This article is written by Yavanika Shah, Team LawSikho.

For any merger or acquisition deal to take place, a critical step is determining the future of the stakeholders. The dealmakers not only select an optimal strategy but also have to execute it and handle consequences along the way with great precaution.

Facebook is the social media website we all grew up with. To date, it has not only grown itself as a well-established brand but also acquired 82 other companies, including WhatsApp and Instagram. The WhatsApp acquisition closed at $16 billion; for about $40 per user of the platform. 

Kudos to Zuckerberg for giving us Facebook around 2005 when each one of us used it for communicating and staying in touch with our pals. Some of us, including me, also found their long lost friends on the website!

Well, there are also a few other people as well you’d want to thank for co-founding Facebook, other than Mark. One of them, named Eduardo Saverin, who invested the initial $15,000 in developing Facebook while Mark was still a sophomore at Harvard was shelved out of his own company! 

Readers who have watched the movie, The Social Network, would loosely know the context. 

So, in 2004, Zuckerberg, a sophomore came up with the idea of Facebook. Although he had a great idea but no money to go about it. It was at this time that he asked Eduardo Saverin, his junior for putting some money and working together for what they called TheFacebook.com. Saverin was a rich Brazilian guy with strong backing. He had a good understanding of the business and even wore suits to lectures at Harvard.

Mark thought the collaboration would be fruitful and sought Saverin’s expertise for mainly 3 things – setting up the company with his 15k$, get funding at later stages and make a business model.

The website went live in February 2004 and by April in the same year, the popularity of the platform got both of them to form an LLC under Florida Laws! As they were expanding, they partnered with another Harvard sophomore, Dustin Moskovitz.

Mark and Moskovitz moved to California while Saverin moved to New York for an internship. It was at this time that things between the partners went south as Saverin wasn’t giving time to the business and shirked off his responsibilities. He even ran unauthorized ads of his own personal business venture on Facebook for free which became a major bone of contention among them.

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Mark, by this time, became adamant to make Saverin quit out of the partnership. The website had gained huge support and had a lot of investors willing to invest. One among them was Peter Thiel, who strategized a plan that would dissolve Saverin’s stake in the company.

According to the plan, the stake held by Saverin would be reduced by creating a new company under Delaware (a state in the US) Corporation that would buy the Florida LLC.

Stock dilution, also known as equity dilution, is the decrease in existing shareholders’ ownership percentage of a company as a result of the company issuing new equity. New equity increases the total shares outstanding which have a dilutive effect on the ownership percentage of existing shareholders. 

This dilution can shift fundamental positions of the stock such as ownership percentage, voting control, earnings per share, and the value of individual shares.

So, in July 2004, a company was incorporated under Delaware laws that acquired TheFacebook.com.

The shareholding changed from:

Mark         Saverin   Moskovitz

65%            30%   5%

To

Mark         Saverin   Moskovitz Thiel       ESOPs

40%             24% 16%              9% 11%

The shareholder’s agreements were signed in October 2004, where Saverin got 3 million shares of the common stock. Further, he handed over the IP rights to Mark and also gave up his voting rights which led to Mark becoming the sole director. 

Everything was perfectly settled. Does it look like a perfect ending where everyone is happy and well-stocked?

Well, no.

The next year proved disastrous for Saverin when in January 2005 Facebook issued 9 million shares. Out of it, Mark took 3.3 million shares, while both Theil and Moskovitz took 2 million shares each.

The share issuance diluted Saverin’s stake from 24% to less than 10%!

Saverin was so indifferent to the entire business ventures of Facebook that he only realized what had happened to his stake in April when he got a letter from the HQ about his stake. It was at this time that Mark fired him when he came to the HQ with his lawyer against the whole stock dilution.

After long court proceedings where Facebook filed a suit that the stock purchase agreement signed by Saverin was invalid, the case met an out of court settlement, with both the parties signing a Non-disclosure agreement.

Do you ever think of the contractual traps or any loophole you should check for when your client joins a company as a co-founder or signs a share-holders agreement?

You bet Saverin didn’t hire a good lawyer before he signed the shareholder’s agreement in October of 2004. This is a mistake made by thousands of entrepreneurs every year.

The story not only proves to be a lesson to entrepreneurs and shareholders, but also for M&A lawyers to ponder over what makes the deals full-proof. Negotiations over shareholders’ agreements are like chess, and the lawyers have to focus on preventing shit from going sideways in the future, by foreseeing all the ways that may happen and writing language in the agreement that covers all such possibilities. 

One Shareholder agreement signed by Saverin without thinking about future problems led him to lose his stake which would eventually be worth a few billion dollars. Damn!

Pointers an M&A lawyer should negotiate upon before signing the deal with reference to stake dilution:

It’s unlikely that you will be able to negotiate a blanket prohibition on issuing shares. However, you should always negotiate on these terms:

• A right to participate in future fundraising rounds before shares are offered to others;
• A requirement that the Board obtain the shareholder’s approval before issuing shares outside certain defined parameters (for example, it might need the approval to issue shares below a certain price, or to issue more shares than an agreed limit); and/or
• A right to have your stake ‘topped up’ or ‘ratchet’ed if future shares are issued below a certain value.

There are many other minority protection rights that shareholders should negotiate, failing which, very tricky situations may arise.

Clauses a lawyer should particularly look for in a shareholders agreement:

• Protection against dilution.
• The right to appoint a director.
• Rights to access information. 
• Tag along and buy out rights.
• Pre-emptive rights. 
• Limits on the Board’s control.
• Protections against a breach.

What are the major concerns during a merger and acquisition deal, from the point of view of a lawyer?

1. Articulating the commercial logic and business intent of your client when he or she is contemplating a transaction and identify a suitable way forward, to bag mandates and perform different kinds of billable tasks.
2. Conceptualizing and implementing variations if the deal structure or negotiations change track.
3. Ensuring procedural requirements are met and that stakeholder alignments necessary as per law are obtained.
4. Developing yourself in deal structuring, execution, due diligence, documentation, negotiation and compliance.

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