Mergers & Acquisitions: What VC Investors Should Know<br />Laurie A. Allen<br />Royse Law Firm, PC<br />10900 Wilshire Blv...
 OVERVIEW<br />Board Consideration of Acquisition Proposal<br />Director Indemnification<br />M&A Planning<br />M&A Transa...
BOARD CONSIDERATION OF ACQUISTION PROPOSAL<br />•	Fiduciary Duties: <br />• To Shareholders<br />		• To Creditors for Trou...
 DIRECTOR INDEMNIFICAITON<br />•  Director Indemnification – Before Assuming Board Seat<br />•	 Update Charter and Bylaws<...
VENTURE M&A PLANNING  <br /><ul><li> Strategic Investors
  Do Not Grant Rights to Block Sale
  No ROFR or Similar Protective Provision
  Notification Rights OK
Drag-Along Rights – From Everybody, Especially Founders
Limit Outstanding Series of Preferred – Think Recapitalize
Late Stage Investors – Preference not Blocking Right</li></ul>5<br />
VENTURE M&A PLANNING  <br /><ul><li> Long Term Liabilities – Keep Them to A Minimum
 LOIs and No-Shop Clauses</li></ul>	• Buyer Will Insist<br />	• Hammer Out All “Big Ticket” Issues as quid pro quo<br />•M...
Discuss Exit Expectations at Investment Stage
Obtain Buy-In from Management and Board on Timing and Expected Returns</li></ul>6<br />
MANAGEMENT M&A PLANNING<br />•Organize Company Books and Records<br />	•  Corporate Minutes/Board Approvals<br />	•   Cap ...
Patent Filings, Discuss Possible Infringement
Properly document and record transfers of IP to the Company
Review Licenses/Third Party Consents
 Resolve or quantify outstanding lawsuits and claims</li></ul>7<br />
MANAGEMENT M&A PLANNING<br />• Tax and ERISA Issues<br /><ul><li>409A Issues – Option Valuation, Severance Agreements, Def...
280G Golden Parachute Payments
ERISA Plan Compliance
Employment Issues
Executive Employment Agreements; Offer Letters
Payments Triggered by Change-in-Control
Stock Options, Bonus Plans Or Other Equity Awards
Comply w/ Employee Classification/Wage and Hour Laws
 Triage Potential Problems with “Consenting” Shareholders </li></ul>8<br />
M&A TRANSACTION PROCESS<br /><ul><li>Preliminary Due Diligence
Negotiate and Sign Letter of Intent
Good Time to InvolveCFO/GC or Legal Counselre Deal Structure, Accounting and Legal issues
In-depth Business and Legal Due Diligence
Purchase Agreement
Ancillary Documents
Closing</li></ul>9<br />
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M&amp;A What V Cs Should Know

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M&amp;A What V Cs Should Know

  1. 1. Mergers & Acquisitions: What VC Investors Should Know<br />Laurie A. Allen<br />Royse Law Firm, PC<br />10900 Wilshire Blvd., Suite 300<br />Los Angeles, CA 90024<br />(310) 481-0125/(310) 770-2696<br />lallen@rroyselaw.com<br />IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein.<br />
  2. 2. OVERVIEW<br />Board Consideration of Acquisition Proposal<br />Director Indemnification<br />M&A Planning<br />M&A Transaction Process & Structures<br />M&A Issues with Selling Shareholder Implications<br />Litigation Expense Funds<br />Holdback Escrow and Escrow Agreements<br />Earn-Outs<br />Shareholder Representative<br />2<br />
  3. 3. BOARD CONSIDERATION OF ACQUISTION PROPOSAL<br />• Fiduciary Duties: <br />• To Shareholders<br /> • To Creditors for Troubled Companies<br />• Best Practices Approach:<br />• Be Informed About the Company’s Value <br /> • Be Actively Engaged in the Process<br /> • Consider All Available Alternatives<br /> • Use a Reasonable Process to Gather Information<br /> • Appoint Special Committee<br />3<br />
  4. 4. DIRECTOR INDEMNIFICAITON<br />• Director Indemnification – Before Assuming Board Seat<br />• Update Charter and Bylaws<br />• Indemnification Agreement – Include Levy language<br />• D&O Insurance<br />• Merger Agreement - D&O Post-Closing Indemnity<br />• Buyer’s Covenant to Continue Director Indemnity for Specified Time<br />• Company Assumes Director Indemnification Agreement or Buyer Directly Indemnifies Former Directors<br />• Covenant to Continue or Obtain New D&O Policy (usually for six years and premium cap)<br />4<br />
  5. 5. VENTURE M&A PLANNING <br /><ul><li> Strategic Investors
  6. 6. Do Not Grant Rights to Block Sale
  7. 7. No ROFR or Similar Protective Provision
  8. 8. Notification Rights OK
  9. 9. Drag-Along Rights – From Everybody, Especially Founders
  10. 10. Limit Outstanding Series of Preferred – Think Recapitalize
  11. 11. Late Stage Investors – Preference not Blocking Right</li></ul>5<br />
  12. 12. VENTURE M&A PLANNING <br /><ul><li> Long Term Liabilities – Keep Them to A Minimum
  13. 13. LOIs and No-Shop Clauses</li></ul> • Buyer Will Insist<br /> • Hammer Out All “Big Ticket” Issues as quid pro quo<br />•Management Roles/Compensation are VC’s Business, Especially if Earn-Out Proceeds Payable to VC Investor <br /><ul><li>Company Charter - Ensure Charter Anticipates Exit
  14. 14. Discuss Exit Expectations at Investment Stage
  15. 15. Obtain Buy-In from Management and Board on Timing and Expected Returns</li></ul>6<br />
  16. 16. MANAGEMENT M&A PLANNING<br />•Organize Company Books and Records<br /> • Corporate Minutes/Board Approvals<br /> • Cap Table/Shareholder Records/Share Certificates<br /> • Tax Returns/Governmental Filings<br /> • Financials/Balance Sheet & Earnings Statement<br /> • Third Party Consents<br /><ul><li> Establish Ownership of IP and Clean-up IP Documents
  17. 17. Patent Filings, Discuss Possible Infringement
  18. 18. Properly document and record transfers of IP to the Company
  19. 19. Review Licenses/Third Party Consents
  20. 20. Resolve or quantify outstanding lawsuits and claims</li></ul>7<br />
  21. 21. MANAGEMENT M&A PLANNING<br />• Tax and ERISA Issues<br /><ul><li>409A Issues – Option Valuation, Severance Agreements, Deferred Compensation
  22. 22. 280G Golden Parachute Payments
  23. 23. ERISA Plan Compliance
  24. 24. Employment Issues
  25. 25. Executive Employment Agreements; Offer Letters
  26. 26. Payments Triggered by Change-in-Control
  27. 27. Stock Options, Bonus Plans Or Other Equity Awards
  28. 28. Comply w/ Employee Classification/Wage and Hour Laws
  29. 29. Triage Potential Problems with “Consenting” Shareholders </li></ul>8<br />
  30. 30. M&A TRANSACTION PROCESS<br /><ul><li>Preliminary Due Diligence
  31. 31. Negotiate and Sign Letter of Intent
  32. 32. Good Time to InvolveCFO/GC or Legal Counselre Deal Structure, Accounting and Legal issues
  33. 33. In-depth Business and Legal Due Diligence
  34. 34. Purchase Agreement
  35. 35. Ancillary Documents
  36. 36. Closing</li></ul>9<br />
  37. 37. BASIC M&A TRANSACTION STRUCTURES<br /><ul><li>Tax Free Reorganizations
  38. 38. Type A – Merger
  39. 39. Type B – Stock for Stock
  40. 40. Type C – Stock for Assets
  41. 41. Type D – Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations
  42. 42. Taxable Transactions
  43. 43. Stock Sale
  44. 44. Asset Sale
  45. 45. Partnership Techniques</li></ul>10<br />
  46. 46. M&A ISSUES /SELLING SHAREHOLDER IMPLICATIONS<br />• Conflict of Interest: Seller’s Counsel<br />• Seller’s Counsel represents Company<br />• Attorney-Client Privilege Stays with Company <br />• Post Closing Dispute: <br /> • Pre-closing VC investor disclosures compromised<br />• Seller’s counsel cannot represent VC investors<br />• Either Waive Conflict of Interest or Retain Separate Investor Counsel<br />11<br />
  47. 47. M&A ISSUES/SELLING SHAREHOLDER IMPLICATIONS<br />• Working Capital Issues<br />• Definition of “working capital”<br /> • Consequences of Late Delivery of Buyer’s Working Capital Statement & Additional Response Time<br /> • Indemnification Claim and/or Working Capital Adjustment<br />• Tax Issues<br />•Shareholder Representative to Review and Approve Tax Returns covering Pre-Closing Activity<br /> • Tax Liabilities Subject to Dispute Resolution Mechanism in Merger Agreement<br />12<br />
  48. 48. M&A ISSUES/SELLING SHAREHOLDER IMPLICATIONS<br />• Joint & Several Liability<br />• Joint Obligors – Do not rely on common law contribution rights<br />• Contribution Provision & Letter of Transmittal<br /> • Joinder and Contribution Agreements<br />• Indemnification<br /> • “Damages” – Always Define to avoid claims for special, incidental, consequential or punitive damages<br /> • Survival of Shareholder Representations and Warranties<br /> • Carve Outs – Time limitations, Caps and Baskets<br />13<br />
  49. 49. LITIGATION EXPENSE FUNDS<br /> •According to SRS:<br />• 2 Out of 3 Deals have Expense Funds •The Average Expense Fund is over $268,000 •Expense Funds Range between $25,000 and $1M •The Average Expense Fund is <1% of the Sale Price<br />• Why set up an Expense Fund?<br />•Deters Buyer Claims<br />•Provides Options for Selling Shareholders<br />•Fair and Equitable Allocation of Expenses<br />14<br />
  50. 50. ESCROW ACCOUNT PROCESS<br />15<br />
  51. 51. ESCROW AGREEMENT ISSUES<br />• Avoiding “Lock Up” of Escrowed Funds<br /> • Avoid Indemnity Claims For “Reasonably Anticipated” Damages<br /> • Escrow Agent will not Mediate Disputes<br /> • Forced to Either Sue Buyer or Wait for Expiration of S/L<br />• Instead . . . <br />• Perfected Security Interests in Escrow Funds<br />• Escrow is a Neutral Fund<br />• Properly Define “Merger Consideration”<br />• If Buyer won’t Concede, consider a Holdback instead of Escrow<br /><ul><li>Tax Treatment of Payments from Escrow</li></ul>• Payments from Escrow<br />• Imputed Interest<br />16<br />
  52. 52. EARN-OUTS<br />•Structure and Terms<br /> • Different Triggers<br /> • Forms of Payment<br /> • Adjustments for Performance<br />• Operational Covenants<br />• Milestones <br />• Should be Based on Clearly Defined Events/Results<br />• Financial Milestones should consider Accounting Method<br />• Length of Earn-Out Period is Key<br /><ul><li>Post-Closing Control of Business
  53. 53. Highly negotiated
  54. 54. Often Tension between Seller and Buyer’s interests</li></ul>17<br />
  55. 55. EARN-OUTS<br />•Regulatory Implications<br />• Tax - Revenue Recognition, Timing and Income Characterization<br />• Accounting - FAS 141(R) Requires Buyer to Record Fair Value of Expected Earn-out at Closing<br />• Securities - Is Right to Receive Earn-out Payment a “Security”?<br /><ul><li> Predictability of Purchase Price
  56. 56. complicates determinations of various payments
  57. 57. financial advisory fees
  58. 58. preferences due to preferred stockholders
  59. 59. calculation of “fair value” for dissenters rights, etc.</li></ul>18<br />
  60. 60. EARN-OUTS<br /><ul><li>Disputes
  61. 61. Post-closing Disagreements Over</li></ul>• Interpretation of a Defined Milestone<br /><ul><li> Confirming Financial/Business Performance
  62. 62. Support to be Provided by Buyer
  63. 63. Whose Fault When Milestone Not Met on Time or at All?
  64. 64. Litigation – How Coordinated and Who Pays?
  65. 65. Earn-outs for Public Company Targets
  66. 66. Rare, but Doable
  67. 67. “Contingent Value Rights”
  68. 68. Third Party Rights Agents for Public Company Shareholders </li></ul>19<br />
  69. 69. SELLER FINANCING AS AN ALTERNATIVE TO EARN-OUTS<br />• Notes at Pre-Negotiated Interest Rates<br /><ul><li>Typically 3-5 yr term with monthly, quarterly or semi-annually
  70. 70. Typically subordinate to Senior Lenders
  71. 71. Unsecured
  72. 72. May be Inadequate Cash for Payments if Material Decrease in Business Cash-Flow
  73. 73. Less Risky Than Earn-Outs if:
  74. 74. Confidence in the Business
  75. 75. Trust and Confidence in the Buyer</li></ul>20<br />
  76. 76. SHOULD THERE BE A SHAREHOLDER REPRESENTATIVE?<br />• Public Company M&A<br /><ul><li>Few, if any, post-closing shareholder obligations
  77. 77. Target is subject to SEC reporting requirements
  78. 78. Seller will pursue litigation against BOD and management, not public shareholders</li></ul>• Private Company M&A<br />• Heavily negotiated shareholder representations/idemnity<br />• Escrows and Holdbacks are usually required to protect Buyer from breaches/working capital differentials<br />21<br />
  79. 79. SHAREHOLDER REPRESENTATIVE<br />•Shareholder Representative<br /> •Speaks and Acts on Behalf of Selling Shareholders if post-closing claim for Indemnification or post-closing purchase price adjustments are made<br />• Role assumed by one of Selling Shareholders or Third Party Agent<br />• Engagement Letter<br />•Scope of Authority<br />• Expense Fund Parameters<br />• Can Appoint Selling Shareholder “Advisor”<br />• Indemnity: Who’s on the Hook?<br />22<br />
  80. 80. APPENDICES<br />23<br />
  81. 81. PORTFOLIO COMPANY CHARTER<br /><ul><li> Company Charter May Not Properly Anticipate Exit
  82. 82. Merger May Include Escrow, Holdback and Earn-Outs, but Liquidation Preferences not Fully Covered by Closing Proceeds
  83. 83. Non-Participating Preferred or Participating Preferred w/ Cap
  84. 84. Either take liquidation preference or portion of the proceeds as if converted, but not both
  85. 85. Forces choice between payment at closing/forfeit future upside or converting to common/hope for future upside
  86. 86. Uncertainty Whether VC Investor Proceeds Subject to Escrow
  87. 87. Have Discussion at the Investment Stage to Avoid Shareholder Controversies Upon Sale</li></ul>24<br />
  88. 88. Fiduciary Duties for VC Board Members<br />Fiduciary Duties in Considering Acquisition Proposal<br /> Duty to Shareholders, not VC Funds<br /> Duty is same whether Target is Public or Private<br /> Minority Shareholder Claim Risk in Certain Situations<br /> Down Round or Cram Down Financings<br /> Former Laid-Off Employee Shareholders <br /> Hostile Significant Shareholder without Board Seat<br />Fiduciary Duty Compliance and Recordkeeping are Key to Successfully Defend Against Minority Shareholder Lawsuits<br />25<br />
  89. 89. Fiduciary Duties for VC Board Members<br />Troubled Company Issues<br />• If in “Zone of Insolvency,” Directors Duty is to Maximize Value for Whole Enterprise (including creditors) <br />• Look for Warning Signs of Insolvency<br />• Ensure Adequate Decision-making Processes<br />• Document Good Faith Exercise of Business Judgment<br />• Consult Counsel, Restructuring and Valuation Experts<br />• Demand Management Accountability<br />• Consult Creditors<br />• Avoid Insider Transactions<br />26<br />
  90. 90. Fiduciary Duties for VC Board Members<br />Business Judgment Rule – Delaware and California<br />Duty of Care<br />Avoid Haste<br /> Carefully Review of All Relevant Material<br /> Seek Out Relevant Information from Management<br /> Ask Questions and Test Accuracy of Information<br /> Rely on Expert Advice<br />Advisors Should be Unbiased and Competent<br /> Observe Corporate Formalities and Document Deliberations<br />27<br />
  91. 91. Fiduciary Duties for VC Board Members<br />Duty of Loyalty<br />• Duty Owed to Corporation and its Shareholders<br />• Prohibits “Self-Dealing” <br />• In re Trados(Del.Ch. 2009) – Director could breach fiduciary duty by improperly favoring interests of preferred over common shareholders who received no consideration<br /> - Implement Process to Represent Common Shareholder Interests<br /> - Drag Along Rights Alone May be Insufficient<br />Good Faith - Duty to Act in a Reasonable and Deliberate Manner and in the Best Interests of the Corporation <br />28<br />
  92. 92. TYPE A REORGANIZATIONS – SECTION 368(a)(1)(A) STATUTORY MERGER<br />Shareholders<br />Target<br />Acquiror<br />Requirements:<br /><ul><li>Necessary Continuity of Interest
  93. 93. Business Purpose
  94. 94. Continuity of Business Enterprise
  95. 95. Plan of Reorganization</li></ul>Tax Effect:<br /><ul><li>Shareholders – Gain recognized to the extent of boot
  96. 96. Target – No gain recognition
  97. 97. Acquiror takes Target’s basis in assets plus gain recognized by Shareholders
  98. 98. Busted Merger – taxable asset sale followed by liquidation
  99. 99. Statutory Merger – 2 or more corporations combined and only one survives (Rev. Rul. 2000-5)
  100. 100. Requires strict compliance with statute
  101. 101. Target can be foreign; Reg. 1.368-2(b)(1)(ii)
  102. 102. No “substantially all” requirement
  103. 103. No “solely for voting stock” requirement</li></ul>29<br />
  104. 104. TYPE B REORGANIZATIONS – SECTION 368(a)(1)(B) STOCK FOR STOCK<br />30<br />Shareholders<br />Acquiror Stock<br />Target Stock<br />Target<br />Acquiror<br /><ul><li>Acquiror’s basis in Target stock is the same as the Shareholder’s basis prior to the acquisition
  105. 105. Solely for voting stock
  106. 106. No Boot in a B
  107. 107. Reorganization Expenses – distinguish between Target expenses and Target Shareholder expenses (Rev. Rul. 73-54)
  108. 108. Creeping B – old and cold stock purchased for cash should not be integrated with stock exchange</li></ul>Acquisition of stock of Target, by Acquiror in exchange for Acquiror voting stock<br />Acquiror needs control of Target immediately after the acquisition<br />Control = 80% by vote and 80% of each class<br />
  109. 109. TYPE C REORGANIZATIONS – SECTION 368(a)(1)(C) STOCK FOR ASSETS<br />31<br />Shareholders<br />Acquiror <br />Stock<br />Acquiror Stock<br />Target<br />Acquiror<br />Target Assets<br /><ul><li>Acquisition of substantially all of the assets of Target, by Acquiror in exchange for Acquiror voting stock
  110. 110. “Substantially All” – at least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets
  111. 111. Target must liquidate in the reorganization
  112. 112. 20% Boot Exception – Acquiror can pay boot (non-stock) for Target assets, up to 20% of total consideration; liabilities assumed are not considered boot unless other boot exists
  113. 113. Reorganization Expenses – Aquiror may assume expenses (Rev. Rul. 73-54)
  114. 114. Assumption of stock options not boot
  115. 115. Bridge loans by Acquiror are boot
  116. 116. Redemptions and Dividends – who pays and source of funds</li></li></ul><li>TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) DIVISIVE SPIN OFF, SPLIT OFF, SPLIT UP<br />32<br />Shareholders<br />Transferee <br />Stock<br />Transferee Stock<br />Transferor<br />Transferee<br />Transferor Assets<br /><ul><li>Divisive – transfer by a corporation of all or part of its assets to another corporation if, immediately after the transfer, the transferor or its shareholders are in control of the transferee corporation. Stock or securities of the transferee must be distributed under the plan in a transaction that qualifies under Section 354, 355, or 356. </li></li></ul><li>TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) NON-DIVISIVE<br />33<br />Merger Treated as Acquisitive D<br />If shareholders of Transferor stock receive Acquiror stock and own at least 50% of Acquiror stock, the transaction may be treated as a non-divisive D REORG even if it fails as an A REORG for lack of continuity<br />Shareholders with 20%<br />Acquiror<br />Stock<br />Acquiror Stock<br />Transferor<br />Acquiror<br />Transferor Assets<br />Merger<br />Failed Type C Treated as D<br />Liquidation / Reincorporation<br />Shareholders<br />Shareholders<br />50%<br />Assets<br />Stock<br />Assets<br />Stock<br />Assets<br />Transferor<br />Acquiror<br />Transferor<br />Acquiror<br />Cash & Stock<br />
  117. 117. TAXABLE STOCK PURCHASES<br />34<br />Cash Reverse Triangular Merger<br />Treated as Stock Sale<br />T Shareholders<br />Cash<br />T<br />P<br />Merger<br />Target Survives<br />S<br />Shareholders have gain or loss<br />P takes cost basis in Target shares<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  118. 118. CASH FORWARD MERGER<br />35<br />T Shareholders<br />Asset sale followed by liquidation of Target<br />Target has gain on sale<br />Target shareholders have gain on liquidation (unless 332 applies)<br />P takes cost basis in Target assets<br />T<br />P<br />Merger<br />P Survives<br />Variation with Merger Sub:<br />T Shareholders<br />T<br />P<br />Merger<br />Sub Survives<br />S<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  119. 119. 36<br />

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