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The Trends, The Structure, The Game…
— by Mark Cameron White of White & Lee LLP

The Trends

• investor acceptance of acquisitions as viable liquidity path- higher valuations given for key technologies, markets (HotMail; 411)
  • instant liquidity w/o 180 day holdbacks and market restrictions
  • avoid need to time IPO
  • eliminates market risk for emerging growth companies
  • going with the numbers - few companies will go IPO
  • frees funds for other investments* more investment banks/brokers jumping into the game- Broadview, Alliant Partners, H&Q, Gerard Mattison
  • in H&Qs case, helps with their venture investments
  • both buy and sell side: small technology targets are welcome…
  • (formerly only smaller business brokers would have an interest)
  • good talent has broken away from larger IBs to set up shop
  • distinct approaches to "shopping the company", ie. Corum’s "shot-gun"
    ~approach vs. more reasoned/focused approach
• acquisitions are being driven by trends in strategic partnering:
  • "time to market" issues for larger distribution partners; migration of product/service offerings to more attractive markets
  • larger competitors need to lock out competitors: offensive and defensive competitive moves
  • "Internet time" has stream-lined organizational decision-making
  • "not invented here" philosophy is dead
  • proliferation of corporate investment funds; business development officers
• startups now planning for acquisition "flips"
  • faster turn-around, so entrepreneurs can score on multiple ventures
  • new ideas spawn new ventures; new organizations with new teams are needed…
    ~who wants to run a public company anyway…
    • suddenly management reports to the world = heightened scrutiny
    • more structure, systems and bureaucracy
    • success driven more by marketing and proliferation than by technology; most entrepreneurs are technologists 

Acquisitions vs. IPOs…What to Do?!

• Valuations:
  • higher value in IPOs; acquiror’s inability to pay market value
  • yet emergence of "pre-emptive IPOs" where buyer pays for combinedvalue resulting from leverage on buyer markets/technology/distribution
  • this trend is driving up acquisition values
  • combined value approach drives appreciation in buyer’s stock post-close;value continues to grow after the deal is done
    • risk can go down; target should study the acquiror (neTrend)
• Liquidity
  • IPO market lockup for 180 days; practical market restrictions afterwards
  • risk of stock in one company…can’t diversify
  • acquisitions equally restrictive unless for cash (if tax not an issue…)
    • in tax-free reorganization typically get restricted stock (must negotiate in Calif "fairness hearing" or S3 registration)
    • in "pooling of interests" deals must hold onto acquiror stock to show continuity of interest
• Competitive Dynamics
  • for internet companies, IPOs can drive up traffic/credibility
  • IPO cash creates war-chest for building service and distribution (but assures that the company must execute independently…)
  • in competitive or restrictive markets, for small niche competitors

IPOs simply make no sense 

• Other Considerations…
  • market timing even if solid IPO candidate
  • personal considerations…
    • ride-out current venture or move on;
    • personality fit with a larger organization;
    • burden of IPO process and personal liability
  • inherent flexibility of acquisitions to meet personal/tax needs:
    • earnouts to reduce acquiror risk (relying on target projections)
    • escrows (10 to 30%…10% in pooling)
    • stock vs. asset deals…tax structuring
• The good news…you don’t have to decide…
  • CRL Networks and GST Telecommunications…
  • SurfMonkey.Com and InfoSpace…

The Acquisition Process

Step One: Preliminary Discussions…Floating the Trial Balloon

• go it alone or hook up with an investment bank (Internet Tools, CRL) - you know acquirors better than anyone…burden on you (Dentech, Kansman)
• IB Agreement (fee on your contacts?; term and obligation?)
• introduction, NDA then first meeting

Step Two: the Letter of Intent

• general (for momentum) vs. detailed (to make sure on same page)
• minimum should include price, structure, and timetable…
• usually non-binding except for good faith negotiation, confidentiality, lock-ups and payment of expenses…
• target should get acquiror to pay transaction costs and lock-ups
• sometimes skip LOI and go directly to definitive agreements
  • for public companies/raising funds (Kansmen)
  • requires diligence review now; question if really have a deal…

Step Three: LOI to Definitive Agreements

• diligence - both ways in stock deal - attorneys and accountants involved
• target should stage disclosure to progress of deal
• documents include:
  1. Reorganization or Merger Agreement;
  2. Employment or Consulting Agreements,
  3. Non-Compete Agreements,
  4. Disclosure Schedules,
  5. Escrow Agreement, and
  6. supporting documents (consents, government filings, legal opinion…)
• consents required:
  1. acquiror needs Board approval; target need Board and SHer approval;
  2. get in "form" - management free to negotiate documents
  3. think of timing (SHer prospectus; Board approval at LOIstage; SHer approval at closing)

Step Four: from Definitive Agreements to Close

• completion of diligence review
• get all approvals: ie: (a) Calif Section 3(a)10 Fairness Hearing; (b)Hart Scott Rodino application; (c) SHer and Board consents, (d) assignment of contracts
• line up financing if cash deal (Kansman)
• essentially a lock-up on the target…get payment?!
• simultaneous signing and close if smaller deal…

Tax Consequences and Structure

• Taxable Asset Deals
  • Why Use?: avoid liability with stock; buy selected assets (not "substantially all")
  • Target is taxed on gain = ordinary gain on A/P, inventory; capital gain on IP and eqpt.; acquiror gets basis on amount paid
  • Target gain is ordinary or capital based on the assets
    • must be held for 1 year for long-term treatment
    • patentable matter is less than 1 year
  • Gain can be delayed with installment Note or under earn-out
  • Gain is taxed twice, once to the target and again as a dividend at ordinary rates to the shareholders - can avoid with a sale of stock
• Taxable Stock Deals
  • Why Use?: when don’t qualify for tax-free treatment or when want cash
  • Only selling SHers are taxed, not the target company
  • Acquiror gets basis in stock equal to purchase price; basis in assets remains unchanged
  • Acquiror can get a stepped-up basis in the assets under a "Section 338" election; both the target company and the target SHers are taxed on gain
    • effect is must be NOL for target company to offset gain
    • target must assure there is no increase in tax for benefits to acquiror (Internet Tools - S corp tax passed through to SHers…)
• Tax-Free Deals
  • IRC Section 368; tax-free reorganizations;
    • must be stock for stock; gain on boot
    • basis unchanged
    • judicial tests: continuity of equity and business interest; part of a single plan
• "A Reorganization" = covers mergers, reverse or forward triangular mergers; up to 50% boot
• "B Reorganization" = statutory merger with no boot
• "C Reorganization" = sale of substantially all target assets for at least 80% stock, 20% or less boot; the target then liquidates and distributes consideration

Other Key Issues

• Pricing the Deal:
  • very different from valuations in private financings
  • "discounted cash flow" as a stand alone company (O2/Unidata)
  • DCF as part of the acquiror; multiples of earnings or revenues
    • examples = Dentech; Internet Tools, CRL Networks…
    • be careful of "Black Shoals" option pricing
  • make/buy decision for acquiror (factor in opportunity cost…)
  • separation of transaction price and employee bonus/options…
• Structure of Payments:
  • consider timing of tax payments in taxable deals
  • no tax on earn-outs or escrows until paid
  • consider installment Note
• Earn-outs:
  • minimize to 25% or less of total consideration if possible
  • will be based on targets projections…so be careful!
  • target will want committed budget/resources by acquiror
  • key target employees will want to control business unit
• Escrows:
  • range of 10-30% for 1-3 years
  • target should try to limit liability solely to escrowed amount
  • target will want ratable release from escrow over the escrow term
  • target will want to limit escrow release to breach of agreement representations - not cross default of non-compete or employment agts
• Non-Competes
  • taxed to individual, do not separately allocate payments for non-compete
  • enforceable with sale of "goodwill"
  • restrict to business definition at time of sale for 1-2 years max.
• Pooling of Interests
  • avoids goodwill amortization; big issue for acquirors
  • 3 pre-combination rules (1) no company control, (2) independence and (3) maintain equity interest
  • FASB and SEC cracking down…not likely to last
• Government Approvals
  • Calif 3(A)10 Fairness Hearings
  • Hart-Scott-Rodino approval
    • requires FTC and DOJ notice
    • test is (a) parties engaged in US commerce, (b) target has $10m of assets/net sales, and acquiror has $100m of assets/net sales, and (c) on close, the acquiror has 15% of target assets or $15m of assets
    • are exemptions
  • State Bulk Sales Laws
    • in assets sales, protect trade creditors
    • notice required only for sale of inventory
    • if notice not given, creditors can exercise against assets purchased by acquiror