Investors in early-stage companies typically expect their stock holding to become liquid through private stock sales, the initial public offering of the company's stock or merger or acquisition of the company. Unfortunately, these transactions are often delayed or canceled altogether by accounting, corporate and technology concerns of the new purchasers. Critical to the completion of these transactions is pre-planning by management to eliminate or minimize these hidden obstacles to liquidity.
Readers may use this article as a checklist to identify and understand how these issues may disrupt the acquisition or IPO process. Companies which address these issues may remove unnecessary barriers to increase company value. This, in turn, will increase shareholder value and the likelihood of the company successfully completing an acquisition or initial public offering of its stock.
Part I: Corporate, Accounting and Valuation Concerns
Issue One: Account for Computer Software Development and Revenue Recognition
Critical to investment in all companies is the accuracy of financial information provided to investors. In this regard, investors are particularly concerned with the accounting treatment given by computer software companies to their software development costs and revenue recognition.
1. Software Development Costs
The accounting issue with software development costs is whether these costs should be expense immediately, or capitalized over the expected useful life of the software. To expense software against current revenues will cause an immediate hit to profits, and inflate future reported income. This will happen when software revenues are not reduced by the development costs incurred to produce these revenues. To capitalize costs also has its problems, as current period expenses are understated causing inflated current period income.
In response to this problem, the accounting profession has adopted Financial Accounting Standards Board No. 86 ("FASB 86"), released in August 1985, which follows the general rule that costs should be applied against the revenues they produce. FASB 86 applies the following rules to three distinct stages of software development and commercialization:
- Pre-Feasibility Stage Costs incurred to establish the technological feasibility of a software program are expensed. For these purposes, technological feasibility is achieved when all planning, designing, coding, and testing has been sufficiently completed such that the program can be produced to meet its design specifications.
- Post-Feasibility/Pre-Release Stage Costs incurred following technological feasibility but prior to commercial release are capitalized and accumulated in the company's R&D account. These costs are not applied against revenues generated during that period.
- Post-Release Stage Commencing with commercial release of the program, costs that have accumulated in the R&D account are amortized over the program's expected useful life (typically 5-7 years).
2. Software Revenue Recognition
The accounting issue with revenue recognition, on the other hand, is to determine when software, and the bundle of services sold or licensed with software, have been sufficiently delivered or provided so that revenue may be recognized. The American Institute of Certified Public Accountants, in a proposed statement of position issued in January 1991, has taken the general view that software revenues are recognized later off (a) the delivery date, or (b) the date on which contingencies relating to the software are substantially removed. This rule breaks down as follows:
- Non-contingent Licenses Revenues can be recognized on delivery of the software if collectibility is probable and there are no contingencies.
- Licenses with Insignificant Contingencies License fees can be recognized on delivery of the software, and remaining fees relating to the contingencies are recognized when completed.
- Licenses with Significant Contingencies If the contingencies are so intertwined with the license of the software such that the contingencies cannot be separately priced (as in a software customization arrangement), then "contract accounting" is applied, and revenue is recognized on a percentage-of-completion basis. If the contingencies can be services and priced separate from the software license, then license fees should be recognized on delivery of the software and contingent revenues should be recognized as services are provided.
Adopting a realistic cost and revenue recognition policy from the outset is far preferable to having to change and retroactively restate the company's financial performance immediately prior to a major financing, acquisition, or IPO. For this reason, and to avoid potential investor lawsuits based on the delivery of misleading financial information, the company should adopt accounting procedures approved by its accountants.
If management anticipates a business combination with another company within two years then the company should attempt to follow rules promulgated by the accounting profession and the SEC which enable the company to account for the combination a "pooling of interests".
Business combinations are accounted for either under the pooling of interests method or the purchase method; the difference can be significant. Generally, purchase accounting will require the surviving company to amortize "goodwill", thereby reducing future profitability; while pooling treatment will permit the survivor to avoid goodwill amortization. If the company does not follow certain pre-combination rules, it forfeits pooling treatment and possible combinations that depend, in part, on continuing gains in profitability that are threatened if purchase accounting is applied.
1. Purchase and Pooling Accounting
Under the purchase method, the combination is viewed as one company acquiring another. From an accounting standpoint, this required that purchase price of the target company to be allocated against the target's net assets. The "goodwill" equal to the amount that the purchase price exceeds the fair market value of the target's net assets (consisting of tangible and intangible assets less liabilities) is then amortized over the life of the acquired assets, not to exceed 40 years. The SEC has determined that software should be amortized from 5-7 years. The effect on the survivor is that earnings are dragged down by the amount amortized each accounting period. For technology companies in which intangible assets are undervalued, the amount being amortized can be substantial. While amortized goodwill will reduce corporate taxes, often the earnings impact is a far more important consideration, particularly for public companies concerned about the market price of their stock.
Pooling accounting treatment, on the other hand, avoids goodwill amortization. In pooling, the ownership interest of two or more companies are joined by an exchange of their voting securities. The effect of pooling is that the historical financial statements of the companies are combined for all accounting periods, including periods prior to the combination. The critical difference with the purchase method is that the survivor will only amortize historical amounts, not goodwill.
2. Qualifying for Pooling Treatment
Managers must be aware, however, that because of accounting and SEC regulations, a company cannot simply elect pooling treatment. It must qualify for it. There are 12 rules - or conditions - to pooling. These rules insure that the companies were independent prior to the combination, and that they will operate as a single entity afterwards. The rules break down into a series of pre-combination, combining, and post-combination requirements.
Before the business combination, management need only be concerned about the following three rules:
- No Company Control Within Two Years Another company cannot have owned over 50% of any combining company within the two-year period prior to the combination (nor can control of the company be maintained in some other way) such as through managerial, financial or contractual arrangements. For example, a subsidiary formed within the prohibited two-year period cannot qualify for pooling treatment.
- Independence Each of the combining companies must be independent of the other, and none may hold more than 10% of the voting common stock of the other at the initiation or consummation of the combination.
If there are any securities held by the target in the survivor, these are "tainted shares". As pooling requires that at lease 90% of a target's stock to be exchanged for stock of the survivor, the target's tainted shares are counted against the remaining 10% of the shares which need not be exchanged.
- Maintain Equity Interests This is perhaps the most significant rule for pre-planning purposes. The rule provides that no company alter the equity interests of its voting common stock, or the interests of its shareholders, in contemplation of the combination within the two-year period before the combination or the period between initiation and consummation of the period between initiation and consummation of the combination. As this rule is somewhat ambiguous, the following is a list of what companies generally may and may not do within these periods.
Companies May Do the Following:
- make distributions to shareholders no greater than normal dividends, determined in relation to earnings and pervious dividend policy.
Companies May NOT Do the Following:
- issue shares to meet shareholders obligations;
- issue bonus shares to employees, unless it can be shows that the shares were promised prior to initiation of the combination;
- make unusual option awards under existing stock option plans (in existence more than two years before the combination) that differ from normal award provisions of the plan;
- change the terms of existing plans for stock grants, warrants or options, such as a change in price, the number of shares granted or acceleration of the exercise date;
- sell a significant segment of assets in contemplation of the business combination;
- force the conversion of convertible securities; or
- reacquire shares of voting common stock in contemplation of the business combination, such as stock purchases made in order to reduce capitalization, reduce dilution or earnings per share, buoy-up a depressed stock price or defend against a take-over. Accordingly, companies should only reacquire securities on a normal or systematic pattern.
In sum, by avoiding unusual stock distribution and repurchase transactions during the two-year period prior to an expected business combination, management preserves the use of pooling and thereby increases the likelihood that the combination will take place.
When a company goes public, the underwriters generally insist that the shareholders agree to hold-back from selling their shares of common stock on the market for a period from 90-180 days following the offering. The reason for this is to stabilize the public trading markets following the offering. The hold-back restriction prevents a large number of unregistered but freely tradable shares from immediately entering the market and lowering the price.
The hold-back typically does not present a problem to shareholders who are already contractually committed to hold-back their stock. Other shareholders who are not so committed may be able to sell their shares on the open market after the IPO under SEC rules 144 - even though these shares are not registered with the SEC.
Rule 144 provides a safe harbor under which restricted securities (consisting of securities issued by a company in a private offering) can be resold without registration with the SEC. Generally, purchasers who are not "affiliates" of the company (consisting of officers, directors or 10% shareholders) can freely resell their stock, subject to no other restrictions. If the stock was previously held for at least three years. The sale of shares held by these shareholders may disrupt the market and thereby prevent the offering from going forward.
The solution is to bind all of the Company's shareholders to the hold-back from the outset. This can be accomplished by placing into the Company's Bylaws, prior to the sale of any of the company's stock, a hold-back provision which binds all of the stock. The rationale for the hold-back applying to everyone is that everyone benefits; all shareholders benefit from the creation of a public market which enhances the liquidity of share holding.
Purchasers of preferred stock in venture financings often demand that the company separately obtain the consent of a majority, or "supermajority" (greater than a majority), of the holders of preferred stock in order for the company to take certain actions. These "protective provisions" are a rights given to the holders of that class or series of preferred stock. As the effect of this type of provision is to give this group of shareholders a veto over the actions requiring their consent, the company should resist these rights if they threaten the Board's ability to direct the company or achieve liquidity.
In practice, shareholders will not act against their interests to prevent the Board from authorization actions intended to enhance the company's value. The threat remains, however, that a small group of renegade shareholders may hold up a transaction which is not to their liking. Management can minimize this threat by:
- resisting or minimizing the percent of shareholders approval required (note that no supermajority vote greater than 66 2/3rds percent of all outstanding shares or a separate class or series of shares can be required of a California corporation with over 100 shareholders);
- providing that separate consent is no longer requires if less than 25% (or some other floor number) of the originally issued shares of that class or series remains outstanding; or
- resisting separate consent for actions likely to enhance shareholder value and liquidity (such as a merger, consolidation, sale of assets, acquisition, or transfer of the company's technology).
Purchasers of new issuances of preferred stock may not wish to wait for an acquisition or IPO to cash out their investment. Instead, these purchasers may want the right to force the company to redeem their shares to achieve liquidity.
Shareholders with stock redeemable at their option, or at the option of the company, should be advised that they may be subject to tax. This tax will fall on the redemption premium of the stock equal to the excess to be received at redemption above the original purchase price of the stock. Due to recent changes in Section 305 of the Internal Revenue Code, redemption premiums (except for a de minimis amount) are taxed as constructive dividends, recognized on an economic accrual basis during the period prior to redemption. The result is that shareholders are taxed on expected redemption premiums before the redemption is actually made.
The company should seek the advice of its tax counsel on exceptions to this tax which may be available. For example, tax may not be due on:
- "participating" preferred stock which is not deemed to be preferred stock under Section 305 (this includes stock which participates in the growth of the company to a significant extent - such as sharing in dividend or liquidation proceeds); or
- preferred stock which is immediately redeemable rather than stock which is redeemable after a specified period of time.
Because of this potential tax liability, the company may discourage its investors from seeking redemption as a means of achieving liquidity.
Early stage investors in venture capital financings typically demand a right of first refusal from the company on future issuances of stock. If exercised, this rights permits investors to maintain their pro-rate ownership of the company's capital stock and not be diluted in subsequent financings necessary to raise working capital.
While granting such a right might be critical to completing an early stage financing, from the company's standpoint the right of first refusal may delay, complicate, and even prevent a subsequent financing. This would be the case where new investors may not participate in a financing as a result of delays, or a reduction in securities available for sale if the right of first refusal is exercised.
The problem with rights of first refusal is the barrier they potentially present to raising additional working capital which will permit the company to mature to the point where it is an attractive acquisition or IPO candidate. Most investors who do not wish to participate will waive their rights of first refusal in such financings as probably it will be in their best interests to do so. But other investors may exercise their right, and thereby jeopardize the financing.
Anticipating this, management should negotiate exceptions to the right of first refusal which will minimize the potentially harmful effects on future financings. Investors interested in enhancing the company's long-run marketability generally are willing to cut-back their right of first refusal if the cut-backs will better enable the Board to fund the company's continuing operations. Experienced investors are willing to do this as they know they are protected by the Board's fiduciary obligation to act in the shareholders' interest. Common exceptions to investor rights of first refusal may include:
- restricting the right of first refusal to holders of large blocks of the company's shares, so that smaller investors cannot hold up financings which are in most investors' best interests;
- requiring investors to take "all or nothing" of the securities offered in the new financing, thereby avoiding the situation where new investors balk at partial investment in the offering; or
- providing that the rights of first refusal will not apply to the issuance of securities in debt financings use to fund operations, or other major corporate transactions.
In addition, the company will want to make exceptions for issuances made to employees, officers, and directors as incentive compensation (perhaps up to a mutually agreed on cap), securities issued on the conversion of other company securities, and securities issued in connection with the license of technology critical to the development of the company's products.
The value of technology companies as acquisition or IPO candidates often depends on a company's ability to attract and retain managers, technicians, and others who are instrumental to the company's success. Once such persons are employed by the company, their compensation can be structured so that they will benefit from remaining with the company. For such persons, compensation typically consists of a base salary and incentive stock or options. Compensation may also include "golden parachute" payments triggered by certain corporate events.
- Incentive Stock and Section 83-b Elections The primary concern in issuing incentive stock is the tax effect on the recipient. Incentive stock issued to founders and other key employees is typically sold subject to a company right of repurchase of blocks of the stock if the founder or employee leaves the company before a defined period; typically such stock vests over 4 years. The purchaser of incentive stock is taxes on each block of stock as it vests. The tax on fully vested blocks of stock is equal to the difference if any, between the purchase price of the stock and the fair market value of the stock when it vest. Purchasers of incentive stock may potentially be subject to enormous tax payments on stock which has appreciated substantially from the time the stock was first purchased.
Fortunately, the tax law permits purchasers of incentive stock to file a pre-emptive "Section 83-b" election to avoid this adverse tax effect. By filing this election within 30 days of the purchase of vesting stock, the purchaser elects to be taxes now on the difference between the purchase price and the fair market value of the stock. As incentive stock is typically priced at its fair market value, there is no difference between price and value, and hence, no tax.
Making this election may be critical to retaining key employees. The severe tax effect of not making the election may cause the delinquent employee to leave the company, as then there is a disincentive to remain and receive taxable vested stock. Furthermore, savvy investors in future financings, or even potential acquirers of the company, may spot the tax liability and, as a result, question the loyalty of key employees.
- Golden ParachutesGolden parachutes are compensation plans that award exorbitant compensation to certain company officers and key employees. These plans are usually triggered on a change in the control of the company resulting in a termination of employment or diminution of management responsibilities of the employee. While golden parachutes may have a adverse tax impact on the recipient and the Company if the compensation award is in excess of amounts permissible under tax law, a more basic concern from the standpoint of investor liquidity is the potential deterrent effect on acquisition of the company.
One of the primary reasons for a business acquisition is the acquirer's belief that the target company is undervalued and a "good buy". In the view of an acquirer, replacement of old management or a restructuring of management responsibilities may be one means of enhancing such change which may be too expensive for an acquirer, taking away a principal reason for the acquisition.
Obviously, current management and the investors view golden parachute awards differently, given their different objectives. At a minimum, for both tax and investor liquidation reasons, management should be sensitive to the size of golden parachute awards and what triggers them.
- Employee Noncompetition Agreements
It would be ideal from the company's perspective if an employee could be prohibited from competing against the company following the employee's termination. This type of agreement is generally not enforceable in California unless the non-compete is made in connection with the sale of a business by the obligated party. With this exception, California courts have consistently held that persons should not be denied the rights to practice their livelihood involving skills learned through prior employment.
However, companies may do the next best thing by denying ex-employees the right to use or disclose the company's proprietary information beyond the term of employment. This prohibition may be placed in an employment or confidentiality agreement entered into at the outset of employment. The critical provision in these agreements for the company will be the definition of what constitutes the information which the employee is prohibited from disclosing or, subsequently, using. The broader the definition, the easier it will be for the company to enforce compliance by the ex-employee and minimize the possibility of post-employment competition.
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Companies which are considering going public should be careful not to issue "cheap stock" or excessive numbers of options which may present the offering of the stock in certain states. Generally, stock sold in the IPO must be registered both with the SEC and the state regulatory agencies administering that state's securities laws. The securities laws of certain states may prevent the offering in those states if cheap stock or excessive options have been issued by the company.
- Cheap Stock
Under guidelines promulgated by the North American Securities Administrators Association (known as "NASAA") adopted by many states, "cheap stock" generally consists of stock recently sold to insiders, promoters, and similar persons at a price less than 85% of the IPO price. Unless the sale of cheap stock can be justified, some states may require that the shares be placed in escrow - typically for 5 years and subject to an "earn-out" test under which shares are released upon the company achieving certain earnings-per-share ratios. Cheap stock may also result in tax on the recipient for receiving stock at a discounted price - and a corresponding charge to compensation expense incurred by the company, resulting in a decrease in the company's earnings.
Companies may "justify" the issuance of cheap stock to the states and try to avoid the negative escrow and tax effects described. Companies which cannot justify cheap stock may not be able to sell stock in the IPO in certain key states.
Typical justifications for the issuance of cheap stock which may be acceptable to state administrators include changed circumstances since issuance of the stock, or price discounts reflecting resale restrictions on the stock. To avoid this problem, management should continually monitor and adjust the company's stock price to accurately reflect changing circumstances.
Excessive Options
Companies with excessive numbers of outstanding warrants or options are also viewed with disfavor by many states because they represent future dilution to IPO investors. As with cheap stock, excessive warrants or options may prevent the offering key states (and thereby minimize the amount raised in the IPO).
Under the NASAA guidelines, the total number of shares subject to warrants and options must be "reasonable". Warrants and options exercisable for more than 10% of the number of shares to be outstanding after the IPO are presumed to be unreasonable. Note that warrants or options issued to financing institutions or in acquisitions are not counted in this 10% limit.
Management can easily circumvent this problem by monitoring the number of warrants and options granted.
In addition to the accounting, corporate and valuation concerns described above, management of technology companies should be aware of technology ownership and scope of use issues which impact company value and liquidity.
The market value of technology companies is primarily determined by the worth of their intangible technology assets. Companies which anticipate going public or being acquired must be able to document, to the satisfaction of underwriters and possible acquirers, that such assets are owned or properly licensed to the company. If the company is not able to demonstrate this, then its value as an investment to new purchasers may be questioned.
To withstand this inquiry, the company should keep detailed records of its technology ownership and license rights. These records should date back to the company's incorporation and cover all portions of the company's technology developed internally or by third parties. Critical indicators of the company's ownership and licensed rights include the following:
- Assignment of Third-Party Inventions
Under the U.S. Copyright Act, ownership of a work belongs to the author of the work, or - for a "work for hire" - the employer or other person for whom the work was created. A work for hire is defined under the Copyright Act as "including works made by employees and certain types of commissioned works". Computer software development and programming is not a work for hire which, if developed by an independent contractor, belongs to the company. The result is that computer programs created by independent contractors belong to the contractor unless expressly assigned to the company in a written, signed agreement. This assignment should also obligate the contractor to execute documents necessary to vest ownership to the software in the company.
Note that the assignment of inventions to the company is also necessary for inventions made by employees who were not specifically hired by the company to invent. In the absence of an agreement, such inventions belong to the employee developed by employees on their own time and with their own tools outside the scope of employment also belong to the employee - not the company.
- Prohibitions on Using Information of Prior Employers
Companies must be careful not to use proprietary information belonging to prior employers of the company's new employees or contractors. Use of such information, even if inadvertent, may subject the company to a claim of infringement of the prior employer's intellectual property interests.
To avoid this result, the company should expressly prohibit, in a written and signed agreement, all of its officers and technical and marketing employees from using this information. The agreement should require the employee to list on an exhibit to the agreement all of the information relating to the company's business which either (a) belongs to the employee as a result of independent activities, or (b) belongs to a prior employer. The agreement should then provide that with the exception of the listed information, all information used, discovered, or invented by the employee while employed by the company belongs to the company.
If, despite the agreement, the information used by the employee belongs to a prior employee, the company may seek damages from the dishonest employee. The written agreement, in addition, may enable the company to defend itself against a lawsuit as an innocent infringer.
- Copyright and Trademark Registration
The copyright or trademark rights in works developed by the company belong to the company under common law, and registration of these rights with the U.S. Copyright Office or Patent and Trademark Office are not necessary to vest ownership. Nevertheless, registration does have several benefits to the company if it wishes to protect its rights by bringing suit against infringers.
For copyright infringement claims, the company must register its copyright interest before suit can be filed. Registration is also necessary to cut off an infringer's "innocent user" defense, and it establishes a presumption that the company's copyright is valid. Finally, registration is a prerequisite for recovering "statutory damages" from the court (if the company cannot prove actual damages suffered as a result of the infringement) and attorneys fees incurred.
Trademark registration has similar litigation benefits, including (a) constructive notice of ownership, (b) a presumption of the trademark's validity for use less than 5 years after registration, (c) incontestable ownership for continuous use of the trademark for 5 years after registration, (d) the right to request U.S. customers to bar the import of goods with infringing trademarks, and (e) the right to request treble damages for infringement.
Unlike federal trademark registration in the United States, registration of trademarks in foreign countries may actually determine ownership. In many European countries, for example, trademark ownership is determined by the first party to file for registration rather than the first party to use the trademark. As a result, the company should register its trademark in major overseas markets where it sells its products.
Not only must companies be able to clearly trace their ownership or license rights to technology, they must actively take steps to protect these rights. Companies which do not protect their technology risk losing their rights, which may significantly diminish the company's value.
Adequate protection of technology consists of common-sense measures intended to prevent inadvertent disclosure and use by unauthorized persons. Measures to be taken may include any or all of the following:
- Non-Disclosure Agreements
All of the company's technical and management employees with access to sensitive business information should, at the time of their employment, execute a non-disclosure agreement. While ex-employees generally may not use secret customer lists or trade secrets, even in the absence of a written agreement, an agreement may broaden the scope of information which is protected. Furthermore, as trade secret protection may be lost by companies which do not make a reasonable effort to maintain secrecy, executed non-disclosure agreements may fortify the company's overall trade secrets program.
- Adopt and Enforce Written Policies and Procedures
Reasonable measures to protect trade secrets should also include the adoption of a written policy which defines what information is confidential, restricts access to it, and sets up procedures for enforcing the policy.
- Federal Registration of Copyrights and Trademarks
In addition to the litigation benefits described above, federal registration of copyright and trademark interests also places third parties on notice of the company's ownership. As a result, federal registration may be the best way to pre-empt third party use of protected technology.
- "License and Not "Sell" Technology
The sale of technology does not cause the company to lose its copyright interest. As such, the company retains the right to license, copy, and distribute the technology. However, it does lose the ability to control the redistribution or that copy of the technology which is sold - possibly resulting in lost royalties and disclosure of the company's trade secrets. Restrictive licensing of technology avoids these problems.
- Technology Audits and Inspections
Restrictive licensing of copyright, trademark, and trade secret rights may not be adequate to protect technology if the company is otherwise lax in enforcing its rights. It is in the company's interest, then, to reserve the right to audit the use of its technology by licensees - and conduct these audits if it has reason to suspect misuse of the technology.
Companies that license technology must be concerned with their rights to continue using the technology in the even of certain foreseeable events, such as the company's acquisition or insolvency of the licenser. Acquirers attracted primarily by the target's technology may lose interest if access to this technology is prohibited by a license agreement.
In view of this action, companies that license their key technology must carefully consider the long-term implications of the terms of the license. Listed below are licensing issues that may impact the future attraction of the company to an acquirer:
- Scope of License Grant
The scope of license granted to a licensee is critical to the proper use and value of technology to the company. Important aspects of the grant of a license which are frequently overlooked include clarification of who may use the technology and whether the license is revocable on breach.
For example, a licensee seeking to be acquired will want the license rights to extend to a potential purchaser or "affiliate" of the licensee. The licensee may further insist on the license not terminating in the event of the licensee's breach under the agreement. In this case, the licensee's breach would result in the payment of monetary damages to the injured licenser but not termination of valuable license rights to the licensee.
- Ownership
The licensee will obviously want the licenser to represent that it has title to the technology, or the right to sublicense the technology to the licensee.
With this exception, the licensee will want ownership of derivatives of the license technology if the licensee intends to modify the technology for incorporation into its products. While the licensee probably will not be able, under the license, to use derivatives without a license to use the underlying technology provided by the licenser - the licensee's ownership of derivatives will prevent the licenser from licensing the derivatives to competitors or charging the licensee additional royalties above royalties payable on the underlying technology.
- Royalty Triggers
The licensee will want to limit the uses of the technology that trigger royalty payments to the licenser, while the licenser will want to expand them. In the context of an acquisition, royalties should not be triggered by sales of the acquirer - such as in the case of royalties payable on a broadly defined "product line" which includes the products of potential acquirers. In addition, the licensee will want to limit sublicense royalties to payments actually received by the licensee, and not payments due from sublicensees yet not received.
Anticipating the licenser's possible insolvency, the licensee will want to allocate a larger portion of license fees to the grant of the license itself, and a smaller portion to the licenser's "executory" obligations under the agreement - such as the obligation to provide maintenance. Under bankruptcy law, the reason is that a trustee for the insolvent licenser may terminate the executory portion of the license. Nevertheless, if the licensee elects to retain its rights in the "intellectual property" and continue the license, it will not have to pay fees for the license if previously paid.
- Confidentiality and Technology Noncompetes
Licensers will require licensees to protect licensed technology which is deemed to be confidential. In the context of discussions with potential acquirers, standard confidentiality provisions will prevent the licensee from freely disclosing licensed technology without the prior permission of the licenser. To overcome this obstacle, the agreement may permit disclosure if the recipient is bound by the same non-disclosure obligations as the licensee.
A further impediment to potential acquisitions may be prohibitions on use of technology to compete against the licenser. While this is a reasonable demand for the licenser to make, an overly board definition of what constitutes competition may inadvertently cover the business of an acquirer. Accordingly, licensees should attempt to restrict prohibited competition to specific products sold or licensed in limited markets.
- Rights of First Refusal on New Developments
Licensers may request a right of first refusal on the use, manufacture, license, or sale of derivatives developed by the licensee. This act should be resisted. The effect of such a right may be to deny an acquirer the opportunity to use the licensee's technology as planned. If the licenser insists on this right, the licensee may reserve the first use of derivatives for affiliates, or for uses in specified markets.
- Assignment of Technology
As technology-motivated acquisitions assume that the acquirer will have access to the licensee's technology, the assignment provision in the license agreement should not prohibit this to take place.
Frequently, an assignment of the license is not triggered at all. This happens when the licensee is acquired as an on-going business entity, and the license is not transferred but remains with the licensee. In this case, management should make sure that an assignment is not triggered by a change in ownership control of the licensee. If it is, then the consent of the licenser may be required before the acquisition proceeds.
To avoid assignment problems, assignment should not be triggered by a change in ownership of the licensee. In addition, the licenser should not be permitted to unreasonably withhold its consent to an assignment. If the licenser's reasonable consent is required, it probably cannot object to an assignment which will not change the licenser's economic position.
While management cannot anticipate all issues that will arise in the course of acquisition negotiations or the IPO process, it can pre-plan to avoid some common pitfalls. To the extent that these obstacles can be removed, the acquisition or IPO will be achieved more easily; pre-planning will only help the company attract its initial investors. There are no losers in this process.
