Minding your M’s and A’s:
Tips on Laying the Groundwork for Successful Mergers & Acquisitions
One of the greatest opportunities to be of strategic value to your company is during a merger or acquisition. Before the transaction even reaches the gate, questions will come flying from the executive team. Showing your poise and tying your input to dollars in the transaction will help you influence the outcome and ultimately help your company either save or earn money.
The first step in any merger or acquisition is due diligence—the time when a company’s warts, wrinkles, and skeletons in the closet are uncovered. As in-house counsel, knowing areas to target (or on the flip side, which areas will be targeted) will ultimately save the company time and money. When anticipating due diligence, put yourself in the shoes of a prospective buyer or acquirer. What would you need to know about this company? What are the shortfalls of the targeted industry? What is the potential liability exposure?
During this phase, you will need to consider and address the following key items and subject matter: articles of incorporation or organization, bylaws, operating agreements, shareholder agreements, financial statements, commercial contracts, permits and licenses, leases, employment and labor-related agreements and policies, inventory lists and valuations, deeds, warranties, intellectual property protections, environmental assessments, software licenses, inventories, budgets and forecasts, bank records, tax returns, and insurance policies.
Preparing for due diligence now and simply being organized moving forward will not only protect you and the company, but also enable you to provide a tremendous value-add. Some simple steps that you can take now include: updating the capitalization table, establishing a baseline understanding of general purchase agreement terms, and knowing how to recognize tax consequences resulting from various deal structures.
Update the Capitalization Table
A capitalization table (aka, cap table) shows the breakdown of ownership in the company. This seemingly simple excel file can be a source of immense conflict and, at times, may even cause the death of potential transactions. Yet, despite its importance, cap table maintenance is often ignored.
Whether you are finally building a cap table from scratch or doing a self-audit, make sure to keep an eye out for some of the more common mistakes, such as:
- Focusing on Percentages Instead of Shares
This is the classic error. From our youth, we are trained to think in percentages when dividing things, so it is only natural for people to focus on their percentage ownership instead of their actual share count. While talking in percentages helps people conceptualize their slice of the pie, it paints a false picture. Ownership breakdown is continuously changing as the company continues to evolve. As a result, due diligence often uncovers a difference between what was papered and management’s general understanding of who owns what. Train executives and directors to think in shares instead of percentages to avoid confusion and conflict.
- Failing to Account for All Equity
Not all equity is granted in the same manner. Often cap tables are missing convertible equity, stock options, and phantom equity payouts, as well as their associated discounts, redemption clauses, and vesting schedules. This leads to surprise and confusion when shareholders catch wind of their fully diluted percentage ownership. Ensuring your team understands the differences and merits of various equity grants, along with how they operate, will help management strategize properly.
- Failing to Keep the Paper Trail Updated
As a company grows and valuations change, some of the simplest misses can yield extremely time-consuming fixes. While it is easy to ignore that rainy day “To Do” list and instead focus on daily fires, which will only lead to headaches down the road. Carving out a couple of hours each month to tackle these easy front-end fixes will ensure that documents are properly signed, necessary approvals were recorded, and the paper trail matches the reality.
Establish a Baseline Understanding of General Purchase Agreement Terms
Familiarizing yourself with a purchase agreement’s structure and possibilities will help reign in outside counsel’s costs and allow you to better advise (and set reasonable expectations for) your company. Generally speaking, a purchase agreement is broken into three main parts:
- The Deal Structure
Is this a merger? Asset purchase? Stock purchase? Which company will survive? How will the seller be compensated? With stock? Cash? A combination? When will the deal close? When the purchase agreement is signed? Or will there be a delayed closing at a later date? Will part of the purchase price be held in escrow in case of a breach? If so, when will that amount be released?
- The Representations, Warranties, and Covenants
The representations, warranties, and covenants provisions account for the majority of the language in a purchase agreement. These provisions are intimately linked to what was uncovered during due diligence. If you are the seller, tailor the representations, warranties, and covenants affirmed by your company to fit the transaction (for example, if the transaction does not involve real property avoid warranting compliance with environmental laws) and redline as necessary to ensure accuracy (e.g., avoid overly broad language). If you are the buyer, identify those issues raised during due diligence and make sure the language is broad enough to encompass any concerns.
- The Termination or Breach Provisions
Develop a game plan in case the deal goes south. For example, consider holding part of the purchase price in escrow to ensure post-closing covenants are completed as promised. If a party fails to follow through, at least your company will receive some sort of remuneration. For some deals, it may be appropriate to incorporate a provision that contemplates how to unwind a deal should company integration fail. In deals where the buyer was selected from among multiple offers, it is common to have a termination fee if the deal does not close in the prescribed time.
Recognize Tax Consequences Resulting from Various Deal Structures
It is inevitable that your company, overcome with excitement around a new deal, will want to race to the finish line. This enthusiasm can push a company to sign a letter of intent (LOI) before considering the tax consequences of the deal, ultimately creating traps down the road. As an in-house attorney, knowing when to raise the red flag and consult a tax professional may save your company from significant tax liability. Common areas where tax penalties may arise include valuation, warrants and phantom equity, and purchase price allocations (in an asset sale).
Whether you expect to be a buyer, a seller, or a survivor, the best time to prepare for your company’s merger or acquisition is now. Knowing what lies ahead and building in certain efficiencies will allow you to respond quickly, impress suitors, and ultimately increase your company’s valuation. It’s common sense and good business.
As a Portland business attorney, Liz assists her clients with securities matters, mergers and acquisitions, and day to day legal needs.[hr]
Carl Sniffen is an Oregon attorney who has spent decades representing the needs and interests of Oregon businesses including start-ups, growth-stage companies, and mature companies.[hr]