M&A in this Toxic Environment

Must-read post from the Deal Professor on the complexion of dealmaking today, and what kind of stuff is likely to work (if anything): Exchange offers, vulture investing, etc.

More on MAC Clauses

I've posted before about MACs (material adverse change clauses; also called MAE - material adverse effect - clauses), particularly around the use of a MAC by Johnson & Johnson in trying to negotiate a lower price for Guidant. As we saw there, exercising a MAC is not only the M&A equivalent of nuclear war, it also can lead to unforeseen effects like an ultimately HIGHER price for the target company.

For those interested in learning more about the arcana behind the legal dimensions of MACs and why they are so hard to exercise, the M&A Law Prof Blog has an excellent post on that very subject.

Counsel - Friend or Foe?

Beyond considerations of competence, how much does your choice of deal counsel matter? For larger companies, what about your internal counsel – are they helping or hurting your cause? As I’ve harped on before, there’s a cost to having your company viewed as being hard to deal with. It’s great to be known as a tough negotiator, but you never want to cross the line to the corporate equivalent of “unreasonable asshole.”

In fact, the biggest problem I’ve encountered isn’t overly-hard negotiating, but rather being a difficult pain in the ass over things that don’t really matter. Very little in corporate law is black and white – it is almost always a balancing of risks and opportunities. When it comes to your deal, a good lawyer will pay a lot more attention to remote risks that carry major potential consequences than to those risks that are likelier but would create only minor problems. Beware those lawyers who can’t tell the difference. If you find yourself arguing more with your own attorney than with the other side, that’s a sign you’ve got a problem.

Agreements, more

So what kind of agreements can be short and sweet? One big and puzzling category, where time and again I've seen an inordinate amount of attention devoted, is that of agreements that can be terminated by either party at any time on 30 days notice. It's a safe bet these agreements could be shorter; after all, you can't build much else in a business around an ongoing agreement that either party can terminate quickly, so damages for breach are likely to be limited.

Every state has a body of commercial law governing contracts that will apply even with the most minimal of terms. Warranties, implied covenants, etc - for the most part all commonsense principles that we all assume when we enter into deals. At its most basic, a written contract really only need contain those specific and idiosyncratic terms that are important to the parties. That will always include price, term and when certain key events need to take place; it will usually also include a few other matters unique to the circumstances. After that, everything else is just risk shifting.

More on Agreements

Blogging has taken a bit of a back seat of late, but a long wait in an airport is always a good cure for that, so here goes. I received several messages back responding to my "lopsided" agreement post with the general theme that it's better to keep agreements as brief as possible.

I'm a big believer in that when it comes to term sheets, and I like it in theory when it comes to definitives, but it's not always easy to achieve. Like haiku, it often takes more time to write a short agreement than a rambling one. In the (large) corporate world, the sheer number of people weighing in will often create a longer agreement, and there's no avoiding long agreements in complex transactions.

However - many commercial transactions can be handled with very brief agreements. In fact, you could write the terms on a cocktail napkin, sign and move forward. I've seen cases where the process of turning an otherwise straightforward transaction into a belt-and-suspenders legal agreement has done more than simply cost time and expense: Deals lost, relationships ruined, and lawsuits created over ambiguities in the "legal" agreement that would never have existed had the parties signed a one-page agreement. Sometimes it's best to just sign a brief letter and move on with your real business.

First Draft Agreements

As a reformed lawyer, I may be more sensitive to how contracts are drafted than some other deal guys. However, a conversation with a former colleague reminded me of a particularly annoying tactic some folks use when sending the initial draft of a definitive agreement - the one-sided, overreaching first draft. It's not something you see every day, but still far too often.

I'm not talking about terms that need to be unilateral or lopsided because of the parties' differing roles, or even terms that are being aggressively negotiated. No, these agreements are laced with terms that favor the drafting party beyond any measure of reason.

Some claim that it makes sense to send over a lopsided contract because (a) the terms may stick and (b) it gives you terms to negotiate back from. I don't find the first point compelling, and the second represents a rather juvenile outlook on negotiating. Sure, lopsided contracts will occasionally work with unsophisticated parties or those you have loads of leverage over. However, in the vast majority of cases they will:

- Piss off your counterparty, harming any useful rapport you may have established
- Make your counterparty dig deeper into the agreement to look for all the other ways you're trying to screw them
- Waste a lot of time as the agreement gets negotiated back to where it should have been in the initial draft

End result: You're back in the same place you would have been had you sent a fairly-written contract, at substantial net expense in time, fees and credibility. You may even lose the deal because of the added delay or trust issues created by your draft.

Trademarks and Cease-and-Desist Letters

Great, thoughtful post in Ventureblog regarding the dust-up over the "Web 2.0" trademark registration. As a reformed lawyer, I would take a point made at the end of the post even further - enterprises that allow their counsel to decide when to send cease-and-desist letters are almost always making a mistake.

Why? Even if the use is in the gray area, there's no downside (from a strictly legal perspective) to sending a letter, and such letters are great evidence (again, from a strictly legal perspective) to establishing that you have properly defended your marks. So, if you as the business person bring a question of possibly infringing use to your trademark counsel, the basic legal answer you get back will be to send a cease-and-desist letter. Of course, savvy trademark counsel will walk you through the pros and cons and potential PR and customer pitfalls of taking this approach. Unfortunately, many will simply apply a mechanistic legal test and advise sending the letter.

This can't be the end of your analysis. In all but the most cut-and-dried cases - say, a similarly-sized competitor making an infringing use, or outright stealing/counterfeiting - informal discussions and attempts to resolve amicably must be used prior to dropping the cease-and-desist letter. Such efforts often work, they are cheap, and they can keep your enterprise from encountering something that seems to be repeated as often as the seasons in the corporate world - big companies getting smacked back on the PR front for bullying behavior toward tiny enterprises.

Gun-Jumping

Sometimes it just doesn't pay to be a tough negotiator - witness Qualcomm's announcement Monday that it is entering into a consent decree with DOJ and paying $1.8M to settle claims of gun jumping in its acquisition of Flarion ("gun jumping" being where the acquiror starts getting a bit too intimate with the seller's business ops before the deal has closed).

While a buyer can't run the acquired business before the deal closes, there's always a healthy negotiation over the amount of control the buyer will exert (via operating covenants written into the acquisition agreement) during the pre-closing period. These covenants are typically designed to ensure that, to the extent possible, the acquired business continues to operate in a straight-and-narrow course until closing. Themes for operating covenants include the permissable amount of new debt, capital expenditue limits, asset sales, etc. - anything that might materially change the nature of what the buyer thought they were buying. However, buyers usually have to stay well clear of anything involving customers and markets, particularly when acquiring a competitor, to avoid the appearance of gun jumping.

Gun jumping is of heightened concern in industries like telecom, where the wait for closing can exceed one year. The long wait obviously increases the operating risk during the pre-closing period, thus ratcheting up the desire to steer the target's course during that period or get a jump on integration. Many M&A lawyers take a very conservative stance on gun jumping, preventing most conversation pre-close on the (not unreasonable) presumption that some business people will jump the gun. Buyers want to get moving; sellers usually want to be compliant - the gun gets jumped.

What's interesting about the Qualcomm news is that the claims don't relate to any over-reaching behavior by Qualcomm executives, but rather the language in the merger agreement itself.

Obviously the size of this fine is not material to Qualcomm or even this deal itself (the $1.8M fine is well less than one-half of one percent of the purchase price). However, I'm sure the threat of this action scuttling or slowing the deal caused many a sleepless night for those involved - and may still, if you are a Qualcomm lawyer.

AT&T - BellSouth MAC

Although unlikely to ever be at the center of a J&J-Guidant-like merger termination drama, I figured the MAC clause in the AT&T-BellSouth merger might be interesting. Here it is, courtesy of the filing at Edgar:

(ii) the term "Company Material Adverse Effect" means
(x) an effect that would prevent or materially delay or impair the ability of the Company to consummate the Merger or (y) a material adverse effect on the financial condition, properties, assets, liabilities, business or results of operations of the Company and its Subsidiaries, including its interest in Cingular, YP.com and their respective Subsidiaries, taken as a whole, excluding any such effect resulting from or arising in connection with changes or conditions (A) generally affecting (I) the United States economy or financial or securities markets, (II) political conditions in the United States or (III) the United States telecommunications industry or any generally recognized business segment of such industry, (B) generally affecting the telecommunications industry (or any generally recognized business segment of such industry) in the Company Region, taken as a whole, (C) resulting from any hurricane, earthquake, or other natural disasters in the Company Region, (D) resulting from the execution, announcement or performance of this Agreement, or (E) resulting from or arising in connection with the financial condition, properties, assets, liabilities, business or results of operations of Cingular, YP.com or any of their respective Subsidiaries; and (iii) the "Company Region" means the states of Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina and Tennessee.

This is pretty straightforward (the AT&T MAC clause mirrors this, only with different regions), and obviously doesn't provide a lot of room to exercise. The interesting part is that problems at Cingular - which is at the center of this deal - can't be the cause of a MAC, no matter how bad such problems might be. Furthermore, problems at the non-Cingular parts of BLS have to be measured against the entire BLS entity in determining if a MAC has occurred. Since Cingular represents something like 60-70% of overall BLS revenue (and growing), problems in the BLS business would have to be awfully dire to constitute a MAC.

Knowing the lawyers involved, I'm quite sure a lot of time and energy went into negotiating this clause, but it's something BLS absolutely had to have (and it's only fair they got it, since AT&T owns 60% of Cingular and effectively runs it already). Closing risk isn't always a major factor in mergers, particularly in small deals with no real regulatory conditions. Here, where closing will take 12-15 months and countless hours spent dealing with the DOJ and FCC, BLS needed to mitigate as much closing risk as possible. Looks like they did so in the MAC at least.

Rights of First Refusal - Bad for the Holder?

Intriguing article from Harvard Business School regarding rights of first refusal (or ROFRs as we corporate tools call them). For those who don't typically deal with ROFRs, they feature prominently in leases, joint ventures, distribution deals, etc. The central thesis of the article is that ROFRs can run to the detriment of the holder.

Huh? Aren't you always better off having a ROFR than not having one? Well, yeah, you are, except that not all ROFRs are created equally. A typical ROFR allows the holder to always move last. I don't think there's any debate that such a right is good to have. The authors, however, focus on what they call "Before and After" ROFRs, which allow the asset holder to set a price ceiling beyond which the asset can be transferred without being subject to the ROFR. While an arrangement like this is clearly inferior to a straightforward ROFR, it's not inherently bad - it won't always work against the holder, and at worst the holder is in the same place they'd be if they didn't have the ROFR.

The bigger point, however, is that you've got to sweat the details in your deals. You can't glaze over when you see the title header for "Right of First Refusal" (or Termination, or Indemnity, or Dispute Resolution, etc . . .). You've got to think through how these provisions will work mechanically if ever exercised, and make sure you're happy with the process. These details are often left to the lawyers; that can be a costly mistake.

Setting Dates

I spent some time today dealing with an annoying and quite avoidable contract issue. Virtually all contracts have important dates - the date the agreement begins, the date it terminates or renews, the outside date upon which a merger can be terminated, the date puts, calls, shotgun rights or other exit mechanisms kick in – you name it. Far too often, these dates are defined based on future occurrences (e.g., “the contact term shall begin once X happens”), other agreements (“the contract term shall begin once Agreement Y is executed”), or, the bane of my existence today, both (“the contract term shall begin on the later of X happening or Agreement Y being executed”).

In the months following an agreement being entered into, terms like this will typically not cause much consternation. Everything you need is at hand. But let’s say you’re dealing with a partnership agreement, distribution contract, long-term lease or the like. Let’s say the original agreement was signed 10-15 years ago, it’s been amended four times and assigned twice. Maybe you’ve picked the agreement up in an acquisition. Now, you’ve got to track down all of those ancillary events and agreements just to determine how the contract is supposed to run, and perhaps even whether it is still in effect. Besides the annoyance, the need to track and follow this trail of dates and agreements greatly increases the chances that someone will inadvertently blow a date under the agreement. Sure, maybe it will be the other side, but do you really feel that confident about your own contract management tools?

I think that, wherever possible, these dates should be clearly set and determined within the contract itself. Yes, there are times when that doesn’t work. But I think that these undefined dates are usually more a product of laziness than inability to reach agreement. In my experience, mutually-acceptable dates can usually be set very easily, and you’re doing future handlers of your contracts a great service by setting them up this way.

Managing Lawyers

I’ve spent a good part of my career as a lawyer, many of my good friends are lawyers, and I have great respect for the work lawyers do. There’s no question that proactive, thoughtful legal advice adds value to any enterprise or deal. Very effective, strategic legal counsel can even be a competitive advantage. However, to expand on my earlier post regarding not over-lawyering term sheets – it’s equally important to manage your lawyers once definitive documents are being negotiated.

If you are fortunate, your lawyers will understand your business, your objectives, your timelines and your risk tolerance. They will work smoothly with the other side’s lawyers and help you bring the deal in on time and on acceptable terms. If you are unfortunate, your lawyers will have no business judgment, obstinate manners and lack any ability to weigh risks and opportunities. They will blow your deal up over meaningless terms, leaving you to try to pick up the pieces.

It can be tempting for non-lawyer deal guys to hand great chunks of the work on the definitive agreements over to the lawyers to work out. However, until and unless you have confidence in how your lawyers work, you’ll want to stay involved in all of those discussions, even if it just means a lot of listening. It’s equally important to make sure you have an understanding with your lawyers about who is in charge on your deals. You are. In any deal, there will be a number of points where you will need to overrule your lawyer’s advice or the position they are pressing for. This makes sense, right? The lawyer SHOULD be pressing more aggressively, and the deal guy should be doing the big picture balancing of the overall deal. Unfortunately (and I’ve run into this across the table far too often), the deal guy will shrug and defer to the attorney on stuff they should be moderating. So the deal bogs down – or derails – while you try to sort it out. While this is less of a problem in smaller companies or when using outside counsel, it can be a major problem in dealing with in-house M&A counsel at larger companies.

Term Sheets - Over-Lawyering

Expanding on the point made in Brad Feld’s latest Term Sheet post re over-lawyering – a term sheet, useful tool as it is, is really nothing more than a handy way to keep track of the key deal terms the business people have agreed upon (in principle). It’s not a binding agreement; it’s a way to determine if you can even get to a binding agreement, and once there, a tool to facilitate the negotiation process.

As such, there’s no need to draft it with legal precision - that can wait for the definitive agreements. Sure, there are cases where you need legal input on key deal terms that are inherently "legal." Some deals will have key terms involving specific IP rights, or apportionment of environmental liabilities, or some other nasty thing that you'll want your attorney to review/draft. Other than that, if you're going to insist on having attorneys review or draft the whole thing, you might as well dispense with it and go straight to the definitives. I have been involved with plenty of deals where no term sheets were exchanged, and many where the “term sheet”, such as it was, consisted of nothing more than an exchange of e-mail. While it's true (as Brad points out) that more detailed term sheets are generally better, at some point the additional detail is outweighed by the cost in time spent at the term sheet phase.

Google - AOL

Google's much-hyped investment in AOL illustrates the value of keeping deals as simple as possible. There can be a great deal of pressure, particularly in large organizations, to structure deals in a way that mitigates the most risk and pleases the most constituencies. That's fine in some cases, but not in a competitive bidding situation, and particularly not in a case like this, where the stakes were so high for Microsoft's opponent. Google NEEDED to keep AOL close, and Microsoft should have pulled out the stops to prevent this from happening.

Sure, valuation had a lot to do with it, but AOL certainly could have gotten the same price from Microsoft. However, while Google's deal is a straightforward minority investment with some ancillary commercial deals, Microsoft apparently insisted on structuring its investment as a joint venture.

If you're AOL, would you rather deal with an investor or a JV partner (with all the attendant minority rights, exit and management issues)? Couple that with Google's greater willingness to push the envelope on promoting AOL's ads, and this was probably an easy decision for AOL even if the parties were even on valuation.

More J&J - Guidant

Good in-depth article via Wharton on use of MAC clauses. It will be amusing to watch this one play out now that Boston Scientific has lobbed a bid in near J&J's original price. Does J&J really believe Guidant's issues cripple it as an asset, or did J&J seize an opportunity to try and get a better price?

The article also alludes to the complicated decision-making process a seller has to go through in evaluating multiple offers. Price is important, but not everything. In a stock deal, the seller has to decide which buyer will do better integrating and realizing the synergies of the deal, thus creating more shareholder value in the new company. Guidant will also obviously be concerned about certainty of getting to closing at the agreed-upon price, given their experience with J&J (my guess is that a Guidant - BSX deal will have a VERY specific MAC clause). In other situations, sellers have to be concerned about closing happening at all. Foreign buyers, companies with activist shareholders, and large buyers who by the merger create industry concentration all may find themselves needing to offer a premium price to win the deal.

Guidant's MAC

Nor surprisingly, Guidant sued Johnson & Johnson today over the latter's backing out of its $26B acquisition. While there is never a good time for a business to have the wheels fall off, there are few that compare in terms of sheer bad timing to the period between signing and closing the sale of your company. Since signing the deal, Guidant has faced product recalls, Spitzer-ization, and an SEC investigation. J&J decided to invoke the Material Adverse Change provision in the agreement and declare the deal off. Of course, they'd be happy to put it back on - at a lower price.

I can really feel for Guidant, having spent most of 2004 working to close the acquisition of my company. I know that Guidant's senior management must have been living and dying by that MAC clause, wondering if the next shoe to fall would put their buyer over the top. This is why negotiating the MAC clause is so important for a seller. It's hard enough for a buyer to walk on a vague MAC clause, but if you are able to negotiate in some specific concepts - either storm clouds you are aware of or just big risks unique to your industry or operations - you will sleep a lot better at night. When we sold AT&T Wireless, we had a couple of really ugly issues hit our business in the midst of running our auction. With telecom mergers taking 9 months or more to close, we tried to push as much of the risk of those problems continuing onto the buyers. We also wanted to make it clear that the issues had been disclosed, the buyers knew about them, and they went ahead with the purchase anyway. Our one-paragraph MAC clause was the most bitterly-fought provision in the whole merger agreement, but it was well worth it.

As a seller, you care about nothing so much as certainty of closing. Every deal has specific issues that can impact whether you get to closing - regulatory approvals, shareholder votes, etc. - but the MAC clause is a constant, and something that deserves a great deal of attention when negotiating every deal. Of course, as a buyer you need to be equally aware of attempts to push too much into the MAC clause. Although the bar to invoking a MAC is very high to begin with, there's no point in boxing yourself in if it can be avoided - or unless you get sufficient price concessions.

More on Working Capital

Questions about inventory and liabilities in working capital – a buyer’s level of concern about these matters will depend a lot on what kind of business is being purchased. In the case of inventory, I would usually have a physical audit done even where inventory is relatively nominal. It’s easy and cheap to do. I wouldn’t do it pre-closing, since there will be a closing statement of working capital that includes inventory levels. You can reconcile to that statement via a post-closing physical audit done as part of the working capital adjustment process. If the inventory records don’t reconcile the seller has to true up.

If inventory is a bigger part of the deal, unique, or of indeterminate quality, you’d want to physically review it as part of diligence. You might go so far as to get specific reps to address any particular inventory concerns. Typically, however, you’ll simply verify that inventory is present pre-close, take the closing statement, and then true up post-closing. In the corporate world, this work will most likely be done by your accounting team, so be sure to stay on their good side.

Liabilities are also pretty easy. You’re going to do a full diligence on your target, much of which will relate to accounting. It won’t take much digging to find understated or omitted payables. If you do find them, you’d want to consider walking – it’s a bit of a red flag . . . Lagging payables that come through post-signing should flow right into any working capital adjustment process.

Otherwise, you account for post-closing unknowns – whether unreported liabilities or litigation – via the reps and warranties and your indemnity rights (asset deals) and price (stock deals). That raises a subject for a later post – why thorough diligence is far more important in stock deals than it is in asset deals.

Working Capital

Brad Feld is running a very informative series on Letters of Intent; the latest post covers price and structure. Brad's comments on working capital shouldn't be taken lightly just because in his example they only account for $1 million in a $150 million deal - working capital is an area where it's very easy for the parties to talk past each other and end up with a very ugly dispute during negotiation of the definitives or even post-closing. It's also an area where you'll want to make sure your accounting professionals are at your side as you draft the LOI and the working capital provisions in the agreement.

While not a major issue in early stage companies, receivables can be a big point of contention in mature company deals, as they can represent several percentage points on the value of a deal. For example, a company selling for $100 million could easily have $4 million in receivables. Absent an explicit discussion of working capital (and many deals get to the point of drafting definitives without ever going through an LOI), the buyer may well assume that the $4 million receivable is an asset included in the purchase price, while the seller assumes it is on top of the purchase price as a working capital adjustment. This is not a negotiation you want to be having after you've already agreed on price.

As the buyer you might even consider detailing in the LOI the treatment of aged receiveables in the working capital adjustment. While you may pay full value for current receivables, you'll probably pay next to nothing (or nothing) for receiveables more than 90-120 days old, and a sliding scale in between. This will be a negotiation of its own, as it directly impacts purchase price. A lot will depend on where you are in diligence, whether the business is similar to your core business, and what your own internal rules are on creating reserves for receivables.