The Overhang Problem

Joseph W. Bartlett, Founder of VC

The crash in valuations of venture-backed companies has produced a problem that we refer to as the "Overhang Problem," having to do with structural issues inside an emerging growth company, which block the opportunity of the company to raise necessary capital from new sources. To illustrate, assume the following hypothetical scenario:

  • Software Inc. is a three year-old software company, with a sound business and management, but is still a year or two away from cash flow break-even.
  • Software Inc. has two classes of stock outstanding, common and preferred. The preferred are divided into three series: Series A, Series B and Series C.
  • The common shareholders include the founder, other members of management and assorted angels. The preferred shareholders are professional investors (VC firms) that participated in each of the three rounds of financing. The majority interest of the Series A, B and C is made up of VCs that have been investing in the Company from inception, i.e., the Series A round.
  • The common shareholders own 30% of the Company on a fully diluted basis and they paid an aggregate of $1 million for their shares.
  • The Series A shareholders put in $10 million for participating preferred, with a 1X liquidation preference.
  • The Series B holders also invested $10 million for participating preferred, but with a 2X liquidation preference (i.e., $20 million plus accrued dividends) and the Series C holders put in $20 million and have a 3X liquidation preference. In liquidation (including a merger), the Series C liquidation preference has to be paid off first, then the Series B, then the Series A, then all the shareholders, the common and the preferred (on an 'as if converted' basis) participating pro rata in proportion to their actual holdings of common stock or their implied holdings, in the case of the preferred shareholders.

Given this scenario, let's assume that Software, Inc. has burned through most of its cash and needs additional financing. All of the above financings were closed prior to the 2001 meltdown. When the Series C closed its investment, the post-money valuation was $100 million. The savage downturn in the market place suggests that Software's current pre-money valuation is $15 million and the company forecasts that it needs $15 million to get to cash flow break even.

Software, Inc. has located a new source of financing, and negotiations commenced with the current owners. The proposal before the board is that the new investors put in $15 million and take a series of participating preferred that enjoys a 3X liquidation preference, participating post pay-off in 50% of the outstanding shares on a fully diluted basis. As a condition of its investment, the new capital source insists that all the holders of Series A, B and C (i.e., the existing VCs) voluntarily convert and surrender their liquidation preference.

The common shareholders are in favor of the transaction, management seeing it as the only hope to retain Software, Inc. as a viable entity and, in the bargain, keep their jobs. Seeing no real alternative, the majority of the A, B and C are willing to go along. These are the "Old Reliable" VCs that have played in every round. However, there are minority VCs, which feel ill used by the Company and their fellow investors, and do not have enough at risk to make much of a difference. They are, therefore, holdouts, opposing any transaction that would entail their surrendering their liquidation preferences, no matter how far underwater they might be. They make unrealistic proposals, seeking to compel the other investors to buy out their blocking positions, and negotiations reach an irreconcilable impasse. The result, of course, is yet another company down the drain, a dirty shame because the cause is not business failure but an awkward financial structure.

One way to fix this financial tangle takes advantage of the old adage "there is nothing new under the sun." Assume for the moment that the principal asset of Software, Inc., besides some intellectual property, is an experienced, motivated and capable work force, including technicians and sales and marketing people. This is fairly common among companies in the "ICE Age" (Information, Communications, Entertainment).

The financial technology entailed in the fix is borrowed from the 1980s, when management buyouts were prevalent. Erstwhile Series D investors, instead of investing $15 million directly, organize NewCo, and fund it with the typical LBO "strips" of securities. In this case, since the junk bond market is on its heels, a combination of (a) a straight or convertible preferred stock, redeemable after a period of years at the option of the holder, with dividends accruing until what amounts to the preferred's maturity and (b) common stock. The preferred, particularly if straight preferred, is the equivalent of debt, but the balance sheet appears somewhat stronger, at least to the undiscerning onlooker, because the instrument is called a "stock" rather than a "bond". The preferred "eats up" the balance sheet of NewCo, meaning that its liquidation preference matches the capital invested in NewCo so that, were NewCo to liquidate immediately after the transaction is closed, the common strip would get nothing. The object of this exercise is to make the common appear cheap for tax purposes, representing what someone once called 'high speed' equity.

The new investors buy preferred and common strips, the common entitling the erstwhile Series D to own about 70% to 75% of the Company fully diluted. Management, including the founder, is offered the opportunity to buy 'high speed' equity at bargain prices... a class of security in fact superior to stock options because the holder owns the stock for tax and Rule 144 holding period purposes from the outset and the profit is, therefore, capital gain. The management shares are subject to vesting and replace management's previous equity participation. To the extent that the founder is a manager, this amounts to reverse vesting.

NewCo then offers to buy Software, Inc. in a squeeze-out merger, paying $15 million in cash. The common, which is dominated by the managers, consents to the transaction, while the minority are left to their appraisal rights, which are negligible under the circumstances. The "Old Reliable" preferred shareholders, by majority vote of each series, approve the transaction up to a given limit. All the existing shareholders, including particularly all the VCs, are offered an opportunity to participate pari passu in funding NewCo and the "Old Reliables" in fact play. Other than the questionable value of their appraisal rights, the holdouts are essentially without remedy and Software, Inc. lives to fight another day.

There are potential glitches, of course. It may be that, buried in some of the Series A, B and/or C documents, supermajority controls over mergers exist, either obvious on the face of the document or lurking in a poorly drafted preemptive right, for example. Further, it helps if there are purely disinterested directors on the board of the target who will vote in favor of the transaction. But, it appears to be unnecessary to jump through all the hoops (fairness opinion, special counsel, etc.) in order to escape "enhanced scrutiny" in the Delaware Chancery Court. The object of this transaction is, on its face, not to scoop the assets at a bargain in favor of the 1980's type corporate raiders but, rather, to correct a malfunction in the system so the Company can be saved from insolvency.

A tip of the hat to my former partner Phil Werner and his partner, Ira White, at Morgan Lewis for providing much of the creative juice.