Best Practices in
Mergers & Acquisitions
ACC-America, San Diego Chapter
July 20, 2006
Presented by: Otto E. Sorensen
Luce, Forward, Hamilton & Scripps LLP
• Use earn outs supported by escrows to bridge the gap
between the value expectations of sellers and the reality of
their historical performance.
• Put cash, rather than shares, in escrow.
• Assure that the deal in principle is clearly understood before
documentation while still being cognizant of the need to avoid
an enforceable deal prior to documentation.
• While contingently issuable shares are registrable, shares
underlying contingently issuable options or warrants are not.
Note: I still think the SEC is wrong about this.
July 20, 2006
© Otto Sorensen 2006
2
• Assure that the target has adequate financial controls and
reporting that the acquiror will not have difficulty satisfying the 8KA financial statement requirements and that the principal
officers of the acquiror will not have difficulty with their
certification requirements post merger.
• Keep the target in a separate subsidiary, regardless of form of
acquisition.
• Get the transaction team together early and make them part of
the negotiation of the deal in principle. Particularly make sure
that the auditors are involved and that it is clear exactly how
they are going to treat all aspects of the acquisition upon audit.
• Do not issue resettable derivatives.
July 20, 2006
© Otto Sorensen 2006
3
• Many sellers believe that the value of their enterprise as
reflected in its financial performance should be enhanced by
possible post merger synergies, such as the ability to cross-sell
and cost savings occasioned by the elimination of duplicative
overhead. The seller must be made to understand that these
intangible benefits will at best be realized at a significantly later
stage and are at worst speculative and therefore cannot be part
of the valuation of the seller’s business.
• Many sellers form an expectation as to the value of their
business by reviewing multiples realized in the significantly
larger transactions. Historically, it has been true that smaller
transactions generally reflect smaller multiples. Demonstrating
this fact to a seller can enhance the likelihood of completing a
transaction.
July 20, 2006
© Otto Sorensen 2006
4
• When acquiring a company, the sales of which are enhanced by
preferences or set asides (such as those for minority owned
firms or small businesses), remember to discount those
revenues to reflect the probable loss of that preference or set
aside.
• Establish your acquisition team at the earliest possible time and
give each member of that team input into not only the
transaction documentation but also the creation of the letter of
intent. This is particularly true with regard to your auditors, in
that accounting rules, particularly those related to acquisitions,
have become less intuitive. It is critical that management
understand how the auditors will treat an acquisition prior to
agreeing to the final letter of intent.
July 20, 2006
© Otto Sorensen 2006
5
• If bank debt is used to finance a portion of the acquisition,
explore with the bank the ability to convert all or part of that debt
to term debt with a term reflecting probable returns from the
acquisition. This will have the salutary effect of improving shortterm liquidity and enhancing the likelihood that the acquiror’s
balance sheet will remain within bank covenants.
• At the risk of sounding New Age, it is important that a bond of
trust be established as soon as possible between the principal
shareholder of the target and the most senior officer of the
acquiror who has deal responsibility. That bond is often
strongest when the senior officer of the acquiror and the
principal owner of the target establish it outside of the
negotiation arena.
July 20, 2006
© Otto Sorensen 2006
6
• Very early in the acquisition process, determine whether
contract or charter provisions create possible obstructions to the
acquisition. For example, one or more shareholders may have
preemptive rights or a creditor may have acceleration rights in
the event of an unapproved change of ownership. Preferred
stockholders may have a right to approve a merger transaction
or to compel a redemption of their preferred stock in the event of
the merger. I have even seen instances in which a holder of
derivative securities had the right to compel a redemption of
those derivative securities in the event of an unapproved
change of control.
July 20, 2006
© Otto Sorensen 2006
7
• Obtain a representation from the target and its principal
stockholders that no person, particularly no employee, has been
promised any benefit upon a change of control. We have seen
instances in which employees have received dangerous and
non-specific assurances that they will “be taken care of” in the
event of a sale of the company. If the employment of such an
employee is terminated post-acquisition, such non-specific
claims can be adjudicated in front of a notably unfriendly labor
commissioner.
• If the target recently reacquired certain of its shares, assure that
it did not grant claw back rights in connection with those
repurchases.
July 20, 2006
© Otto Sorensen 2006
8
• Assure that the key employees of the target are committed, both
contractually and spiritually, to continued employment with the
target following the change in control. Ideally, document any
changes in employment relationships when the definitive
agreement is signed rather than in satisfaction of a closing
condition so that the deal cannot be held hostage to
employment agreements.
• Transaction termination fees. In its most recent transaction
termination fee study, conducted in 2004, Houlihan Lokey
Howard & Zukin reports that 22% of all transactions included
reciprocal termination fees. In the vast majority of such cases,
the termination fees were equal for the target and the acquiror.
The median size of the termination fee was 2.9% of transaction
value.
July 20, 2006
© Otto Sorensen 2006
9
• Prior to the preparation of definitive documents and even prior to
the conduct of any significant diligence, the parties should agree
to a summary of terms or a letter of intent or memorandum of
understanding. These should cover such terms as the price to
be paid for the target, the nature of the consideration (e.g., cash,
equity, or debt), transaction structure, basic employment terms
for those employees of the target who are deemed to be of
critical importance by the acquiror, the scope and timing of due
diligence by each party, conditions to closing, preclosing
covenants, stand still provisions, and nondisclosure provisions.
However, it may be preferable to have those elements of a
preclosing agreement which are intended to be binding to be set
forth in a separate document.
July 20, 2006
© Otto Sorensen 2006
10
• The active and enthusiastic participation of key managers of the
target company can be critical to completing a transaction.
Their enthusiasm will be enhanced to the extent that they
believe they will prosper under the new regime. An effective
technique for instilling this belief is to cause them to have
contacts, during the due diligence process, with satisfied
employees of the acquiror who themselves were previously
employees of earlier target companies.
July 20, 2006
© Otto Sorensen 2006
11
• Various studies have concluded that indemnification obligations
in acquisition transactions are subject to caps approximately
85% of the time, earnouts based on the target’s post-closing
performance are used in approximately 25% of transactions, the
most frequent escrow period supporting an indemnification
provision is 12 months and the most common escrow amount is
approximately 15% of the transaction price. These studies also
conclude that a slight majority of the transactions providing for
indemnification also provide for baskets with regard to that
indemnification.
July 20, 2006
© Otto Sorensen 2006
12
• As a practical matter, public valuations in an industry provide a
cap, rather than an estimate, of private valuations in that
industry. The market will generally not tolerate a public
company which apparently overpays for a target based on
public company valuations. Private targets should understand
that private company valuations are generally lower than public
company valuations as a consequence of many factors,
including generally smaller size and lack of access to public
capital markets.
July 20, 2006
© Otto Sorensen 2006
13
• Target companies sometimes propose a downstream issuance
of shares in the event that the shares issued at the initial closing
do not maintain or increase their value by a specified amount.
An acceptance of such a proposal is inadvisable from a buyer’s
perspective, in that its stock price could frequently be affected
by factors far beyond its control. An effective counterproposal is
to provide for a claw back of stock issued at closing in the event
that the value of such stock increases.
July 20, 2006
© Otto Sorensen 2006
14
• The buyer’s integration plan should be evaluated to determine
its probable effect on the assets and operations of the target, in
part because that analysis can reveal errors in the valuation
model being applied to the target. For example, if the
integration plan calls for replacing the target’s commission
based sales structure with the acquiror’s non-commission based
sales structure, the revenue and cost of sales projections for the
target should reflect that change in structure. This is one of the
many reasons that the integration plan should be created early
on and be part of the due diligence process.
July 20, 2006
© Otto Sorensen 2006
15
• The integration plan can also impact the documentation. For
example, if an integration plan calls for a significant reduction in
force, legal due diligence should focus on the labor laws and
regulations of the jurisdiction in which the reduction of the force
is to occur, and the documentation of the transaction should
clearly have very strong representations and warranties with
regard to the severance and related employment obligations.
• A clear communication of the integration plan to managers of
both the target and the acquiror is critical. In the absence of
such a clear communication, employee morale, performance,
and longevity can be jeopardized.
July 20, 2006
© Otto Sorensen 2006
16
• Multiple acquisitions within a six-month period in which the
acquiror issues securities to a total of more than 35 nonaccredited investors can create challenging integration issues.
The severity of those issues is reduced if no relationship exists
between the sellers and none of the transactions are contingent
upon any of the other transactions.
• If all of the target shareholders are not signatories to the
acquisition agreement and acquiror securities are being issued
as part of the acquisition consideration, a separate document to
be signed by each target shareholder should include the resale
restrictions required by applicable securities registration
exemptions.
July 20, 2006
© Otto Sorensen 2006
17
• Especially if the target is a public company the shares of which
are widely held, the buyer should obtain unanimous Board of
Director agreements to recommend a vote in favor of the deal
(without affecting the “fiduciary out”), and non-compete
agreements, at the time the definitive agreement is signed.
• An independent investor advisor retained to counsel
unsophisticated shareholders of a target company can be very
helpful in satisfying the private placement requirement that only
sophisticated people or people advised by sophisticated
advisors are to be issued stock in an exempt offering.
July 20, 2006
© Otto Sorensen 2006
18
• Acquirors often neglect their disclosure obligations when
engaged in M&A transactions. Both the Ralston-Purina case
and Regulation D contemplate that significant disclosures be
made to shareholders of a target company. This requirement is
generally easily satisfied by a public company. Private acquirors
have more difficulty satisfying this requirement.
• Public companies should avoid closing an acquisition or even
signing a letter of intent while in registration with regard to a
previous acquisition or financing.
July 20, 2006
© Otto Sorensen 2006
19
• The evergreen period for a resale registration statement should
never exceed that period of time after which the registrable
securities could be sold under Rule 144, either without any
volume limitation or subject to a volume limitation that would
nevertheless permit the sale of all remaining shares in a threemonth period.
• A buyer should obtain the right to impose blackout periods in the
use of a resale registration statement to assure that the buyer
has the ability to halt the use of that resale registration
statement when it becomes materially misleading. Sellers will of
course seek to limit the number and duration of blackout periods
that can be imposed and may attempt to negotiate penalties for
blackout periods that exceed those limits.
July 20, 2006
© Otto Sorensen 2006
20
• If a buyer anticipates that Regulation D may not be available
with regard to shares issued in a transaction, either because of
a possible integration with other acquisitions or because the
target has a large number of shareholders, a buyer can
register the issuance of its shares on Form S-4. If it anticipates
that it will be making a number of such acquisitions, it can use
a shelf registration under Rule 415 on Form S-4. The
requirements for a Form S-4 acquisition shelf are set forth in
the Service Corporation International No Action Letter (Pub.
Avail. Dec. 2, 1985).
July 20, 2006
© Otto Sorensen 2006
21
• Issuers with small market capitalizations may find the filing of an
acquisition shelf registration to be disadvantageous, in that the
market may consider the potential overhang effects of the shelf
when valuing the securities of the issuing company. The filing of
an acquisition shelf can also sometimes prompt questions from
regulators with regard to the appropriateness of disclosing the
filing company’s acquisition program and strategy.
July 20, 2006
© Otto Sorensen 2006
22
• Another alternative for acquisitions in which Regulation D is not
available is the exemption from registration found in Section
3(a)(10) of the 33 Act, which exempts from registration securities
issued in acquisition transactions following a fairness hearing by
an appropriate state authority. California is one of several states
that provide for such fairness hearings. Shares issued under
Section 3(a)(10) are freely tradable, except those which are
issued to former affiliates of the acquired company or to persons
who become affiliates of the buyer, which shares must be resold
pursuant to Rule 145. Although some issuers fear the delay
which may be occasioned by the fairness hearing process, our
experience has been that as little as four weeks can transpire
between the filing of the application and the fairness hearing
itself.
July 20, 2006
© Otto Sorensen 2006
23
• When conducting an acquisition program, remember that even
insignificant acquisitions can trigger a target financial statement
disclosure requirement if in aggregate any of the regulatory tests
for significance exceeds the 50% threshold. In that event,
financial statements covering at least a majority of the
individually insignificant businesses acquired must be filed.
• Beware change of control vesting acceleration provisions in
options held by key employees. Will that newly minted
millionaire really want to continue to work for the acquired
company?
July 20, 2006
© Otto Sorensen 2006
24
• Post closing working capital adjustments can be particularly
important to an acquiror whose access to cash flow to support a
new acquisition is not as robust as it might be. The working
capital of the acquired company on the closing date should be
determined as soon as possible after the closing and should be
supported by post agreement pre-closing covenants and
representations and warranties. The purpose of any such
clause is to assure that those controlling the target prior to
closing do not artificially increase the purchase price by
engaging in conduct which reduces artificially either cash or
other current assets. Any working capital adjustment should be
paid in cash from escrow. Alternatively, it can also be structured
as an offset against an earnout payment.
July 20, 2006
© Otto Sorensen 2006
25
• In crafting a working capital adjustment provision, thought must
be given to historical seasonal fluctuations in cash flow.
• When crafting an earnout provision, exculpatory language with
regard to the operation of the target post-merger should be
included. Earnout provisions can create some of the most
contentious post-closing disputes, and such exculpatory
language can increase the likelihood that the buyer will prevail in
any such dispute.
July 20, 2006
© Otto Sorensen 2006
26
Notes with regard to the care and feeding of investment
bankers:
1.
An investment banker’s tail period should not exceed six months
and it should apply only to companies identified by the
investment banker upon termination of the engagement and with
whom the investment banker has had substantive discussions.
2.
A company should always negotiate strongly for a right to
terminate the engagement prior to its scheduled expiration
period. This is particularly important in instances in which a
monthly fee is being paid to the investment banker.
July 20, 2006
© Otto Sorensen 2006
27
3.
Investment bankers sometimes seek to obtain an additional fee
upon the signing of a letter of intent. Such provisions are
unacceptable. An investment banker is being paid to help you
win the war, not a battle.
4.
If a fee to be paid to an investment banker is based in part on
downstream transaction consideration, the investment banker
should receive his fee applicable to the downstream payment
when that downstream payment is actually made. If the
investment banker is not willing to agree to such provision, he
should agree that the downstream payment should be
discounted to its net present value for purposes of determining
the amount of his fee.
5.
Fees should be earned upon closing, not upon entry into an
agreement in principal or even a definitive agreement.
July 20, 2006
© Otto Sorensen 2006
28
• Reasonable non-compete provisions which are entered into in
connection with a sale of a business are enforceable under
California law. They can also be controversial. A buyer will rightly
claim that he is paying for a business, including its goodwill, and
has no wish to see that goodwill diluted through competition with
the former owners of the target. The owners of the target will argue
that they are willing to refrain from competition as long as they are
employed, but that, if their employment is terminated, they will have
to put food on the table in some fashion. Such an argument can be
refuted by pointing out that the shareholder, if he is terminated, will
still have the proceeds of sale with which to provide for himself and
his family. If necessary, a severance package can also help
address these issues. A buyer should never rely solely upon a noncompete provision. The conditions to closing should include the
delivery of confidentiality and non-disclosure agreements by each
selling shareholder.
July 20, 2006
© Otto Sorensen 2006
29
•
From a buyer’s point of view, letters of intent should be as non-specific
as possible for two reasons. First, a buyer’s negotiating power tends to
increase during the course of a transaction and delaying the negotiation
of contentious provisions can therefore inure to a buyer’s benefit.
Second, the execution of a letter of intent which is too specific can be a
disclosable event under federal securities laws.
July 20, 2006
© Otto Sorensen 2006
30
Merger and acquisition techniques occasioned by the
Sarbanes-Oxley Act.
1. The acquisition agreement should contain a representation
with regard to the target’s internal controls and disclosure
controls. An acquiror should independently verify the
effectiveness of those controls.
2. Buyers may wish to perform a pro forma corporate
governance audit to verify compliance with the SarbanesOxley Act and any applicable listing standards on the part
of the buyer after giving effect to the acquisition.
July 20, 2006
© Otto Sorensen 2006
31
3.
4.
July 20, 2006
Determine whether the acquisition will have any impact on
the independence of the directors of the buyer.
If the target uses the same auditor as the buyer, the audit
committee of the buyer should approve in advance any
non-audit services that will be performed by the auditor
after the closing date to preserve the independence of the
auditor. Any non-audit services that are not approved or
which are prohibited should be terminated on or before
closing.
© Otto Sorensen 2006
32
5.
6.
July 20, 2006
Sarbanes-Oxley generally prohibits the extension of credit
to directors and executive officers. If an owner or
employee of the target is to become a director or executive
officer of the buyer, his compensatory arrangements,
including benefit plans and perquisites, with the target
should be reviewed to assure that they will not result in an
extension of credit subsequent to his becoming a director
or executive officer of buyer.
Disclosures of pro forma financial information, whether on
a Form 8-K report or otherwise, made with regard to an
acquisition should be evaluated to assure that they comply
with Sarbanes-Oxley mandated rules regarding the use of
non-GAAP financial measures.
© Otto Sorensen 2006
33
July 20, 2006
© Otto Sorensen 2006
34
3727519
July 20, 2006
© Otto Sorensen 2006
35