INTRODUCTION TO DRAFTING THE CONTRACT: · PDF fileINTRODUCTION TO DRAFTING THE CONTRACT: ......

Copyright © 2010 by K&L Gates LLP. All rights reserved.

Sandy K. FeldmanPartner, New York

January 19, 2012

INTRODUCTION TO DRAFTING THE CONTRACT: ELEMENTS OF ACQUISITION/SALES AGREEMENTS

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Contents PageStructuring Acquisitions

Preliminary Planning

The Sale Process

Due Diligence

The Acquisition Agreement

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Structuring Acquisitions

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Structuring Acquisitions

Three Alternative Structures� Stock Purchase Agreements� Asset Purchase Agreements� Merger Agreements

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Stock Purchase Agreements

Result:P Shareholders T Shareholders

[now has purchase price]

P

T

P Shareholders T Shareholders

P T

Purchase Price

Stock

Stock Purchase

5

Asset Purchase AgreementsAsset Purchase:

Result:


T[now has purchase price

and retained assets, if any]

P[now has purchased assets]


TPPurchase Price

Assets

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Merger AgreementsMerger (Reverse Subsidiary)

Result:P Shareholders T Shareholders

[now has merger consideration]

P

T


P

PS

TMerger

Consideration

Merger

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Key Considerations

� Liabilitiesa) litigation, tax, environmental, pre-closingb) successor liability

� Third party consentsa) leases, licenses, customer contracts, etc.b) government permits and licenses

� Tax considerationsa) NOLs, sales and transfer taxes, foreign based incomeb) Step-up in asset basis – IRC 338(h)(10)

� Real estate issuesa) benefit of the recording statute

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Key Considerations (cont’d)

� Employee issuesa) Retirees/pension liabilities, active/disabled employees,

employee claimsb) Union agreements

� Conveyance of certain assetsa) e.g., foreign patents and trademarks

� Who should be the seller (e.g., credit issues)?� Accounting Treatment

a) Recap accounting� Insurance

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Stock Purchase Agreements

� Assumption of all liabilities, including unknown and contingent liabilities of acquired company

� Acquirer does not get a stepped up basis in target’s assets, unless Section 338(h)(10) election is available

� Joint and several liability issues� Not easily used to acquire 100%

of a company with many shareholders or with shareholders who refuse to sell (e.g., dissenting family stockholders)

� Corporate franchises, permits, licenses, and local qualifications to do business generally remain intact

� Minimizes third party consents

� No sales tax or bulk sales issues

� If Section 338(h)(10) election is available, can get asset step-up

Stock PurchaseDisadvantagesAdvantagesForm

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Asset Purchase Agreements

� Significantly higher tax burden on seller� Must make separate provision for

individual assets and liabilities� Corporate franchises, licenses, permits

and qualifications to do business must be renewed

� Often requires more third party contractual consents than other types of transactions

� Transfer taxes and recording fees for real estate

� Strength of indemnity protection – what if selling company distributes all of the sale proceeds?

� Very rare in public company context due to tax inefficiency and residual liability issues for the Seller

� Take assets free of liabilities unless specifically assumed

� Can select particular corporate assets for purchase

� Acquirer gets stepped-up tax basis in target’s assets

� No minority investors� Does not require shareholder

approval unless sale of substantially all assets

� No joint and several liability issues

� No liability for prior income taxes

Asset PurchasesDisadvantagesAdvantagesForm

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Merger Agreements

� Assumption of all liabilities, including unknown and contingent liabilities (parent is protected in case of triangular merger)

� Tax basis of assets depending on structure

� Joint and several liability issues� Appraisal rights� Shareholder litigation of unfair

process

� Can squeeze out minority or dissenting shareholders

� Simple documentation� Clears up stock title issues� May be tax free� Tax basis of assets depending

on structure (equivalent of 338(h)(10))

MergersDisadvantagesAdvantagesForm

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Procedural� Assemble team of company management and legal

and other professional advisors� Working Group List� Contacts Distribution List� Obtain press and other background on the industry and parties

Substantive� Does Hart-Scott-Rodino apply ($63.4 million minimum), other

time-consuming regulatory approvals/procedures?� Committee on Foreign Investment in the United States ("CFIUS")

—"national security"; "critical infrastructure ... whether physical or virtual ..."

� Regulated industry approvals?

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Preliminary Planning (cont’d)

General� Before commencing the negotiation of a transaction,

whether through a proposal or a definitive agreement, determine what are the client’s objectives

� What is the client’s leverage based upon knowledge of the seller and the process?

� Determine what information is needed to make quality decisions

a) Determine how to use leverage to achieve primary objectives

b) Is competition likely?c) How quickly should the transaction proceed?

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� Employee Issues� Retention in light of potential sale� Contact with potential buyers

� Clear identification of what is to be sold� Has the business historically been run on a stand-

alone basis

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� Seller documentary preparation/preparation of schedulesa) auction vs. “one-off” dealb) are enough employees “in the know” to prepare schedulesc) schedules as source of due diligenced) appetite of Seller for representations/indemnification

� seller favorable drafting or “middle of the road”e) form of consideration/tax issues

� cash� stock� notes� liquidity issues � tax planning� securities laws

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� Drafting process� Accounting� Audited financial statements

� are they available?� will buyer need them for own SEC reporting

purposes?

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The Sale Process

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The Sale Process

� Engagement Letter� Auction Procedures� Confidentiality Agreements� Offering Memorandum� Letters of Intent and Agreements in Principle� Term Sheets and Offer Letter

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Engagement Letter with Financial Advisor

� “exclusive” financial advisor� scope of assignment� calculation of fee

� cash received by seller� debt assumed by buyer� other consideration

� termination tail� 6 – 18 months

� advisor indemnified

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Auction Procedures

Non-binding indication of interest� Selected buyers advance to round two

Due diligence and data roomMark-up of purchase agreement for final bidBid letter; final bids required to specify:

� price� source of funds; financing conditions� conditions to closing� other material issues (e.g., employees, taxes,

environmental)

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Confidentiality Agreements

� Non-public information typically is only provided by the seller under a confidentiality agreement

� Scope of confidentiality agreement� Normally covers the recipient, its affiliates and

agents� Confidentiality obligation does not apply to publicly

available information or information obtained independently

� Prohibits use of confidential information for any purpose other than evaluation of the transaction

� For antitrust or business reasons, access to certain information may be restricted

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Confidentiality Agreements (cont’d)

� Term of agreement� Usually 1-2 years

� No Solicit of:� Employees� Customers

� Standstill� In the case of a public company, the agreement will

typically contain “standstill” provisions� Recipient will be prohibited from acquiring or offering to

acquire company securities or seeking to influence control or management of the company

� Standstill term is typically 12-24 months

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Offering Memorandum

� In the case of sales of private companies or subsidiaries or divisions of public companies, the sell side banker usually prepares an offering memorandum

� The offering memo is only circulated to parties who have signed a confidentiality agreement

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Use of Letter of Intent andAgreements in Principle� Is a letter of intent or agreement in principle appropriate?

� May be publicly disclosed� If publicly disclosed may increase opportunity for

competition� From Buyer’s perspective, should be avoided in a public

transaction, if possible� Both parties should insist on no public disclosure until

signing of a definitive agreement� Although usually not binding, provisions in a letter of

intent will influence negotiation when preparing the definitive agreement

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Use of Letters of Intent andAgreements in Principle (cont’d)If a letter of intent is not appropriate, proceed to definitive agreement

� Most public company transactions are negotiated and documented without a letter of intent

� Letters of intent and agreements in principle are quite common in private deals

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Letters of Intent/Agreements in Principle

� Typically non-binding expressions of interest, with some binding provisions� Binding letters of intent pose risks because they

generally are not sufficiently detailed� May attach a term sheet or incorporate similar provisions� Binding provisions may include --

� Exclusivity or “No-Shop”� Expense reimbursement� Obligation to negotiate in good faith

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Term Sheets and Offer Letter

� Typically addresses principal issues of the transaction� Price and form of consideration; price adjustment

mechanics� Structure� Anticipated timing to complete transaction� Tax and accounting treatment� Employee arrangements� Material conditions to closing, e.g. third party consents

approval, regulatory approvals, financing, ancillary agreements (supply contract, etc.)

� Due diligence “out”

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Term Sheets and Offer Letter (cont’d)

� Although a term sheet or offer letter is generally not binding, negotiating position is frequently established by positions taken, or issues not raised, in the term sheet or offer letter

� Term sheets are frequently used to sketch out a transaction which then proceeds directly to negotiation of definitive agreements

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Due Diligence

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Due Diligence

� Overview� Data Rooms� Process and Timing� Objectives� Types of Due Diligence� Items to be Reviewed� Checklist� Due Diligence Report

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Overview

On the buy-side, while you will have representations and warranties about the target company in a definitive purchase agreement, those should only be viewed as a backstop for the unexpected. The first line of defense is good due diligence.

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Data Rooms

� Common in private deals and frequently used in auctions of public companies

� May be organized online or by delivery of CD-ROMs

� Organization of the due diligence process will affect price and terms of any offer, or whether an offer is made

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Process and Timing

� Preliminary due diligence at inception of transaction� Identification of critical path issues -- fundamental

business/financial considerations or legal/structural impediments

� More intensive due diligence as transaction proceeds to negotiating definitive agreement -- definitive agreements rarely permit a due diligence “out”

� On the sell-side, it is extremely important to gather and organize all relevant due diligence before the sale process starts. Chasing down due diligence requests and disclosing new information while negotiating terms of a purchase will cause delays and increase transaction fees, and could affect price.

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Objectives� To learn the nature of the target's business� To evaluate the target's financial strengths and weaknesses� To identify potential contingent liabilities (e.g.,

environmental, litigation, taxes, pension and benefits, and product liability)

� To evaluate internal controls� To evaluate adequacy of protection of intellectual property

and goodwill� To identify required governmental and contractual consents

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Objectives (cont’d)

� To identify regulatory requirements for completing the transaction

� To help ensure that the company is operating within the confines of the law

� To help ensure that the acquisition agreement contains representations that reasonably protect the buyer from “unknowns”

� To identify other similar transactions in which target has been involved -- this may enhance negotiating position

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Objectives (cont’d)

� Many issues identified in due diligence are ultimately incorporated into the transaction agreement -- through pricing, covenants, conditions and representations and warranties

� Business and financiala) Projectionsb) Accountingc) Synergies

� Plant tours

� Management and personnel

� Review of information systems; data storage and disaster recovery planning

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Types of Due Diligence

� Review of material contracts � Employee compensation and benefits � Litigation� Regulatory matters� Employment matters� Intellectual property� Real Property� Environmental review� Tax matters� Insurance� Discontinued operations/Prior acquisitions

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Due Diligence Checklist

Items to be Reviewed:� Management presentation/Financial forecasts� Financial statements� Accounting records, including company records

and accountants’ work papers� Corporate policy manuals, employee handbooks,

compliance and internal controls materials, disclosure controls

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Due Diligence Checklist (cont’d)

Items to be Reviewed� Corporate documents

a) Charterb) By-Lawsc) Shareholder minute booksd) Director and Committee minute bookse) Stock Books

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� Material contracts for:a) assignability;b) termination;c) covenants;d) non-competes; e) unusual burdensome provisions; f) funding obligations; g) indemnities;h) existing breaches or defaults; i) governing law; and j) other contingent liabilities

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� Financing (debt, guarantees, letters of credit)� Leasing� Shareholder agreements� Non compete agreements� Employment/severance agreements� Collective bargaining agreements� Supply agreements� Distribution agreements� Marketing agreements� Customer agreements� Other material contracts

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� Employee compensation and benefits, includinga) severance and change of control arrangementsb) unfunded benefitsc) retiree benefits

� Litigationa) Pending and threatened litigationb) Documents relating to current suits and

governmental or regulatory proceedingsc) Litigation letters from audit

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Due Diligence Checklist (cont’d)� Regulatory matters

� Permits� Licenses� Other governmental authorizations� Policies to comply with regulations� Sarbanes-Oxley Issues

� Employment mattersa) Labor practices and historical relationsb) Employment policy manualc) Benefit plans (medical, dental, disability, pension, profit sharing,

stock incentive and other benefit plans)d) Employment/severance agreementse) Worker's compensationf) Discrimination claims

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� Intellectual property� Patents� Trademarks� Copyrights� Trade secrets� Software� Licensing agreements

� Real property (owned and leased) a) Title; title insurance surveysb) Zoning and easementsc) Landlord consentsd) Environmental

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� Environmental� Permits, licenses, registrations and other authorizations� Environmental audits, studies and reports� Regulatory filings� Notices of any violations and all correspondence with

regulatory authoritiesa) Documents relating to contaminated sites, clean-up

efforts, and spillsb) Documents relating to exposure to contaminants by any

personsc) Documents relating to the existence of any asbestosd) Discontinued businesses

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� Tax matters� Tax returns� Net operating losses� Open tax audits/disputes

� Insurancea) Policies (coverage limits; retention amounts, etc.)

� coverage post-closing� tail or run-off insurance

b) Outstanding claims/disputes with insurersc) Claims history

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Reps & Warranties Special Survival Period

Reps & Warranties General Survival Period Due Diligence Period

PreliminaryDiscussion

Letterof

Intent

Signingof

PurchaseAgreement

EstimatedWorkingCapital

Calculation

Closing FinalWorkingCapital

Calculationand Adjustment

Pre-Signing Pre-Closing Post-Closing, Survival Period

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� General Structure

� Representations and Warranties

� Indemnification

� Conditions to closing

� Price Adjustments as at Closing

� Other Issues

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Structure� General structure

� stock purchase agreement� asset purchase agreement� merger agreement

� In all cases, structure of agreement is same� what is being purchased/consideration� representations and warranties� covenants� conditions� termination� indemnity, if applicable

� Drafting Tips� Start with “first draft” precedent, not fully negotiated, executed version� Be reasonable, if first draft excludes items the other side will likely

require, it will be the other side’s version of those items which will form the basis of the negotiation

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Representations and Warranties

� Purposes:� disclosure/due diligence� possible recourse following closing if business is not “as

represented”� closing condition

� Types� general corporate authority representations� capitalization (stock transaction or merger)� ownership of assets (asset transaction)� business representations

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Representations and Warranties

� Specific important representations� Financial Statements� Undisclosed Liabilities� Compliance With Laws� Material Adverse Change

� prospects� exceptions

� industry changes� economy/market conditions� announcement of transaction

� Who makes the representations?� seller� buyer� selling stockholders, if any?

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Representations and Warranties (cont’d)

Special Issues� Materiality� Knowledge� Listing and scheduling� Specificity (i.e. financial statements representation only, or

also A/R, inventory, etc.)� Survival

a) typical period 6-36 months (with 12-24 months being average)(at least one audit cycle)

b) certain representations typically survive longer (e.g., tax, environmental)

c) compare to public deal where no survival

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Indemnification� Most heavily negotiated part of a purchase agreement� Matters indemnified

� breaches of representations and warranties� breaches of covenants� other matters of concern from due diligence

� Limitations� Baskets/Deductibles� Caps (often 10 - 25% of purchase price, not more than purchase price, but will

exclude certain fundamental items, such as capitalization and taxes)� Duration� Caps and brackets should only apply to breaches of representations and warranties� Limitations on types of damages recoverable, e.g. “special” and “consequential” –

buyer beware� “Anti-sandbagging”

� Indemnity is only as good as the credit behind it� Escrow� Hold back� Guarantee

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Conditions to Closing

� Standard:� Accuracy of representations and warranties� Compliance with covenants� Receipt of governmental approvals (e.g., expiration or termination of HSR

waiting periods)� No injunction

� More negotiable� Litigation� Third party consents� legal opinions

� Very sensitive� Due diligence� Financing

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Price Adjustments at Closing� Types of Adjustments

� working capital� net worth� net assets

� Mechanics� Target� Closing estimate� Final balance sheet� Dispute resolution provisions

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Additional Purchase Price following Closing

� Earn-Outs

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Other Issues

� Employee issues� Maintenance of seller benefits vs. institution of buyer

benefits� Severance/change of control issues� Potentially large liabilities

� Underfunded pension plans� Retiree medical benefits

� WARN Act issues� COBRA

� Treatment of intellectual property� License vs. sale

� Third-party consents

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Other Issues (cont’d)

� Non-competition clauses� Scope/duration (as Seller limit it to Seller and downstream

affiliates)� Allocation of purchase price and tax issues

� Legal Opinions

� Post-closing arrangements� Transition services� Supply and/or sale arrangements

� Dispute resolution� Courts vs. arbitration

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Sandy K. Feldman(212) [email protected]

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