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M&A Process: Best Practices for the Corporate Counsel
Paul Glaser Cisco Systems, Inc. - Corporate Development
Mark Gorman Cisco Systems, Inc. – M&A Legal Services
Doug CogenFenwick & West LLP – Co-Chair, M&A Group
June 17, 2008
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Agenda
M&A Process and Documentation Overview
Key Transaction Structuring Issues
Due Diligence
• Diligence Process Best Practices
• Key Diligence Issues, by Subject Area
1917336
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Process StageProcess StageM&A Process/Documentation Overview
Initial Contacts
Transaction Structuring
Due Diligence
Transaction Documentation
NDA / No Shop Agreement / Standstill
Term Sheet
Diligence Requests / Materials / Analyses
• Priority Due Diligence Items Request• Comprehensive Due Diligence Request• IP and other Subject Matter Questionnaires• Follow-on Due Diligence Requests
Definitive Agreements
• Acquisition (Merger, Asset Purchase, Stock Purchase)
• Escrow
• Voting
Disclosure Schedules
Employment
• “Key” Employment Agreement / Offer Letter• Non-Competition Agreement• Re-vesting Agreement
DocumentationDocumentation
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M&A Process/Documentation Overview (cont’d)
Pendency
Closing
Post-Closing
Permit Application / Fairness HearingS-4 Registration StatementHSR, Foreign Antitrust and Other Regulatory FilingsThird Party ConsentsStockholder ApprovalsBroader Employee Group DocumentationIntegration Planning (Observe HSR Timing)
Closing CertificatesLegal/Tax OpinionsOption Assumption/Grant AgreementsContract Amendments/TerminationsEscrow Agreement, etc.
“Clean Up” Documentation (i.e., Confirmatory IP Assignments)
Integration
• Partner & Customer Outreach
• Employee Communications
• Physical Property Management
• Finance and G&A Integration
• IT/Systems Transition
Contract Assignments / Transfers / Amendments
Process StageProcess Stage DocumentationDocumentation
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Key Transaction Issues
Structure
• Asset Purchase / Stock Purchase / Merger / Tender or Exchange Offer
– Scope of Acquisition
– Liability Isolation / Management
– Tax Treatment (Target, Target Stockholders, Acquiror)
– Number and Type of Target Stockholders
– Securities Law Compliance (Private Placement / S-4 Registration / Sec. 3(a)(10) Fairness Hearing
– Target Contract Assignment Issues
– Hostile Transaction Issues
• Public or Private Acquiror / Public or Private Target
Consideration
• Form: Cash / Stock / Debt
• Purchase Price Adjustments: Enterprise Value (cash v. debt only) / Net Working Capital / Transaction Expenses
• Earnouts
• Treatment of Target Equity Incentives: Assumption / Substitution / Cash-Out / Termination
• Additional Employee Payments / Equity Incentives / Retention Bonuses
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Key Transaction Issues (cont’d)
Deal Lock-Ups and Fiduciary Matters
• No Shop / Go Shop
• Fiduciary Right to Change Board Recommendation
• Fiduciary Termination Right
• Scope and Number of Voting Agreements / Proxies
• “Crown Jewel” Options, Licenses
Employee Matters
• Key Employees (Commit at Signing)
– Non-Competition Agreements
• Broad Employee Retention Closing Condition
• Employee Benefit Matters
Regulatory Matters: Antitrust “Efforts” and Closing Condition
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Key Transaction Issues (cont’d)
Key Closing Conditions • Stockholder Approval[s]
• Regulatory Clearance
• No Material Adverse Effect
• Rep & Warranty “Bring Down”
• Employee-Related Conditions
• Third Party Consents
• No Litigation
Indemnification / Escrow • Survival of Reps Period
– “Special/Fundamental” Reps
• Other Indemnified Liabilities
• Liability Cap
• Size of Escrow
• “Baskets” and Deductibles / “Mini-Baskets”
• Control of Defense of Third Party Claims
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Due Diligence
Detailed investigation of acquisition Target
• Confirm, revise valuation
• Plan / revise integration plan
• Protect against liabilities (structural changes and indemnification terms)
• Tune conditions to closing (permit termination)
Covers key business and operations, and integration issues
Team approach – across disciplines
• Business / Technical / Operations
• Financial / Accounting / Tax
• Legal
– Corporate
– Legal Compliance
– Commercial
– IP
– Litigation
• Employment / HR
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Due Diligence Process
Start early, to help shape the deal value, terms, protections
Know what you’re looking for; try to avoid surprises
Diligence is an iterative process
• 1. Get context through business unit discussions and Target officer interviews; 2.Review documents; 3. Ask follow-up questions; 4. Consider solutions
– Provide regular updates throughout
• Keep the entire organization informed and aligned
– Watch out for information ‘imbalance’
– Discuss solutions at every stage
– With proper updates, any summary at the end should be redundant
– Diligence and integration should be continuous and seamless
– Diligence output/reporting must be useful and usable after the closing
• Diligence, Representations and the Disclosure Schedule must reflect each other and be re-tuned throughout the deal process
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Due Diligence Process
Target’s Disclosure Schedule
Acquisition Agreement
Reps + Warranties
‘Special’ Indemnities
Issues found in diligence should match Target’s
Disclosure Schedule (“N
o Surprises”)
‘New’ issues and docum
ents disclosed in schedules
need to be diligenced
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Reps support value and define liabilities, set scope for Disclosure Schedule
Disclosure Schedule modifies Reps unless limited for ‘informational purposes only’
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Business/Technical/Operations
Integration Plan
What is Acquiror’s goal?
• Expand product offering? Grow into a new or adjacent business? Acquire engineering or sales talent?
Key personnel
Customer base, channel overlap?
Asset values
Market position
Quality of technology and products
Synergies with Acquiror
• Revenue synergies and dis-synergies
• Cost synergies
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Financial/Accounting/Tax
Key Balance Sheet Items:
• Amount of liquid assets
• Inventory – book to physical, reserves
• Significant creditors / Long-term liabilities
• Unfunded employee benefits?
• Amount of capitalized R&D
• Aging of receivables
Statement of Operations:
• Operating trends
• Revenue recognition policy
• Margins (by product line)
• Operating costs
• NOL carryforwards
• Internal controls and systems
• Audit
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Additional Accounting/Tax/ERISA Issues
Aggressive tax planning and transfer pricing
• Incorrect reporting positions
• Sales and use (often issues in early-stage companies)
• NOLs
83(b) (taxability of vesting equity)
Quality of balance sheet
Earnings management / revenue recognition issues
Revenue forecasts and lack of historical information
Contingent liabilities
Tax liabilities / liens
Poor internal systems and controls (S-OX integration plan)
Adequate reserves, properly booked: A/R, inventory, warranty
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Corporate - Capitalization
Preferred Stock rights, esp. those triggered by M&A
Authorized and outstanding stock, options, etc.
Tie Board approvals, issuances, transfers and cancellations to capitalization and financial statements
Confirm that contracts or Board approvals to issue shares or rights to shares are reflected in cap table
Understand terms of option plan and any non-plan options
Are optionees bound by acquisition terms?
Equity claims by former employees?
Vesting
• Acceleration upon M&A event
• Accounting issues
• Retention issues
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Corporate - Contracts & Debt AgreementsReview material contracts
Is Target in default?
Determine scope of Target’s rights• Sufficient for business as conducted? As proposed to be conducted?
Determine scope of Target commitments & liabilities and any restrictions on Target’s business
“Most favored customer” clauses
Exclusivity terms / Fields or scope of use for key rights
Remaining term of key contracts
Customer support obligations
Channel issues
Is contract assignable?• Does transaction constitute an “assignment”?
Debt agreements: prepay or leave in place?• Insider loans, bank lines, vendors, etc.
• Understand key terms: interest rate, maturity, status of collateral, prepayment penalties, etc.
• What obligations must be satisfied at close vs. over several years
– Fixed-term real estate leases
• Tax issues for Acquiror, acquisition sub
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IP Overview
Identify the key IP assets of the business
Inbound: What Rights Does Target Have?• Ownership vs. License
• Assignments / Employee Invention Assignments / Consultant Agreements
• Inbound Licenses (e.g., redistributed technology; development and support tools, general use/infrastructure)
• Business partners: Joint Development / Acquisitions / Inter-Company Agreements
• Supply chain: Suppliers / Vendors / Manufacturers
Outbound: How Has It Been Exploited?• Direct Customer Agreements: Software Licenses / Beta/Eval Licenses / Product Sales /
Professional Services / Support & Maintenance
• Source Code Escrows
• Government Contracts
• Product Warranties
• Channel Agreements: OEMs / Sales Reps / Distributors / Resellers
How Has It Been Protected?• Patent, copyright, trademark, trade secret protection
Are There Risks To Value?• Liens, litigation, clouds on title, questions of validity, non-transferability
• Privacy, open source, export restrictions, university/gov’t rights, int’l law
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IP - Inbound
Identify Target core IP / Confirm Chain of Title• Briefing from business and technical teams
• Target responses to the IP Questionnaire
• Identify what is owned vs. licensed
• Open Source use / exposure
• Confirmatory assignments
Identify all contributors to core Target IP• Employees, Consultants, Acquisitions, Joint Development, Inbound Licenses
(including Open Source licenses), Patent Licenses or Cross-Licenses
Ensure license rights are adequate for Target’s business as presently conducted and as proposed to be conducted by the client
• Discuss client’s plans for business with team
Licenses• Will Target licenses cover Acquiror?
• Will Acquiror licenses cover Target?
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IP - Outbound
Identify all outbound agreements and rights granted and identify:
• Exclusive rights granted
• Unfavorable terms
• Provisions inconsistent with client’s practices
Identify all obligations to be assumed by client and determine if any are inconsistent with plans for the business
Determine whether client’s IP will be encumbered by Target agreements
• IP portfolio caught by cross-license?
Source Code
• Identify license rights granted by Target
• Review source code escrow release triggers
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Litigation
Who is Target suing? Who is suing them? Who is threatening/could potentially sue them?
• Acquiror friends/foes
• Acquiror’s supply chain partners
• SEC / DOJ
• Employees: Employer liability, non-solicitation agreements
Diligence review
• Review notices of claims / potential claims & related correspondence
• Review pleadings and briefs
• Review insurance correspondence
• Interview Target’s litigation counsel
Likelihood and amount of exposure
Importance to Target’s business
Costs of prosecution/settlement– compare to size of the deal
Is litigation indicative of future patterns of liability associated with Target’s business?
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Employment Agreements
“Map” employment/compensation terms against Acquiror’s HR policies
• “Integration/reconciliation” model or “stand-alone sub” model
Review agreements for acceleration provisions for equity awards
Review agreements for severance and deferred bonuses
Review “Cause” and “Good Reason” definitions in context of planned integration
Review agreements for 280G tax gross-up provisions
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Section 409A
Aimed at limiting ability to control timing (i.e., deferring) of when a person will be taxed on compensation. Generally applies wherecompensation “vests” in one year but becomes taxable in a different year
If forms of deferred compensation are not 409A-compliant, the recipient is subject to a 20% federal excise tax and the amount of deferred compensation is deemed to be wages and subject to withholding taxes by the payor
Documentary and operational compliance required January 1, 2009 (until December 31, 2008, good faith compliance has been required)
Three common areas in M&A transactions where one encounters 409A:
• Stock Options
• Employment Agreements
• Nonqualified deferred compensation plans (SERPs, top-hat plans)
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Section 280G (Golden Parachute Payments)
Code Sections 280G and 4999 deny a corporate tax deduction and impose a 20% individual excise tax with respect to “parachute payments” upon a change of control
A parachute payment exists if payments are (1) made to a disqualified individual, (2) are contingent on the change in ownership or control, and (3) such payments collectively equal or exceed three times the individual’s “base amount” (average 5-year compensation)
Disqualified individuals: officers (rule of thumb, VPs and above, but based on facts and circumstances), 1% shareholders (includes vested options), and highly compensated individuals (lesser of highest paid 1% or 250 highest paid employees)
Private deals: 70% of disinterested shareholders can vote to approve (or disapprove) the payments. If approved, the shareholder vote cleanses the payments.
• Recipient of parachute payment must agree to waive right to receive excess over 3x prior to vote
• Can’t condition deal on approval of the 280G shareholder vote
• Must provide all shareholders the ability to vote
• An information statement describing the payments is provided to shareholders in connection with the vote
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Other Subjects for Diligence
Other Target Assets
• Lien searches (obtain pay-off letters and lien releases for closing)
• Security agreements
• Leases
• On-site inspections
• Off-site assets
Environmental Issues
• Does Target own real estate?
• Use of Target’s facilities
• Liability for prior owners & operators
• Involve environmental consultants
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Key Transaction Documents
Merger/Asset Purchase/Stock Purchase Agreement
Ancillary Agreements (negotiated with Acquisition Agmt)
• Escrow Agreement
• Voting Agreement
• Employment / Non-Competition Agreements
• Stock (Vesting) / Option Agreements
• Benefits/Acceleration Waiver
• Parachute Payment Waiver
• Shareholder Representation Agreement (Private placement of stock)
Other Closing Documents
• Legal, Tax Opinions
• Certificate/Agreement of Merger
• Target Contract Consents/Amendments/Terminations
• Target Equity ‘Spreadsheet’