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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
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Asset Purchase AgreementsAsset Purchase:
Result:
P Shareholders T Shareholders
T[now has purchase price
and retained assets, if any]
P[now has purchased assets]
P Shareholders T Shareholders
TPPurchase Price
Assets
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Merger AgreementsMerger (Reverse Subsidiary)
Result:P Shareholders T Shareholders
[now has merger consideration]
P
T
P Shareholders T Shareholders
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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Preliminary Planning
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Preliminary Planning
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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Preliminary Planning (cont’d)
� 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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Preliminary Planning (cont’d)
� 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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Preliminary Planning (cont’d)
� 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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Due Diligence Checklist (cont’d)
� 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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Due Diligence Checklist (cont’d)
� 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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Due Diligence Checklist (cont’d)
� 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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Due Diligence Checklist (cont’d)
� 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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Due Diligence Checklist (cont’d)
� 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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Due Diligence Checklist (cont’d)
� 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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The Acquisition Agreement
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The Acquisition Agreement
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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The Acquisition Agreement
� 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]