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

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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’