“Ask the Attorney” – Acquiring a Company (Part 1)

by Scott Edward Walker on April 28th, 2010

Introduction

This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”

I have two goals here: (i) to encourage entrepreneurs to ask law-related questions regardless of how basic they may be; and (ii) to provide helpful responses in plain English (as opposed to legalese).  Please give me your feedback in the comments section.  Many thanks, Scott

Question

My co-founder and I are friggin crushing it.  We launched our company 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 you should be thinking about.  I will address five significant ones in this post and five more in part 2 next week.

1.  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 (e.g., 90-120 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 is generally advantageous to execute a separate letter agreement and skip the LOI (i.e., proceed directly to the negotiation and execution of a definitive acquisition agreement) for the reasons discussed in #2 below.

2.  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.  (See my post on investment bankers.)  Accordingly, it is 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: (i) as noted above, by executing an exclusivity letter agreement and skipping the negotiation of an LOI; or (ii) by executing an LOI that includes a binding no-shop provision, but is otherwise non-binding (except perhaps with respect to expense reimbursement and/or other “special” provisions) and is as non-specific/general as possible.

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.

3.  Do Your Diligence.  A comprehensive due diligence investigation is critical to the success of any acquisition.  The fundamental purpose of due diligence is to validate assumptions with respect to valuation and to identify risks.  Accordingly, there are typically three separate investigations: operational/strategic, financial and legal.  Clearly, the scope of your investigations must be tailored to the particular transaction; however, it cannot be emphasized enough that most deals fail due to inadequate diligence — resulting in the buyer (i) overpaying for the target, (ii) assuming significant unknown liabilities and/or (iii) experiencing major integration problems.

4.  Buy Assets, Not Stock (Equity).  It is generally in your interest to purchase assets, not equity, of the target for two principal reasons: (i) you will get a stepped-up tax basis in the acquired assets; and (ii) you will minimize the assumption of any unwanted liabilities.  Indeed, in a stock transaction or merger, the buyer assumes all of the target’s liabilities (known and unknown) by operation of law; 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).

5.  Protect Against a Fraudulent Conveyance Claim.  You need to be very careful if you’re going to be acquiring a “struggling” company.  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 avoid (or set aside) the sale on the ground that there was “actual” fraud (i.e., the sale was actually intended to hinder, delay or defraud creditors) or, more likely, “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).

To minimize this risk, you must do two things: (i) build the best possible record that “fair consideration” or “reasonably equivalent value” was paid (e.g., by obtaining a fairness opinion from a reputable investment bank); and (ii) require that (A) the sale proceeds be used for the benefit of the seller and not be distributed to the seller’s stockholders and/or (B) adequate arrangements are made to pay-off the seller’s creditors.  (You can learn more about fraudulent conveyance and related issues in my post “Buying a Distressed Business: Ten Tips for Entrepreneurs.”)

Conclusion

I hope the foregoing is helpful.  Indeed, acquiring another company is tricky and raises a host of issues that need to be buttoned-down.  If you would like to learn about some of the typical mistakes entrepreneurs make in connection with doing deals generally, you should check out my video “Five Mistakes Entrepreneurs Make in Dealmaking” on YouTube.

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