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Lessons from a Private Equity Earn Out: How I Lost £550K Due to a Lowercase 'C'

73 points by seasicksteve 2y ago

fortran77 2y ago
The "P" in "Parties" also needed to be capitalized.
- blackeyeblitzar 2y ago
  What I don’t get is even in the absence of capitalization wouldn’t the default interpretation be whatever the prevailing reasonable meaning would be?
  - hluska 2y ago
    In legalese, there is a massive difference between proper and improper nouns. Capitalization matters a tremendous amount.
    - gamblor956 2y ago
      Capitalization matters very little in legalese, but punctuation is king. This is because, unlike with punctuation, capitalization was not (and still is not) consistent across legal documents. Some people/firms use all caps for defined terms; others standard capitalization, and many don't capitalize at all on the grounds that a a defined term is not a proper noun unless it is a person, place, or thing.
      - hluska 2y ago
        In the article, the author lost half a million over capitalization. Using just that example (because it’s what we’re talking about) explain how it matters very little.
        gamblor956 2y ago
        No, the author did not lose any money over capitalization. The author did not understand that capitalization was irrelevant. What was relevant was that the author failed to properly disclosed a "connected person" as defined in the legal agreement. The law he was referencing would have done nothing to address/correct his failure, regardless of the capitalization used.
    - giomasce 2y ago
      How do you write a noun that is not meant to be capitalized but happens to be place just after a full stop?
      - hluska 2y ago
        You capitalize it, just like you did with the first word of that sentence. That’s because it is an improper noun. My quote was: “In legalese, there is a massive difference between proper and improper nouns.” Do you understand or would you like more help?
        giomasce 2y ago
        Your quote is also: "Capitalization matters a tremendous amount". But at least in some positions capitalization is mandated by grammar rules. So, when a noun should appear in such a position (e.g., just after a full stop), how does one distinguish between its two forms (capitalized and not capitalized)? There should be a way, if that "matters a tremendous amount".
  - deleted 2y ago
    [deleted]
  - phoenixy1 2y ago
    From the article, it's not clear that the prevailing reasonable meaning was Connected Parties. In fact, it sounds like the author thought the meaning was connected parties -- otherwise he would not have bothered to disclose the relationships of the two shareholders who were connected parties (lowercase) but not Connected Parties (uppercase).
blackeyeblitzar 2y ago
I feel like in general, the complex structures and legalese in the startup world are set up against founders and against employees. Is there anyone pushing for simplification or standard forms or structures that are not just in the VC’s or acquirer’s interests?
- ralph84 2y ago
  Attorneys like repeat business. They’re much more likely to do business again with a private equity firm than a founder, so even if they nominally represent the founder they’re not going to do anything that would jeopardize their prospects for future business with the private equity firm.
  - vmfunction 2y ago
    > so even if they nominally represent the founder they’re not going to do anything that would jeopardize their prospects for future business with the private equity firm. Ouch! Seems like there should be some 'unionised' legal representation for founders. Seems like representation for founder and VC to be a conflict in interests. This seems to be much heavily emphasised on capital vs talent.
    - JumpCrisscross 2y ago
      > Seems like there should be some 'unionised' legal representation for founders Just pick a lawyer who works for founders. (Any competent firm will also find this in conflicts.)
      - lazide 2y ago
        You’re the only one who reliably can work in your best interest, and even then it’s hit and miss sometimes. Always ask questions, figure out others actual and stated interests, and look for incongruencies. And look to be as educated as possible. Easy to say, hard to do. There is no ‘sure thing’ in this world.
  - 2y ago
RcouF1uZ4gsC 2y ago
I feel the biggest issue was that there was a desperation for the sale which caused to the OP to agree to something out of their comfort zone and experience. Once you do that, the advantage is for the acquiring company.
- sealeck 2y ago
  Presumably any private equity firm you'd want to work for would respect the fact that you were capable of getting a good deal for your founder client (and the implicit assumption that because they have additional evidence that you are a better lawyer who is also loyal to their clients that they are more likely to hire you)?
  - egl2021 2y ago
    "...you'd want to work for..." This is a misleading framing. The private equity firm only wants to make the deal work financially and only for them. Anything else is secondary. You shouldn't be thinking about their respect, wanting to work for them, or anything beyond the deal terms.
hluska 2y ago
When dealing with private equity, there are three things to remember: 1.) You may negotiate with them two or three times in your life. They negotiate with people two or three times a day. You are the least experienced and most vulnerable party. 2.) They are not your friends. They’ll pretend but they’re not. If you’re in music, think better paid A&R with fewer morals. 3.) If a term can sink a deal, they were never interested in signing. Adults can deal with disagreements without crashing the whole plane.
- bankcust08385 2y ago
  If it's not fatal, don't "marry" a third-party of questionable integrity for some cash.
- tptacek 2y ago
  This particular story doesn't seem like a negotiation failure so much as a grave failure of this person's legal counsel in drafting the final agreement.
  - hluska 2y ago
    They chose the wrong counsel - they went to a general practice firm as opposed to finding a lawyer capable of navigating 1 - 3. A lawyer may be great at holding little old ladies’ hands while preparing their wills. That does not mean they’re qualified to deal with PE.
    - tptacek 2y ago
      The legal work handling our side of the Matasano acquisition was nosebleed expensive, and it was specialized.
    - smcin 2y ago
      Can you give more constructive advice on how to find a lawyer that both can draft a non-trivial agreement with PE, and is affordable? What specifics do you look for?
deleted 2y ago
[deleted]
infecto 2y ago
Great article and great takeaways. People should always keep in mind that in business people are not your friends. Does not mean they are evil though. The takeaway here is the what I take as the main point. Hire proper legal representation.
- deisteve 2y ago
  [dead]
Havoc 2y ago
If you read this carefully you'll notice this story is presented back to front. >revenue must not have involvement with "connected parties." >disclosed that two of my shareholders also worked at companies that were customers ...and surprise surprise the revenue gets disputed. Disclosing things doesn't invalidate pieces of the contract - if anything it strengthens it given solid evidence to the opposing party here. That's it. End of story. And yes, good advice - lawyers may have saved this. The rest reads like the result of a desperate laymans search for anything that might back an alternate interpretation....absolutely anything that might get these two obviously excluded revenue pieces back into scope. To call it a longshot would be generous: >Had the "C" in "connected parties" been capitalized, it would have fallen under the HMRC Taxation of Chargeable Gains Act, which in the UK formally defines a Connected Party as a person who has control of a company, which was not the case with either of my shareholders. Why would UK tax law definitions have any bearing on interpretation of what revenue is in scope for a valuation calculation? But lets assume it somehow is via some unnamed mechanism. The act doesn't even mention "Connected Party" let alone define it. It does talk about connected persons but you'd need to squint pretty hard to turn party in persons via a capital C...and ignore the minor detail about it dealing with tax matters not M&A matters. I'm gonna go out on a limb here and say there was no lawyer involved in the capital C part of the story at all.
- gamblor956 2y ago
  I'm gonna go out on a limb here and say there was no lawyer involved in the capital C part of the story at all Agreed. If "Connected Persons" in the UK tax law was intended to govern the contract's interpretation, that would have been explicitly called out in the contract. (Note: in the U.S., M&A law is part of tax law, but even in this context it is understood that a term has its common/dictionary meaning unless the language of the agreement specifically states that a statutory or regulatory meaning is intended.) But also, capitalization isn't generally relevant for determining whether a noun refers to a defined term or not; for example "Connected Persons" "connected persons" and "CONNECTED PERSONS" are all read the same, unless there is something in the contract that specifically states otherwise. It used to be common for the first usage of a defined term to be all caps. This story reads like someone thought they could save money by not having a (subject-matter competent) lawyer review everything and it came back to bite them in the ass.
gnicholas 2y ago
I used to be a lawyer in SV, and whenever my lawyer friends talk about earnouts, it's always in the context of what a bad deal they are for founders. Basically, they take a lot of lawyer time to negotiate, in order to make them as close to airtight as possible. And if anything goes wrong, it takes a lot of lawyer time to resolve them. And lawyer time equals money (as much as $2k/hr, billed in 6 minute-increments). So you could pay six figures negotiating an earnout, and another six figures when things don't go as planned. That doesn't mean they're always a bad idea — just the vast majority of the time. A candid lawyer will counsel you away from an earnout, and if a lawyer doesn't mention the potential downsides of earnouts, I'd consider that a big red flag.
- gamblor956 2y ago
  I work for a company that does a lot of acquisitions. Basically all of our acquisitions involve earnouts, and they're never a bad deal for the sellers. In many cases, without the earnout the deal doesn't happen because the price the seller wants is higher than we'd be willing to pay unless the continued performance of the business post-acquisition justified the higher price tag. But whether earnouts are good or bad for sellers is industry specific. I don't work for a tech company, and we don't deal with VC or PE firms at all. Our acquisitions are all companies with real revenue streams, established histories of revenue, and non-tech business models that don't require exponential growth or "scale", so earnouts are extremely straightforward.
  - gnicholas 2y ago
    Yes, earnouts can help bridge a valuation gap — and if the buyer is reasonable/kind, then they can create a win-win scenario. The question is whether a seller can accurately identify whether their counterparty is reasonable/kind. This is the sort of thing that lawyers should be able to help with, since they're involved in many deals. But as mentioned above, they may have misaligned interests that cloud their judgment.
  - pottertheotter 2y ago
    All of the horror stories I've heard from others about earnouts involved "companies with real revenue streams, established histories of revenue, and non-tech business models that don't require exponential growth or 'scale'". There's so many ways that even the most "straightforward" of earnout terms becomes non-straightforward.
com 2y ago
Excellent advice. I’m not convinced that it’s possible to get the 100-day integration to start only after the earn-out is completed. Anybody managed to get this in the sale agreement?
linkjp 2y ago
[dead]

73 points by seasicksteve 2y ago

fortran77 2y ago

The "P" in "Parties" also needed to be capitalized.

blackeyeblitzar 2y ago
What I don’t get is even in the absence of capitalization wouldn’t the default interpretation be whatever the prevailing reasonable meaning would be?
- hluska 2y ago
  In legalese, there is a massive difference between proper and improper nouns. Capitalization matters a tremendous amount.
  - gamblor956 2y ago
    Capitalization matters very little in legalese, but punctuation is king. This is because, unlike with punctuation, capitalization was not (and still is not) consistent across legal documents. Some people/firms use all caps for defined terms; others standard capitalization, and many don't capitalize at all on the grounds that a a defined term is not a proper noun unless it is a person, place, or thing.
    - hluska 2y ago
      In the article, the author lost half a million over capitalization. Using just that example (because it’s what we’re talking about) explain how it matters very little.
      - gamblor956 2y ago
        No, the author did not lose any money over capitalization. The author did not understand that capitalization was irrelevant. What was relevant was that the author failed to properly disclosed a "connected person" as defined in the legal agreement. The law he was referencing would have done nothing to address/correct his failure, regardless of the capitalization used.
  - giomasce 2y ago
    How do you write a noun that is not meant to be capitalized but happens to be place just after a full stop?
    - hluska 2y ago
      You capitalize it, just like you did with the first word of that sentence. That’s because it is an improper noun. My quote was: “In legalese, there is a massive difference between proper and improper nouns.” Do you understand or would you like more help?
      - giomasce 2y ago
        Your quote is also: "Capitalization matters a tremendous amount". But at least in some positions capitalization is mandated by grammar rules. So, when a noun should appear in such a position (e.g., just after a full stop), how does one distinguish between its two forms (capitalized and not capitalized)? There should be a way, if that "matters a tremendous amount".
- deleted 2y ago
  [deleted]
- phoenixy1 2y ago
  From the article, it's not clear that the prevailing reasonable meaning was Connected Parties. In fact, it sounds like the author thought the meaning was connected parties -- otherwise he would not have bothered to disclose the relationships of the two shareholders who were connected parties (lowercase) but not Connected Parties (uppercase).

blackeyeblitzar 2y ago

I feel like in general, the complex structures and legalese in the startup world are set up against founders and against employees. Is there anyone pushing for simplification or standard forms or structures that are not just in the VC’s or acquirer’s interests?

ralph84 2y ago
Attorneys like repeat business. They’re much more likely to do business again with a private equity firm than a founder, so even if they nominally represent the founder they’re not going to do anything that would jeopardize their prospects for future business with the private equity firm.
- vmfunction 2y ago
  > so even if they nominally represent the founder they’re not going to do anything that would jeopardize their prospects for future business with the private equity firm. Ouch! Seems like there should be some 'unionised' legal representation for founders. Seems like representation for founder and VC to be a conflict in interests. This seems to be much heavily emphasised on capital vs talent.
  - JumpCrisscross 2y ago
    > Seems like there should be some 'unionised' legal representation for founders Just pick a lawyer who works for founders. (Any competent firm will also find this in conflicts.)
    - lazide 2y ago
      You’re the only one who reliably can work in your best interest, and even then it’s hit and miss sometimes. Always ask questions, figure out others actual and stated interests, and look for incongruencies. And look to be as educated as possible. Easy to say, hard to do. There is no ‘sure thing’ in this world.
- 2y ago

RcouF1uZ4gsC 2y ago

I feel the biggest issue was that there was a desperation for the sale which caused to the OP to agree to something out of their comfort zone and experience. Once you do that, the advantage is for the acquiring company.

sealeck 2y ago
Presumably any private equity firm you'd want to work for would respect the fact that you were capable of getting a good deal for your founder client (and the implicit assumption that because they have additional evidence that you are a better lawyer who is also loyal to their clients that they are more likely to hire you)?
- egl2021 2y ago
  "...you'd want to work for..." This is a misleading framing. The private equity firm only wants to make the deal work financially and only for them. Anything else is secondary. You shouldn't be thinking about their respect, wanting to work for them, or anything beyond the deal terms.

hluska 2y ago

When dealing with private equity, there are three things to remember: 1.) You may negotiate with them two or three times in your life. They negotiate with people two or three times a day. You are the least experienced and most vulnerable party. 2.) They are not your friends. They’ll pretend but they’re not. If you’re in music, think better paid A&R with fewer morals. 3.) If a term can sink a deal, they were never interested in signing. Adults can deal with disagreements without crashing the whole plane.

bankcust08385 2y ago
If it's not fatal, don't "marry" a third-party of questionable integrity for some cash.
tptacek 2y ago
This particular story doesn't seem like a negotiation failure so much as a grave failure of this person's legal counsel in drafting the final agreement.
- hluska 2y ago
  They chose the wrong counsel - they went to a general practice firm as opposed to finding a lawyer capable of navigating 1 - 3. A lawyer may be great at holding little old ladies’ hands while preparing their wills. That does not mean they’re qualified to deal with PE.
  - tptacek 2y ago
    The legal work handling our side of the Matasano acquisition was nosebleed expensive, and it was specialized.
  - smcin 2y ago
    Can you give more constructive advice on how to find a lawyer that both can draft a non-trivial agreement with PE, and is affordable? What specifics do you look for?

deleted 2y ago

[deleted]

infecto 2y ago

Great article and great takeaways. People should always keep in mind that in business people are not your friends. Does not mean they are evil though. The takeaway here is the what I take as the main point. Hire proper legal representation.

deisteve 2y ago
[dead]

Havoc 2y ago

If you read this carefully you'll notice this story is presented back to front. >revenue must not have involvement with "connected parties." >disclosed that two of my shareholders also worked at companies that were customers ...and surprise surprise the revenue gets disputed. Disclosing things doesn't invalidate pieces of the contract - if anything it strengthens it given solid evidence to the opposing party here. That's it. End of story. And yes, good advice - lawyers may have saved this. The rest reads like the result of a desperate laymans search for anything that might back an alternate interpretation....absolutely anything that might get these two obviously excluded revenue pieces back into scope. To call it a longshot would be generous: >Had the "C" in "connected parties" been capitalized, it would have fallen under the HMRC Taxation of Chargeable Gains Act, which in the UK formally defines a Connected Party as a person who has control of a company, which was not the case with either of my shareholders. Why would UK tax law definitions have any bearing on interpretation of what revenue is in scope for a valuation calculation? But lets assume it somehow is via some unnamed mechanism. The act doesn't even mention "Connected Party" let alone define it. It does talk about connected persons but you'd need to squint pretty hard to turn party in persons via a capital C...and ignore the minor detail about it dealing with tax matters not M&A matters. I'm gonna go out on a limb here and say there was no lawyer involved in the capital C part of the story at all.

gamblor956 2y ago
I'm gonna go out on a limb here and say there was no lawyer involved in the capital C part of the story at all Agreed. If "Connected Persons" in the UK tax law was intended to govern the contract's interpretation, that would have been explicitly called out in the contract. (Note: in the U.S., M&A law is part of tax law, but even in this context it is understood that a term has its common/dictionary meaning unless the language of the agreement specifically states that a statutory or regulatory meaning is intended.) But also, capitalization isn't generally relevant for determining whether a noun refers to a defined term or not; for example "Connected Persons" "connected persons" and "CONNECTED PERSONS" are all read the same, unless there is something in the contract that specifically states otherwise. It used to be common for the first usage of a defined term to be all caps. This story reads like someone thought they could save money by not having a (subject-matter competent) lawyer review everything and it came back to bite them in the ass.

gnicholas 2y ago

I used to be a lawyer in SV, and whenever my lawyer friends talk about earnouts, it's always in the context of what a bad deal they are for founders. Basically, they take a lot of lawyer time to negotiate, in order to make them as close to airtight as possible. And if anything goes wrong, it takes a lot of lawyer time to resolve them. And lawyer time equals money (as much as $2k/hr, billed in 6 minute-increments). So you could pay six figures negotiating an earnout, and another six figures when things don't go as planned. That doesn't mean they're always a bad idea — just the vast majority of the time. A candid lawyer will counsel you away from an earnout, and if a lawyer doesn't mention the potential downsides of earnouts, I'd consider that a big red flag.

gamblor956 2y ago
I work for a company that does a lot of acquisitions. Basically all of our acquisitions involve earnouts, and they're never a bad deal for the sellers. In many cases, without the earnout the deal doesn't happen because the price the seller wants is higher than we'd be willing to pay unless the continued performance of the business post-acquisition justified the higher price tag. But whether earnouts are good or bad for sellers is industry specific. I don't work for a tech company, and we don't deal with VC or PE firms at all. Our acquisitions are all companies with real revenue streams, established histories of revenue, and non-tech business models that don't require exponential growth or "scale", so earnouts are extremely straightforward.
- gnicholas 2y ago
  Yes, earnouts can help bridge a valuation gap — and if the buyer is reasonable/kind, then they can create a win-win scenario. The question is whether a seller can accurately identify whether their counterparty is reasonable/kind. This is the sort of thing that lawyers should be able to help with, since they're involved in many deals. But as mentioned above, they may have misaligned interests that cloud their judgment.
- pottertheotter 2y ago
  All of the horror stories I've heard from others about earnouts involved "companies with real revenue streams, established histories of revenue, and non-tech business models that don't require exponential growth or 'scale'". There's so many ways that even the most "straightforward" of earnout terms becomes non-straightforward.

com 2y ago

Excellent advice. I’m not convinced that it’s possible to get the 100-day integration to start only after the earn-out is completed. Anybody managed to get this in the sale agreement?

linkjp 2y ago

[dead]