforce announced that it is acquiring Israeli company Datorama, for a sum estimated by entities close to the transaction to be approximately 850 million dollars, we decided to take a look at how to conduct an exit in the best way possible.
Who decides when and if to make an exit: The board of directors, the shareholders, the CEO?
The board of directors is the body that sets and determines company policy and instructs the CEO as to which direction he should take. The CEO is the supreme executing authority in the company and it is his duty to take all the steps necessary to put the company’s policy into practise. The shareholders, including the investors, expect to make a profit on their investment, but although they will be required to approve the move, they have no direct influence on the decision as to whether or not to go to exit.
However, in extreme situations, shareholders who are dissatisfied with the policy line taken by the board of directors can act to change the composition of the board to one they believe will promote their agenda. Ultimately, it is the board of directors that determines when and whether to make an exit.
A decision of this nature is made quite a way in advance and places the company in an exit-oriented mode of operation. The CEO will put the plan into action, but the final word will be that of the board of directors. As part of the process, the shareholders will be asked to approve the move and, theoretically, they can torpedo it if the expected return on investment is low or even negative.
How do you draw up an exit agreement, which clauses require special attention, and above all – what you should not do
In order to ensure an advantage at exit, investors need to lay the foundation for it already at the first stage when they invest in the company, whether in the framework of an investment agreement or another separate agreement. When an exit is conducted as part of the issuance of preferred shares, the preferred stock aspect become redundant as the shares revert to being ordinary shares. The same thing would happen in a merger in which the preferred stock is of the merging company. Therefore, in order to assure preferred rights, mainly in regard to registration for trade, this should be grounded in an agreement.
An exit through issuance of the company’s shares to the public is done by means of a prospectus. In this scenario, the most important issue for shareholders is the post-IPO “lock-up period” during which pre-IPO shareholders are not permitted to sell their shares. Moreover, internal information policy restricts employees and officers from selling shares on an ongoing basis, and only permits them to do so at set regular time slots that commence after publication of financial statements and end a few days before the end of a quarter. It is therefore not always possible to maximize profit resulting from the exit.
In IPOs in the US, investors who sign an agreement with the company that promises registration rights and priority in registering the shares for trading have an advantage. Such an agreement would provide investors a priority right in relation to other shareholders, and in some cases even give them the power to force the company to register their shares.
An outline of the sale of the company or its activity is often considered a “liquidation” for the purpose of realizing investors’ rights. Defining an exit as “liquidation” will give investors an advantage and precedence in receiving monies they paid as consideration in the transaction. Therefore, as long as the company is not a publicly-traded company, it is important that investors safeguard their surplus rights within the framework of the company’s articles of association, particularly with regard to definition of the surplus financial rights attached to shares allocated to investors.
What kinds of exit are there – selling, minority shareholding or consulting
Exits are divided into two main categories – an IPO or a sale. In the case of an IPO, the company registers its shares for trading on any recognised stock exchange in the world and raises capital from investors. This move prices the company’s share value, but it is subject to fluctuations due to the market’s pricing of the share and this could rise or fall. In this scenario, the exit is indirect and depends on the ability of the shareholders to sell the shares through trading.
In a sale scenario, things are different. Here the consideration for the shares is given on the closing date of the transaction and, if it is given in cash, the shareholder realizes his shares on that date. If the consideration is given in shares in the acquiring company, realization of their value may be subject to certain conditions, such as a lock-in period, an obligation to sell the shares in increments and, of course, the share price on the market.
An intermediate option for an exit exists in an area that is starting to gain momentum in Israel – the secondary market – which enables a meet-up with money in advance of an IPO or merger. In such a scenario, a third party (usually funds specializing in the field, or large investors who already own shares in the company), buys the shares in a private transaction and becomes a shareholder in the company, in expectation of a full exit later on.
This track allows for a release of pressure among employees and founders, who are keen to see a certain return for their labor, particularly when they have economic needs. This track is also suited for early investors, who invested a small amount at the beginning and do not have the required endurance to continue, or simply do not wish to as it does not suit their economic model. Such an exit allows them to remain in the company until the full exit is conducted. In general, we’re talking about a replacement of shareholders.
How is payment made and to what does the seller commit?
The payment can be in any negotiable “currency”: In cash or in the securities of the buyer, which the seller can exercise by selling them on the stock market. The principle of an exit is that against an asset that was not tradable until that time, you receive money or a negotiable asset.
In an exit by way of an IPO, the only obligation that applies to the shareholders is a lock-in for a certain period on selling their shares. Things are different in the case of an exit through the sale of the company. In general, the buyer will ask to impose certain restrictions on the controlling shareholders and shareholders, both in relation to restriction on the sale of the shares on the market and in terms of non-competition with the acquiring company for a certain period, or even requiring the seller to continue to work for the company for a certain period of time.
In the event of a purchase by a giant company, the latter will not limit the sale of the shares on the market but may insist on the continued employment of employees and managers and may sometimes link the opportunity for them to sell shares to a schedule that fits such a commitment.
How can you ensure employees benefit from the sale of a company or its future merger?
Two tracks exist – the exercise of options and bonuses on the transaction. The exercise of options is carried out through a share options plan (in accordance with Section 102 of the Income Tax Ordinance) in a track that provides a tax benefit at a rate of only 25%. In other words, if an employee is entitled to ILS 10,000 he will pay 2,500 shekels in tax. This kind of program establishes a vesting period, based on windows of time set by the company.
Nevertheless, in order to enjoy the tax benefit in this track, options and shares are subject to a sale blockage for a period of two years from their allotment. Employees who received options as part of their employment conditions (a common practice in technology companies), can exercise the options for shares on the closing date of the sale of the company and shall receive for them the same consideration as any other shareholder – either in the form of shares in the acquiring company or in cash.
Exercising in this way is usually ‘net’, meaning that the employee receives a certain number of shares at no cost , less the exercise price he would have had to pay. The main obstacle for the employees is the number of options it is possible to exercise at the time of the transaction, and whether the two-year restriction period set by the Tax Authority has expired. The solution lies along two different paths: Acceleration of the eligibility period in the case of transfer of control to the buyer and arrangement of the issue with Income Tax.
Usually, in order to overcome this obstacle, the bonus option is used to reward employees when the company is sold. This is a decision of the company, the significance of which is that the shareholders waive part of the consideration in favor of the employees. In such a case, taxation is according to the tax rate applicable to each employee.
The writer is a senior partner at law firm Hamburger Evron & Co. and Head of the Technology and Corporate Department