This is a guest post by Aaron Woo of Vanguard Legal. Licensed to practice law in Texas, Aaron is a Vixul partner helping some of our portfolio companies. Aaron has graciously volunteered to write a two-part series of guest posts to help the founders of tech services founders understand the legal aspects of going through an M&A. This first part will talk about what you need to fix right now to ensure a smooth M&A transaction. The second part will discuss the legal actions taken at the time of a transaction. Please note that this article does not constitute legal advice. You can read the second part here.
Selling or acquiring a company can be a daunting process which can seem overwhelming at times. To simplify the mystique of the closing process, it is simply a mechanism for the buyer and seller:
(i) to agree on a fair price for the business based on key assumptions and affirmations regarding the condition of the Company; and
(ii) to allocate pre and post-closing risk and uncertainty.
Even though a sale may not be on the horizon for you, you have to work today to make sure you don’t have issues in the future. This includes reducing risk by having the right contracts in place and not entering into agreements that can compromise the condition of the company to a buyer.
Here is what a tech services founder needs to fix today before it becomes a problem in the future.
Incorporation Agreements
The most important documents during the M&A transaction are the incorporation agreements, which include the by-laws, certificate of incorporation, minutes, and shareholder agreements, among others. (Editor’s note: You can read more on these agreements on the Vixul blog.) These agreements define the rules for any sale of shares.
Some of the salient points to watch out for in your incorporation agreements are:
Capital Structure
Buyers will want to inspect the company's organizational documents to understand its existing ownership, voting, and economic structure. They also need to understand if they will face a “ghost shareholder” problem because of undocumented promises of equity. The Incorporation Agreements will also determine if and how the proceeds from Closing are paid to the existing equity holders and address any tax consequences that arise.
ROFR, ROFO
Prior to closing, sellers will also need to ascertain that current equity holders do not have any “Rights of First Refusal” (ROFR) or “Rights of First Offer” (ROFO) that need to be exercised or waived prior to the sale of company equity to a third-party buyer. An ROFR/ROFO allows existing equity owners the right to acquire any shares of the company before it can be offered to a third party. However, the pricing of the shares can be affected depending on whether an owner is granted an ROFR versus an ROFO.
Drag-Along, Tag-Along, Pre-Emptive Rights
If only a portion of the company will be sold, the sellers must ascertain whether "tag-along" rights can be triggered by the minority owners or “drag-along” rights can be exercised by the majority shareholders. Tag-along rights protect minority owners from being left behind if the majority owners decide to sell their equity, while drag-along rights allow majority owners to compel minority owners to sell their shares in the event a buyer wants to acquire the entire company.
Additionally, the seller will also need to confirm whether any "pre-emptive" rights can be invoked by any current owners who remain with the company to protect against any unauthorized dilution of their ownership.
Waivers of Consents
If all the owners agree to proceed with closing, they can simply "waive" their ability to invoke any of the rights prescribed to them in the organizational and governance documents.
Current with Legal Requirements (taxes, licensing needs)
Good Standing
Buyers will require that the entity they are acquiring has not lapsed because it has not paid state taxes. Otherwise, there may not be an actual entity to buy equity in or buy assets from.
Governmental Licenses
All licenses and permits required to run the business must be effective. Buyers usually require that all expiration dates of such licenses and permits be identified. Any licenses or permits that have lapsed will usually need to be current prior to closing.
Most Favored Nations
This provision allows a customer who gets the best pricing offered to any customer in the company’s customer base. Most acquirers will require that the company identify Customers who get such preferential pricing treatment. Buyers generally do not like MFN provisions because it restricts their ability to adjust pricing, especially for larger, long term customers. Additionally, MFN provisions are problematic because it may be deemed a restraint on trade and therefore increase anti-trust scrutiny.
Non-competes
The Buyer will want to know if the target is bound to any non-competes which may restrict how the company operates and interfere with the buyer’s plans. Non-Competition restrictions on the Company are problematic because they can eliminate the business from important markets and revenue streams the buyer plans to enter. If the buyer discovers that the company is subject to a non-compete which interferes with their strategic markets, this could ultimately result in the diminution of the purchase price, or worse yet, termination of the deal.
Consent of Customers
Some customers in their MSAs will require a consent or notice for an M&A event. The customer may have concerns about business continuity. “Consents” are contractual provisions that require the company to obtain a customer’s permission before a certain event can happen whereas "Notices" are usually formal announcements that inform the customer that a certain event will occur.
In the event that the company is sold, the “assignment” provision in a contract will determine whether a consent or notice is required. Additionally, whether the deal is structured as an “asset purchase” or a “stock purchase” will determine whether an “assignment” has occurred (in the case of an asset purchase) or “change of control” (in the case of a stock purchase) thus triggering any notice or consent requirements.
However, these provisions may be buried in any of your contracts, not just your customer contracts. As such, you’ll want to review your material agreements, such as vendor agreements, leases, licenses, and financing documents to determine which one of these requirements is applicable.
IP Assignments
The company’s ownership of intellectual property is important, especially for those that offer technology goods and products. It is imperative that all personnel (founder, employees and contractors) who were involved with the development or the engineering of the company’s products sign “IP Assignments”. These personnel should also sign Non-Disclosure Agreements which prevent them from using any of the company’s technical information or knowledge elsewhere in competition with the Company.
Missing IP Assignments are problematic because they create uncertainty as to whether the Company actually owns the IP, and uncertainty in IP ownership can affect the purchase price that a buyer is willing to pay. Buyers will normally require the seller to obtain all missing IP assignments prior to Closing, but at this point, the personnel whose signature is being obtained may demand additional compensation for the IP assignment.
Wrapping Up
These issues should be fixed now and maintained for the lifetime of your tech services business. You should address them as soon as possible because the longer you keep them unresolved, the harder it is to fix them.
What happens if something is not correct? It doesn’t always mean that the deal will collapse. However, the buyer may ask for various warranties and representations back by escrow to clear the issue. Hence in the second part of this series, we will discuss the legal implications at closing time. Please subscribe to stay updated.
This article is not legal advice.