By Daniel Lopez, Richard Vernon Smith, Douglas S. Mintz, and Richard Harroch
After years of sky-high valuations, private equity funds and strategic buyers will have ample opportunity to purchase technology companies at a discount in the wake of the COVID-19 crisis. This article highlights the unique opportunities and risks associated with acquiring a distressed private technology company.
1. Finding Distressed Tech Deals and Identifying Decision Makers
In addition to traditional sourcing outlets, buyers can access potential targets by purchasing debt and other claims from existing creditors. If done thoughtfully, a buyer can transform itself from a hopeful outside bidder into a creditor armed with special rights. Specifically, being a creditor may enable buyers to utilize information and inspection rights contained in credit agreements to enhance due diligence and implement special legal structures to complete an acquisition, as discussed further below.
Once a target has been selected, buyers should take care in identifying the “real” decision makers. This analysis is typically straightforward in the non-distressed context because the board, management team, and key stockholders can usually negotiate and approve a deal, while creditors are simply repaid.
However, in the distressed context, creditors are an additional and important stakeholder group that can dictate terms. What’s more, buyers targeting companies with tiered debt structures and syndicated loans must navigate a web of liens, covenants, remedies, and intercreditor agreements to determine which creditor (or group of creditors) are needed to approve a deal.
2. Selecting a Structure for a Distressed Tech Company Acquisition
Distressed tech company acquisitions are often structured as a purchase of assets, and not as a merger or equity purchase. The two principal reasons are: (1) this structure minimizes the buyer’s assumption of unwanted liabilities of the seller and (2) the buyer obtains a stepped-up tax basis in the acquired assets. If the distressed company has significant net operating losses that the buyer may be able to use (which are subject to the IRS change of ownership rules), a reverse triangular merger may make sense.
But deals can use traditional acquisition structures or creditor-driven structures outside of or through bankruptcy court (“out-of-court” versus “in-court”). Each structure carries different levels of deal expense, execution speed, and post-closing liability risk. Here are the key points for nine alternative acquisition structures:
Equity Purchase Structure
- Target equity acquired directly or by a merger.
- Buyer indirectly bears the risk of all target liabilities.
- Buyer should require the seller to pay before closing all known liabilities and receive payoff letters and/or releases to the extent possible.
- Indemnity can mitigate liability but recourse may be impaired if equity holders receive little/no consideration.
- Buyer should consider obtaining representations and warranty insurance (RWI).
Asset Purchase Structure
- Seller assets acquired (all or in part).
- Seller retains all pre-closing liabilities, except for specific liabilities assumed by Buyer or operation of law.
- Same indemnity and RWI considerations as Equity Purchase Structure above.
“Acqui-Hire” – License and Waiver
- Buyer hires certain seller employees/service providers, receives a robust release of claims, and receives a non-exclusive license to use the seller’s intellectual property (optional).
- No equity, assets, or liabilities are transferred.
- Same indemnity consideration as Equity Purchase Structure above.
- RWI likely not available.
- Increasingly popular structure for VC-backed companies (which often have talented teams, but minimal revenue or monetizable intellectual property).
“ABC” – Assignment for Benefits of Creditors
- Seller assigns to an assignee.
- Assignee liquidates the assets and distributes proceeds to creditors.
- Assets generally transferred free and clear of liens and liabilities, except for (1) claims by creditors senior to foreclosing party and (2) risk that bankruptcy court may later unwind sale.
Foreclosure (Private Sale)
- Creditor forecloses on, and then sells, defaulting seller’s secured assets.
- Buyer must be a third party—foreclosing creditor cannot buy assets (subject to limited exceptions).
- Assets generally transferred free and clear of liens and liabilities, except for (1) claims by creditors senior to foreclosing and (2) risk that bankruptcy court may later unwind sale.
Foreclosure (Public Sale)
Same as private foreclosure sale except:
- Sale must be advertised and accessible to general public (which adds time to sale process).
- Foreclosing creditor may bid for/acquire the assets (and therefore competes with any buyer).
- Lower risk of bankruptcy court scrutinizing/unwinding sale due to fairer process.
Section 363 Sale under the Bankruptcy Code
- Seller finds a “stalking horse” bidder to acquire its assets. (The “stalking horse” bidder sets the initial bid on the assets of a bankrupt company.)
- Seller and stalking horse sign asset purchase agreement (APA), which includes auction procedures, topping rights, and break-up fee/expense reimbursement.
- Seller files a motion in bankruptcy court. Can be before or after stalking horse identified.
- Creditors notified and formal auction conducted (~20-30 days). Bidders propose purchase price and edits to stalking horse APA.
- Seller seeks court approval after final bidder selected.
- Creditor approval required with respect to its secure collateral.
- Assets transferred free and clear of liens and liabilities.
Pre-Packaged & Pre-Negotiated Bankruptcy Plans
- Creditors and company negotiate a plan of reorganization before filing in bankruptcy court, which allows company to be sold as a going concern.
- Pre-packaged plan: formal creditor vote obtained before filing.
- Pre-negotiated plan: creditor vote not obtained before filing, but agreements with key creditors and lock-up/support agreements evidence approval.
- Securities issued pursuant to court approved plan exempt from registration under the Securities Act of 1933 and “Blue Sky” laws.
- Usually faster than a “free-fall” bankruptcy, where debtor files with no plan.
“Free Fall” Bankruptcy Filing
- Debtor files for bankruptcy with no pre-agreed exit from bankruptcy and relies upon Chapter 11 protections to negotiate with creditors and possible buyers.
- Longer time frame to resolution compared to other in-court proceedings.
- Rare event for larger companies.
- Creditors and debtor attempt to agree on a reorganization plan.
- Securities issued pursuant to court approved exit exempt from registration under the Securities Act of 1933 and “Blue Sky” laws.
3. Due Diligence Issues in Distressed Acquisitions
In distressed tech company acquisitions, buyers still need to undertake due diligence, but the diligence may need to be accelerated and limited. And because of the coronavirus “stay at home orders,” in-person diligence may be limited or difficult.
Key due diligence issues will include:
- What liabilities are to be assumed and which liabilities are to be specifically excluded?
- What accounts payable have been deferred?
- How likely are accounts receivables to be collected?
- Are the assets to be acquired subject to a third-party lien or encumbrance?
- What is the condition of the assets?
- How has turnover in employees affected the ability of the business to continue?
- What litigation is pending or threatened?
- What key contracts need to be assumed and do those contracts need to be renegotiated?
- What COVID-19 related legal risks (such as litigation risk) does the target business face?
- Is the seller in compliance with federal, state, and local orders related to the pandemic?
- Are there supply chain risks?
- Is the seller in compliance with health and safety laws with respect to its workplaces and employees in light of the danger posed by the pandemic?
- How is key intellectual property to be transferred and subject to what third=party licenses or other rights?
- What are the termination rights under key contracts? Do the seller’s contracts include “force majeure” clauses that may enable it or the counterparty to terminate the agreement or suspend performance or payment?
- Will key customers of the seller continue with the buyer? What is the financial condition of those customers?
- What IT, cybersecurity, and data breach issues has the seller encountered? Has the seller had problems with hackers interfering with video conferences or taken steps to prevent that risk?
For a comprehensive discussion of due diligence issues in mergers and acquisitions, see A Comprehensive Guide to Due Diligence Issues in Mergers and Acquisitions.
4. Additional Key Issues in Distressed Tech Company Acquisitions
Once a structure has been selected and the parties are in execution mode, buyers should take ownership of the following issues in the sprint to closing. Buyers cannot assume that a seller’s management team will be invested in the transaction or properly focused on these issues because they will likely receive sub-optimal deal consideration or just abandon a “sinking ship” altogether by resigning. Also, unlike a non-distressed deal, buyers will likely have limited or no recourse against selling stockholders for post-closing claims or liabilities. Put simply, many seller problems become buyer problems.
- Fiduciary Duties. As with any potentially contentious deal, the parties should ensure that the seller’s directors and officers fulfill their fiduciary duties in order to avoid creditor and stockholder claims that may scuttle a deal or haunt buyers for years after closing. This is especially important in conflicted transactions in which an existing stockholder or creditor is the buyer or receiving special treatment. See Financing a Distressed Private Company: De-Risking Inside Rounds for a brief discussion of fiduciary duties and risk-mitigation tools for conflicted transactions, such as the use of independent committees, informed stockholder votes, and independent valuations and opinions.
- D&O Insurance, Exculpation, and Indemnification. In addition to taking the foregoing front-end precautions to reduce fiduciary claim risk, the parties should also ensure that the seller’s organizational documents properly insulate directors and officers with exculpation, indemnification, and advancement provisions, and that those obligations are adequately backstopped with robust D&O insurance. See Time to Review D&O Liability Protections in Distressed Private Companies for a more detailed review of director and officer mitigation tools.
- Transition Services. Buyers must carefully consider which transition services will be needed after closing. These costs may be substantial and impact overall deal pricing because the seller may be unable to provide any transition services, and the entire workforce may be terminated at closing.
- Fraudulent Transfer Issues. A buyer of a distressed tech company runs the risk that the sale is later deemed to be a “fraudulent transfer” and set aside. Under federal law, state law, and/or the U.S. Bankruptcy Code, the sale can be voided upon a showing by dissatisfied creditors or by a bankruptcy trustee subsequent to a bankruptcy filing that there was “actual” fraud (i.e., the sale was actually intended to hinder, delay, or defraud creditors) or “constructive” fraud (i.e., the sale was made for less-than-fair consideration or reasonably equivalent value, and the target was insolvent at the time of, or rendered insolvent by, the sale). Counsel working with the buyer can limit this risk by building an appropriate record and structuring how the proceeds can be used to ensure creditors are protected.
- Escrow or Hold-Back of a Portion of the Purchase Price. A buyer may want to hold-back or escrow a portion of the purchase price to take into account any indemnification protection of the buyer under the acquisition agreement. In the distressed M&A context, a hold-back or escrow often serves as a buyer’s sole source of post-closing recovery because the seller and its equity holders may be unable or unwilling to satisfy indemnification obligations. If the seller agrees to the escrow or hold-back, it will try and negotiate for a short period of time that the escrow or hold-back lasts.
- Third-Party Consents. A distressed tech company sale will often require a number of consents from third parties, including: (1) the seller’s stockholders and board of directors; (2) counterparties to the seller’s key commercial contracts; (3) landlord consents if any leases are to be assigned; and (4) lenders to the seller (including any related releases of liens).
- Regulatory Hurdles. The buyer needs to review whether any regulatory hurdles must be addressed. For example, the federal Hart-Scott-Rodino Act should be examined for any anti-trust issues, assuming the dollar thresholds are met in the transaction. For foreign buyers, a filing with the Committee on Foreign Investment in the United States (CFIUS) may be prudent or mandatory. CFIUS has jurisdiction to review national security implications of takeovers of U.S. businesses by a foreign party, especially from China. Other regulatory hurdles should be reviewed in connection with banks, financial services companies, healthcare organizations, and other regulated businesses.
- Employee Compensation. Buyers should cause sellers to pay in full all wages and other amounts due to employees. In addition to severe reputational damage and harm to employees, a buyer may be responsible for paying these amounts, and the sellers’ directors and officers may face personal liability under federal and state wage and hour laws for earned but unpaid wages.
- WARN Act. The Worker Adjustment and Retraining Notification (WARN) Act requires employers with 100 or more employees to provide at least 60 days’ advance written notice before a mass layoff affecting 50 or more employees. Some states, such as California, have their notification rules. Although these rules may seem simple, a technical analysis is required to determine if previous pre-closing layoffs are counted towards any layoffs that are planned at closing.
About the Authors:
Daniel Lopez is an M&A and corporate partner in the San Francisco office of Orrick, Herrington & Sutcliffe LLP. He advises private equity funds and private and public companies in the tech, life sciences and energy sectors on strategic transactions, including debt and equity investments, acquisitions and dispositions. Daniel also counsels boards, special committees, investors and other key stakeholders on fiduciary duty, securities law and corporate governance matters. He can be reached through Orrick’s website.
Richard V. Smith is a partner in the Silicon Valley and San Francisco offices of Orrick, Herrington & Sutcliffe LLP, and a member of its Global Mergers & Acquisitions and Private Equity Group. He specializes in the areas of mergers and acquisitions, corporate governance and activist and takeover defense. Richard has advised on more than 500 M&A transactions and has represented clients in all aspects of mergers and acquisitions transactions involving public and private companies, corporate governance, and activist and takeover defense. He is the co-author of the 1,500-page book “Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements,” published by Bloomberg Law. He can be reached through LinkedIn.
Douglas Mintz is a restructuring partner in the Washington, D.C., office of Orrick, Herrington & Sutcliffe LLP. He has deep experience representing lenders, debtors and official and ad hoc committees. He works primarily with bank and hedge fund investors and co-leads Orrick’s hedge fund client initiative. Doug also represents debtors in the energy and technology sectors. He can be reached through Orrick’s website.
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a venture capital fund in the San Francisco area. His focus is on internet, digital media, and software companies, and he was the founder of several internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He is the co-author of the 1,500-page book “Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements,” published by Bloomberg. He was also a corporate and M&A partner at the law firm of Orrick, Herrington & Sutcliffe LLP, with experience in startups, mergers and acquisitions, and venture capital. He has been involved in over 200 M&A transactions and 500 startups. He can be reached through LinkedIn.