(Editor’s note: “Ask the Attorney” is a weekly VentureBeat feature allowing start-up owners to get answers to their legal questions. Submit yours in the comments below and look for answers in the coming weeks. Author Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs.)
Question: My co-founder and I are friggin crushing it. We launched our startup about two years ago, and we now have an opportunity to buy a couple of struggling companies in our space. We have lawyers we work with, but I was wondering if you could just give me a heads-up on some of the legal issues we should be thinking about. Thanks!
Answer: Wow – that’s a pretty broad question. There are, in fact, many issues that should be on your radar – more than we have time to get into in a single column. In the interest of time and space, I’ll examine five this week and five next Monday.
Execute an Exclusivity Agreement. Your first step in connection with a potential acquisition should be to execute a tightly-drafted exclusivity (or “no-shop”) letter agreement with the seller, granting your company the exclusive right for a period of time (often around 90 days) to negotiate with the seller and to complete your due diligence investigation. Such an agreement is often part of a letter of intent (an “LOI”). However, from your perspective, as the buyer, it’s generally better to execute a separate letter agreement and skip the LOI, proceeding directly to the negotiation and execution of a definitive acquisition agreement. (See below for the reason why.)
Avoid Negotiating the Material Terms in an LOI. The seller’s negotiating leverage is strongest prior to the execution of an LOI — particularly if an investment banker has effectively created a competitive selling environment (or the perception of one). So, it’s in the seller’s (not the buyer’s) interest to negotiate the material terms of the deal in an LOI.
You, as the buyer, can avoid this trap in one of two ways: By executing an exclusivity letter agreement and skipping the negotiation of an LOI or by executing an LOI that includes a binding no-shop provision, but is otherwise non-binding and is as non-specific/general as possible. (Note that you may want to make it somewhat binding with respect to expense reimbursement and/or other “special” provisions.)
Either approach will give you not only strong negotiating leverage, but also the time and flexibility to complete your due diligence investigation prior to agreeing to any material terms – without getting into a bidding war with other prospective buyers.
Do Your Diligence. A comprehensive due diligence investigation is critical to the success of any acquisition. The fundamental purpose of due diligence is to identify risks and validate your valuation assumptions. There are typically three separate investigations: operational/strategic, financial and legal. Clearly, the scope of your investigations must be tailored to the particular transaction. Keep in mind that most deals fail due to inadequate diligence — resulting in the buyer overpaying for the target, assuming significant unknown liabilities and/or experiencing major integration problems.
Buy Assets, Not Stock (Equity). It is generally in your interest to purchase assets, not equity, of the target for two principal reasons: You will get a stepped-up tax basis in the acquired assets and you’ll minimize the assumption of any unwanted liabilities.
In a stock transaction or merger, the buyer assumes all of the target’s liabilities (known and unknown). In an asset transaction, however, the buyer only assumes those liabilities that are expressly agreed to in the acquisition agreement (subject to the doctrine of “successor liability” – which requires the assumption of certain liabilities as a matter of public policy).
Protect Against a Fraudulent Conveyance Claim. If you’re acquiring a “struggling” company, keep your guard up. One of the issues you need to worry about is a subsequent “fraudulent conveyance” claim by a dissatisfied creditor of the seller (which is a complex issue). What happens is, after the deal has closed, a creditor would sue your company to void (or set aside) the sale on the ground that there was “actual” fraud (in other words, the sale was actually intended to hinder, delay or defraud creditors) or, more likely, “constructive” fraud (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).
To minimize this risk, you’ll have to do two things: Build the best possible record that “fair consideration” or “reasonably equivalent value” was paid (such as by obtaining a fairness opinion from a reputable investment bank) and require that the sale proceeds be used for the benefit of the seller and not be distributed to the seller’s stockholders and/or adequate arrangements are made to pay-off the seller’s creditors.
Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.
VentureBeat's mission is to be a digital town square for technical decision-makers to gain knowledge about transformative enterprise technology and transact. Discover our Briefings.