By Richard D. Harroch, David A. Lipkin, and Richard V. Smith
Effectively negotiating merger and acquisition agreements for a privately held technology company involves addressing and resolving a number of key business, legal, tax, intellectual property, employment, and liability issues. Such agreements are often heavily negotiated, and a poorly negotiated transaction can result in significant risks to the selling company and its shareholders, including with respect to the certainty of closing the deal and potential post-closing indemnification liabilities to the buyer.
This article discusses a number of the hotly contested key issues in acquisitions of privately held technology companies. The ability to achieve success in any negotiation depends on a number of factors: the leverage a party has in the negotiation, the price and other key terms the parties may have already agreed upon at the letter of intent stage, the risks a party is willing to take with respect to closing conditions and post-closing liability exposure, whether there is competition among bidders for the target company, the quality of the lawyers involved, and the skill of the negotiating team.
1. Price/Consideration Issues
The price and type of consideration are issues that will need to be addressed early in the process, preferably in the letter of intent, and these go beyond agreeing on the “headline” price. Here are some of these issues:
- Whether the purchase price will be paid all cash up front.
- If the stock of the buyer is to represent part or all of the consideration, the terms of the stock (common or preferred), liquidation preferences, dividend rights, redemption rights, voting and Board rights, restrictions on transferability (if any), and registration rights. In addition, if the buyer is a public company, it will be important to consider whether that stock should be valued at signing or valued at closing, and whether a “collar” arrangement that limits upside and downside risk may be appropriate.
- If a promissory note is to be part of the buyer’s consideration, what the interest and principal payments will be, whether the promissory note will be secured or unsecured, whether the note will be guaranteed by a third party, what the key events of default will be, and the extent to which the seller has the right to accelerate payment of the note upon a breach by the buyer.
- Whether the price will be calculated on an “indebtedness free and cash free” basis at the closing (enterprise value) or whether the buyer will assume or take subject to the seller’s indebtedness and be entitled to the seller’s cash (equity value).
- Whether there will be a working capital adjustment to the purchase price, and if so, how working capital will be calculated. This is ultimately just an adjustment up or down to the purchase price. The buyer may argue that it should get the business with a “normalized working capital” and the seller will argue that if there is a working capital adjustment clause, the target working capital should be low or zero. This working capital mechanism, if not properly drafted or if the target amounts are improperly calculated, could result in a significant adjustment in the final purchase price to the detriment and surprise of the adversely affected party.
- If part of the consideration is an earnout, how the earnout will work, the milestones to be met (such as revenues or EBITDA and over what period of time), what payments are to be made if milestones are met, what protections (such as acceleration of payment of the earnout if the business is sold again by the buyer) will be offered the seller to enhance the likelihood of the earnout being paid, information and inspection rights, and more. Earnouts are complex to negotiate and tend to be the source of frequent post-closing disputes and sometimes litigation. Precision in drafting these provisions and agreeing on suitable dispute resolution processes are essential, although also difficult to accomplish.
2. Escrow/Holdback Issues
In many acquisitions of privately held technology companies, an escrow or holdback of a portion of the purchase price is negotiated to protect the buyer from losses due to breaches of the seller’s representations and warranties or covenants or specified contingencies (such as a shareholder’s exercise of dissenters’ rights). Sometimes there is a second escrow or holdback to help protect the buyer in the event of a post-closing price reduction based on a working capital adjustment provision. In certain transactions there may also be a special escrow/holdback to protect the buyer from specific matters, such as pending or threatened litigation. It is rare that a company can be sold on an “as is” basis without post-closing indemnities, in which case there would be no escrow/holdback. Here are some of the key issues associated with escrow/holdbacks:
- The amount of the general escrow/holdback for indemnification claims by the buyer and the period of the escrow/holdback (the typical negotiated outcome is a 5% to 15% escrow that is held by a third party for a minimum period of 9 to 18 months).
- With increasing frequency, in transactions with private equity bidders, it is becoming the norm for the majority of the escrow/holdback to be replaced with a provision that relegates the buyer to pursuing claims against a policy of “representations and warranties insurance” procured by the buyer or the seller for post-closing indemnification claims. Although this is not seen often in deals with strategic acquirers, if they are competing against private equity firms for an attractive target, strategic acquirers may feel compelled to agree to this structure as well.
- The seller will attempt to negotiate that the escrow will be the exclusive remedy for breaches of the acquisition agreement (except perhaps for breaches of certain defined “fundamental representations,” such as with respect to capitalization and organization of the seller, and for breaches of pre-closing covenants). Buyers who are willing to agree to this limitation typically will seek an exception for losses due to “fraud” or “actual fraud.”
- If a portion of the consideration paid in the transaction consists of the buyer’s stock, the buyer and seller will need to agree on whether the escrow will be all cash, all stock, or some combination of both, and how and when the stock will be valued for purposes of the indemnity. The negotiation on this topic becomes more complicated if the buyer’s stock is not publicly traded or if the escrow will include both preferred stock and common stock.
- In target companies with multiple (sometimes hundreds of) shareholders, it will be important for there to be a “shareholder representative” who post-closing represents on a unified basis the interests of the former shareholders with respect to indemnity and escrow/holdback issues. Traditionally this role was filled by one of the seller’s significant shareholders, but more frequently in recent years sellers have found it attractive to hire professional outside firms (such as Shareholder Representative Services or Fortis) that specialize in fulfilling this role.
3. Representations and Warranties of Seller
The representations and warranties of the seller can be all-encompassing, covering all elements of a seller and the business operations of the seller, including financial statements, corporate authorization, liabilities, contracts, title to assets, employee matters, compliance with law, and much more. For the sale of a privately held technology company, the representations and warranties relating to its intellectual property will also be particularly important.
- The representations and warranties in the definitive acquisition agreement typically serve three buyer-driven purposes. First, the buyer uses the representations and warranties to confirm its due diligence findings, and what it has learned about the seller. Second, if, after signing, the buyer determines that the representations and warranties were untrue when made (or would be untrue as of the proposed closing date), the buyer may not be required to consummate the acquisition (and may be entitled to terminate the agreement). Third, if the representations and warranties are untrue at either of such times, the buyer may be entitled to be indemnified post-closing for any losses the buyer suffers arising from such misrepresentation by the seller.
- The seller should make sure that representations about the selling company are only made by the selling company. Occasionally, a buyer will argue that a major selling shareholder who controls the selling company or owns a major stake in the selling company should join the selling company in making representations.
- Careful M&A lawyers representing sellers negotiate materiality qualifiers, knowledge qualifiers, and thresholds for disclosure so that immaterial violations do not result in breach of the acquisition agreement. They also work closely with the seller to prepare a schedule of exceptions to the seller’s representations and warranties (commonly referred to as the “Disclosure Schedule”) which, if accurate and complete, will protect the seller and its shareholders from indemnification liability for inaccuracies in such representations and warranties. A similar negotiation takes place around the closing conditions and the terms of indemnification.
- The seller’s representations and warranties regarding its financial statements, intellectual property, contracts, and liabilities merit particular attention and are discussed in the following sections.
4. Financial Statement Representations and Warranties of the Seller
For the buyer, representations of the seller as to its financial statements are critical. The buyer will expect that the acquisition agreement will include, at minimum, the following representations and warranties related to the seller’s financial statements:
- That the audited and unaudited statements of income, cash flow, and shareholders’ equity for specified periods and as of specified dates (the “Financials”) have been prepared in accordance with generally accepted accounting principles (“GAAP”), or international financial reporting standards in some cases, consistently applied throughout the time periods indicated and consistent with each other.
- That the Financials present fairly in all material respects the seller’s financial condition, operating results, and cash flows as of the dates and for the periods indicated in the Financials.
- That there has been an absence of recent changes in the seller’s accounting policies.
- That the seller’s internal controls have been adequate in connection with the preparation of financial statements by the seller.
The seller’s M&A attorney will attempt to limit the scope of these representations and warranties by the time period covered (such as only for the current year (or portion thereof) and the past one or two years), and by specific exceptions that may be set forth in the Disclosure Schedule. The representations regarding unaudited financial statements are typically qualified to the effect that footnotes required by GAAP have not been included in the unaudited financial statements, and that there may be immaterial changes resulting from normal year‑end adjustments in a manner consistent with past practice.