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Due Diligence, Mergers & Acquisitions Part I

August 15, 2014,

A merger or acquisition can be a great way to grow your business. Joining forces or purchasing another company increases your market share and potential profits. There's no real way to know if the venture will pay off. However, the proper due diligence can provide reassurance that the move you're making is a good one. Due diligence is a multi-step process, so in this post we're going to focus on just one part: liabilities.
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Understanding Liabilities

Any merger or acquisition comes with a degree of risk. Liabilities are the debts and obligations incurred through the course of doing business. Loans are considered a liability as are accounts payable and accrued expenses. It's important to take a look at the total number and dollar value of all liabilities. Also, look at the company's payment history. Are bills paid on time? Is there a record of default? These are red flags that should give you pause. Remember, once you've assumed liabilities the responsibility is yours.

Unrecorded Liabilities

An unrecorded liability is exactly as it sounds. This type of liability won't show up on any records or accounting statements. Before you call off your merger or acquisition, understand that unrecorded liabilities are normal. A common example is vacation time. Let's say an employee rolls over vacation time and, come retirement, hasn't used it all. He or she will be owed money in exchange for the hours. This can be a substantial cost if enough employees have banked their hours. The best way to find out about a company's unrecorded liabilities is to ask the right questions and request the relevant documents, or you can hire an experienced attorney.

Due diligence is a critical component of any merger or acquisition. Failure to do your homework can have dire financial consequences.

About Structure Law Group

Structure Law Group is a San Jose based firm that specializes in business issues including business formations, commercial contracts and litigation.

Mergers and Acquisitions: Understanding the Difference

May 23, 2014,

A quick scan of the headlines shows come confusion about the deal between AT&T and DirecTV. Some media outlets are calling it an acquisition while others say the 48 billion dollar purchase is a merger. Mergers and acquisitions are similar with a few important distinctions. In this post we'll address the key differences between these two kinds of transactions.

What is a Merger?

One component of mergers and acquisitions is relational. Mergers are seen as the more friendly way of doing business. When two firms merge, both shed their old companies to form a new one. A good example is the merger between Daimler-Benz and Chrysler. In this scenario, both companies ceased to exist. They issued new stock as Daimler-Chrysler. Mergers are a common occurrence between two companies of equal size and standing.

What is an Acquisition?

An acquisition is when one company purchases another. The target company is absorbed by the purchaser and no longer exists. A recent example is the acquisition of Bell South by AT&T. AT&T bought Bell and reformed it as AT&T South.

Mergers and Acquisitions: The Benefits

There are several perceived benefits to merging or acquiring another company. A business can save money on labor and expand its reach into new markets. Also, bigger companies have more purchasing power. Finally, a target company might have a unique product or skill set that creates new revenue for the parent.

So is the deal between AT&T and DirecTV a merger or acquisition? The telecommunications giant is buying the satellite provider. However, DirectTV will still keep its name but will be operating under AT&T. Confused? You're not alone. The media can't seem to decide. Given the basic definitions we discussed earlier this would be an acquisition.

There are many types of mergers and acquisitions. If you're considering either one make sure to get some assistance. Legal professionals, like the ones at Structure Law Group, are needed to sort through the mess.

About Structure Law Group

Structure Law Group is a San Jose based firm that specializes in business issues including business formations, commercial contracts and litigation.

Asset Purchases May Come With Hidden Liabilities

September 11, 2013,

One of my clients is a medium sized manufacturing plant here in San Jose. Although not a high-tech business, they have extensive capital assets and specialized skills. The business is being run by the second generation of family members, and the third generation is now being trained to take the reins someday. The family has recognized that many of their competitors are still being run by the first generation of owners, and it does not look like those businesses are likely to transition to other family members. As the owners of the competitive businesses age and want to retire, they will be looking to sell their manufacturing plants. My client wants to buy them. We recently sat down and discussed acquisition strategies. I explained that there are two common ways to buy a business - either you buy the stock, or you buy the assets. What most people do not realize, is that even when you are only buying the assets, you could be liable for up to three times the purchase price in state taxes that should have been paid by the seller.

Most people know that when you buy the stock of a corporation (or membership interests in an LLC), you get all of the assets as well as all of the liabilities in that company. As a result, many of my clients want to buy only the assets of a company as a strategy to avoid the liabilities (known and unknown) that come with a business with history behind it. To accomplish this, we draft an asset purchase agreement that includes lists of which assets we are buying, which liabilities we are buying, and which liabilities we are not taking on. For example, when you buy the stock of a company, you get all of its employees including their accrued and unpaid vacation time. When you buy the assets of a company, we ask the selling business to terminate all of its employees so that we can start over by hiring them in the acquiring company as new employees, without any potential claims for what came before. However, many people do not realize that certain tax liabilities may follow the business of the company rather than the company itself. So, if you buy enough of the assets to be considered as having purchased the company, you could be buying tax liabilities... even if they are on your list of items excluded from the sale.

Each of the Franchise Tax Board (state franchise and income taxes), the Board of Equalization (sales taxes) and the Employer Development Department (employment taxes) has the right to come after the buyer of a business for unpaid taxes in an amount up to the entire purchase price. So, if you pay $100,000 for the assets of a company, you could be liable for unpaid taxes of up to $100,000 to each of those three government entities. Your $100,000 purchase price just became $400,000!

Most asset purchase agreements deal with this concern in two ways: First, they request a representation and warranty from the seller that there are no unpaid taxes. Second, the agreement includes an indemnification provision whereby the seller has to indemnify the buyer if any claim for unpaid taxes is made against the buyer for the time period before the company's assets were purchased. However, an indemnification provision is not enough protection. All it does is provide a contractual claim against the seller. The buyer still has to sue the seller and get a judgment and then collect that judgment.

A much better way to protect yourself as a buyer of a business is not to rush into things. In only 60 days, you can get tax clearance certificates from all three entities showing you exactly how much unpaid taxes, if any, are outstanding. Each agency has its own requirements for submitting such a request. If the agency does not return a tax clearance certificate within 60 days (30 days for the EDD), then the buyer may not be held liable for outstanding taxes of the seller's business. So, take your time, open an escrow, and get tax clearance certificates prior to closing escrow on the purchase. And of course, consult with an attorney if you need help with an acquisition. Otherwise that $100,000 business may cost you $400,000 in the end.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Closing a Business Transaction is A Lot Like Riding a Mountain Bike

June 10, 2013,

As a business and M&A lawyer in San Jose, it is not uncommon for me to burn the midnight oil hammering out a deal for a Silicon Valley client. There is often a need to break from the perpetually connected life to recharge the lithium cells, so to speak. On a recent bike ride in Santa Clara on the local single track, it occurred to me that the life of a deal can be contained in a single mountain bike ride.

A ride starts with the first drop of a pedal. Any deal starts with the first realization that two people or groups can get together and construct a process that will create value for both of them. Whether it is a simple software license, or a complex strategic alliance and funding deal, it is that first pedal that moves everything forward.

Whether you are involved in a transaction deal or a single track mountain bike ride, you need the right tools to make it all work. For a lawyer, it is the years of learning that just begin after you leave law school. The late nights wrestling with creating a structure that will reduce risks and the time spent attending or teaching professional seminars all contribute to the base of knowledge that comes to bear in every transaction. Making sure your tires fit the trail and your derailleur is adjusted and chain oiled can make the difference between a ride and an ordeal.

Both deals and rides can vary in how they start. Sometimes, you are thrown right into the negotiations, having just met the client minutes before, like the ride that starts with a pounding incline over gravel and sharp rock. Other times, there are in depth discussions over goals and approaches, like the trail that starts level and smooth through redwood shade.

Then, there is the slog. I ride in the mountains, and it is very typical for rides to start uphill, and end downhill. Cranking slowly up a ponderous grade is not glamorous, but is critical to getting to your goal. Even a business deal built on insightful strategy needs implementation, and it is the late nights and weekends, slogging through reams of documentation and often mind-numbing minutiae that lead to success. It is sweaty ponderous work, but somebody has got to do it.

The home stretch is where things can get, shall we say, interesting. In mountain biking, the downhill is where skill is required to keep bike and body together. Any mountain biker will tell you about their last "endo," so named because your body has just gone "end over" the handle bars. Road rash and cracked ribs are the usual result. In deals, it is the same. At some point, some new fact or number is looked at just a little bit differently, or a recalcitrant stockholder will not cooperate, or a delayed negotiation on a major issue leads to stalemate, or a lawsuit from left field hits, and you have received the legal equivalent of a body slam. Although the first few minutes may feel like it is the end of the world, most times you pick yourself up, assess the damage, figure out the fix (time to replace the rear derailleur drop out or buy out that difficult stockholder) and continue on your way. In rare circumstances (like you just snapped your collar bone or the Federal Trade Commission will not approve your deal), you lick your wounds and try again another way on another day. But this is rare.

There is an old lyric that goes "... you better watch your speed, trouble ahead trouble behind, don't you know that notion just crossed my mind". All parties to a deal want it done yesterday, and the business case for doing so can be convincing. Going too fast on a mountain bike, however, can lead to the dreaded endo, and a whole other parade of orthopedic and epidermal horribles. In a business deal, it can be worse. The Time Warner AOL acquisition was rumored to have been negotiated and signed under a very compressed time schedule, and is taught in business schools as one of the worst mergers in American history. Go fast, but be deliberate and do it right.

Everyone will tell you that deals are not a sprint. In any ride, you need to make sure your energy stays fueled, or you will "bonk", hit the wall, run out of gas, or hit countless other metaphors that mean you've just come to a full and complete stop. In a transaction, we call it deal fatigue. Bringing up countless new issues as a deal gets closer to close, experiencing unexpected delays, or a thousand other things, can kill a deal as fast as any bonk. The cure: deal with it upfront. Before a ride I slam a peanut butter sandwich (whole grain bread, thank you very much). Before a deal, the more I know about the parties, their business, motivation, experience and interests, and the more I know about getting done the type of deal in which I am involved, the less chance my transaction will bonk.

I could go on, but the last conference call just ended, the next turn of the agreement went out the door, and it is time to go spin the local single track.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

I Gave It All To You, So Why Don't You Like Me: Post-Closing Disputes in Mergers and Acquisitions

May 22, 2013,

As a veteran M & A lawyer in San Jose, where deal making has never gone out of style, I have been though my share of mergers and acquisitions. For business counsel, the closing of a deal is one of the times I get to spike the ball in the end zone as I watch the cash flow to a happy (and relieved) seller. Needing only to put together a closing package, my work is done and I am off to popping the corks at the closing dinner. Or is it?

From sole proprietors and small businesses to large corporations, many business owners enter the sale process believing the closing of a deal is accompanied by a one-way ticket to paradise. They often find out, however, that the fun is just beginning. The first year after closing presents a number of challenges, all of which must be carefully managed to make sure the seller gets the full value of the business.

As I have discussed in prior blogs there are a number of adjustments, associated with audits and working capital, which occur within the first three to six months after closing, including the following:

Post-Closing Audit
The first concerns the post-closing audit. Typically, a selling company's books will close on the actual closing date, and funds will be held back to deal with any adjustments exposed by the audit. Hopefully, the buyer and seller will have agreed in advance to the accounting procedures which must be used, i.e., how generally accepted accounting principles will be interpreted. Otherwise, the first fight will be over whose interpretation should control. This is particularly difficult, because each side may be constrained to using accounting procedures that differ from each other. Key issues in accounting procedures that can lead to disputes revolve around revenue recognition (a favorite for software companies), collectability of receivables, and valuation of hard assets.

Adjustment of Working Capital
The second concerns the working capital adjustment. This follows closely behind the audit, because it is the audit that establishes whether the working capital adjustment established in the acquisition agreement has been satisfied. I have talked before about the working capital adjustment, and like any post-closing adjustment, it is critical to ensure that the parties establish agreed upon accounting procedures to make sure they are not comparing apples to oranges.

Earnouts
The mother of all battles, however, usually occurs around earnouts. I have spoken about earnouts before. Earnout disputes are so pervasive in merger and acquisition deals that litigation attorneys have another word for them: inventory. This is also where the seller must be the most involved. Earnouts depend on business performance, and as much as the seller wants to start their new life, their presence and operation of the company post-closing can make a large difference in the amount ultimately received for their business. Changing business operations, sales approaches, and collection procedures are all matters the former owner needs to watch carefully. One of the biggest issues comes in the form of administrative overhead allocations, with the earnout payment being reduced due to a reduction in net earnings as a result of over allocation of administrative overhead.

Breach of Fiduciary Duty
Another fruitful area for litigation is where a representation or warranty may be breached. We discussed these in past blogs, and noted that, in most deals, funds are held back to satisfy buyer damages arising out of a breach of a representation or warranty. A seller that remains on the shop floor, so to speak, often has the institutional knowledge and relationships to prevent or minimize the acts or omissions that lead to a breach, and thereby reduce the ultimate hit against the holdback that might otherwise occur.

Resolving post-closing disputes is not easy. Most acquisition agreements will require disputes to be resolved through arbitration, which is usually faster than waiting for a court (especially here in California with our impacted court system). Arbitration, however, is not simple, fast or inexpensive. Where post-closing adjustments are involved, many of the issues revolve around accounting concepts, requiring accounting experts to be retained. These experts are not cheap. Where a seller's representation has been breached, complex indemnification provisions are often triggered, which can muddy ultimate resolution. It is not unusual for post-closing disputes to add a year or more to ultimate payout to a seller.

For this reason, sellers should expect that their full payout from the sale of their business may require continued involvement for a year or two after the closing. Sellers may find, however, that the additional involvement is a small price to pay.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Closing the Deal: Boring is Best

March 27, 2013,

Having represented both buyers and sellers in mergers and acquisition transactions in Silicon Valley for more years than I care to admit, I have been through a number of closings. Some M&A closings that I have been involved in were smooth affairs, accomplished through an exchange of a single phone call with a confirming email, while others have stretched into all night marathons. Although it is often difficult to know whether your deal will allow you to finish at a reasonable time, there are a number of actions you can take to make sure your closing is as smooth and stress free as possible.

Obtain Third Party Consents:
The most important task for both the seller and acquirer is to plan ahead. Everything you will need, to accomplish the closing, will take longer than you think. One item which often delays a closing is getting the necessary consents to the transaction required from third parties. Certain third parties, often parties to major relationships that the acquired company, post-closing, requires for its operations, have rights under their contracts to consent to any change in control. Many of these contracts create significant value for the acquired company and their continued existence are often a key incentive for the buyer proceeding with the deal. It is best to identify these material agreements early on and plan a strategy for securing the necessary consents. Other areas where third party consents might be required are when a party, often a strategic investor, has a right of first refusal that is triggered by the transaction.

Obtain Stockholder Approval:
Stockholder approval, especially where large numbers of stockholders exist, can often be a gating item. As with third party consents, it is critical that the parties design a strategy early on for soliciting approvals from the stockholders, and, if necessary, investigate and resolve any securities compliance issues that might exist. This may require significant advance planning and document creation, particularly for securities compliance purposes.

Complete Agreements and Disclosure Schedules Before Closing:
Part of planning ahead is to front load all of the work that needs to be accomplished for the closing. For those transactions in which a closing follows sometime after the contract signing, agreements and schedules required for the closing, such as key employment agreements and disclosure schedules, should be completed and attached to the contract as part of signing. The temptation to put these types of schedules and agreements off until the closing can prove costly, as these types of documents, particularly a disclosure schedule, can raise issues which may require significant time to resolve.

Remove Contingencies:
As a closing approaches, it is critical to make sure all contingencies pertaining to the closing are removed or waived. One way to ensure this is to make sure, during contract negotiation, that contingencies are based on standards that are objective and easy to determine. One area that can be problematic is a contingency based on the occurrence of a material adverse effect. Because these tend to be very broadly and qualitatively designed, it is best to objectify them as much as possible. This can be accomplished by tying the effect to financial or other measures, or limiting it to known risk issues.

Have a Pre-Closing Review:
Expectations during this period need to be rational. If there is any deal term or contingency that is open, the transaction simply is not ready to close. For this reason, it is always a good idea for the deal team to conduct a pre-closing a few days before the planned closing date, to make sure all remaining issues and contingencies are resolved and that the documentation is sufficiently in order to close.

Be Closely Involved:
The most important task for the business executive is to understand that his or her job at this point in time is not necessarily to run the business, but to get the deal done. The executive needs to be closely involved with the transaction, and should not merely rely on his or her advisors. There is no substitute for carefully reviewing all of the documents involved in the transaction. In addition, the executive needs to ensure that the entire deal team be available for the inevitable last minute decisions.

Like many things in life, closings benefit from advanced planning and hard work early on. Save the surprises for birthdays and holidays. When it comes to closings, boring is best.


The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Closing Conditions Common in Acquisition Agreements, Part 2

January 22, 2013,

The pace of merger and acquisition activity in Silicon Valley continues unabated, and the satisfaction of conditions to make sure both parties conclude a deal with all loose ends tied up becomes critical to a final closing. In my last blog, I discussed certain standard closing conditions contained in merger and acquisition documentation, particularly the requirement of stockholder approval and the use and impact of dissenters' rights. In this blog, I will cover some of the other commonly used conditions in acquisitions of privately held companies.

Being a technology transfer lawyer, many of my clients' deals focus on the need to retain key employees after the company is sold. For that reason, a key closing condition included in most acquisition agreements requires that certain employees with the acquired company agree to continue working with the company for a period of time after the closing. Often this obligation is structured by requiring the employees to sign employment agreements or consulting agreements with the buyer. Managing this process can be tricky, because employees will want to agree to terms they find preferable (e.g., receiving additional options and higher salary) and some key employees may be reticent to work with a buyer they do not know. In addition, negotiations occur between the key employee and an acquirer before a deal is closed, which is sometimes an awkward process.

Covenants Not to Compete
A corollary to this condition is the buyer's desire to have key employees sign covenants not to compete. Although generally unenforceable in California, these covenants can be enforced where the key employee holds sufficient stock, and has sufficient control, in the acquired company to warrant protection of the buyer's interest after the sale. The covenant must also be for a reasonable time, and limited to a reasonable geographic area. Because of these somewhat vague standards, buyers often want these covenants signed by as many of the key employees/stockholders as they can. Key employees, understandingly, become very apprehensive about signing these documents, because many are not receiving enough money from the deal to be able to afford being shut out of the industry in which they have developed a substantial expertise.

Employee Releases
Where a selling company's shares are closely held, or where a substantial percentage of the shares are held by a small group, a buyer will often want the stockholders to release the company from any claims the stockholders may have. This may present a problem if any selling company stockholder has any claims, or even hard feelings, against the selling company. Requiring them to sign a release provides them great leverage in getting their claims or concerns resolved in their favor.

Material Adverse Impact
Another key closing condition is the absence of any "material adverse impact". It is often defined as an impact to the acquired company that is material and adverse. Helpful, huh? There lies the problem with this condition. Although it behooves parties to objectively define what is both material and adverse, too many times parties want to rely on an "I'll know it when I see it" standard. Using objective standards here is critical, because there is precious little time to use standard dispute resolution proceedings to decide who is right or wrong when you are trying to close a deal.

Regulatory Requirements
Satisfaction of regulatory requirements is another important closing condition. Where publicly-tradable securities are being issued, acceptance of an appropriate registration statement by the SEC is often a condition. For acquired companies with a smaller stockholder group, mature buyers can often get the selling stockholders to agree that shares issued in the acquisition will be registered after the closing. Other regulatory requirements could include bulk sales filings for certain types of deals, and antitrust filings.

Legal Opinions
One of the last closing conditions, which is unfortunately one of the last to be considered, is the infamous legal opinion. This is a letter written by one party's counsel to the other party providing certain legal conclusions, or opinions, about the state of the party and the transaction. Because legal opinions are provided, or rendered, to a non-client, attorneys are very sensitive about their content, and the opinion letter itself is an almost incomprehensible collection of jargon and assumptions. The opinion is also based on factual representations provided by management, and attorneys typically provide, right before the closing, confirmation documents concerning facts on which their opinions are based.

Because every deal is unique, other closing conditions may be present, and some of those discussed above may be absent. In any event, it is important that both attorneys and their clients work toward their completion, so that the closing a business sale can proceed with as little controversy as possible.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Closing Conditions or Why Isn't the Future What I Thought It Was, Part 1

September 19, 2012,

Whether an acquisition is in San Jose, Cupertino, San Francisco, or anywhere else in California or the United States, any corporate lawyer will tell you that a buyer will not close a deal unless certain conditions are satisfied. Fortunately, closing conditions contained in mergers and acquisitions documentation have become standardized. Exceptions, however, always arise based on the unique attributes of the transaction, and standard does not always mean simple.

Some merger or acquisition closing conditions are standard and rarely require negotiation. For example, one of the standard closing conditions is that there is no injunction, law, or court order that prevents the transaction from proceeding. Outside of an actual known threat to a transaction, these clauses are rarely negotiated in a private company acquisition transaction.

Another standard closing condition is that the requisite corporate approvals will be secured. Because the respective Board of Directors of the each company will have approved the acquisition agreement, this is usually a noncontroversial item.

Similarly, stockholder approval is a standard condition but it can derail a deal if the company does not approach it carefully. Stockholder approval adds an additional wrinkle: dissenters' rights. These rights allow a stockholder to receive in cash the fair market value of its stockholdings, based on the value of the selling company, absent any change in value arising as a result of the acquisition. To receive this cash payment, the stockholder must vote against the acquisition. It is not sufficient for the stockholder to simply abstain from voting. To enable the stockholder to take advantage of its dissenters' rights, the selling corporation must provide notice of the right to exercise dissenters' rights, and the notice must contain specific provisions.

Why would the corporation want to allow one of its stockholders to have this right? To protect the transaction, that's why. Any stockholder who had the right to exercise its dissenters' rights, but failed to do so, can never attack the validity of the transaction. The only exception to this is if there was a problem with stockholder approval. In essence, dissenters' rights give the stockholder the choice between selling-out or going along with the deal. From the corporation's standpoint, it can feel comfortable that a transaction will proceed since all it has to do is buy-out its disgruntled stockholders.

Or can it? The problem with dissenters is that they have to be paid. If the deal is a cash deal, then the purchase price proceeds can be used to pay off the dissenters. If, however, the acquisition is a merger, where shares are going to be exchanged, the issue is tricky. Recall my discussion some time ago about an acquirer wanting to have working capital in the purchased company so that it can conduct business after the closing. Any payment to a dissenting stockholder will reduce the amount of the seller's working capital (assuming that the buyer will not use its own working capital to pay the dissenter).

The reduction in working capital arising out of a payment to dissenters will lead to a closing condition limiting the number of stockholders which can dissent to the deal. Typically, this number is less than 5% of the stock entitled to vote. Sellers who find themselves faced with such a condition find that a stockholder or stockholders holding a relatively small number of shares have, essentially, a veto right on a transaction. For this reason, executives of selling companies need to review their stockholder lists carefully to determine if there is any likelihood that a stockholder will exercise its dissenters' rights.

In my next blog, I'll discuss some of the other conditions that might crop up in a common acquisition deal.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

Your Company Has Just Signed an Acquisition Agreement - Now What?

August 6, 2012,

As a Silicon Valley corporate attorney who often represents the selling company in mergers and acquisitions, I know that a huge amount of effort goes into signing an acquisition agreement. As I have discussed in past blogs, issues from earnouts to preparing exceptions schedules will have turned into countless hours of negotiations, documentation, and late night telephone calls for both the seller and the acquiring company and their corporate lawyers. In the end, the agreement is signed and everyone gets some well-needed sleep, only to wake up to the final sprint to closing.

In this blog, I will discuss what happens when a deal does not close simultaneously with the signing of the acquisition agreement. Similar to a contract for buying a house, many merger and acquisition deals require the buyer and seller to sign an agreement, and then perform additional items before the final closing.

At the same time as the deal team pours over the necessary closing tasks, there is still a business to run. Even though the seller remains in control of the business, the buyer wants to make sure it eventually acquires a company that is in good working order. For this reason, commitments are designed to guide business operations pending the closing.

Many aspects of the "operational covenants," as they are sometimes called, are fairly standard. Material actions, such as entering into major contracts or making substantial capital expenditures, are called out as matters requiring the buyer's consent before proceeding. The parties will negotiate the thresholds that are required for materiality and will typically allow exceptions for activities in the ordinary course of business.

In addition to the operational issues, there are a number of deal-oriented provisions. The first is our old friend the no-shop provision, explained in a prior blog ("Merger and Acquisition Letters of Intent - Binding the Nonbinding," May 30, 2011). These provisions may become more involved than those in a letter of intent, and arguments revolve around, among other things, exceptions for unsolicited offers which a board believes must be accepted to satisfy its fiduciary duties, and the length of time the no-shop restriction will exist.

A buyer will typically want to continue to have access to the seller's books and records. Once the deal is signed, the desire of the buyer to speak directly with the seller's employees and customers increases. Sellers are reticent to allow a buyer to speak directly with the seller's material customers, even if the deal has been publicly announced. To the extent the buyer needs to speak with the seller's customers, the specific customers to whom the buyer can speak are usually specifically negotiated. The buyer will also want to speak directly with the seller's key employees. Negotiations often focus on the buyer's ability to terminate the transaction if certain key employees do not continue with the business.

A key aspect of deal-oriented provisions is the parties' commitments to secure the necessary stockholder and regulatory approvals. As part of the stockholder approval process, the buyer will usually require that the seller's Board of Directors unanimously recommend stockholder approval. Often, voting agreements are signed as part of the acquisition agreement signing to lock-up the votes of the major stockholders.

Regulatory approvals can run the gamut from simple bulk sales notices and escrows (for small, asset-based transactions), to Premerger Notifications to the Federal Trade Commission and Department of Justice (for multi-million dollar acquisitions). Timing issues on these matters need to be considered carefully, due to the need to prepare necessary filings and provide appropriate notice.

A critical post-signing activity is the Seller's need to secure consents to the transaction from important suppliers and customers. Often, a seller's material contracts will contain provisions that require the other party to approve a transaction to prevent the contract from being breached. Securing this consent can be a quick formality, or a delay ridden nightmare. It is very important for the seller to determine which contracts require the approval of the other party to the contract, and the process, and time required, to secure the necessary approval. The best approach is for the seller to review all of its materials agreements even before the deal starts, so that the approval process can begin very quickly after the acquisition agreement is signed.

Although signing an acquisition agreement is a giant step forward in any transaction, there can be a number of tasks ahead that must be handled very carefully to ensure the long sought closing actually will occur. An experienced team is essential in this regard

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific Questions relating to this article should be addressed directly to the author.

Fighting Over Profits - The Earnout, Part 2

April 13, 2012,

Although most of my career as a merger and acquisition and corporate lawyer has been spent in San Jose, issues involving earnouts do not have geographic boundaries. While many companies are acquired for their team or their technology, other companies are acquired because they make money for their stockholders. Earnouts provide an opportunity for a buyer to be assured that the company it has just bought will meet its objectives for the deal.

To construct an earnout that measures a company's success in making money, a tension arises between allowing the selling company to operate on its own, thereby mimicking its performance as it existed before it was sold, and integrating the seller's operations with the buyer. Buyers will want to integrate the seller as quickly as possible, but doing so will prevent the parties from determining how well the seller itself is performing.

The most important issue to determine is how profits will be calculated. As discussed in a previous blog, issues involving the use of GAAP become much more important as more revenue and expense items are measured. A detailed approach to calculating profits will help reduce disputes and provide guidance for the seller's managers to use in maximizing the earnout.

Earnouts constructed to measure profits typically require the seller to operate as a separate division, or even a separate entity. To take advantage of synergies, some operations are centralized with the buyer, such as finance and administration. The first area of dispute involves the manner in which administrative overhead, and the type of overhead, will be charged against the earnout. Outside of textbook ratios, there is no magic number and the result is usually reached through negotiation.

Often sales forces are consolidated, and the allocation of sales-related expenses and commissions can be very difficult, especially when the buyer's existing sales department is leveraged to produce sales for the seller. As with overhead, there are no easy answers and the approaches ultimately used are reached through negotiation.

Because of their complexity, earnout amounts are often disputed. Because of this, care must be taken to create an appropriate dispute resolution mechanism. Regardless of the dispute resolution process used for the acquisition agreement as a whole, arbitrating any earnout disputes has a number of advantages. First, the arbiter, or arbiters, can be specified as having expertise in accounting issues, or even in calculating earnouts. Relevant industry experience can be listed as a necessary attribute. Second, the arbitration can focus solely on determining the arbitration amount. Third, the parties can be required to go through nonbinding mediation. If successful, mediation can avoid the expense of an arbitration proceeding. Fourth, the proceedings can be kept confidential.

Earnouts, especially those based on profits, can be very complex and prone to dispute. Because of this, care must be taken by all parties to create a mechanism that will adequately measure performance while minimizing the opportunity for controversy.

Continue reading "Fighting Over Profits - The Earnout, Part 2" »

I'll Pay You Tuesday for Your Company Today - The Earnout, Part 1

March 29, 2012,

Whether you are negotiating an acquisition in Silicon Valley or Small Town, USA, a part of the purchase price is often deferred. I have discussed in prior blogs those portions of the purchase price that are held back to reduce the buyer's risk of liabilities and issues with post-closing audits. In future blogs, I will discuss a common purchase price deferral that will pay the seller based on the performance of the business AFTER it is sold, often called a contingent purchase price, or an "earnout."

An earnout serves two purposes. First, it can bridge a valuation gap that may exist between the buyer and the seller. In a sense, the buyer is saying "If your business is worth that much, prove it." Second, the buyer uses an earnout to protect against risks arising out of everything from insufficient due diligence to difficulty in integrating operations, that the ultimate value will be less than the purchase price.

There are a number of advisors, in addition to a merger and acquisition attorney, that are critical to creating an accurate earnout. First among equals is a CPA. An experienced CPA should be brought in early and often to provide advice concerning the general nature of generally accepted accounting principles ("GAAP"), where interpretations can vary, and how the parties have recognized revenue and expense items and the extent to which they differ. The second is both the buyer's and seller's accounting departments. Managing an earnout requires specific knowledge of the accounting functions of the parties involved, and many disputes can be avoided by understanding each party's processes and how they are to be managed through the earnout period.

In a typical earnout, the buyer and seller negotiate revenue and other operational goals, and schedule payments based on the satisfaction of these goals at the conclusion of a particular period, typically one or two years. This creates a number of challenges, and opportunities for expensive and time consuming litigation.

The first major issue is how the parties determine whether a goal is satisfied. Agreements will typically require that the parties use GAAP to determine any accounting related issues. Any accountant will tell you, however, that GAAP is more of an art than a science. In defining how GAAP will be used, the parties need to determine how GAAP will be interpreted. One approach is to say that GAAP will be interpreted consistent with how the seller has interpreted GAAP. A better, but more time consuming approach, is to use the interpretations that are used by the buyer, determine the variances from the seller's policy, and define as specifically as possible the interpretations that will be used to determine the earnout. This determination should be part of an exhibit attached to the acquisition agreement.

Technology companies, particularly those working in the software or Internet areas, often have unique revenue recognition issues. The manner in which revenue is treated for these companies needs to be defined very precisely with the assistance of the seller's CPA.

What if the buyer's books are not GAAP? There are a couple of approaches. First, the earnout can be limited to performance goals that can be relatively less difficult to define and determine, such as specific gross revenue. Second, the books can be converted to GAAP as part of a post-closing audit. Even if this method is used, however, it will be important to find those areas, such as revenue recognition, that are critical to the final amount of the earnout and define how it will be interpreted. Third, and most important, send a large retainer to litigation counsel, because the failure to use an accepted accounting method, such as GAAP, can often lead to disputes.

In a future blog, I will discuss how to calculate earnout amounts.

Risky Representations - Part 2

February 13, 2012,

As a merger and acquisition lawyer in Silicon Valley, I have been involved in numerous business transactions, from small startups transferring their technologies after getting acquired by other companies, to medium-sized and larger technology and pharmaceutical companies going public. With Facebook's impending IPO, many companies in San Jose, Sunnyvale, Santa Clara and Mountain View are expecting another technology boom. A company hoping to take advantage of the imminent dot-com boom and sell its business should make sure its books are in order and hire a good M&A attorney to prepare an acquisition agreement.

As discussed in my last blog, a seller will often make a number of commitments to a buyer concerning the seller's business. These commitments, known as representations and warranties, allocate between the buyer and seller many of the risks existing in the seller's business.

One of the most important documents accompanying the representations and warranties is a schedule that describes certain items requested to be disclosed, and any exceptions to the content of the representations and warranties. This document, which goes by "Schedule of Exceptions" or "Disclosure Schedule," is really a description of the main documents and key agreements of the seller, and disclosures of material facts concerning the buyer and its operations. It can often take as much time to prepare and negotiate as the acquisition agreement itself. There are a number of things the seller can do to help expedite the preparation of this document.

First, keep good corporate records. As I discussed in my blog on due diligence, organizing the seller's major documents, and making sure they are readily available, will considerably reduce the time to close the transaction.

Second, appoint someone who has intimate knowledge of the seller and its operations to assist in gathering requested documentation and answer the inevitable questions. Typically, the company's chief financial officer or controller will fill this role.

Third, get all of the documents to the company's attorney as soon as possible. The lawyers will need to review the documents and decide what types of schedules and disclosures will be required. This is a very time consuming process.

Fourth, discuss early on any areas where the company thinks a buyer might be concerned. This is not a time to sweep difficult issues under the rug, but a time to get them out in the open. There is nothing worse than being blind-sided at the last minute with the proverbial skeleton in the closet. Worse, failing to disclose difficult issues known to management can lead to a fraud claim, a claim for which the seller's liability is never limited. Areas that raise concerns include any transactions between the seller and any of its insiders, litigation and threats of litigation, and accounting irregularities.

Fifth, start preparing the Disclosure Schedule as soon as possible. Attorneys that are experienced in acquisition transactions are aware of the likely representations that will be requested, and can start organizing and preparing the substance of the Disclosure Schedule even before the acquisition agreement is distributed. Delivering a completed Disclosure Schedule to buyer's counsel sooner rather than later will surface any issues so they can be resolved in a timely manner.

Sixth, review the Disclosure Schedule with your attorney to determine if any issues exist that will delay closing. There are two major areas that need to be reviewed. The first is the approval that is required for the transaction to proceed. Almost always, this will involve approval by the board of directors and the shareholders of the Company. It may require preparation and delivery of a separate disclosure document to the shareholders to assist them in determining whether to approve the transaction. The second is the existence of any material agreements, desired by the buyer to operate the business, that require approval of the other party in order to close the transaction.

Continue reading "Risky Representations - Part 2" »

Risky Representations - Part 1

February 6, 2012,

Those endless representations and warranties in your acquisition agreement aren't just for your merger and acquisition lawyer. Ignore them at your own risk.

Mergers and acquisitions in San Jose and elsewhere are a lot more complex than those of the past when deals were closed with a handshake. As acquisition documentation becomes more extensive, companies frequently turn to mergers and acquisitions attorneys to assist them with their transactions. One issue on which an attorney will focus deals with the representations and warranties of a seller.

A seller's representations and warranties, which are the commitments that a seller will make to a buyer concerning the state of the seller's business, make up one of the more extensive sections of an acquisition agreement and serve a number of functions. This is because they allocate between the buyer and seller many of the risks existing in the buyer's business.

Representations allocate risk in a fairly straightforward manner. The seller will make a statement of fact regarding its business. If the seller's statement is wrong, and the buyer is damaged as a result, the seller will compensate the buyer for any damages the buyer incurs.

An example helps illustrate the point. Let's say that the seller states that it has paid all of its taxes, a very common representation. After the closing, the business that was sold gets hit with a sales tax audit, and is found to have underpaid its sales taxes. Because the seller's representation was wrong (i.e., it hadn't paid all of its taxes), the buyer, all other things being equal, can look to the seller for reimbursement for the amount of the additional sales tax liability.

The situation above describes the simplest form of risk allocation in an acquisition agreement. In this form, the seller bears the risk whether the seller knew there was a problem or not.

Some types of risk allocation shift risk only if the seller knew there was a problem. These representations, sometimes referred to as knowledge-qualified representations, allow a seller to escape liability in a representation if the seller did not know a problem existed.

In our sales tax example above, let's say that the representation stated that the seller did not know of any nonpayment of taxes. Let's also say that the seller's officers were completely unaware that they had failed to pay any sales taxes. In that situation, the seller would not be liable for the sales tax liability.

Because acquisition agreements are prepared by lawyers, the concept of knowledge can mean different things. For example, does knowledge mean the subjective knowledge of the seller's CEO, or the subjective knowledge of all of the seller's employees? Does knowledge mean just what is in employees' memories, or should employees be required to look through their files? If employees are required to look through files, should they also be required to look through other documentation, such as public records and other resources? For these reasons, it is critical that the concept of knowledge be defined so that the seller knows what they have to do to satisfy the representation, and both parties know how the risk is to be allocated.

What if the seller wants to allocate the risk of an item back to the buyer? When a seller makes a representation that he or she knows may not be entirely correct, the seller will disclose an "exception." The seller provides this disclosure in a schedule commonly attached to acquisition agreements, known as a "disclosure schedule," or a "schedule of exceptions." Unless the agreement specifies otherwise, a buyer cannot recover for damages for an item that has been disclosed.

Going back to our sales tax example, if the seller knew there was a problem, the seller would describe the problem in a disclosure schedule. The seller would say something like "Seller underpaid its sales tax liability for the periods 2008 through 2010, which liability seller believes to be between $50,000 and $75,000." The buyer could not thereafter bring a claim for reimbursement for the later assessed tax liability as a result of the seller's disclosed exception.

As I mentioned above, representations and warranties, and their accompanying disclosures, are heavily negotiated. One point of contention is whether the risk of an item, even when disclosed, should be allocated to the buyer. Buyers with sufficient leverage will force the seller to remove the disclosed item, or affirmatively accept the risk associated with the item. Another point of contention is what the concept of knowledge means, and whether knowledge can qualify a particular representation. For these reasons, it is critical to spend a lot of time understanding the representations and warranties of any acquisition agreement so that you can understand the risks that may exist for you in a deal.

Continue reading "Risky Representations - Part 1" »

Merger and Acquisition Letters of Intent - Hold Me Back!

June 28, 2011,

Most letters of intent describing acquisitions in Silicon Valley, as elsewhere, will describe the material points of a transaction. Although a properly drafted letter of intent will provide that the business points of the deal are nonbinding, it is difficult in the course of any negotiation to change a business point already agreed upon. As a result, take care to describe those points that are most important to a transaction and to leave others to be negotiated as part of the definitive agreement.

The most important point is obviously the purchase price. This can be expressed, among other ways, as an absolute amount. If the transaction is a merger, the absolute amount is converted into a conversion or exchange rate based on the market value of the acquirer's stock over a period of time preceding the closing.

It is very unusual for the price to be paid all at once. Typically, the amount ultimately paid will be subject to post-closing adjustments based on issues unrelated to financial performance (often referred to as a holdback) as well as issues related to financial performance or other milestones (often referred to as an earnout). These provisions must be considered very carefully, as they are often a source of litigation. This blog will only discuss the holdback.

The liability holdback is the most significant holdback and is used to cover any liabilities which may arise after the closing. The holdback is used to help protect the buyer when the state of the Company, often described as representations and warranties, is found to be inaccurate. These liabilities can arise when the Company is sued after the closing, e.g., when an infringement claim is made, or can arise if a representation is inaccurate, e.g., when a cost of a particular liability is found to be greater than originally disclosed. Liability holdbacks will also cover any liability arising out of the seller's failure to perform an obligation.

The percentage of the liability holdback varies considerably, although they typically are between 10% and 20% of the purchase price. For known claims that cannot be quantified yet, a separate holdback can be created, and the amount held back can vary with the amount of the claim.

The audit holdback, another common holdback, is that amount of money to be used to cover any adjustment which may be required to adjust, following a post-closing audit, an inaccurate working capital cushion. The employee retention holdback is another holdback that is used where employees are crucial to a target company, where an amount is held back for a period of time and reduced if employees depart the target company after the closing.

The amount of time that funds will be held back varies. Liability holdbacks typically run between one and two years. Audit holdbacks will typically run for 90 to 120 days after the closing to encourage the audit to be completed. Employee retention holdbacks can run to one year, and potentially longer.

My next blog will discuss the earnout, and the portions of this important mechanism that are usually found in a letter of intent.

Merger and Acquisition Letters of Intent - Binding the Nonbinding

May 30, 2011,

In negotiating a recent acquisition for a client selling a business in Santa Cruz, we were presented with a letter of intent outlining the terms of the transaction. The letter was well-constructed, and contained the material aspects of the deal, all of which were nonbinding. There were, however, a number of terms that were expressly made binding.

There are four binding terms most commonly used in nonbinding letters of intent for acquisitions of privately held companies. The first is that the parties will agree to standard nondisclosure obligations. The second is that the acquirer will be allowed to conduct a diligence investigation of the target. The third is that each party will pay its own fees incurred in connection with the transaction. If the transaction is a stock transaction, there may be some negotiation over whether the target can pay fees, under the theory that a stock deal is a deal among stockholders, rather than the corporation.

The fourth is the most hotly negotiated term - the "no shop" or "exclusivity" provision. The no shop is just as it sounds: the target company agrees not to "shop" itself while the transaction is in process. Acquirers usually demand this term so that their offer is not used by the target to get a better deal, and so that the time and expense they spend in the due diligence and negotiation process is not thwarted by another suitor. An acquirer will also ask that the target company stop any discussions with any other potential acquirer, and notify the acquirer if the target company receives any other acquisition inquiries.

Target companies attempt to insert a number of qualifications and limitations to the no shop clause. First, the target will request a "fiduciary out". In this exception, the no shop is ineffective where an unsolicited alternate offer must be accepted in order for the target's board of directors to satisfy its fiduciary duties. Second, the target will attempt to impose strict time deadlines which, if not met, will cause the no shop to expire. The primary deadline will be on the parties entering into a definitive agreement. Other deadlines include the acquirer's completion of its due diligence investigation, and the closing of the acquisition.

Other binding terms include break-up fees where one party, typically the acquirer, will pay the other party, typically the target, if the acquirer decides not to proceed with the transaction.

As with most deals, the extent of number and type of binding terms in a letter of intent depends on the relative bargaining strength of the parties.

Continue reading "Merger and Acquisition Letters of Intent - Binding the Nonbinding" »