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M&A Today – The Numbers & The Law
Numbers:
Mitch Manassa, KPMG LLP
Lee Singer, FGMK
Law:
Neal White, MW&E
Scott Glickson, Gordon & Glickson
February 12, 2004
THE NUMBERS
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Sarbanes-Oxley 404
Revenue Recognition
Purchase Price Allocation
Normalization of Financial
Statements
Off-Balance Pitfalls
SARBANES-OXLEY 404
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Effective dates
Due diligence considerations
Acquisition/Merger considerations
Seller pitfalls
Private equity
RESTATEMENTS IN RECENT YEARS
One third of all restatements were attributed to revenue recognition
issues
Main Reasons
 Sales contingencies not disclosed to
IPR&D
accounting or management
Other
6%
 Sales booked before delivery
17%
Acquisition
completed
4%
Revenue
 Significant rights of return existed
Loan loss
33%
 Software revenue recognized before
9%
underlying services were performed
Cost
Revenue
 False sales agreements and
& cost
28%
3%
documentation
 “Bill and hold” sales not deferred
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Source: Financial Executive Research Foundation
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REVENUE RECOGNITION
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Relevant guidance for technology
firms
Complexities in revenue recognition
Due diligence considerations
ACCOUNTING GUIDANCE
What are the rules?
 Basic principles under SAB 101:
– Persuasive evidence
– Delivery
– Fixed and determinable
payment terms
– Collectibility
 Other recognition “areas”:
– Percentage of completion
– Completed contract
– Installment sales
– Upfront fees
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Transaction considerations:
 Maintenance & service
contracts
 Multiple/bundled elements
 Distributor/reseller
agreements
 Customer contracts are key
 Bill and hold transactions
 Side agreements
 Extended payment terms
 Customizing or installation
 Price determination
agreements
REVENUE ANALYSIS
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Categorize customers as many ways as
possible:
– End users, resellers, distributors, or related
parties;
– Customers by product or service;
– Customers by industry;
– Customers by geography; and
– One-time verses recurring.
Understand the unique contractual
arrangements that exist for each type of
customer such as:
– Milestone completion;
– Rights of approval/return; and
– Cancellation clauses.
PURCHASE PRICE ALLOCATION
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Identifiable intangible assets
IPR&D
Goodwill (remainder)
Post-merger amortization
Valuations
NORMALIZATION OF
FINANCIAL STATEMENTS
PURPOSE
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To remove excess charges or
credits in the financial statements;
adjusting the financial statements to
conform with GAAP and recasting
the financial statements to
anticipate the major changes that
will effect the business after merger
or acquisition has been completed
PURPOSE
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What prior operations might have
looked like under normal conditions
and on a consistent basis;
or
What prospective buyers might
reasonably be expected to obtain
from the company in the future
using history as a guide.
COMMON NORMALIZATION
ADJUSTMENTS
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Balance Sheet Adjustments
Income Statement Adjustments
Other
BALANCE SHEET
ADJUSTMENTS
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Non operating assets, excess
assets and asset shortages
Loans to/from related parties
INCOME STATEMENT
ADJUSTMENTS
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Compensation of owner or family
members
Fringe benefits
Non-recurring income and
expenses
Income and expenses related to
excess assets, non-operating
assets and asset shortages
Related party revenues and
expenses
OTHER
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Non cash items
Corporate cost allocations
Income taxes
OFF-BALANCE SHEET PITFALLS
PURPOSE
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Amounts that are not typically
booked in a GAAP financial
statement, but may have a major
effect on forecasted earnings;
and
To alert a prospective buyer about
monetary amounts that may have a
material effect on financial
performance.
TYPICAL OFF-BALANCE
SHEET PITFALLS
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Warranty obligations (Fin 45, 46)
Related party guarantees
Lease commitments
Maintenance contracts
Purchase agreements
Deferred taxes
Shelf life of product
Income, sales and use tax audits
Non compete agreements
Product liability
The Law – A Mock Negotiation
Law:
Neal White, McDermott, Will & Emery
Scott Glickson, Gordon & Glickson
THE DEAL
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The Company - $200 Million Revenue
manufacturer of wireless video wristwatch email
web-browser solar powered telephone
Has been S-Corporation for more than 10 years
Founder/CEO owns 75% on fully diluted basis,
25% represented in minority investors and
employees
Founder has guaranteed company obligations on
lease on manufacturing facility
The Buyer – Public Company, NASDAQ Listed
The Proposed Price -$50 Million in public company
stock and cash
Hart Scott Rodino Notification Required
THE ISSUES THAT THE PARTIES
WANT TO RESOLVE IN THE TERMS
SHEET BEFORE PROCEEDING
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Asset vs. Stock deal (parties have determined
it is neutral from tax perspective)
Representation and warranty regarding no
infringement of third party rights by the
product technology
Representation and warranty regarding steps
taken to protect trade secrets and other
confidential information
Representation and warranty of accuracy of
all information provided in due diligence and
that everything relevant has been disclosed
THE ISSUES THAT THE PARTIES
WANT TO RESOLVE IN THE TERMS
SHEET BEFORE PROCEEDING
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Purchaser’s right to walk for material
adverse change
Founder’s condition that his lease guaranty
be released at closing
Limitations on liability
1. Statute of Limitations
2. Cap on Liability
3. Basket For Immaterial Claims
4. Joint and several liability of sellers
INTELLECTUAL PROPERTY REP
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Seller owns and possesses or has the right to use
under a valid and enforceable license, sublicense,
agreement or permission all Intellectual Property
constituting Purchased Assets. Each item of
Intellectual Property included in the Purchased
Assets will be owned or available for use by
Purchaser upon the Closing on terms and
conditions identical to those that Seller enjoys
immediately before the Closing,
Seller has not interfered with, infringed upon or
misappropriated any Intellectual Property rights of
third parties as a result of its use of the Purchased
Assets,
INTELLECTUAL PROPERTY REP
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All persons creating any Intellectual Property
as employees or contractors have assigned
all rights therein to the Company
Seller has never agreed to indemnify any
Person for or against any interference,
infringement or misappropriation with respect
to the item, except pursuant to ordinary
course sales supply contracts with customers;
Seller has taken all necessary action to
preserve and protect all Intellectual Property
BUYER’S AND SELLER’S CONDITIONS
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Material Adverse Change
It shall be a condition to Purchaser’s
obligation to close that there shall have been
no material adverse change in the financial
condition, business, assets or prospects in the
Company, whether Company specific or
related to general industry or economic
trends,
Release of Guaranty
It shall be a condition to Sellers’ obligation to
close that Founder shall have been released
from his lease guaranty.
ACCURACY OF INFORMATION
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All information which has been provided to Purchaser by
or on behalf of the Sellers is true and complete and no
material fact has been omitted therefrom which would
make such information misleading. Sellers has made or
caused to be made reasonable inquiry with respect to
each covenant, agreement, obligation, representation
and warranty of Sellers contained in this Agreement and
none of the aforesaid covenants, agreements,
obligations, representations or warranties contains any
untrue statement of a material fact or omits to state a
material fact necessary to make such covenant,
agreement, obligation, representation or warranty not
misleading. Sellers have disclosed to Purchaser all
information that Purchaser could reasonably determine
to be material to its acquisition of the Company.
INDEMNIFICATION THRESHOLD & CAP
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No amount will be payable by the Sellers in
indemnification unless and until the Damages
exceed $10,000 in the aggregate. However, this
threshold limitation does not apply to any breach
of any of Sellers’ representations and warranties of
which Sellers had knowledge at any time before
the date on which such representation or warranty
was made, or (d) any intentional breach by Seller
of any covenant or obligation (If the aggregate
amount of all Damages exceeds $10,000 then the
Sellers shall be jointly and severally for all of the
Damages from the first dollar. Seller’s maximum
liability under this Agreement is the purchase
price.