Papering the legals for a high-tech deal presents a number of challenges beyond those that exist in any asset or share purchase transaction. The significant additional dimension is speed-high-tech M&A happens in Internet time, at a very fast pace. And yet, there is still much legal work to be done on such a deal. So herewith some suggestions if you are contemplating acquiring an Internet, software or some other high-tech company (hereinafter referred to as the "Target").
Phased Disclosure of Confidential Information
Prior to being allowed access to confidential information about the Target, you will invariably be asked to sign a non-disclosure agreement. Under this agreement, you will undertake to keep confidential the information you learn about the Target. Even in the absence of such an agreement, you will likely have a legal obligation not to disclose confidential information learned from the Target.
As a result, sound advice for you as the purchaser-as well as for Targets-is to be very careful about how information on the Target is disclosed to the potential purchaser. Remember, forbidden fruit (in the form of trade secrets or highly sensitive confidential information) is the tastiest, so you'll have to be careful to restrain your technical staff as they give the Target's technology the once over.
For example, if you are particularly interested in the Target's software assets, you should not review the source code (the high-level crown jewels of a software program) for the software until you have a general understanding of the business parameters of the deal. Thus, the business people should clearly set out the core points of the deal in a letter of intent before the engineers begin their due diligence review of the guts of the software.
Even this review by engineers should be done in stages, and should go no further at each stage than is necessary for you to determine that you do not wish to go to a further stage. By following such a phased disclosure approach, you can attempt to minimize the risk of being contaminated with the trade secrets and other proprietary information of the Target.
The danger to guard against is that the deal ultimately does not go forward, but you've learned a great deal about the Target's technology. This would lead to the suspicion that any competitive products that you released subsequently contained secret elements of the Target's technology. It is therefore in both parties' best interest to control, very carefully, the exposure of the purchaser to the trade secrets and confidential information of the Target.
Understand What You are Buying
This sounds trite, but you must understand what you are buying, and why. This means more than knowing the difference between purchasing shares or assets, though of course this is an important question as well. Rather, you have to decide if, for example, you are buying a balance sheet, or merely some intellectual property assets and access to people.
For instance, many high-tech start ups are in fact little more than some valuable technological assets and a handful of key and even more valuable people. At the other end of the spectrum, if the Target is a long established software company with sales in the tens of millions of dollars, you will also be "buying" this business' financial statements.
These two different types of deals present the purchaser with very different risk profiles. The due diligence for these two deals would be, therefore, quite dissimilar. The representations and warranties in the definitive purchase agreement would also look different. So, before you embark on these stages of the deal, you need a clear picture of exactly what you are buying.
Agree on Valuation Early On
Once you have decided what you are buying, it is necessary to determine what you will pay for it. This sounds like a rather straightforward exercise, but valuing knowledge-based companies, or certain of their assets, is fiendishly difficult.
Asset-based valuations are, for the most part, not relevant because the value of the high-tech assets-such as software or patents-carried on the books rarely indicates their true value. Earnings-based valuations can also be tricky, given that many technology companies have uneven earnings, or in the case of most dot coms, non-existent earnings.
So you will likely need to come up with some new valuation methodology that better captures the dynamics of your market space. Companies like Cisco and Nortel Networks often base their valuations, for example, on so many millions of dollars for each engineer of the Target, coupled with what market leadership the Target's novel technology can afford the purchaser, and how quickly. These sorts of valuation approaches can result in seemingly astronomical prices paid for virtually start up companies, but there is some solid business purpose behind most of them.
Whatever the parameters driving the valuation, the key is to agree upon the approach early on, and to have an understanding that it will be adhered to even if the various numbers driving the formula change as the due diligence exercise unfolds and reveals some surprises. There are lots of high-tech M&A deals where valuation questions plague the participants throughout the acquisition process, and a lot of angst can be avoided if the valuation rules of the road are firmly established early in the process.
Do Tax Homework Early
The tax regime applicable to all acquisition scenarios is complex and often times unruly. With technology-based deals, the tax issues can become even more complicated.
Should the technology assets be purchased by your off-shore affiliate to try to take advantage of international tax planning opportunities? How should the going forward business be structured to capitalize on R&D tax incentives? If there is a Canada-U.S. dimension to the deal, as there often is, how will future intercompany transfer pricing come into play?
The sellers of the business will also be asking a series of tax-related questions. If the purchaser is a US public company, and shares of this company are to be received by the Canadian-based sellers, how can the so-called exchangeable share vehicle be used to defer Canadian income tax until the Canadian sellers are ready to liquidate their shares? And will the $500,000 capital gain exemption be available? Or, if options are part of the compensation package going forward, how will these be treated?
These are just some of the important tax questions that can arise on the sale of a high-tech business. So all parties need to get their tax advice early. Given the speed with which these deals need to move, tax advisors need to be consulted at the earliest stages of the transaction, ideally even before the letter of intent is signed.
So, now that you have some of the prep work under control, you can move on to due diligence and the definitive agreements, topics for next month's column.
George S. Takach is a partner in the Toronto office of McCarthy Tétrault, where he is Head of the High-Tech Law Group. This column is intended to convey brief, timely but only general information and does not constitute legal advice; readers are encouraged to speak with legal counsel to understand how the general issues noted above apply to their particular circumstances.