Mergers & Acquisitions: A Strategy for High Technology Companies
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Table of Contents
Why Do Companies Acquire Other Companies?
What Creates Value in an Acquisition?
What Destroys Value in an Acquisition?
Why Do Some Acquisitions Fail?
Acquisition vs. IPO
Positioning TechCo to Be Acquired
When Should TechCo Consider Being Acquired?
The Acquisition Process
Use of an Investment Banker
Valuation and Pricing Issues
Risk Reduction Mechanisms
Personnel Issues
Acquisition Structure
Type of Consideration Used
Tax-Free Acquisition
Acquisition Accounting
Letter of Intent
Disclosure of Acquisitions
Time and Responsibility Schedule
Definitive Agreements
Board Approval
Necessary Consents
Integration Issues
Appendix B: S-4 Merger Time and Responsibility Schedule
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
| TechCo Reasons to Be Acquired | LargeCo Reasons to Make an Acquisition |
|
Access to complementary products and markets Access to working capital Avoid dilution of building own infrastructure Best liquidity event for founders and investors Best and fastest return on investment Faster access to established infrastucture Gain critical mass Improve distribution capacity More rapid expansion of customer base |
Acquire key technology Acquire a new distribution channel Assure a source of supply Eliminate a competitor Expand or add a product line Gain creative talent Gain expertise and entry in a new market Gain a time-to-market advantage Increase earnings per share |
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:
- Produces a product or service that is:
-
- critically acclaimed in the industry trade journals,
- strongly endorsed by good, referenceable customers, and
- a strategic fit with LargeCo's products and distribution
- Has a strong development team in a mission-critical area
- Has few conflicting or overlapping products or infrastructure; and
- Is profitable and can demonstrate revenue and profit growth.
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
| Participants | TechCo Market Plan | Contact LargeCo Candidates | Negotiate Letter of Intent | Conduct Due Diligence | Negotiate and Sign Agreements | Closing of Merger | Company Integration |
| Management | ü | ü | ü | ü | ü | ü | ü |
| Board of Directors | ü | ü | ü | ||||
| Investment Banker | ü | ü | ü | ü | |||
| Lawyers | ü | ü | ü | ü | |||
| Accountants | ü | ü | ü | ü |
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.
- Comparable Public Companies. One way of determining TechCo's value is to take the market value of stocks of comparable, publicly traded companies in TechCo's industry as a multiple of such companies' earnings and revenues. Those values are then adjusted to account for the size, liquidity and performance differences between TechCo and those companies. The difficulty with this analysis is in selecting "comparable" companies and accurately adjusting TechCo's value to reflect the differences between TechCo and such companies.
- Comparable Transactions. Another way of determining TechCo's value is to compare the amount paid in acquisitions for other companies in TechCo's industry. When using this valuation method, consider the following. While the stock market values all public companies daily, acquisitions occur over time. If a comparable transaction occurred some time before TechCo's proposed transaction, are the factors essential to that valuation still present? Another factor that can influence valuation is the consideration used in the transaction. A LargeCo with a highly valued stock can pay a higher price than a LargeCo with a less valued stock. Alternatively, if TechCo believes that LargeCo's stock is undervalued by the market, it may be willing to accept a lower price at closing on the expectation of market appreciation in LargeCo's stock after the closing.
- Discounted Cash Flow Analysis. A third way of determining TechCo's value is to assign a value in today's dollars to the cash flow to be generated by TechCo's future operations. This type of analysis has two difficulties. First, under this analysis, TechCo's value depends on the credibility of TechCo's projections of its future operations. While historical performance is a known quantity, LargeCo and TechCo may disagree on how TechCo will perform in the future. Second, a substantial portion of the value represented by this type of analysis is the residual value created by TechCo's investment in early years. This is another likely source of disagreement between LargeCo and TechCo.
- Purchase Price Denomination. If LargeCo pays cash for TechCo, LargeCo will express the purchase price in dollars. In an acquisition where LargeCo issues
stock to pay for TechCo, LargeCo may express its offered purchase price in any of the following ways.
- As Dollar Value of Shares. If LargeCo expresses the price as a certain dollar value of its shares, LargeCo must specify the mechanism for determining the number of shares to be issued at the closing of the transaction. For example, LargeCo could offer that number of shares determined by dividing $25 million by the average of the closing prices of LargeCo's stock for the ten trading days ending three days before the closing of the merger. LargeCo may not want to use this pricing mechanism if it believes that its stock price will fall between the date it signs the merger agreement and the date it closes the transaction. Such a drop in LargeCo's stock price could result in TechCo's shareholders receiving a significantly larger number of shares in the merger. This could be a problem if such an increase would require LargeCo to obtain the approval of its shareholders (which would not be required if fewer shares were issued) or if LargeCo's management believed that the transaction would become EPS dilutive. TechCo also might worry about a dollar purchase price that calculates the number of shares at the closing date. TechCo will not want the number of shares issued in the transaction to be reduced if LargeCo's stock market price goes up before the closing date. TechCo will want its shareholders to share in market appreciation resulting from a favorable response to the announcement that LargeCo is acquiring TechCo.
- As Fixed Number of Shares. These concerns can be eliminated if LargeCo denominates its price as a certain number of shares to be issued in the acquisition. However, this pricing method leaves both parties with the risk that the dollar purchase price could go up or down by millions of dollars between signing and closing the deal. Arguably, the dollar purchase price should not matter to LargeCo as long as the merger will increase LargeCo's EPS. It may matter to TechCo, however, if TechCo has outstanding preferred stock and LargeCo's offered price is not a great deal more than the amount invested in TechCo by its venture investors. The charter documents of many privately held TechCos treat an acquisition as a "liquidation." They typically require that the holders of the preferred stock receive their liquidation preferences before any consideration goes to the holders of the common stock. If a sharp drop in LargeCo's stock price resulted in all of the stock having to be paid to the preferred shareholders, TechCo might find that it would be unable to obtain common shareholder approval of the acquisition. The parties also need to consider how options and warrants will be treated in this calculation. For example, is the number of shares offered by LargeCo intended to be in exchange for outstanding shares, options and warrants, or only for outstanding shares? This issue is particularly sensitive if options or warrants are significantly "under water" (i.e., the exercise price to acquire the TechCo shares is far greater than the price offered by LargeCo).
- As a Percentage of Combined Entity. In mergers between companies of relatively equal size, LargeCo frequently will express the purchase price as that number of shares that will give the TechCo security holders a certain percentage of the combined entity. For example, the LargeCo and TechCo security holders will have 55% and 45%, respectively, of the post-closing capital of LargeCo. Parties use this form of pricing when they want to value LargeCo and TechCo based on their expected contribution to the combined company's future performance instead of the market price for the stock. Again, the market value of the transaction can fluctuate dramatically from the date of signing until closing. Again, the parties need to delineate clearly which LargeCo or TechCo shares, options or warrants are included in the numerator and the denominator. Again, either LargeCo or TechCo may argue that "under water" warrants and options should be excluded from the calculation.
- Collars. One way of dealing with these "market" risks is to price the transaction subject to a "collar." A "collar" is a range of LargeCo stock prices within which there is an agreed-upon pricing method. For example, LargeCo might offer to pay TechCo $25 million of stock within a collar of $10 to $15 per share, 2,500,000 shares if the stock price is less than $10 per share, and 1,666,666 shares if the stock price is greater than $15 per share. This approach ensures that in no event will LargeCo have to issue more than 2,500,000 shares in the acquisition. Alternatively, if LargeCo's stock was trading at $12 per share at the date it was making its offer to TechCo and historically LargeCo's stock had stayed in a range of $10 to $15, it could offer TechCo 2,083,333 shares within a collar of $10 to $15, $31,249,995 of stock if the stock price is greater than $15, and $20,833,333 of stock if the stock price is less than $10. The decision whether to denominate the price in dollars or shares and with or without a collar depends upon each party's guess about what will happen to LargeCo's stock price between signing and closing and which risk it is most important to avoid.
- Net Asset Test. If either LargeCo or TechCo believes that TechCo's balance sheet is likely to become significantly weaker or stronger between the date the definitive agreement is signed and the closing date, it may suggest that the purchase price be adjusted to reflect a change in TechCo's net assets. For example, if TechCo had $2 million of working capital at the date of signing and LargeCo expected it to decline to $500 thousand by the closing date, LargeCo might want to have the purchase price reduced to reflect that change. On the other hand, a profitable TechCo might negotiate to have LargeCo increase the purchase price by the amount of any increase in its working capital from the signing date to the closing date.
- Earnouts. In an "earnout," some portion of TechCo's purchase price will be paid by LargeCo only if TechCo achieves negotiated performance goals after the closing. Parties typically use an earnout when they agree that a higher TechCo valuation would be justified if TechCo were to meet forecasted performance goals. TechCo may propose an earnout when it believes that its future performance will be substantially better than its historical performance. Likely earnout candidates include an early stage TechCo with a product line separate from that of LargeCo, a turnaround TechCo or a TechCo in a hot industry sector. Well-considered earnouts can allow TechCo to increase its sale price, provide continuing motivation to TechCo's management, and increase TechCo's value in the hands of LargeCo. Earnouts, however, are difficult to manage, and, since the goals agreed upon at closing are rarely relevant 2 years later, tend to create divergent incentives for continuing management. Ill-conceived or badly implemented earnouts can demotivate TechCo's management, reduce TechCo's value to LargeCo, and result in litigation. (See Fenwick & West's booklet "Structuring Effective Earnouts" for a more detailed discussion of this method of pricing an acquisition.)
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
privately held TechCos who obtain specific shareholder approval in connection with the acquisition. Given the penalties involved,
however, TechCos should consult their tax advisors before putting in place any golden parachutes.
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:
Table 3: Acquisition Structure Alternatives
| Business Considerations |
Merger | Asset Purchase | Stock Purchase |
| What do you buy? | TechCo's stock | Specified TechCo assets & liabilities |
TechCo's stock |
| Can LargeCo avoid TechCo liabilities? | No | Yes | No |
| What TechCo shareholder approval is required? | Typically majority vote |
Typically majority vote |
Must contract with each TechCo shareholder |
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:
Table 4: Acquisition Consideration Alternatives
| Business Considerations | Cash | Stock | Promissory Note |
| How liquid is it? | Most liquid | Depends (whether stock is restricted or freely tradable) | Not liquid |
| Can it be tax-free? | No (but installment treatment may be available for cash basis tax payers) | Yes (tax is deferred until the shareholder sells his LargeCo stock) | Yes (tax is deferred until payments are made under the note) |
| What is the level of risk? | No risk | Depends (subject to LargeCo performance and market risk) | Depends (subject to LargeCo credit worthiness) |
| What is the impact on transaction speed? | Fastest | Slowest (because of securities law compliance) | Slower (because of securities law compliance) |
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
| Business Considerations | Merger | Asset Purchase | Stock Purchase |
| How much stock must be used to have the stock received be tax-free? |
Straight - 50% stock Forward triangular - 50% stock Reverse triangular - 80% stock |
80% stock | 100% stock |
| What is the surviving structure? (having a subsidiary means continuing administrative burden and liability insulation) |
Straight - LargeCo holds Forward triangular - LargeCo's subsidiary holds TechCo's assets Reverse triangular - LargeCo holds TechCo as a subsidiary |
LargeCo holds |
LargeCo holds |
| Who gets taxed if tax-free requirements are not met? |
Straight or forward triangular - LargeCo & TechCo's shareholders Reverse triangular - TechCo's shareholders only |
TechCo and TechCo's shareholders | TechCo's shareholders |
| What is the effect of doing a taxable deal on basis? |
Straight or forward triangular - Step-up in basis of TechCo assets Reverse triangular - Step-up in basis of TechCo stock |
Step-up in basis of TechCo assets | Step-up in basis of TechCo stock |
| How does LargeCo benefit from doing a taxable deal? |
Straight or forward triangular - Greater depreciation on TechCo assets Reverse triangular - Less gain if LargeCo sells TechCo stock |
Greater depreciation on TechCo assets | Less gain if LargeCo sells TechCo stock |
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:
- Straight Merger. In a straight merger, TechCo merges directly into LargeCo, with LargeCo surviving the merger. LargeCo ends up holding all TechCo's assets and is liable for all TechCo's liabilities. In a straight merger, at least 50% of the consideration paid needs to be stock to get tax-free treatment for the stock received. A straight merger permits the most flexibility with respect to consideration.
- Forward Triangular Merger. In a forward triangular merger, TechCo merges into a newly formed subsidiary of LargeCo, with LargeCo's subsidiary surviving the merger. LargeCo's subsidiary ends up holding all TechCo's assets and is liable for all TechCo's liabilities. As in a straight merger, at least 50% of the consideration paid in a forward triangular merger needs to be stock to get tax-free treatment for the stock received. In a forward triangular merger, TechCo's liabilities are isolated in LargeCo's subsidiary, without putting the remainder of LargeCo's assets and business at risk.
- Reverse Triangular Merger. In a reverse triangular merger, a newly formed subsidiary of LargeCo merges into TechCo, with TechCo surviving the merger. Since TechCo survives the merger, it retains all its assets and liabilities without any need to have them assigned to LargeCo or LargeCo's subsidiary. A reverse triangular merger frequently is used when critical TechCo contracts or licenses have nonassignment provisions, and there is real concern that consent will not be granted or will be granted only after extorting additional consideration from LargeCo. LargeCo also may propose a reverse triangular merger in some cases if it believes that the merger may fail to qualify as a tax-free reorganization. If that happens in a reverse triangular merger, there will be a tax risk only to TechCo's shareholders. If it happens in a straight or forward triangular merger, LargeCo must pay TechCo's corporate level tax too. For example, if TechCo had a basis in its assets of $2 million and was sold to LargeCo for $40 million, LargeCo could be faced with tax liability on $38 million of gain. Thus, if LargeCo is paying a high price for a TechCo with a low basis in its assets, it may view the reverse triangular merger as having significantly less tax risk. For a reverse triangular merger to be tax-free with regard to the stock received, at least 80% of the total consideration paid must be stock and TechCo must retain substantially all of its assets.
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:
- the transaction had to be solely for common stock of the acquirer,
- no more than 10% of the consideration could be paid out for fractional shares and dissenters,
- the target could not change its equity structure in contemplation of the transaction,
- no more than 10% of the consideration could be held in escrow to indemnify the acquirer for breaches of general representations and warranties;
- the escrow had to terminate at the earlier of the first audit (for items covered by audit) or one year from closing;
- affiliates of both companies were prohibited from selling shares from a period beginning 30 days prior to closing until the release of financial statements containing at least 30 days of combined operations; and
- no other restrictions on resale or voting could be imposed on shares issued to the target.
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
| Characteristic | Cash Bonus Plan | Stock Bonus Plan | Recapitalization |
| Tailor to Benefit only Key Players? | Yes | Yes | No |
| Requires Shareholder Approval? | Generally, No | Yes | Yes |
| Requires Securities Compliance? | Generally, No | Yes | Yes |
| Employees Taxed When? | Receipt | Receipt | Sale of Stock |
| Employees Taxed at What Rate? | Ordinary Income | Ordinary Incom | Capital Gains |
| Reduces Total Liquidation Preferences? | No | No | Depends |
Cash Retention Bonus. A cash retention bonus plan can be structured to be offered only to those employees who are critical to the continuing entity, promising them a cash bonus if they stay through the acquisition. The bonus can be a set dollar amount or calculated as a percentage of the purchase price paid. Such a plan is easy to implement, easily understood by the participants, cost effective and generally does not require shareholder approval or securities law compliance. A contractual obligation by TechCo to pay cash bonuses to its employees will be assumed by LargeCo in a merger. LargeCo will, of course, reduce the purchase price offered by the amount of the retention bonus and thus reduce the amount paid to the holders of the preferred stock. In the above scenario, the holders of the common stock (including the employees) would receive nothing for their shares in the acquisition. The employees receiving the cash bonus will be taxed at ordinary income tax rates (rather than the capital gains rates they would likely have enjoyed had the employees received payment for their common stock). Note that if LargeCo were to do an asset acquisition and did not assume the obligation, whether the employees got paid would depend on whether there was enough consideration to pay the bonus. Once bonuses have accrued, they are considered "wages" which must be paid by the employer. If the "employer" cannot pay, under some circumstances the individual officers and managers may be individually liable for the unpaid wages.
Stock Bonuses. Stock bonus plans are sometimes used in place of cash bonus plans. In order for the participants to receive anything in the acquisition, however, the stock bonused must be senior in priority to some or all existing preferred stock or the bonus plan must require payment in LargeCo's stock in the acquisition. In some cases TechCo will adopt a new stock option plan which provides certain key employees with options to buy a new class of stock with senior participation rights. To implement these plans, the company must amend its charter and obtain shareholder approval. Further, in California, the California Department of Corporations (the "Department") requires that stock bonus plans and such changes in the charter be qualified or exempt from securities qualification. TechCo would have to either qualify the bonus plan and charter amendment with the Department or limit the participants to those who are officers, directors, accredited investors or those who are sophisticated in financial matters. Some critical employees that TechCo wishes to retain may not qualify for this exemption. Further, the participants will recognize tax upon receipt of the bonused stock valued at its fair market value and, if the acquisition currency is unregistered stock, participants may not be able to sell the stock in time to pay their taxes. Given a stock plan's additional complexities and limited benefit, a cash bonus plan may be preferable.
Recapitalizations. TechCo could also do a recapitalization. If TechCo had raised $50 million and is now valued at $4 million, it could recapitalize by amending its charter to allow the common stock to receive up to X in acquisition proceeds before the preferred, but leave the preferred liquidation preferences unchanged. Alternatively, TechCo could amend its charter to convert outstanding preferred stock (which had $50 million in liquidation preferences) into a new series of preferred stock with, for example, only $3 million in liquidation preferences, leaving $1 million for distribution to the holders of the common stock. This approach reduces total liquidation preferences, in effect, restarting the company. Either will require amending the charter and obtaining preferred shareholder approval, which may be difficult to obtain. In addition, note that all common shareholders (including former employees) benefit under recapitalizations, rather than just those employees who are currently critical. TechCo would have to qualify the charter amendment with the Department unless the current holders of the preferred stock are all officers, directors, accredited investors or those who are sophisticated in financial matters or another exemption is available. If unsophisticated investors hold preferred stock, an exemption may not be available. Filing with the Department for a permit will increase the cost of doing the recapitalization, and, if the Department will not grant a required permit, it will be impossible to do the recapitalization. A recapitalization is most likely to be used when TechCo is raising new money and the new investor is not willing to invest unless the employee retention issue is addressed or liquidation preferences of existing preferred stock are significantly reduced to reflect TechCo's economic condition at the time of the new investment. If it is clear that TechCo will be sold near term, it is wise for the investor putting in new money to force the clean up the overhang of liquidation preferences at the time of its investment, rather than waiting for the acquirer to put an offer on the table and fighting the issue out then.
When TechCo is Near Bankruptcy
Insolvency. A company is insolvent if it cannot pay its undisputed debts as they come due or if its debts exceed the fair value of its assets. If TechCo is near insolvency when it decides to be acquired and the deal price paid won't fully satisfy TechCo's creditors, LargeCo and TechCo's board of directors will want to protect themselves from claims by TechCo's creditors and shareholders. TechCo's board has an obligation to make sure it receives reasonably equivalent value for its assets, and LargeCo seeks to avoid successor liability.
Cash Asset Purchases Typical. In such a case, LargeCo will generally want to acquire TechCo's assets for cash, not do a stock for stock merger with TechCo. In a merger, LargeCo, or its subsidiary, assume all of the obligations and debts of TechCo by operation of law - to be avoided in these circumstances where the purchased assets are worth less then TechCo's liabilities. In an asset purchase, LargeCo can select the TechCo assets that it wants to buy and generally avoid unrelated TechCo liabilities. A cash asset purchase provides TechCo with the means to pay its creditors after LargeCo acquires the desired assets. LargeCo's stock is not a desirable acquisition currency in such circumstances because it will have to be resold for cash before creditors can be paid.
Successor Liability. Even in an asset acquisition, LargeCo might be liable for TechCo's obligations under a "successor in interest" theory. This can happen if there is an express or implied assumption of the obligation, if no value is paid to the creditors in the acquisition, if the purchaser is a mere continuation of the target, the transaction was fraudulently arranged to escape debts or for products liability claims against the prior business, where the pre-existing business is continued without interruption. In addition, certain types of statutory liability (such as unpaid California sales tax) will follow the purchased assets into LargeCo's hands.
There follows a table and summary of major considerations when acquiring a company near bankruptcy:
Table 7: Acquisition Alternatives When TechCo Near Bankruptcy
| Characteristic | Asset Sale | Pre Negotiated Bankruptcy | Wait and Shop at Bankruptcy | Assignment for Benefit of Creditors |
| Summary | Best if target assets value less than debts & few or manageable creditors | Best if large or aggressive creditors & assets critical at fair price | Best if target price unrealistic or uncertain; target files bankruptcy; bid if fair price | Notify creditors and potential buyers; sell assets to liquidator. Cheaper/faster than bankruptcy |
| Private/Public? |
Private |
Private agreement; Public auction |
Public |
Semi Private |
| Shareholder Approval Required? |
Yes |
No |