Articles Posted in Mergers & Acquisitions

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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.

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Any Silicon Valley mergers and acquisitions lawyer helping clients buy and sell high technology companies is invariably provided with a simple letter of intent, happily signed by a couple of companies without input from their tax and legal advisors, and asked to prepare binding documents. In one case, my San Jose business client was not too worried about the lack of detail in the letter because, after all, it was just a “letter of intent”. She was less than happy when I told her that she had actually signed a binding agreement, particularly since very little due diligence had been performed on the target company and a number of ‘minor’ issues that were important to her still required resolution.

A letter of intent (also called “LOI”, or memorandum of understanding, or “MOU”) is usually a short letter that outlines the basic business terms of a deal. Without language expressly stating that the letter is nonbinding, and that no obligations arise except under a definitive agreement, however, that letter you signed may be a legally binding contract. Even with this kind of language, a letter of intent can morph into a binding contract IF the parties conduct themselves as if the target company has been acquired. Announcing a deal (when not otherwise legally required), combining operations before a closing, and similar actions, can create a contract from conduct. With no definitive agreement signed, the letter of intent may be used as evidence to set the terms of the deal.

Why do you want an LOI to be nonbinding? Letters of intent are usually prepared and signed after the initial business proposition and marketing analysis have been performed. They are typically signed before the acquirer has a chance to really investigate the target. This is because neither party will want to conduct an expensive diligence investigation until each is sure they have a deal. If the letter of intent is binding, then the acquiring company may find itself purchasing a lot of problems of which it wasn’t aware when it signed the letter of intent.

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Acquiring a financially troubled company, whether in San Jose, Palo Alto, or New York often requires consideration of the bankruptcy process. If the seller is already in bankruptcy, the buyer must convince the bankruptcy court that it represents the best source of funds to repay existing creditors. If the bankrupt company has attractive technology, there may be other buyers, and the court will typically award that company to the buyer who will pay the most money.

If the seller is not yet in bankruptcy, the parties may decide to purchase the company through a bankruptcy proceeding. If planned properly, the bankruptcy process can provide the buyer with a number of advantages. First, the seller’s assets are purchased free of any liens or other claims (although courts continue to wrestle with allowing subsequent successor liability claims). Second, because the assets are purchased “as-is,” sale documentation is typically shorter than for sales outside of bankruptcy, and stockholder approval is not required.

Planning for purchasing a company through a bankruptcy involves entering into arrangements with the selling company’s creditors and other stakeholders before the bankruptcy filing. As part of these arrangements, a reorganization plan and acquisition agreement may be prepared and agreed to prior to the filing. Once the appropriate pieces are in place, the seller will file for bankruptcy and include the pre-agreed reorganization plan in its bankruptcy documentation. The sale can be completed in a few months barring no other suitors or other unforeseen impediments. Bankruptcy counsel is necessary for both parties to properly shepherd the transaction through the proceedings, and corporate counsel is critical to insure that documentation is accurate and necessary corporate formalities are followed.

Financially troubled companies often provide the opportunity for others to purchase businesses at a relatively lower cost. Reaping the advantages successfully requires balancing the needs of all the business’s stakeholders.

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Technology start-up companies in Silicon Valley exist in a highly dynamic environment, where survival can be crushed by competition from a kid in a garage or a fund partner refusing further investment. As a last gasp, some companies may try to be acquired. Companies which have had to take refuge from their creditors may be able to sell their business through bankruptcy proceedings.

When compared to a standard sale of a business, sales of financially troubled companies require the professional advisors to manage a number of different stakeholders to successfully close a transaction. More so than in standard transactions, professional advisors play an important role in helping a transaction proceed smoothly. Under certain circumstances, their fees may be paid by the buyer or the bankrupt estate.

Most acquisitions of financially troubled companies are structured as an asset purchase. This prevents the acquirer from having to automatically assume liabilities that it doesn’t want. The existing creditors are then left with satisfying their claims out of the proceeds from the sale. Most companies, however, need the products or services of its creditor vendors to survive. In the case of technology companies, these vendors often include technology and hardware suppliers who are core to the company’s business. Irritated suppliers may not want to deal with the company even after its acquisition. Creditors and stockholders of the company may have claims against the company’s board of directors if a company is sold for less than the reasonably equivalent value of its assets. At the same time, key employees of the company, aware of the company’s financial stress, may be looking for alternate opportunities. The importance of these stakeholders, and how they are managed as part of the acquisition, is at the heart of any purchase of a financially troubled company.

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In my last segment, I mentioned a recent deal involving a Northern California company structured as a stock sale. Having tax advisors assist at the early stages helped keep the transaction on track. The next major issue was allocating the risk of business liabilities between the buyer and the seller.

Like any stock purchase transaction, liabilities of the seller stay with the business. This is often a significant disincentive to the buyer, because it must hold an entity that cannot escape its past liabilities. Two mechanisms are commonly used to alleviate the buyer’s risk.

First, a working capital cushion may be created to provide a source of funds to pay the ongoing debts of the business. The amount of the cushion is agreed in the purchase documentation. A portion of the purchase price is then held back at the closing in an escrow. The amount of net assets as of the closing is determined through a post closing audit, and the held back amounts are distributed following the audit to the buyer or seller depending on any difference between the agreed amount and the amount determined under audit.

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In a recent acquisition that I handled for a company in Santa Cruz, the buyer decided to purchase, with cash, the stock of the company rather than its assets. Acquisitions through stock or equity purchases are a common method of buying a company. From an administrative standpoint, equity purchase acquisitions are one of the easiest deal structures to implement.

In an equity purchase acquisition, a company is bought by purchasing all of the ownership interests of that company. If the company is a corporation, a buyer purchases all of the company’s shares of stock from the company’s stockholders. If the company is a limited liability company or partnership, a buyer purchases all the ownership interests of the company from its members, in the case of a limited liability company, or its partners, in the case of a partnership. This discussion will focus on a stock purchase, although the basic issues outlined here are the same when dealing with a limited liability company or partnership.

The administrative benefit of a stock purchase transaction is that ownership changes simply by transferring all of the company’s shares. Contrast this with an asset purchase structure, where each desk, chair and personal computer must be accounted for and sold to the buyer.

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Because acquisition transactions in Silicon Valley move very quickly, it is a good idea to understand the basics of deal structure. Every approach contains trade-offs among a number of different factors, including ease of closing, tax impact, risk preferences, third party involvement, and regulatory issues. This post examines the asset purchase structure.

Asset purchase agreements are used when the buyer does not want to assume any liabilities of the seller, except for those specifically outlined in the agreement (and those from which applicable law does not permit the buyer to escape). This structure is typically used for small owner-operator businesses, such as restaurants, retail establishments, and small service or manufacturing businesses. It can also be used where actual, or a fear of, residual liabilities exist, such as with businesses performing hazardous operations.

In addition to their liability-limiting feature, asset purchase transactions can provide tax benefits to the buyer. For example, some of the assets purchased in the transaction can be depreciated over time.

The tax impact may of the transaction, however, require attention and negotiation. Assets which are not intended for resale may be subject to sales tax. Although the seller is liable for any sales tax in California, parties often negotiate and apportion this liability in sale documentation. Because different types of assets and obligations create different tax obligations, parties are required to agree to an allocation of the assets purchased to particular classes and report the allocations to the taxing authorities.

Special tasks face buyers purchasing a restaurant or a company which principally sells merchandise from stock. In these cases, a buyer, in cooperation with the seller, will make a “bulk sales” notice. If the buyer fails to do so, the buyer may be liable for claims of the purchased company, even if the buyer merely purchased the company’s assets.

Assets can be purchased with cash or stock. If stock is used, securities laws must be complied with, which can increase expense and time to close a sale. If a mixture of cash and stock is used, tax impacts might arise in corporate transactions depending on the relative proportion of each component.

Asset transactions create administrative burdens. All assets must be listed and accounted for. This often requires taking a physical inventory and making adjustments if the inventory predates the closing. If the business has valuable contracts, the contracts need to be reviewed to determine if they can be assigned to the buyer. If not, the other party to the contract may need to consent to the assignment, a potentially time consuming and frustrating process.

Because only assets are being purchased, employees of the purchased business may have to be terminated. Any employees with accrued vacation will have to be paid that vacation. The buyer will then have the option to hire those employees back, or bring in its own employees. For companies with a large number of employees which expect to close facilities after the acquisition, federal and California law may require advance notification to affected employees.

Asset deals provide the best liability limitation for buyers. However, their complexity may render them unwieldy for larger transactions and their use should be explored prior to committing to any sale.

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Finding a buyer for the sale of a business is a lot like dating. Your prospects and your ultimate happiness increases with the number of people you meet. Whether you cruise the bars in San Jose, or schmooze partners at a trade show in San Francisco, building interest in your company is a critical step in finding buyers.

One of the key tools used in building business acquisition interest is a set of documentation often referred to as a “book”. The book will describe the business, the industry, and the potential for growth. It may also include financial statements, projections, and risk factors.

The content of the book must be considered carefully. Financial projections should be accompanied by appropriate disclaimers, and competitive and other risks to the business post-sale should be outlined. If the sales transaction is in the high tens of millions of dollars, language stating that an acquisition could reduce competition or permit other forms of market dominance should be avoided.

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In Part 1 of this entry, I discussed the importance of a business owner choosing the right professional advisors to assist in the sale of the company, whether in San Jose or Palo Alto, and some of the different types of experts.

Although there is overlap, advisors that assist with businesses having a substantial sales price are investment bankers that specialize in mergers and acquisitions. These professionals often help in cleaning up a company’s operations, provide pre-acquisition strategic guidance, act as chief negotiators in the sales transaction, and provide advice and formal opinions concerning deal valuation.

Compensation is a key issue in any agreement with an advisor. Compensation can involve payment of an initial fee, such as where acquisition solicitation materials are prepared, to a commission, such as where the broker takes an active role in negotiations that are successfully closed. Brokers and investment bankers will typically request a non-refundable engagement fee and a success fee. The latter can take many forms. One form provides for a set amount, plus a percentage commission based on the transaction value. Another form provides for a commission percentage which changes with the transaction value, often providing higher percentage commissions for higher values to encourage the advisor to be more aggressive in its pricing negotiations. Exceptions or adjustments to the fee structure are often made for introductions or transactions then in process which were not sourced with the assistance of the professional. Most advisor contracts contain a “tail”, which allows the advisor to collect a success fee for transactions occurring within a certain period, typically 12 – 18 months after the advisory relationship ends. Sometimes the tail can be limited to transactions for which the introduction was made by the advisor.

Advisors can go a long way toward guiding a company and its stakeholders through a successful transaction. Management, however, can’t expect that the advisor will take care of everything involved, and must be prepared to contribute extensively toward the transaction’s success.

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Every business owner at one time or another wants to sell their Silicon Valley business and move from Los Altos, Mountain View or San Jose to Tahoe or Tahiti. Being bogged down in daily operations doesn’t leave a lot of time for an owner to make the necessary contacts to build interest in their company. Owners wish they could just have someone else sell their business.

There are a number of professional advisors that can assist in the sale of a company. Like fundraising, however, management cannot simply pass to someone else a function this important. One of the key reasons for management involvement is that a business buyer is typically found through the company’s own contacts.

As with any advisor, choosing the right professional to advise on potential acquirers and transaction terms is a combination of validation by your network, expertise, and your own personal comfort with the individual with whom you will be working.

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