| Mergers & Acquisitions: A Strategy for High Technology Companies |
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Mergers & Acquisitions: A Strategy for High Technology CompaniesJacqueline A Daunt of Fenwick & West LLPTable of ContentsIntroduction
Deciding to Be Acquired
Key Deal Issues
Troubled Company M&A Issues
Implementing the Deal
Conclusion Appendix A: Letter of Intent Appendix B: S-4 Merger Time and Responsibility Schedule About the Author Mergers & Acquisitions: A Strategy for High Technology Companies 2002 Update A recent survey showed that between two and five emerging technology companies (TechCos) are acquired for every one that does an initial public offering (IPO). Acquisitions can provide strategic, operating and financial benefits to both TechCo and the company acquiring it (LargeCo). A strategic acquisition can provide TechCo's shareholders with earlier liquidity than an IPO, with less risk and dilution. It also can provide TechCo with the immediate leverage of LargeCo's established manufacturing or distribution infrastructure, without the dilution, time and risk of internal development. A strategic acquisition can provide LargeCo with the new products and technologies necessary to maintain its competitive advantage, growth rate and profitability. Ill-conceived or badly done acquisitions, however, can result in expense and disruption to both businesses, the discontinuance of good technologies and products, employee dissatisfaction and defection, and poor operating results by the combined company. By understanding the key factors that lead to a successful acquisition, TechCo and LargeCo can improve the probability of achieving one. Why Do Companies Acquire Other Companies? When considering an acquisition, TechCo's first step should be to identify the strategic reasons why it wants to be acquired. For example, while TechCo may seek liquidity for its founders and investors, it also may have concluded that its future success requires the synergies of complementary resources and access to the infrastructure of a major corporation. An IPO could provide TechCo's shareholders with liquidity, but would not immediately address TechCo's need for product synergy or provide an established infrastructure. Those needs could be better met by finding a strategic buyer for TechCo. Equally important is to identify LargeCo's strategic objectives in acquiring TechCo. For example, LargeCo may seek to acquire a product line or key technology, gain creative, technical or management talent, or eliminate a competitor. Ultimately, LargeCo will acquire TechCo because it believes acquisition is a more effective means of meeting a strategic need and increasing shareholder value than internal development. If TechCo understands its own and LargeCo's strategic objectives, it can focus on candidates that are most likely to meet its needs and value the assets that it has to offer. While the objectives of individual companies will vary, the following table identifies common strategic objectives that TechCos and LargeCos try to achieve through an acquisition. Table 1: Common Strategic Objectives for Acquisitions
What Creates Value in an Acquisition? LargeCo's acquisition objectives will determine which TechCo attributes are the most valuable. If TechCo identifies early the strategic objectives for the most likely LargeCo merger candidates, it can focus its energy on developing those attributes. There are, however, certain TechCo attributes that are likely to enhance TechCo's value. Proprietary technology or products with significant competitive advantage are always valuable. Market leadership in a fast-growing market segment also increases TechCo's value. Studies show that market-share leaders are significantly more profitable than companies with smaller market shares. Strong management in TechCo's areas of value will lend credibility to TechCo's projections of future growth. Nonduplicative infrastructure and relationships add to TechCo's value since LargeCo will not have to terminate redundant personnel or unwind arrangements with unwanted third parties. The greatest source of TechCo value, however, is the financial performance and joint economics expected in the hands of LargeCo. If TechCo reached $5 million in sales in a fast-growing market segment without the benefit of a sales force or an institutional presence, LargeCo's sales force, brand name recognition and established customer base may allow it to increase those results dramatically in the first year with minimal incremental cost. What Destroys Value in an Acquisition? Just as there are certain TechCo attributes that are likely to enhance its value, there are also certain TechCo characteristics that are likely to reduce its value. An unprofitable TechCo or one with performance volatility will have difficulty persuading LargeCo that its future performance projections are credible. Excessive liabilities or litigation threats may frighten off LargeCo from an otherwise good deal, unless TechCo's shareholders are willing to indemnify LargeCo for those risks. If key TechCo managers are visibly reluctant to continue working with LargeCo after the acquisition, LargeCo may be concerned about TechCo's ability to perform after the closing. A TechCo that requires substantial capital to accomplish its goals faces two hurdles. It must persuade LargeCo that the goals are attainable with the requested capital, and that it is worth both the purchase price and the additional capital. Strategically irrelevant TechCo operations tend to defocus or stall merger negotiations. LargeCo does not want to buy such assets, and TechCo will want to be paid for their value or to remove them from the company before the acquisition. It also is dangerous for TechCo to go into negotiations with a limited operating horizon (i.e., with minimal cash). It may find that its only source of bridge financing is LargeCo, which will put it in a much weaker negotiating position. TechCos with a divided Board of Directors, investor group or management team also have a more difficult time in acquisition negotiations. They will find that these groups spend more time negotiating among themselves than in negotiating with LargeCo. Gaining a reputation for being over-shopped also can reduce TechCo's value. It leads LargeCo to believe that many other potential acquirers have already examined TechCo and rejected it as undesirable. Why Do Some Acquisitions Fail? Many acquisitions fail to deliver the synergies and value promised. To avoid these pitfalls, TechCo needs to understand the most common reasons why acquisitions fail. If LargeCo does inadequate technical due diligence, it may discover after closing that TechCo's technology does not perform at the expected level. Sometimes, there is a clash between LargeCo's and TechCo's corporate cultures, and TechCo's key personnel become disenchanted or leave. If TechCo's personnel are a critical part of its value, LargeCo should make a special effort to "recruit" them, designing an employment package and environment that will retain and motivate them. There may not be a true strategic fit, and LargeCo may discover that its sale force cannot easily sell TechCo's products. If LargeCo does an inadequate intellectual property audit, it may later discover that TechCo does not have clear title to its technology. Lastly, LargeCo may change its mind about the strategic importance of TechCo's technology or products and conclude that it does not desire to continue them within LargeCo's organization. Most of these problems can be avoided if they are addressed during negotiations and the due diligence process. When should TechCo pursue a strategic acquisition and when should it pursue an IPO? When evaluating this issue, the following factors should be considered: Infrastructure. To go public and maintain its stock price, TechCo generally must establish a consistent, stable pattern of growth and profitability. To do that, TechCo will need to establish professional manufacturing, distribution, finance, and administration and management. Building the infrastructure necessary to operate as a successful, publicly traded company is time consuming, expensive and dilutive to the present equity holders. While TechCo may command a higher valuation in an IPO than it can in an acquisition, the potential for a higher valuation may not be worth the expected dilution. Moreover, an independent growth strategy can be risky if TechCo is likely to be overtaken by better capitalized competitors. IPO Windows. The IPO market is volatile and reacts to factors that are outside TechCo's control. IPO windows may open and close in a cycle different than TechCo's growth, capital and liquidity needs. For example, the adoption of government regulation of, or bad press about, TechCo's industry can affect TechCo's ability to go public. It may not affect the profitability of TechCo's business, however, nor its potential attractiveness to a LargeCo already in that industry. Public Disclosure. The process of going public requires that TechCo disclose important information about its strategy, competitive advantage and finances that it might prefer to keep confidential. Once public, such disclosures continue as TechCo is required to file regular 10-Ks, 10-Qs and proxy statements. Moreover, there is an increasing risk that TechCo will be sued by its shareholders if, with hindsight, TechCo's public disclosures prove to be materially inaccurate. TechCo may prefer to be acquired to avoid that public disclosure and potential liability. Cost. A public offering is expensive. For example, if TechCo wanted to make a $40 million offering, the underwriters typically would take a 7% commission on the stock sold, and the legal, accounting and printing fees would exceed $1,200,000. Complying with the SEC's public reporting requirements imposes additional administrative burdens, requires substantial executive attention and might cost TechCo an additional $50,000 to $150,000 per year. TechCo will find that being acquired generally is less expensive than doing an IPO and LargeCo typically will pay TechCo's reasonable acquisition expenses. Quarterly Financial Performance. Once TechCo is public, it must publish financial statements and respond to the analysts on a quarterly basis. A public company frequently finds that it makes business decisions with one eye on how the market will respond. By getting acquired by LargeCo, many TechCos hope to be able to focus on long-term investment and business plan execution. Liquidity for TechCo Shareholders. While TechCo may think that going public will provide its shareholders with liquidity, that liquidity may be initially illusory. Many TechCos sell relatively few shares in their IPO and many more do not get serious analyst coverage. There may be little market interest in TechCo's stock, with few shares trading daily (TechCo's "float"). Further, underwriters will require TechCo's shareholders to sign "Market Standoff Agreements," agreeing not to sell any of their shares into the public market for at least 180 days after TechCo's IPO. TechCo's shareholders may find that, although TechCo is now "public," their stock is relatively illiquid. If TechCo's shareholders receive freely tradable LargeCo stock that has a significant float, they may receive more real liquidity more quickly than is possible through a TechCo IPO. Positioning TechCo to Be Acquired The best way for TechCo to position itself to be acquired (or to go public) is to demonstrate consistent revenue and earnings growth and ownership of a fast-growing technology, customer or market franchise. TechCo should consider avoiding early and excessive product or market diversification. Attempting to create multiple products or to attack multiple markets simultaneously strains the resources of an emerging company and reduces the probability that TechCo will execute its strategy well. A more diverse product or market focus also reduces the likelihood of a good strategic fit with LargeCo and increases the probability that some of TechCo's assets will have a low value to LargeCo. TechCo also may want to establish market acceptance of its products through partners instead of establishing its own sales and distribution capability. Using such partnering relationships can enable TechCo to avoid the cost and time of establishing its own production, sales or marketing infrastructure, which will often duplicate that of LargeCo. (See Fenwick & West's booklet "Corporate Partnering: A Strategy for High Technology Companies" for a more detailed discussion of partnering.) From a legal perspective, TechCo should ensure that it has clear title to its intellectual property and it should avoid nonassignable or onerous contracts. To avoid accounting disputes during negotiations, TechCo should keep its financial statements in accordance with generally accepted accounting principles (GAAP) and have annual audits. When Should TechCo Consider Being Acquired? It is difficult to predict at what stage TechCo will obtain the best valuation in an acquisition. However, TechCo may be an attractive acquisition candidate at an earlier stage than it expects. For example, TechCo may want to consider being acquired once it:
This stage may be optimal because TechCo can reach it most quickly, with the least amount of invested capital, personnel and risk. Once TechCo concludes that it wants to be acquired, it needs to understand the acquisition process. There are several stages involved in preparing for, negotiating and closing an acquisition. Each stage requires the participation of different players. From first contact with an investment banker until completion of the integration of LargeCo and TechCo operations, the acquisition process can take more than a year. The following table shows some of the more important acquisition stages and the key participants during those stages of the process. Table 2: Acquisition Process and Participants
Presale Preparation. TechCo may want to obtain advice from an investment banker when it first considers being sold. TechCo should select its banker based on its experience in mergers and acquisitions in TechCo's specific industry doing transactions of similar deal size and its contacts with relevant potential buyers. Before reaching the decision that it should be acquired, TechCo can have an investment banker review its business, financial and strategic plans, and help it evaluate its business alternatives. With early advice, TechCo can address value-enhancing or detracting factors and sometimes improve its valuation. Based on an analysis of TechCo's business strengths and weaknesses, industry trends, TechCo's competitive positioning, and recent M&A activity, the investment banker can advise TechCo on a range of expected acquisition values. These early activities can help TechCo position itself to command the highest valuation and attract the most qualified prospective purchasers. The investment banker can also prepare a detailed timeline to better prepare TechCo for the length of the process and how much of management's time will be needed. Assistance During the Marketing Process. Once TechCo decides to be acquired, the investment banker can prepare detailed marketing materials describing TechCo's key attributes. The investment banker approaches the marketing process by conducting a detailed analysis of TechCo, its industry and the strategic reasons why LargeCo might want to acquire TechCo. The investment banker will also prepare a detailed list of potential buyers to be contacted during the marketing process. Using a banker at this stage in the process enables LargeCo to ask "tough" questions of the banker and be more forthright in their evaluation of TechCo without offending TechCo's management. Due Diligence. When potential buyers conduct initial due diligence on TechCo, the investment banker can assist the process by ensuring that LargeCo gets information necessary to submit a binding offer to acquire TechCo. It is important to anticipate what information will be the most important to LargeCo to avoid embarrassing "surprises" later. The investment banker can assist TechCo by pointing out sources of synergy and supporting TechCo's desired valuation by financial analyses based on comparable public and private companies. Familiarity with TechCo's industry also will allow the banker to suggest alternatives if difficulties arise with a current LargeCo prospect. Negotiations Phase. During this process, the investment banker will help TechCo determine which offer to accept based on valuation, structure, tax considerations, LargeCo currency (if stock is the primary consideration), and other relevant issues. Once an offer is accepted, it is critical to communicate to the investment banker which issues are most important to TechCo in order to properly position the negotiation discussions. To ensure an efficient final agreement phase, the investment banker can help coordinate communication with TechCo's lawyers and accountants to make certain all of TechCo's advisors understand the implications of the definitive agreement. If requested, an investment banker can provide TechCo's Board of Directors with a formal "fairness opinion" on the terms offered by LargeCo. If LargeCo and TechCo agree that they are a good strategic fit, the next step is to determine the terms of the LargeCo-TechCo merger. LargeCo's focus will be on paying no more than TechCo's value; structuring the acquisition to obtain the most desirable tax, accounting and risk profile; and negotiating agreements with key personnel. When considering LargeCo's offer, TechCo should keep in mind the needs of its different constituencies. TechCo's shareholders typically want the highest possible price, paid in a liquid but tax-free manner. They also want to limit their personal liability for indemnities and reduce the amount of any consideration held in escrow as security for such indemnities. TechCo's management will want to retain the largest number of TechCo's employees on the best possible terms and have LargeCo deal fairly with terminated employees. On a personal level, TechCo's executives will want to negotiate a good employment package and avoid long noncompetition agreements in case their relationship with LargeCo does not prove successful. Perhaps even more than LargeCo, TechCo's management will want to avoid the risk of a "broken deal." TechCo's employees will be concerned about their jobs, their reporting relationships and the uncertainty caused by the acquisition. To negotiate a successful acquisition, all of these concerns must be addressed. TechCo Valuation. One of the most important LargeCo issues is to pay a fair value for TechCo. Valuation is highly subjective. The "fair" value for TechCo will vary significantly from one LargeCo to another, depending on a variety of factors. An investment banker can assist TechCo in determining its valuation and in price negotiations with LargeCo. When negotiating its value, TechCo should remember that public LargeCos, issuing stock in a merger, will not want the merger to be dilutive of their earnings per share (EPS). This means that LargeCo cannot issue so many shares to TechCo's shareholders that the merger reduces LargeCo's EPS. LargeCos typically use three methods to triangulate on a reasonable TechCo valuation.
There are inherent risks in negotiating, documenting and closing an acquisition since the parties have to make critical decisions regarding price and terms based on partial knowledge. There follow some mechanisms used by LargeCo and TechCo to manage these risks. Exclusive Negotiating Period. At the time the parties agree on price and the other key deal terms, LargeCo generally will require TechCo to cease negotiating with other potential buyers and negotiate exclusively with LargeCo. LargeCo will not want to invest substantial time and resources in performing due diligence and negotiating a deal with TechCo, only to have TechCo use LargeCo's offer to start a bidding war by other potential buyers. TechCo will want to keep the period during which it has to pull itself off the market as short as possible. To meet its fiduciary obligations, TechCo's Board of Directors will want to reserve the right to notify its shareholders of other offers and may even reserve the right to accept unsolicited and clearly superior offers. The exclusive negotiating period should be no longer than reasonable for LargeCo to complete due diligence and negotiate the definitive documents - usually between 30 and 60 days. Break-Up Fee. Both LargeCo and TechCo may be concerned that they will be damaged if the deal fails to close after they have signed definitive acquisition agreements and announced the transaction. As noted above, LargeCo will not want TechCo to use LargeCo's offer to start a bidding war. TechCo will worry that an acquisition announcement may cause its customers to delay orders until they know whether LargeCo intends to continue marketing and supporting existing TechCo products. Similarly, if the announcement causes TechCo's employees to focus on their resumes instead of on their jobs, TechCo can be seriously damaged if the acquisition fails to close. Either LargeCo or TechCo may propose a "break-up fee" as a way to address this risk. A "break-up fee" requires the party responsible for the break-up to pay the other party a negotiated amount of liquidated damages. The amount of the break-up fee should reflect the damages likely to be sustained by the damaged party. Some parties dislike break-up fees because they believe that it implies permission not to close (as long as the break-up fee is paid) and they would prefer an unequivocal obligation to close. LargeCo Due Diligence. LargeCo will do much of its due diligence under a non-disclosure agreement signed with TechCo before the parties agree on a letter of intent. Many TechCos, however, will not give LargeCo access to their most confidential financial, technical, intellectual property, and customer information until a price has been negotiated. As a result, LargeCo must decide whether TechCo is a strategic fit and arrive at a proposed purchase price based on its own product and market due diligence, without access to TechCo's more detailed information. Once the parties agree upon the basic deal terms and while LargeCo's lawyers are preparing the definitive agreements, LargeCo will conduct due diligence to discover if its assumptions about TechCo were accurate. LargeCo generally will want to do due diligence in the following areas: product/technology, sales/marketing, financial/accounting, and legal/intellectual property. (See Fenwick & West's booklet "Acquiring and Protecting Technology: The Intellectual Property Audit" for a more detailed discussion of due diligence issues when acquiring technology.) LargeCo and TechCo should try to identify and discuss particular sensitivities or unusual problems or liabilities as early in the due diligence process as possible. Early disclosure is more efficient, builds credibility, and is less likely to result in last-minute price renegotiations. LargeCo should avoid placing an unnecessary burden on TechCo staff during the due diligence process. TechCos rarely have the administrative and financial infrastructure that LargeCo has, and do not maintain the same type of records. It is often preferable to have LargeCo's personnel do much of the due diligence. This enables LargeCo to obtain more accurate information in the form expected, and will reduce the burden on TechCo. LargeCo also needs to be sensitive to confidentiality concerns. A stream of LargeCo personnel, Federal Express envelopes with LargeCo's return address, or faxes containing confidential information sent to locations that are not secure can easily result in rumors that LargeCo intends to acquire TechCo. Lastly, LargeCo should remember that the purpose of due diligence is to quantify risk, not to bring TechCo's records into line with LargeCo's. Such conforming changes can be accomplished after the merger. If LargeCo discovers unexpected TechCo liabilities during the due diligence process, it may withdraw from the deal, reduce its offered price, or ask TechCo's shareholders to indemnify it for damage from unusual liabilities. TechCo should avoid allowing LargeCo to put a "due diligence out" in the definitive acquisition agreement. A "due diligence out" is a condition to closing that allows LargeCo to decide at the closing whether TechCo is too risky to acquire. To avoid the risks of customer confusion, employee distraction and the reputation of being "left at the altar," TechCo should require LargeCo to complete all due diligence before signing and announcing the definitive agreement. LargeCo generally will insist on the right to refuse to close if there is a "material adverse change" in TechCo's business between signing and closing. If TechCo anticipates that the merger announcement will cause such a change, the parties should negotiate a definition of "material adverse change" that will not penalize TechCo for expected changes to its business, yet will protect LargeCo from unexpected material adverse changes to TechCo's business. TechCo Representations and Warranties, Indemnities and Escrows. Besides doing its own due diligence, LargeCo's definitive agreement will contain detailed representations and warranties about TechCo's business. If those representations are inaccurate, TechCo is expected to disclose the inaccuracies in an "exception schedule" detailing TechCo's problems and liabilities. LargeCo also will ask TechCo to attach detailed lists of TechCo's assets, contracts and liabilities to the definitive agreement as part of TechCo's "disclosure schedule." If LargeCo suffers damage because a privately-held TechCo failed to disclose any of the requested information, LargeCo will expect TechCo's shareholders to indemnify it. Given this indemnity obligation, TechCo should strive for complete and accurate disclosure. To mitigate against an unreasonable disclosure burden, however, TechCo will want to limit some disclosure obligations to those items that are "material" to TechCo or of which TechCo has "knowledge." Every business has liabilities that arise in the ordinary course. It is inappropriate (and harmful to the relationship with continuing TechCo management) for LargeCo to make claims for every dollar of liability that is discovered after the closing. To reflect this reality, TechCo will want its breaches to cause a certain threshold of damages (called a "basket") before LargeCo has any right to indemnification. Once the basket limit is reached, however, LargeCo will want to recover all its damages, including the basket, while TechCo will prefer that LargeCo recover only the damages in excess of the basket. TechCo will want to limit potential liability under the indemnity while LargeCo will prefer unlimited liability for damages. When TechCo's major shareholders are also its key managers, TechCo should expect requests for broader indemnities and escrows. When outside investors hold most of TechCo's shares, however, they will want to limit the dollar amount of their personal liability for indemnities. They also will prefer to limit LargeCo to a negotiated amount of escrowed consideration. LargeCo also may want to hold a portion of the merger consideration in escrow as security for such indemnity obligations. Since acquisitions can no longer be accounted for as a "pooling," acquirers are asking for larger and longer escrows. It is unlikely that 10% of the shares issued going into escrow for one year for breaches of general representations and warranties will continue to be the norm. To minimize conflicts over escrow claims, LargeCo and a TechCo shareholders' representative should have regular scheduled post-closing meetings to identify and address indemnity issues. Escrows and shareholder indemnities are rare in acquisitions of a publicly-held TechCo. In public-public acquisitions, LargeCo generally will assume the risk of problems discovered post-closing. TechCo Due Diligence. If LargeCo is paying cash for TechCo at the closing, there is little need for TechCo to do due diligence on LargeCo. If LargeCo is paying for TechCo with its stock, a promissory note or an earnout, however, TechCo will want to do due diligence on LargeCo. Many of the considerations relating to LargeCo's due diligence will apply when TechCo is doing due diligence on LargeCo. If LargeCo is public, its federal securities filings will supply much of the desired information, although TechCo may want more detailed information about LargeCo's operations. Key Shareholder Pre-Approval. One acquisition risk is whether TechCo's shareholders will approve the acquisition negotiated by TechCo's management and approved by TechCo's Board of Directors. TechCo will have similar concerns if LargeCo must obtain its shareholders' approval. Legal formalities required to obtain shareholder approval mean that there will be a delay between signing the definitive agreement and obtaining shareholder approval to that agreement. To manage this risk, the parties may want to ask key shareholders (officers, directors and 10% shareholders) to sign an Affiliates Agreement at the time the definitive acquisition agreement is signed, agreeing to vote in favor of the transaction. License to Key Technology. If LargeCo's principal reason to acquire TechCo is to obtain a critical piece of technology, LargeCo may want to negotiate a license to that technology. The license could be signed at the same time as the definitive acquisition agreement since it would rarely require shareholder approval or compliance with time-consuming legal formalities. Thus, even if the acquisition did not close, LargeCo would still have access to the critical technology. TechCo will want to ensure that the license terms would be acceptable if the acquisition did not close. Stress Level. Acquisitions are, by their nature, highly stressful. First, there is the unavoidable increase in work load required by the acquisition process. TechCo's managers need to negotiate the deal, respond to due diligence requests, generate requested schedules, and make decisions regarding the integration of the two companies, all in addition to handling TechCo's day-to-day operations. Second, there is the uncertainty about the future. Who will be kept and under what financial terms? Who will be fired? How will operations change in the new organization? Third, a potential acquisition creates mass personal insecurity. Everyone in TechCo's organization will be concerned about his future and his ability to perform in the new organization; rumors will abound and TechCo's ability to perform will deteriorate. It is in the best interests of both LargeCo and TechCo to minimize the effects of this stress. Absent the type of planning recommended below, LargeCo may find that TechCo experiences employee turmoil, low morale and poor financial performance because of the acquisition. To minimize the impact of employee turmoil, and particularly if TechCo's and LargeCo's corporate cultures are substantially different, the parties may want to engage an organizational development consultant to assist them with the integration issues. Confidentiality. Acquisition negotiations must be kept strictly confidential until LargeCo and TechCo have signed the definitive acquisition agreements and are prepared to answer the myriad questions that arise upon an announcement of the acquisition. The fewer people who know about acquisition negotiations and the shorter the period that they are required to maintain confidentiality, the more likely each company will be to manage information release successfully. To assist in maintaining confidentiality, most LargeCos use code names instead of TechCo's real identity on internally generated documents. Initial meetings should be held off-site and in locations where the principals are unlikely to be observed. The parties should try to limit the more intrusive types of LargeCo due diligence until it is certain that the agreement will be signed, rather than risk early leaks and employee disruption. Key Employees. LargeCo and TechCo need to identify which TechCo personnel must be retained as board members, executives or key employees and the key factors necessary to retain and motivate them. This issue needs early focus and should be resolved before the parties announce the acquisition. LargeCos tend to think of compensation matters as a "human resources" detail; whereas it may be a "show stopper" to the affected employee. Salary, bonus, stock option and other compensation arrangements and reporting relationships must be discussed and agreed upon. To maximize employee retention, however, the parties also should address more intangible issues of corporate culture. Some TechCo employees will want assurances that they will not be required to move. For others, the key issue may be the availability of cutting-edge technological tools or additional personnel in an area where they have had inadequate resources. LargeCo should plan to interview each key TechCo employee to recruit him or her to join the LargeCo team. As soon as possible after the announcement, LargeCo should commence the process of weekly team-building meetings between the counterparts from the two companies. These should continue until employee surveys indicate that there has been a successful integration of TechCo's key employees with their LargeCo counterparts. Reduction in Force. Just as LargeCo and TechCo need to determine which employees must be retained, they also must decide which employees will become redundant. If TechCo has more than 100 employees and the acquisition will result in more than 50 employees being terminated, the parties must comply with the Worker Adjustment and Retraining Notification Act. The WARN Act requires that terminated employees receive either 60 days' termination notice or 60 days' severance pay. The parties should determine for what period terminated employees will be needed to integrate TechCo into the LargeCo organization. They then should design a "transition" package that motivates them to remain with TechCo during the transition period. One way of providing such motivation is to condition special option vesting, severance and bonus payments on remaining during the transition period. Out-placement and resume assistance programs should be provided, if possible. The parties should determine transition packages and assistance programs before the acquisition is announced to TechCo's employees. LargeCo personnel should meet with each employee on the day of the acquisition announcement to explain the details of his or her individual package and answer any questions he or she may have regarding insurance and out-placement services. It is important to handle terminations with dignity and compassion. Failure to do so will result in low morale for those who have lost their jobs and turmoil in the departments concerned. It also may result in distrust and resentment by the employees that LargeCo wants to retain and motivate. Noncompetition Agreements. The two most important noncompetition agreement issues are scope of the noncompete and price. Ideally, the noncompetition agreement should be no broader than the product and market area that TechCo is selling to LargeCo. If the key employee is a significant TechCo shareholder, it is not necessary to pay additional consideration for the noncompetition agreement. If the key employee owns little or no TechCo stock, however, LargeCo needs to consider the fairness of expecting him or her to sign a noncompetition agreement without additional consideration. In California, it is not clear that a noncompetition agreement is enforceable against an employee who holds less than 3% of TechCo's stock. The parties should get tax advice if they intend to allocate a portion of the purchase price to the noncompetition agreement since it can have significant tax consequences.
Golden Parachutes.
"Golden parachutes" are arrangements that provide a key employee,
because of a change in control of the company, with benefits equal to
three or more times such employee's average annual compensation over
the last five years. Recipients of golden parachutes must pay a 20%
excise tax, which is not deductible by the acquired corporation. Under
certain limited circumstances, golden parachutes can be exempted if
they are paid by Employee Benefit Issues. The parties should discuss how the acquisition will affect TechCo's health plans, profit sharing plans, bonus plans, employee loans, stock options and other employee benefits. While LargeCos typically have more complete employee benefits than TechCos, some TechCo perquisites, such as generous car allowances and country club memberships, may be discontinued. TechCo also should consider the tax ramifications to employees of early option exercises. For example, employees may owe alternative minimum tax on the difference between the fair market value of TechCo's stock on the date of exercise and the option exercise price of incentive stock options exercised before an acquisition. TechCo 401(k) Plan. If TechCo has a 401(k) plan it should be reviewed carefully to determine if there are unique features that should be carried over to LargeCo's 401(k) plan. LargeCos typically merge the plans and the investment vehicles after the merger and transfer TechCo's records for its plan assets. Before merging the plans, LargeCo will want to verify whether TechCo's plan complies with the pension plan discrimination tests. Another key issue is how LargeCo wants to structure the acquisition. For example, does LargeCo want to acquire TechCo's stock or its assets? There follows a table and summary of possible acquisition structures and their impact on key business considerations:
Merger. In a merger, either TechCo or LargeCo (or LargeCo's subsidiary) merges into the other by operation of law, with TechCo's shareholders exchanging their shares for LargeCo shares. A merger is the simplest mechanism for acquiring another company and results in LargeCo (or LargeCo's subsidiary) automatically receiving all of TechCo's assets. State merger laws typically require majority TechCo shareholder consent to approve a merger. The law also provides a mechanism for cashing out those TechCo shareholders who are unwilling to accept LargeCo stock in the merger (dissenting shareholders). A drawback to using a merger is that LargeCo (or its merger subsidiary) will automatically assume all of TechCo's liabilities. LargeCo can exchange its stock, promissory notes or cash for the TechCo stock in a merger. Asset Purchase. If LargeCo wants to avoid unrelated TechCo liabilities, it may prefer to acquire TechCo's assets rather than merge with TechCo. Asset acquisitions require that the parties specify the assets and liabilities to be transferred and thus entail more due diligence and transfer mechanics than a merger. LargeCo can exchange its stock, promissory notes or cash for TechCo's assets. Stock Purchase. LargeCo may want to purchase all of TechCo's outstanding stock from TechCo's shareholders. This commonly occurs if TechCo has very few shareholders or if TechCo or LargeCo is a foreign company that cannot legally do a merger. Since LargeCo acquires all of TechCo's stock, TechCo remains in existence as LargeCo's subsidiary, with all of its assets and liabilities intact. One significant drawback to a stock purchase is that, unlike a merger, the law does not provide a means of cashing out large numbers of "dissenting shares" under a stock purchase. Most LargeCos are unwilling to have minority shareholders, which could occur if a TechCo shareholder refused to agree to sell his or her shares to LargeCo on the offered terms. As a result, a stock purchase is impractical if TechCo has either many shareholders or even one shareholder with substantial holdings who strongly disapproves of the acquisition. What consideration will LargeCo use in the acquisition? The most common choices are cash (in a fixed amount or in an "earnout"), stock, debt and assumption of liabilities. From LargeCo's perspective, a cash transaction is the simplest and fastest to accomplish, but it will reduce the amount of cash available for other purposes. For TechCo's shareholders, a cash transaction offers maximum liquidity, but will be immediately taxable (although installment treatment may be possible for cash basis tax payers if the cash is to be paid over time). If they believe LargeCo's stock is a good investment, TechCo's shareholders may prefer freely tradable LargeCo stock. It is highly liquid, yet tax can be deferred until it is sold. LargeCo may wish to pay with a promissory note due over time. Using debt may permit LargeCo to defer the cash drain for the acquisition until TechCo's assets are producing the cash flow with which to pay off the note. TechCo's shareholders, receiving a note on the sale of TechCo, may be concerned that LargeCo will be unable or unwilling to pay off the note when it becomes due. Absent a LargeCo with substantial assets, TechCo may insist that such a note be secured by the assets sold to LargeCo. The following table summarizes some of the key business considerations involved in selecting from among the three most commonly used forms of acquisition consideration:
A completely "tax-free" acquisition is one in which TechCo's shareholders exchange their TechCo stock solely for LargeCo stock, or cause TechCo to transfer its assets to LargeCo solely for LargeCo stock. The TechCo shareholders will have the same basis in the LargeCo stock issued in the merger as they had in their TechCo stock. Provided they receive only LargeCo stock in the transaction, TechCo's shareholders will pay tax on the gain only when they sell their LargeCo stock. If TechCo's shareholders believe that LargeCo's stock is a good investment, converting their TechCo investment into LargeCo stock on a tax-free, instead of after-tax, basis is beneficial. TechCo's shareholders will be currently taxed on any cash received. The following table shows the matrix of possible tax-free acquisition structure alternatives and their impact on key business considerations. Each alternative is discussed in greater detail below. Table 5: Tax-Free Acquisition Structure Alternatives
The following check list of key requirements for obtaining tax-free treatment of an acquisition is for purposes of identifying areas of concern only. Since these rules are dynamic and complex, you should consult your tax advisor regarding the application of these requirements to your company and facts. To qualify as a tax-free reorganization under the Internal Revenue Code, several requirements must be satisfied. Two of the more important are that LargeCo must continue TechCo's business in some form and TechCo's shareholders must not sell back their LargeCo shares received in the merger to LargeCo after the acquisition (the "continuity of interest" test). There are three ways of accomplishing tax-free acquisitions: Merger. A merger can offer the most flexibility in structuring a transaction in a way that is tax-free to TechCo's shareholders. There are three types of mergers:
Stock for Assets Acquisition. In a stock for assets acquisition, LargeCo issues its stock to TechCo in exchange for substantially all of TechCo's assets. If the desired assets make up substantially all of TechCo's business, LargeCo can avoid acquiring strategically irrelevant operations that it does not want, as well as unrelated TechCo liabilities. LargeCo can offer cash and assumed liabilities for nearly 20% of the total consideration paid and still have TechCo receive the stock portion on a tax-free basis. TechCo must liquidate and distribute LargeCo's shares to its shareholders to avoid corporate and shareholder level tax. LargeCo may prefer a taxable, instead of tax-free, acquisition of assets. A taxable asset purchase gives LargeCo a "step-up" in the basis of TechCo's assets to their current fair market value. In a tax-free transaction, these assets are carried over to LargeCo's balance sheet with the same depreciated value at which they were carried on TechCo's balance sheet. Thus, a taxable asset purchase provides LargeCo with larger tax deductions for depreciation (of tangible assets) and amortization (of intangible assets) than are available under a tax-free asset purchase. Of course, in a taxable asset purchase TechCo must pay corporate level tax on the sale and TechCo's shareholders must pay tax on the consideration distributed to them. This is not a problem if TechCo has a net operating loss (NOL) greater than the purchase price and if the purchase price is less than the amount the TechCo shareholders invested in TechCo. In that event, there is no gain, and no income or capital gains tax would be due. The transaction still would be subject to sales tax, however. Stock for Stock Acquisition. In a stock for stock acquisition, TechCo's shareholders exchange their shares solely for LargeCo's stock. After the exchange, LargeCo must own at least 80% of TechCo's stock. Since only LargeCo stock may be used, stock for stock acquisitions are the least flexible in the type of consideration that may be used. On June 29, 2001, The Financial Accounting Standards Board (FASB) adopted Statements of Financial Accounting Standards No. 141, Business Combinations and No. 142, Goodwill and Other Intangible Assets. Statement 141 eliminated pooling accounting for acquisitions unless they were initiated prior to July 1, 2001. An acquisition is deemed "initiated" once the companies are in price negotiations. Statement 142 changed the rules on amortization of intangibles. Under Statement 142, intangibles such as patents, copyrights, etc. will continue to be amortized over their life, but goodwill is no longer subject to amortization. Instead, goodwill must be reviewed annually, or more frequently if impairment indicators arise, for impairment and if goodwill is found to be impaired it must be written down to the extent of the impairement. Acquisitions initiated after July 1, 2001 must be accounted for as a purchase, but the goodwill will not have to be amortized. Up until June 30, 2001, many LargeCos preferred to have an acquisition accounted for as a "pooling" instead of a "purchase." Prior to that date, in a tax-free merger accounted for as a purchase, the income statements of TechCo and LargeCo were combined only after the closing of the acquisition. TechCo's assets were recorded on LargeCo's balance sheet at their fair market value on the date the acquisition was consummated. The difference between the price paid by LargeCo and the net book value of TechCo's assets was treated as goodwill, which was then amortized as expense against LargeCo's future income creating a "hit to its earnings," without a corresponding tax deduction. Purchase accounting was generally not desirable when acquiring TechCos because much of their value relates to their technology that has little, if any, book value. Since TechCos tend to expense the vast majority of the money they expend on technology development, these valuable assets generally are carried at very low balance sheet values, resulting in large goodwill charges that would reduce the LargeCo's earnings for many years to come. In pooling accounting, the historical financial statements of LargeCo and TechCo were combined and restated as though the two companies had always been one. TechCo's net asset values were not revised. They were carried over onto LargeCo's balance sheet at the same value at which they had been carried on TechCo's balance sheet. No goodwill was recorded and therefore none needed to be amortized. There was no "hit to LargeCo's future earnings." There were significant structuring drawbacks to using pooling accounting. Among the pooling restrictions:
With the elimination of pooling, companies have much more flexibility on how they structure their transactions. Targets can reprice options, cut special severance, vesting or compensation deals with executives, or negotiate a partially stock and partially cash transaction for example. Acquirers can impose resale restrictions on stock, or require larger escrows and hold the escrowed shares for a longer period. Affiliates of neither the target or the acquirer will be subject to the pooling lockup. Acquisitions often occur during a down-turn in the economy or when TechCo's valuation is depressed or it is near insolvency or bankrupt. While these circumstances create a myriad of other issues, the following section addresses two of the most common: how does TechCo keep its key employees motivated to help sell the company and what structure should be used to acquire a TechCo near insolvency? The Problem. A TechCo that was venture backed may find that the total liquidation preferences required by its charter to be paid to the holders of the preferred stock on an acquisition exceed any reasonably expected price that could be offered for TechCo. For example, a company might have raised $50 million in invested capital, yet only be worth $10 million. Employees realize that if the purchase price is allocated in accordance with the preferred stock liquidation preferences, they, as holders of common stock, will receive nothing in the acquisition. Management becomes demoralized and may be unwilling to support an acquisition that will only benefit the holders of the preferred stock. This conflict could stall or even foreclose acquisition negotiations. The Solution. TechCo can solve this problem by creating a cash or stock bonus plan or by doing a recapitalization. Frequently, a cash retention bonus plan is the simplest solution. There follows a table and summary of major considerations in adopting key employee incentive plans: Table 6: Employee Incentive Plan Alternatives
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