Mergers & Acquisitions: A Strategy for High Technology Companies

Mergers & Acquisitions: A Strategy for High Technology Companies

Jacqueline A Daunt of Fenwick & West LLP

Table of Contents


Why Do Companies Acquire Other Companies?
What Creates Value in an Acquisition?
What Destroys Value in an Acquisition?
Why Do Some Acquisitions Fail?

Deciding to Be Acquired

Acquisition vs. IPO
Positioning TechCo to Be Acquired
When Should TechCo Consider Being Acquired?
The Acquisition Process
Use of an Investment Banker

Key Deal Issues

Valuation and Pricing Issues
Risk Reduction Mechanisms
Personnel Issues
Acquisition Structure
Type of Consideration Used
Tax-Free Acquisition
Acquisition Accounting

Troubled Company M&A Issues

Employee Incentive Issues
When TechCo is Near Bankruptcy

Implementing the Deal

Letter of Intent
Disclosure of Acquisitions
Time and Responsibility Schedule
Definitive Agreements
Board Approval
Necessary Consents
Integration Issues


Appendix A: Letter of Intent

Appendix B: S-4 Merger Time and Responsibility Schedule

About the Author

Mergers & Acquisitions: A Strategy for High Technology Companies

2002 Update


recent survey showed that between two and five emerging technology
companies (TechCos) are acquired for every one that does an initial
public offering (IPO). Acquisitions can provide strategic, operating
and financial benefits to both TechCo and the company acquiring it
(LargeCo). A strategic acquisition can provide TechCo’s shareholders
with earlier liquidity than an IPO, with less risk and dilution. It
also can provide TechCo with the immediate leverage of LargeCo’s
established manufacturing or distribution infrastructure, without the
dilution, time and risk of internal development. A strategic
acquisition can provide LargeCo with the new products and technologies
necessary to maintain its competitive advantage, growth rate and
profitability. Ill-conceived or badly done acquisitions, however, can
result in expense and disruption to both businesses, the discontinuance
of good technologies and products, employee dissatisfaction and
defection, and poor operating results by the combined company. By
understanding the key factors that lead to a successful acquisition,
TechCo and LargeCo can improve the probability of achieving one.

Why Do Companies Acquire Other Companies?

considering an acquisition, TechCo’s first step should be to identify
the strategic reasons why it wants to be acquired. For example, while
TechCo may seek liquidity for its founders and investors, it also may
have concluded that its future success requires the synergies of
complementary resources and access to the infrastructure of a major
corporation. An IPO could provide TechCo’s shareholders with liquidity,
but would not immediately address TechCo’s need for product synergy or
provide an established infrastructure. Those needs could be better met
by finding a strategic buyer for TechCo.

important is to identify LargeCo’s strategic objectives in acquiring
TechCo. For example, LargeCo may seek to acquire a product line or key
technology, gain creative, technical or management talent, or eliminate
a competitor. Ultimately, LargeCo will acquire TechCo because it
believes acquisition is a more effective means of meeting a strategic
need and increasing shareholder value than internal development. If
TechCo understands its own and LargeCo’s strategic objectives, it can
focus on candidates that are most likely to meet its needs and value
the assets that it has to offer. While the objectives of individual
companies will vary, the following table identifies common strategic
objectives that TechCos and LargeCos try to achieve through an

Table 1: Common Strategic Objectives for Acquisitions

TechCo Reasons to Be Acquired LargeCo Reasons to Make an Acquisition

Access to complementary products and markets

Access to working capital

Avoid dilution of building own infrastructure

Best liquidity event for founders and investors

Best and fastest return on investment

Faster access to established infrastucture

Gain critical mass

Improve distribution capacity

More rapid expansion of customer base

Acquire key technology

Acquire a new distribution channel

Assure a source of supply

Eliminate a competitor

Expand or add a product line

Gain creative talent

Gain expertise and entry in a new market

Gain a time-to-market advantage

Increase earnings per share

What Creates Value in an Acquisition?

acquisition objectives will determine which TechCo attributes are the
most valuable. If TechCo identifies early the strategic objectives for
the most likely LargeCo merger candidates, it can focus its energy on
developing those attributes. There are, however, certain TechCo
attributes that are likely to enhance TechCo’s value. Proprietary
technology or products with significant competitive advantage are
always valuable. Market leadership in a fast-growing market segment
also increases TechCo’s value. Studies show that market-share leaders
are significantly more profitable than companies with smaller market
shares. Strong management in TechCo’s areas of value will lend
credibility to TechCo’s projections of future growth. Nonduplicative
infrastructure and relationships add to TechCo’s value since LargeCo
will not have to terminate redundant personnel or unwind arrangements
with unwanted third parties. The greatest source of TechCo value,
however, is the financial performance and joint economics expected in
the hands of LargeCo. If TechCo reached $5 million in sales in a
fast-growing market segment without the benefit of a sales force or an
institutional presence, LargeCo’s sales force, brand name recognition
and established customer base may allow it to increase those results
dramatically in the first year with minimal incremental cost.

What Destroys Value in an Acquisition?

as there are certain TechCo attributes that are likely to enhance its
value, there are also certain TechCo characteristics that are likely to
reduce its value. An unprofitable TechCo or one with performance
volatility will have difficulty persuading LargeCo that its future
performance projections are credible. Excessive liabilities or
litigation threats may frighten off LargeCo from an otherwise good
deal, unless TechCo’s shareholders are willing to indemnify LargeCo for
those risks. If key TechCo managers are visibly reluctant to continue
working with LargeCo after the acquisition, LargeCo may be concerned
about TechCo’s ability to perform after the closing. A TechCo that
requires substantial capital to accomplish its goals faces two hurdles.
It must persuade LargeCo that the goals are attainable with the
requested capital, and that it is worth both the purchase price and the
additional capital. Strategically irrelevant TechCo operations tend to
defocus or stall merger negotiations. LargeCo does not want to buy such
assets, and TechCo will want to be paid for their value or to remove
them from the company before the acquisition. It also is dangerous for
TechCo to go into negotiations with a limited operating horizon (i.e.,
with minimal cash). It may find that its only source of bridge
financing is LargeCo, which will put it in a much weaker negotiating
position. TechCos with a divided Board of Directors, investor group or
management team also have a more difficult time in acquisition
negotiations. They will find that these groups spend more time
negotiating among themselves than in negotiating with LargeCo. Gaining
a reputation for being over-shopped also can reduce TechCo’s value. It
leads LargeCo to believe that many other potential acquirers have
already examined TechCo and rejected it as undesirable.

Why Do Some Acquisitions Fail?

acquisitions fail to deliver the synergies and value promised. To avoid
these pitfalls, TechCo needs to understand the most common reasons why
acquisitions fail. If LargeCo does inadequate technical due diligence,
it may discover after closing that TechCo’s technology does not perform
at the expected level. Sometimes, there is a clash between LargeCo’s
and TechCo’s corporate cultures, and TechCo’s key personnel become
disenchanted or leave. If TechCo’s personnel are a critical part of its
value, LargeCo should make a special effort to "recruit" them,
designing an employment package and environment that will retain and
motivate them. There may not be a true strategic fit, and LargeCo may
discover that its sale force cannot easily sell TechCo’s products. If
LargeCo does an inadequate intellectual property audit, it may later
discover that TechCo does not have clear title to its technology.
Lastly, LargeCo may change its mind about the strategic importance of
TechCo’s technology or products and conclude that it does not desire to
continue them within LargeCo’s organization. Most of these problems can
be avoided if they are addressed during negotiations and the due
diligence process.

Deciding to Be Acquired

Acquisition vs. IPO

When should TechCo pursue a strategic acquisition and when should it pursue an IPO? When evaluating this issue, the following
factors should be considered:

To go public and maintain its stock price, TechCo generally must
establish a consistent, stable pattern of growth and profitability. To
do that, TechCo will need to establish professional manufacturing,
distribution, finance, and administration and management. Building the
infrastructure necessary to operate as a successful, publicly traded
company is time consuming, expensive and dilutive to the present equity
holders. While TechCo may command a higher valuation in an IPO than it
can in an acquisition, the potential for a higher valuation may not be
worth the expected dilution. Moreover, an independent growth strategy
can be risky if TechCo is likely to be overtaken by better capitalized

IPO Windows.
The IPO market is volatile and reacts to factors that are outside
TechCo’s control. IPO windows may open and close in a cycle different
than TechCo’s growth, capital and liquidity needs. For example, the
adoption of government regulation of, or bad press about, TechCo’s
industry can affect TechCo’s ability to go public. It may not affect
the profitability of TechCo’s business, however, nor its potential
attractiveness to a LargeCo already in that industry.

Public Disclosure.
The process of going public requires that TechCo disclose important
information about its strategy, competitive advantage and finances that
it might prefer to keep confidential. Once public, such disclosures
continue as TechCo is required to file regular 10-Ks, 10-Qs and proxy
statements. Moreover, there is an increasing risk that TechCo will be
sued by its shareholders if, with hindsight, TechCo’s public
disclosures prove to be materially inaccurate. TechCo may prefer to be
acquired to avoid that public disclosure and potential liability.

A public offering is expensive. For example, if TechCo wanted to make a
$40 million offering, the underwriters typically would take a 7%
commission on the stock sold, and the legal, accounting and printing
fees would exceed $1,200,000. Complying with the SEC’s public reporting
requirements imposes additional administrative burdens, requires
substantial executive attention and might cost TechCo an additional
$50,000 to $150,000 per year. TechCo will find that being acquired
generally is less expensive than doing an IPO and LargeCo typically
will pay TechCo’s reasonable acquisition expenses.

Quarterly Financial Performance.
Once TechCo is public, it must publish financial statements and respond
to the analysts on a quarterly basis. A public company frequently finds
that it makes business decisions with one eye on how the market will
respond. By getting acquired by LargeCo, many TechCos hope to be able
to focus on long-term investment and business plan execution.

Liquidity for TechCo Shareholders.
While TechCo may think that going public will provide its shareholders
with liquidity, that liquidity may be initially illusory. Many TechCos
sell relatively few shares in their IPO and many more do not get
serious analyst coverage. There may be little market interest in
TechCo’s stock, with few shares trading daily (TechCo’s "float").
Further, underwriters will require TechCo’s shareholders to sign
"Market Standoff Agreements," agreeing not to sell any of their shares
into the public market for at least 180 days after TechCo’s IPO.
TechCo’s shareholders may find that, although TechCo is now "public,"
their stock is relatively illiquid. If TechCo’s shareholders receive
freely tradable LargeCo stock that has a significant float, they may
receive more real liquidity more quickly than is possible through a
TechCo IPO.

Positioning TechCo to Be Acquired

best way for TechCo to position itself to be acquired (or to go public)
is to demonstrate consistent revenue and earnings growth and ownership
of a fast-growing technology, customer or market franchise. TechCo
should consider avoiding early and excessive product or market
diversification. Attempting to create multiple products or to attack
multiple markets simultaneously strains the resources of an emerging
company and reduces the probability that TechCo will execute its
strategy well. A more diverse product or market focus also reduces the
likelihood of a good strategic fit with LargeCo and increases the
probability that some of TechCo’s assets will have a low value to
LargeCo. TechCo also may want to establish market acceptance of its
products through partners instead of establishing its own sales and
distribution capability. Using such partnering relationships can enable
TechCo to avoid the cost and time of establishing its own production,
sales or marketing infrastructure, which will often duplicate that of
LargeCo. (See Fenwick & West’s booklet "Corporate Partnering: A Strategy for High Technology Companies"
for a more detailed discussion of partnering.) From a legal
perspective, TechCo should ensure that it has clear title to its
intellectual property and it should avoid nonassignable or onerous
contracts. To avoid accounting disputes during negotiations, TechCo
should keep its financial statements in accordance with generally
accepted accounting principles (GAAP) and have annual audits.

When Should TechCo Consider Being Acquired?

is difficult to predict at what stage TechCo will obtain the best
valuation in an acquisition. However, TechCo may be an attractive
acquisition candidate at an earlier stage than it expects. For example,
TechCo may want to consider being acquired once it:

  • Produces a product or service that is:
    • critically acclaimed in the industry trade journals,
    • strongly endorsed by good, referenceable customers, and
    • a strategic fit with LargeCo’s products and distribution
  • Has a strong development team in a mission-critical area
  • Has few conflicting or overlapping products or infrastructure; and
  • Is profitable and can demonstrate revenue and profit growth.

This stage may be optimal because TechCo can reach it most quickly, with the least amount of invested capital, personnel and

The Acquisition Process

TechCo concludes that it wants to be acquired, it needs to understand
the acquisition process. There are several stages involved in preparing
for, negotiating and closing an acquisition. Each stage requires the
participation of different players. From first contact with an
investment banker until completion of the integration of LargeCo and
TechCo operations, the acquisition process can take more than a year.
The following table shows some of the more important acquisition stages
and the key participants during those stages of the process.

Table 2: Acquisition Process and Participants

Participants TechCo Market Plan Contact LargeCo Candidates Negotiate Letter of Intent Conduct Due Diligence Negotiate and Sign Agreements Closing of Merger Company Integration
Management ü ü ü ü ü ü ü
Board of Directors ü ü ü        
Investment Banker ü ü ü ü      
Lawyers     ü ü ü ü  
Accountants       ü ü ü ü

Use of an Investment Banker

Presale Preparation.
TechCo may want to obtain advice from an investment banker when it
first considers being sold. TechCo should select its banker based on
its experience in mergers and acquisitions in TechCo’s specific
industry doing transactions of similar deal size and its contacts with
relevant potential buyers. Before reaching the decision that it should
be acquired, TechCo can have an investment banker review its business,
financial and strategic plans, and help it evaluate its business
alternatives. With early advice, TechCo can address value-enhancing or
detracting factors and sometimes improve its valuation. Based on an
analysis of TechCo’s business strengths and weaknesses, industry
trends, TechCo’s competitive positioning, and recent M&A activity,
the investment banker can advise TechCo on a range of expected
acquisition values. These early activities can help TechCo position
itself to command the highest valuation and attract the most qualified
prospective purchasers. The investment banker can also prepare a
detailed timeline to better prepare TechCo for the length of the
process and how much of management’s time will be needed.

Assistance During the Marketing Process.
Once TechCo decides to be acquired, the investment banker can prepare
detailed marketing materials describing TechCo’s key attributes. The
investment banker approaches the marketing process by conducting a
detailed analysis of TechCo, its industry and the strategic reasons why
LargeCo might want to acquire TechCo. The investment banker will also
prepare a detailed list of potential buyers to be contacted during the
marketing process. Using a banker at this stage in the process enables
LargeCo to ask "tough" questions of the banker and be more forthright
in their evaluation of TechCo without offending TechCo’s management.

Due Diligence.
When potential buyers conduct initial due diligence on TechCo, the
investment banker can assist the process by ensuring that LargeCo gets
information necessary to submit a binding offer to acquire TechCo. It
is important to anticipate what information will be the most important
to LargeCo to avoid embarrassing "surprises" later. The investment
banker can assist TechCo by pointing out sources of synergy and
supporting TechCo’s desired valuation by financial analyses based on
comparable public and private companies. Familiarity with TechCo’s
industry also will allow the banker to suggest alternatives if
difficulties arise with a current LargeCo prospect.

Negotiations Phase.
During this process, the investment banker will help TechCo determine
which offer to accept based on valuation, structure, tax
considerations, LargeCo currency (if stock is the primary
consideration), and other relevant issues. Once an offer is accepted,
it is critical to communicate to the investment banker which issues are
most important to TechCo in order to properly position the negotiation
discussions. To ensure an efficient final agreement phase, the
investment banker can help coordinate communication with TechCo’s
lawyers and accountants to make certain all of TechCo’s advisors
understand the implications of the definitive agreement. If requested,
an investment banker can provide TechCo’s Board of Directors with a
formal "fairness opinion" on the terms offered by LargeCo.

Key Deal Issues

LargeCo and TechCo agree that they are a good strategic fit, the next
step is to determine the terms of the LargeCo-TechCo merger. LargeCo’s
focus will be on paying no more than TechCo’s value; structuring the
acquisition to obtain the most desirable tax, accounting and risk
profile; and negotiating agreements with key personnel. When
considering LargeCo’s offer, TechCo should keep in mind the needs of
its different constituencies. TechCo’s shareholders typically want the
highest possible price, paid in a liquid but tax-free manner. They also
want to limit their personal liability for indemnities and reduce the
amount of any consideration held in escrow as security for such
indemnities. TechCo’s management will want to retain the largest number
of TechCo’s employees on the best possible terms and have LargeCo deal
fairly with terminated employees. On a personal level, TechCo’s
executives will want to negotiate a good employment package and avoid
long noncompetition agreements in case their relationship with LargeCo
does not prove successful. Perhaps even more than LargeCo, TechCo’s
management will want to avoid the risk of a "broken deal." TechCo’s
employees will be concerned about their jobs, their reporting
relationships and the uncertainty caused by the acquisition. To
negotiate a successful acquisition, all of these concerns must be

Valuation and Pricing Issues

TechCo Valuation.
One of the most important LargeCo issues is to pay a fair value for
TechCo. Valuation is highly subjective. The "fair" value for TechCo
will vary significantly from one LargeCo to another, depending on a
variety of factors. An investment banker can assist TechCo in
determining its valuation and in price negotiations with LargeCo. When
negotiating its value, TechCo should remember that public LargeCos,
issuing stock in a merger, will not want the merger to be dilutive of
their earnings per share (EPS). This means that LargeCo cannot issue so
many shares to TechCo’s shareholders that the merger reduces LargeCo’s
EPS. LargeCos typically use three methods to triangulate on a
reasonable TechCo valuation.

  • Comparable Public Companies.
    One way of determining TechCo’s value is to take the market value of
    stocks of comparable, publicly traded companies in TechCo’s industry as
    a multiple of such companies’ earnings and revenues. Those values are
    then adjusted to account for the size, liquidity and performance
    differences between TechCo and those companies. The difficulty with
    this analysis is in selecting "comparable" companies and accurately
    adjusting TechCo’s value to reflect the differences between TechCo and
    such companies.
  • Comparable Transactions.
    Another way of determining TechCo’s value is to compare the amount paid
    in acquisitions for other companies in TechCo’s industry. When using
    this valuation method, consider the following. While the stock market
    values all public companies daily, acquisitions occur over time. If a
    comparable transaction occurred some time before TechCo’s proposed
    transaction, are the factors essential to that valuation still present?
    Another factor that can influence valuation is the consideration used
    in the transaction. A LargeCo with a highly valued stock can pay a
    higher price than a LargeCo with a less valued stock. Alternatively, if
    TechCo believes that LargeCo’s stock is undervalued by the market, it
    may be willing to accept a lower price at closing on the expectation of
    market appreciation in LargeCo’s stock after the closing.
  • Discounted Cash Flow Analysis.
    A third way of determining TechCo’s value is to assign a value in
    today’s dollars to the cash flow to be generated by TechCo’s future
    operations. This type of analysis has two difficulties. First, under
    this analysis, TechCo’s value depends on the credibility of TechCo’s
    projections of its future operations. While historical performance is a
    known quantity, LargeCo and TechCo may disagree on how TechCo will
    perform in the future. Second, a substantial portion of the value
    represented by this type of analysis is the residual value created by
    TechCo’s investment in early years. This is another likely source of
    disagreement between LargeCo and TechCo.
  • Purchase Price Denomination. If LargeCo pays cash for TechCo, LargeCo will express the purchase price in dollars. In an acquisition where LargeCo issues
    stock to pay for TechCo, LargeCo may express its offered purchase price in any of the following ways.

    • As Dollar Value of Shares.
      If LargeCo expresses the price as a certain dollar value of its shares,
      LargeCo must specify the mechanism for determining the number of shares
      to be issued at the closing of the transaction. For example, LargeCo
      could offer that number of shares determined by dividing $25 million by
      the average of the closing prices of LargeCo’s stock for the ten
      trading days ending three days before the closing of the merger.
      LargeCo may not want to use this pricing mechanism if it believes that
      its stock price will fall between the date it signs the merger
      agreement and the date it closes the transaction. Such a drop in
      LargeCo’s stock price could result in TechCo’s shareholders receiving a
      significantly larger number of shares in the merger. This could be a
      problem if such an increase would require LargeCo to obtain the
      approval of its shareholders (which would not be required if fewer
      shares were issued) or if LargeCo’s management believed that the
      transaction would become EPS dilutive. TechCo also might worry about a
      dollar purchase price that calculates the number of shares at the
      closing date. TechCo will not want the number of shares issued in the
      transaction to be reduced if LargeCo’s stock market price goes up
      before the closing date. TechCo will want its shareholders to share in
      market appreciation resulting from a favorable response to the
      announcement that LargeCo is acquiring TechCo.
    • As Fixed Number of Shares.
      These concerns can be eliminated if LargeCo denominates its price as a
      certain number of shares to be issued in the acquisition. However, this
      pricing method leaves both parties with the risk that the dollar
      purchase price could go up or down by millions of dollars between
      signing and closing the deal. Arguably, the dollar purchase price
      should not matter to LargeCo as long as the merger will increase
      LargeCo’s EPS. It may matter to TechCo, however, if TechCo has
      outstanding preferred stock and LargeCo’s offered price is not a great
      deal more than the amount invested in TechCo by its venture investors.
      The charter documents of many privately held TechCos treat an
      acquisition as a "liquidation." They typically require that the holders
      of the preferred stock receive their liquidation preferences before any
      consideration goes to the holders of the common stock. If a sharp drop
      in LargeCo’s stock price resulted in all of the stock having to be paid
      to the preferred shareholders, TechCo might find that it would be
      unable to obtain common shareholder approval of the acquisition. The
      parties also need to consider how options and warrants will be treated
      in this calculation. For example, is the number of shares offered by
      LargeCo intended to be in exchange for outstanding shares, options and
      warrants, or only for outstanding shares? This issue is particularly
      sensitive if options or warrants are significantly "under water" (i.e., the exercise price to acquire the TechCo shares is far greater than the price offered by LargeCo).
    • As a Percentage of Combined Entity.
      In mergers between companies of relatively equal size, LargeCo
      frequently will express the purchase price as that number of shares
      that will give the TechCo security holders a certain percentage of the
      combined entity. For example, the LargeCo and TechCo security holders
      will have 55% and 45%, respectively, of the post-closing capital of
      LargeCo. Parties use this form of pricing when they want to value
      LargeCo and TechCo based on their expected contribution to the combined
      company’s future performance instead of the market price for the stock.
      Again, the market value of the transaction can fluctuate dramatically
      from the date of signing until closing. Again, the parties need to
      delineate clearly which LargeCo or TechCo shares, options or warrants
      are included in the numerator and the denominator. Again, either
      LargeCo or TechCo may argue that "under water" warrants and options
      should be excluded from the calculation.
  • Collars.
    One way of dealing with these "market" risks is to price the
    transaction subject to a "collar." A "collar" is a range of LargeCo
    stock prices within which there is an agreed-upon pricing method. For
    example, LargeCo might offer to pay TechCo $25 million of stock within
    a collar of $10 to $15 per share, 2,500,000 shares if the stock price
    is less than $10 per share, and 1,666,666 shares if the stock price is
    greater than $15 per share. This approach ensures that in no event will
    LargeCo have to issue more than 2,500,000 shares in the acquisition.
    Alternatively, if LargeCo’s stock was trading at $12 per share at the
    date it was making its offer to TechCo and historically LargeCo’s stock
    had stayed in a range of $10 to $15, it could offer TechCo 2,083,333
    shares within a collar of $10 to $15, $31,249,995 of stock if the stock
    price is greater than $15, and $20,833,333 of stock if the stock price
    is less than $10. The decision whether to denominate the price in
    dollars or shares and with or without a collar depends upon each
    party’s guess about what will happen to LargeCo’s stock price between
    signing and closing and which risk it is most important to avoid.
  • Net Asset Test. If
    either LargeCo or TechCo believes that TechCo’s balance sheet is likely
    to become significantly weaker or stronger between the date the
    definitive agreement is signed and the closing date, it may suggest
    that the purchase price be adjusted to reflect a change in TechCo’s net
    assets. For example, if TechCo had $2 million of working capital at the
    date of signing and LargeCo expected it to decline to $500 thousand by
    the closing date, LargeCo might want to have the purchase price reduced
    to reflect that change. On the other hand, a profitable TechCo might
    negotiate to have LargeCo increase the purchase price by the amount of
    any increase in its working capital from the signing date to the
    closing date.
  • Earnouts. In an
    "earnout," some portion of TechCo’s purchase price will be paid by
    LargeCo only if TechCo achieves negotiated performance goals after the
    closing. Parties typically use an earnout when they agree that a higher
    TechCo valuation would be justified if TechCo were to meet forecasted
    performance goals. TechCo may propose an earnout when it believes that
    its future performance will be substantially better than its historical
    performance. Likely earnout candidates include an early stage TechCo
    with a product line separate from that of LargeCo, a turnaround TechCo
    or a TechCo in a hot industry sector. Well-considered earnouts can
    allow TechCo to increase its sale price, provide continuing motivation
    to TechCo’s management, and increase TechCo’s value in the hands of
    LargeCo. Earnouts, however, are difficult to manage, and, since the
    goals agreed upon at closing are rarely relevant 2 years later, tend to
    create divergent incentives for continuing management. Ill-conceived or
    badly implemented earnouts can demotivate TechCo’s management, reduce
    TechCo’s value to LargeCo, and result in litigation. (See Fenwick &
    West’s booklet "Structuring Effective Earnouts" for a more detailed discussion of this method of pricing an acquisition.)

Risk Reduction Mechanisms

are inherent risks in negotiating, documenting and closing an
acquisition since the parties have to make critical decisions regarding
price and terms based on partial knowledge. There follow some
mechanisms used by LargeCo and TechCo to manage these risks.

Exclusive Negotiating Period.
At the time the parties agree on price and the other key deal terms,
LargeCo generally will require TechCo to cease negotiating with other
potential buyers and negotiate exclusively with LargeCo. LargeCo will
not want to invest substantial time and resources in performing due
diligence and negotiating a deal with TechCo, only to have TechCo use
LargeCo’s offer to start a bidding war by other potential buyers.
TechCo will want to keep the period during which it has to pull itself
off the market as short as possible. To meet its fiduciary obligations,
TechCo’s Board of Directors will want to reserve the right to notify
its shareholders of other offers and may even reserve the right to
accept unsolicited and clearly superior offers. The exclusive
negotiating period should be no longer than reasonable for LargeCo to
complete due diligence and negotiate the definitive documents – usually
between 30 and 60 days.

Break-Up Fee.
Both LargeCo and TechCo may be concerned that they will be damaged if
the deal fails to close after they have signed definitive acquisition
agreements and announced the transaction. As noted above, LargeCo will
not want TechCo to use LargeCo’s offer to start a bidding war. TechCo
will worry that an acquisition announcement may cause its customers to
delay orders until they know whether LargeCo intends to continue
marketing and supporting existing TechCo products. Similarly, if the
announcement causes TechCo’s employees to focus on their resumes
instead of on their jobs, TechCo can be seriously damaged if the
acquisition fails to close. Either LargeCo or TechCo may propose a
"break-up fee" as a way to address this risk. A "break-up fee" requires
the party responsible for the break-up to pay the other party a
negotiated amount of liquidated damages. The amount of the break-up fee
should reflect the damages likely to be sustained by the damaged party.
Some parties dislike break-up fees because they believe that it implies
permission not to close (as long as the break-up fee is paid) and they
would prefer an unequivocal obligation to close.

LargeCo Due Diligence.
LargeCo will do much of its due diligence under a non-disclosure
agreement signed with TechCo before the parties agree on a letter of
intent. Many TechCos, however, will not give LargeCo access to their
most confidential financial, technical, intellectual property, and
customer information until a price has been negotiated. As a result,
LargeCo must decide whether TechCo is a strategic fit and arrive at a
proposed purchase price based on its own product and market due
diligence, without access to TechCo’s more detailed information. Once
the parties agree upon the basic deal terms and while LargeCo’s lawyers
are preparing the definitive agreements, LargeCo will conduct due
diligence to discover if its assumptions about TechCo were accurate.
LargeCo generally will want to do due diligence in the following areas:
product/technology, sales/marketing, financial/accounting, and
legal/intellectual property. (See Fenwick & West’s booklet "Acquiring and Protecting Technology: The Intellectual Property Audit"
for a more detailed discussion of due diligence issues when acquiring
technology.) LargeCo and TechCo should try to identify and discuss
particular sensitivities or unusual problems or liabilities as early in
the due diligence process as possible. Early disclosure is more
efficient, builds credibility, and is less likely to result in
last-minute price renegotiations.

should avoid placing an unnecessary burden on TechCo staff during the
due diligence process. TechCos rarely have the administrative and
financial infrastructure that LargeCo has, and do not maintain the same
type of records. It is often preferable to have LargeCo’s personnel do
much of the due diligence. This enables LargeCo to obtain more accurate
information in the form expected, and will reduce the burden on TechCo.
LargeCo also needs to be sensitive to confidentiality concerns. A
stream of LargeCo personnel, Federal Express envelopes with LargeCo’s
return address, or faxes containing confidential information sent to
locations that are not secure can easily result in rumors that LargeCo
intends to acquire TechCo. Lastly, LargeCo should remember that the
purpose of due diligence is to quantify risk, not to bring TechCo’s
records into line with LargeCo’s. Such conforming changes can be
accomplished after the merger.

LargeCo discovers unexpected TechCo liabilities during the due
diligence process, it may withdraw from the deal, reduce its offered
price, or ask TechCo’s shareholders to indemnify it for damage from
unusual liabilities. TechCo should avoid allowing LargeCo to put a "due
diligence out" in the definitive acquisition agreement. A "due
diligence out" is a condition to closing that allows LargeCo to decide
at the closing whether TechCo is too risky to acquire. To avoid the
risks of customer confusion, employee distraction and the reputation of
being "left at the altar," TechCo should require LargeCo to complete
all due diligence before signing and announcing the definitive
agreement. LargeCo generally will insist on the right to refuse to
close if there is a "material adverse change" in TechCo’s business
between signing and closing. If TechCo anticipates that the merger
announcement will cause such a change, the parties should negotiate a
definition of "material adverse change" that will not penalize TechCo
for expected changes to its business, yet will protect LargeCo from
unexpected material adverse changes to TechCo’s business.

TechCo Representations and Warranties, Indemnities and Escrows.
Besides doing its own due diligence, LargeCo’s definitive agreement
will contain detailed representations and warranties about TechCo’s
business. If those representations are inaccurate, TechCo is expected
to disclose the inaccuracies in an "exception schedule" detailing
TechCo’s problems and liabilities. LargeCo also will ask TechCo to
attach detailed lists of TechCo’s assets, contracts and liabilities to
the definitive agreement as part of TechCo’s "disclosure schedule." If
LargeCo suffers damage because a privately-held TechCo failed to
disclose any of the requested information, LargeCo will expect TechCo’s
shareholders to indemnify it. Given this indemnity obligation, TechCo
should strive for complete and accurate disclosure. To mitigate against
an unreasonable disclosure burden, however, TechCo will want to limit
some disclosure obligations to those items that are "material" to
TechCo or of which TechCo has "knowledge."

business has liabilities that arise in the ordinary course. It is
inappropriate (and harmful to the relationship with continuing TechCo
management) for LargeCo to make claims for every dollar of liability
that is discovered after the closing. To reflect this reality, TechCo
will want its breaches to cause a certain threshold of damages (called
a "basket") before LargeCo has any right to indemnification. Once the
basket limit is reached, however, LargeCo will want to recover all its
damages, including the basket, while TechCo will prefer that LargeCo
recover only the damages in excess of the basket. TechCo will want to
limit potential liability under the indemnity while LargeCo will prefer
unlimited liability for damages. When TechCo’s major shareholders are
also its key managers, TechCo should expect requests for broader
indemnities and escrows. When outside investors hold most of TechCo’s
shares, however, they will want to limit the dollar amount of their
personal liability for indemnities. They also will prefer to limit
LargeCo to a negotiated amount of escrowed consideration.

also may want to hold a portion of the merger consideration in escrow
as security for such indemnity obligations. Since acquisitions can no
longer be accounted for as a "pooling," acquirers are asking for larger
and longer escrows. It is unlikely that 10% of the shares issued going
into escrow for one year for breaches of general representations and
warranties will continue to be the norm. To minimize conflicts over
escrow claims, LargeCo and a TechCo shareholders’ representative should
have regular scheduled post-closing meetings to identify and address
indemnity issues.

Escrows and shareholder indemnities are rare in acquisitions of a publicly-held TechCo. In public-public acquisitions, LargeCo
generally will assume the risk of problems discovered post-closing.

TechCo Due Diligence.
If LargeCo is paying cash for TechCo at the closing, there is little
need for TechCo to do due diligence on LargeCo. If LargeCo is paying
for TechCo with its stock, a promissory note or an earnout, however,
TechCo will want to do due diligence on LargeCo. Many of the
considerations relating to LargeCo’s due diligence will apply when
TechCo is doing due diligence on LargeCo. If LargeCo is public, its
federal securities filings will supply much of the desired information,
although TechCo may want more detailed information about LargeCo’s

Key Shareholder Pre-Approval.
One acquisition risk is whether TechCo’s shareholders will approve the
acquisition negotiated by TechCo’s management and approved by TechCo’s
Board of Directors. TechCo will have similar concerns if LargeCo must
obtain its shareholders’ approval. Legal formalities required to obtain
shareholder approval mean that there will be a delay between signing
the definitive agreement and obtaining shareholder approval to that
agreement. To manage this risk, the parties may want to ask key
shareholders (officers, directors and 10% shareholders) to sign an
Affiliates Agreement at the time the definitive acquisition agreement
is signed, agreeing to vote in favor of the transaction.

License to Key Technology.
If LargeCo’s principal reason to acquire TechCo is to obtain a critical
piece of technology, LargeCo may want to negotiate a license to that
technology. The license could be signed at the same time as the
definitive acquisition agreement since it would rarely require
shareholder approval or compliance with time-consuming legal
formalities. Thus, even if the acquisition did not close, LargeCo would
still have access to the critical technology. TechCo will want to
ensure that the license terms would be acceptable if the acquisition
did not close.

Personnel Issues

Stress Level.
Acquisitions are, by their nature, highly stressful. First, there is
the unavoidable increase in work load required by the acquisition
process. TechCo’s managers need to negotiate the deal, respond to due
diligence requests, generate requested schedules, and make decisions
regarding the integration of the two companies, all in addition to
handling TechCo’s day-to-day operations. Second, there is the
uncertainty about the future. Who will be kept and under what financial
terms? Who will be fired? How will operations change in the new
organization? Third, a potential acquisition creates mass personal
insecurity. Everyone in TechCo’s organization will be concerned about
his future and his ability to perform in the new organization; rumors will abound and TechCo’s ability to perform will
deteriorate. It is in the best interests of both LargeCo and TechCo to
minimize the effects of this stress. Absent the type of planning
recommended below, LargeCo may find that TechCo experiences employee
turmoil, low morale and poor financial performance because of the
acquisition. To minimize the impact of employee turmoil, and
particularly if TechCo’s and LargeCo’s corporate cultures are
substantially different, the parties may want to engage an
organizational development consultant to assist them with the
integration issues.

Acquisition negotiations must be kept strictly confidential until
LargeCo and TechCo have signed the definitive acquisition agreements
and are prepared to answer the myriad questions that arise upon an
announcement of the acquisition. The fewer people who know about
acquisition negotiations and the shorter the period that they are
required to maintain confidentiality, the more likely each company will
be to manage information release successfully. To assist in maintaining
confidentiality, most LargeCos use code names instead of TechCo’s real
identity on internally generated documents. Initial meetings should be
held off-site and in locations where the principals are unlikely to be
observed. The parties should try to limit the more intrusive types of
LargeCo due diligence until it is certain that the agreement will be
signed, rather than risk early leaks and employee disruption.

Key Employees. LargeCo and TechCo need to identify which TechCo personnel must be retained as board members, executives or key employees
and the key factors necessary to retain and motivate them. This issue needs early focus and should be resolved before
the parties announce the acquisition. LargeCos tend to think of
compensation matters as a "human resources" detail; whereas it may be a
"show stopper" to the affected employee. Salary, bonus, stock option
and other compensation arrangements and reporting relationships must be
discussed and agreed upon. To maximize employee retention, however, the
parties also should address more intangible issues of corporate
culture. Some TechCo employees will want assurances that they will not
be required to move. For others, the key issue may be the availability
of cutting-edge technological tools or additional personnel in an area
where they have had inadequate resources. LargeCo should plan to
interview each key TechCo employee to recruit him or her to join the
LargeCo team. As soon as possible after the announcement, LargeCo
should commence the process of weekly team-building meetings between
the counterparts from the two companies. These should continue until
employee surveys indicate that there has been a successful integration
of TechCo’s key employees with their LargeCo counterparts.

Reduction in Force.
Just as LargeCo and TechCo need to determine which employees must be
retained, they also must decide which employees will become redundant.
If TechCo has more than 100 employees and the acquisition will result
in more than 50 employees being terminated, the parties must comply
with the Worker Adjustment and Retraining Notification Act. The WARN
Act requires that terminated employees receive either 60 days’
termination notice or 60 days’ severance pay. The parties should
determine for what period terminated employees will be needed to
integrate TechCo into the LargeCo organization. They then should design
a "transition" package that motivates them to remain with TechCo during
the transition period. One way of providing such motivation is to
condition special option vesting, severance and bonus payments on
remaining during the transition period. Out-placement and resume
assistance programs should be provided, if possible. The parties should
determine transition packages and assistance programs before the
acquisition is announced to TechCo’s employees. LargeCo personnel
should meet with each employee on the day of the acquisition
announcement to explain the details of his or her individual package
and answer any questions he or she may have regarding insurance and
out-placement services. It is important to handle terminations with
dignity and compassion. Failure to do so will result in low morale for
those who have lost their jobs and turmoil in the departments
concerned. It also may result in distrust and resentment by the
employees that LargeCo wants to retain and motivate.

Noncompetition Agreements.
The two most important noncompetition agreement issues are scope of the
noncompete and price. Ideally, the noncompetition agreement should be
no broader than the product and market area that TechCo is selling to
LargeCo. If the key employee is a significant TechCo shareholder, it is
not necessary to pay additional consideration for the noncompetition
agreement. If the key employee owns little or no TechCo stock, however,
LargeCo needs to consider the fairness of expecting him or her to sign
a noncompetition agreement without additional consideration.

California, it is not clear that a noncompetition agreement is
enforceable against an employee who holds less than 3% of TechCo’s
stock. The parties should get tax advice if they intend to allocate a
portion of the purchase price to the noncompetition agreement since it
can have significant tax consequences.

Golden Parachutes.
"Golden parachutes" are arrangements that provide a key employee,
because of a change in control of the company, with benefits equal to
three or more times such employee’s average annual compensation over
the last five years. Recipients of golden parachutes must pay a 20%
excise tax, which is not deductible by the acquired corporation. Under
certain limited circumstances, golden parachutes can be exempted if
they are paid by
privately held TechCos who obtain specific shareholder approval in
connection with the acquisition. Given the penalties involved, however,
TechCos should consult their tax advisors before putting in place any
golden parachutes.

Employee Benefit Issues.
The parties should discuss how the acquisition will affect TechCo’s
health plans, profit sharing plans, bonus plans, employee loans, stock
options and other employee benefits. While LargeCos typically have more
complete employee benefits than TechCos, some TechCo perquisites, such
as generous car allowances and country club memberships, may be
discontinued. TechCo also should consider the tax ramifications to
employees of early option exercises. For example, employees may owe
alternative minimum tax on the difference between the fair market value
of TechCo’s stock on the date of exercise and the option exercise price
of incentive stock options exercised before an acquisition.

TechCo 401(k) Plan.
If TechCo has a 401(k) plan it should be reviewed carefully to
determine if there are unique features that should be carried over to
LargeCo’s 401(k) plan. LargeCos typically merge the plans and the
investment vehicles after the merger and transfer TechCo’s records for
its plan assets. Before merging the plans, LargeCo will want to verify
whether TechCo’s plan complies with the pension plan discrimination

Acquisition Structure

key issue is how LargeCo wants to structure the acquisition. For
example, does LargeCo want to acquire TechCo’s stock or its assets?
There follows a table and summary of possible acquisition structures
and their impact on key business considerations:

Table 3: Acquisition Structure Alternatives

Merger Asset Purchase Stock Purchase
What do you buy? TechCo’s stock Specified TechCo
assets & liabilities
Can LargeCo avoid TechCo liabilities? No Yes No
What TechCo shareholder approval is required? Typically
majority vote
majority vote
Must contract with each TechCo shareholder

In a merger, either TechCo or LargeCo (or LargeCo’s subsidiary) merges
into the other by operation of law, with TechCo’s shareholders
exchanging their shares for LargeCo shares. A merger is the simplest
mechanism for acquiring another company and results in LargeCo (or
LargeCo’s subsidiary) automatically receiving all of TechCo’s assets.
State merger laws typically require majority TechCo shareholder consent
to approve a merger. The law also provides a mechanism for cashing out
those TechCo shareholders who are unwilling to accept LargeCo stock in
the merger (dissenting shareholders). A drawback to using a merger is
that LargeCo (or its merger subsidiary) will automatically assume all
of TechCo’s liabilities. LargeCo can exchange its stock, promissory
notes or cash for the TechCo stock in a merger.

Asset Purchase.
If LargeCo wants to avoid unrelated TechCo liabilities, it may prefer
to acquire TechCo’s assets rather than merge with TechCo. Asset
acquisitions require that the parties specify the assets and
liabilities to be transferred and thus entail more due diligence and
transfer mechanics than a merger. LargeCo can exchange its stock,
promissory notes or cash for TechCo’s assets.

Stock Purchase.
LargeCo may want to purchase all of TechCo’s outstanding stock from
TechCo’s shareholders. This commonly occurs if TechCo has very few
shareholders or if TechCo or LargeCo is a foreign company that cannot
legally do a merger. Since LargeCo acquires all of TechCo’s stock,
TechCo remains in existence as LargeCo’s subsidiary, with all of its
assets and liabilities intact. One significant drawback to a stock
purchase is that, unlike a merger, the law does not provide a means of
cashing out large numbers of "dissenting shares" under a stock
purchase. Most LargeCos are unwilling to have minority shareholders,
which could occur if a TechCo shareholder refused to agree to sell his
or her shares to LargeCo on the offered terms. As a result, a stock
purchase is impractical if TechCo has either many shareholders or even
one shareholder with substantial holdings who strongly disapproves of
the acquisition.

Type of Consideration Used

consideration will LargeCo use in the acquisition? The most common
choices are cash (in a fixed amount or in an "earnout"), stock, debt
and assumption of liabilities. From LargeCo’s perspective, a cash
transaction is the simplest and fastest to accomplish, but it will
reduce the amount of cash available for other purposes. For TechCo’s
shareholders, a cash transaction offers maximum liquidity, but will be
immediately taxable (although installment treatment may be possible for
cash basis tax payers if the cash is to be paid over time). If they
believe LargeCo’s stock is a good investment, TechCo’s shareholders may
prefer freely tradable LargeCo stock. It is highly liquid, yet tax can
be deferred until it is sold. LargeCo may wish to pay with a promissory
note due over time. Using debt may permit LargeCo to defer the cash
drain for the acquisition until TechCo’s assets are producing the cash
flow with which to pay off the note. TechCo’s shareholders, receiving a
note on the sale of TechCo, may be concerned that LargeCo will be
unable or unwilling to pay off the note when it becomes due. Absent a
LargeCo with substantial assets, TechCo may insist that such a note be
secured by the assets sold to LargeCo. The following table summarizes
some of the key business considerations involved in selecting from
among the three most commonly used forms of acquisition consideration:

Table 4: Acquisition Consideration Alternatives

Business Considerations Cash Stock Promissory Note
How liquid is it? Most liquid Depends (whether stock is restricted or freely tradable) Not liquid
Can it be tax-free? No (but installment treatment may be available for cash basis tax payers) Yes (tax is deferred until the shareholder sells his LargeCo stock) Yes (tax is deferred until payments are made under the note)
What is the level of risk? No risk Depends (subject to LargeCo performance and market risk) Depends (subject to LargeCo credit worthiness)
What is the impact on transaction speed? Fastest Slowest (because of securities law compliance) Slower (because of securities law compliance)

Tax-Free Acquisition

completely "tax-free" acquisition is one in which TechCo’s shareholders
exchange their TechCo stock solely for LargeCo stock, or cause TechCo
to transfer its assets to LargeCo solely for LargeCo stock. The TechCo
shareholders will have the same basis in the LargeCo stock issued in
the merger as they had in their TechCo stock. Provided they receive
only LargeCo stock in the transaction, TechCo’s shareholders will pay
tax on the gain only when they sell their LargeCo stock. If TechCo’s
shareholders believe that LargeCo’s stock is a good investment,
converting their TechCo investment into LargeCo stock on a tax-free,
instead of after-tax, basis is beneficial. TechCo’s shareholders will
be currently taxed on any cash received.

The following table shows the matrix of possible tax-free acquisition structure alternatives and their impact on key business
considerations. Each alternative is discussed in greater detail below.

Table 5: Tax-Free Acquisition Structure Alternatives

Business Considerations Merger Asset Purchase Stock Purchase
How much stock must be used to have the stock received be tax-free?

Straight – 50% stock

Forward triangular – 50% stock

Reverse triangular – 80% stock

80% stock 100% stock
What is the surviving structure? (having a subsidiary means continuing administrative burden and liability insulation)

Straight – LargeCo holds
TechCo’s assets

Forward triangular – LargeCo’s subsidiary holds TechCo’s assets

Reverse triangular – LargeCo holds TechCo as a subsidiary

LargeCo holds
TechCo’s assets

LargeCo holds
TechCo as a

Who gets taxed if tax-free requirements are not met?

Straight or forward triangular – LargeCo & TechCo’s shareholders

Reverse triangular – TechCo’s shareholders only

TechCo and TechCo’s shareholders TechCo’s shareholders
What is the effect of doing a taxable deal on basis?

Straight or forward triangular – Step-up in basis of TechCo assets

Reverse triangular – Step-up in basis of TechCo stock

Step-up in basis of TechCo assets Step-up in basis of TechCo stock
How does LargeCo benefit from doing a taxable deal?

Straight or forward triangular – Greater depreciation on TechCo assets

Reverse triangular – Less gain if LargeCo sells TechCo stock

Greater depreciation on TechCo assets Less gain if LargeCo sells TechCo stock

following check list of key requirements for obtaining tax-free
treatment of an acquisition is for purposes of identifying areas of
concern only. Since these rules are dynamic and complex, you should
consult your tax advisor regarding the application of these
requirements to your company and facts.

To qualify as a tax-free reorganization under the Internal Revenue
Code, several requirements must be satisfied. Two of the more important
are that LargeCo must continue TechCo’s business in some form and
TechCo’s shareholders must not sell back their LargeCo shares received
in the merger to LargeCo after the acquisition (the "continuity of
interest" test). There are three ways of accomplishing tax-free

Merger. A merger can offer the most flexibility in structuring a transaction in a way that is tax-free to TechCo’s shareholders.
There are three types of mergers:

  • Straight Merger.
    In a straight merger, TechCo merges directly into LargeCo, with LargeCo
    surviving the merger. LargeCo ends up holding all TechCo’s assets and
    is liable for all TechCo’s liabilities. In a straight merger, at least
    50% of the consideration paid needs to be stock to get tax-free
    treatment for the stock received. A straight merger permits the most
    flexibility with respect to consideration.
  • Forward Triangular Merger.
    In a forward triangular merger, TechCo merges into a newly formed
    subsidiary of LargeCo, with LargeCo’s subsidiary surviving the merger.
    LargeCo’s subsidiary ends up holding all TechCo’s assets and is liable
    for all TechCo’s liabilities. As in a straight merger, at least 50% of
    the consideration paid in a forward triangular merger needs to be stock
    to get tax-free treatment for the stock received. In a forward
    triangular merger, TechCo’s liabilities are isolated in LargeCo’s
    subsidiary, without putting the remainder of LargeCo’s assets and
    business at risk.
  • Reverse Triangular Merger.
    In a reverse triangular merger, a newly formed subsidiary of LargeCo
    merges into TechCo, with TechCo surviving the merger. Since TechCo
    survives the merger, it retains all its assets and liabilities without
    any need to have them assigned to LargeCo or LargeCo’s subsidiary. A
    reverse triangular merger frequently is used when critical TechCo
    contracts or licenses have nonassignment provisions, and there is real
    concern that consent will not be granted or will be granted only after
    extorting additional consideration from LargeCo. LargeCo also may
    propose a reverse triangular merger in some cases if it believes that
    the merger may fail to qualify as a tax-free reorganization. If that
    happens in a reverse triangular merger, there will be a tax risk only
    to TechCo’s shareholders. If it happens in a straight or forward
    triangular merger, LargeCo must pay TechCo’s corporate level tax too.
    For example, if TechCo had a basis in its assets of $2 million and was
    sold to LargeCo for $40 million, LargeCo could be faced with tax
    liability on $38 million of gain. Thus, if LargeCo is paying a high
    price for a TechCo with a low basis in its assets, it may view the
    reverse triangular merger as having significantly less tax risk. For a
    reverse triangular merger to be tax-free with regard to the stock
    received, at least 80% of the total consideration paid must be stock
    and TechCo must retain substantially all of its assets.

Stock for Assets Acquisition.
In a stock for assets acquisition, LargeCo issues its stock to TechCo
in exchange for substantially all of TechCo’s assets. If the desired
assets make up substantially all of TechCo’s business, LargeCo can
avoid acquiring strategically irrelevant operations that it does not
want, as well as unrelated TechCo liabilities. LargeCo can offer cash
and assumed liabilities for nearly 20% of the total consideration paid
and still have TechCo receive the stock portion on a tax-free basis.
TechCo must liquidate and distribute LargeCo’s shares to its
shareholders to avoid corporate and shareholder level tax. LargeCo may
prefer a taxable, instead of tax-free, acquisition of assets. A taxable
asset purchase gives LargeCo a "step-up" in the basis of TechCo’s
assets to their current fair market value. In a tax-free transaction,
these assets are carried over to LargeCo’s balance sheet with the same
depreciated value at which they were carried on TechCo’s balance sheet.
Thus, a taxable asset purchase provides LargeCo with larger tax
deductions for depreciation (of tangible assets) and amortization (of
intangible assets) than are available under a tax-free asset purchase.
Of course, in a taxable asset purchase TechCo must pay corporate level
tax on the sale and TechCo’s shareholders must pay tax on the
consideration distributed to them. This is not a problem if TechCo has
a net operating loss (NOL) greater than the purchase price and if the
purchase price is less than the amount the TechCo shareholders invested
in TechCo. In that event, there is no gain, and no income or capital
gains tax would be due. The transaction still would be subject to sales
tax, however.

Stock for Stock Acquisition.
In a stock for stock acquisition, TechCo’s shareholders exchange their
shares solely for LargeCo’s stock. After the exchange, LargeCo must own
at least 80% of TechCo’s stock. Since only LargeCo stock may be used,
stock for stock acquisitions are the least flexible in the type of
consideration that may be used.

Acquisition Accounting

June 29, 2001, The Financial Accounting Standards Board (FASB) adopted
Statements of Financial Accounting Standards No. 141, Business
Combinations and No. 142, Goodwill and Other Intangible Assets.
Statement 141 eliminated pooling accounting for acquisitions unless
they were initiated prior to July 1, 2001. An acquisition is deemed
"initiated" once the companies are in price negotiations. Statement 142
changed the rules on amortization of intangibles. Under Statement 142,
intangibles such as patents, copyrights, etc. will continue to be
amortized over their life, but goodwill is no longer subject to
amortization. Instead, goodwill must be reviewed annually, or more
frequently if impairment indicators arise, for impairment and if
goodwill is found to be impaired it must be written down to the extent
of the impairement. Acquisitions initiated after July 1, 2001 must be accounted for as a purchase, but the goodwill will not have to be amortized.

until June 30, 2001, many LargeCos preferred to have an acquisition
accounted for as a "pooling" instead of a "purchase." Prior to that
date, in a tax-free merger accounted for as a purchase, the income
statements of TechCo and LargeCo were combined only after the closing
of the acquisition. TechCo’s assets were recorded on LargeCo’s balance
sheet at their fair market value on the date the acquisition was
consummated. The difference between the price paid by LargeCo and the
net book value of TechCo’s assets was treated as goodwill, which was
then amortized as expense against LargeCo’s future income creating a
"hit to its earnings," without a corresponding tax deduction. Purchase
accounting was generally not desirable when acquiring TechCos because
much of their value relates to their technology that has little, if
any, book value. Since TechCos tend to expense the vast majority of the
money they expend on technology development, these valuable assets
generally are carried at very low balance sheet values, resulting in
large goodwill charges that would reduce the LargeCo’s earnings for
many years to come.

pooling accounting, the historical financial statements of LargeCo and
TechCo were combined and restated as though the two companies had
always been one. TechCo’s net asset values were not revised. They were
carried over onto LargeCo’s balance sheet at the same value at which
they had been carried on TechCo’s balance sheet. No goodwill was
recorded and therefore none needed to be amortized. There was no "hit
to LargeCo’s future earnings."

There were significant structuring drawbacks to using pooling accounting. Among the pooling restrictions:

  • the transaction had to be solely for common stock of the acquirer,
  • no more than 10% of the consideration could be paid out for fractional shares and dissenters,
  • the target could not change its equity structure in contemplation of the transaction,
  • no more than 10% of the consideration could be held in escrow to indemnify the acquirer for breaches of general representations
    and warranties;
  • the escrow had to terminate at the earlier of the first audit (for items covered by audit) or one year from closing;
  • affiliates of both companies were prohibited from selling shares from a period beginning 30 days prior to closing until the
    release of financial statements containing at least 30 days of combined operations; and
  • no other restrictions on resale or voting could be imposed on shares issued to the target.

the elimination of pooling, companies have much more flexibility on how
they structure their transactions. Targets can reprice options, cut
special severance, vesting or compensation deals with executives, or
negotiate a partially stock and partially cash transaction for example.
Acquirers can impose resale restrictions on stock, or require larger
escrows and hold the escrowed shares for a longer period. Affiliates of
neither the target or the acquirer will be subject to the pooling

Troubled Company M&A Issues

often occur during a down-turn in the economy or when TechCo’s
valuation is depressed or it is near insolvency or bankrupt. While
these circumstances create a myriad of other issues, the following
section addresses two of the most common: how does TechCo keep its key
employees motivated to help sell the company and what structure should
be used to acquire a TechCo near insolvency?

Employee Incentive Issues

The Problem.
A TechCo that was venture backed may find that the total liquidation
preferences required by its charter to be paid to the holders of the
preferred stock on an acquisition exceed any reasonably expected price
that could be offered for TechCo. For example, a company might have
raised $50 million in invested capital, yet only be worth $10 million.
Employees realize that if the purchase price is allocated in accordance
with the preferred stock liquidation preferences, they, as holders of
common stock, will receive nothing in the acquisition. Management
becomes demoralized and may be unwilling to support an acquisition that
will only benefit the holders of the preferred stock. This conflict
could stall or even foreclose acquisition negotiations.

The Solution.
TechCo can solve this problem by creating a cash or stock bonus plan or
by doing a recapitalization. Frequently, a cash retention bonus plan is
the simplest solution. There follows a table and summary of major
considerations in adopting key employee incentive plans:

Table 6: Employee Incentive Plan Alternatives


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