Microsoft has just acquired enterprise software startup BlueStripe Software and "shuttered" it: a process not uncommon in the software development community whereby the acquired target company ("Target") is shut down following the acquisition, its team of developers absorbed into the business of the acquirer, and its products discontinued and rebuilt under the purchaser's badge.
There are many opportunities out there today for corporate acquirers to snap up talented development teams and integrate them and their disruptive technologies into their product offering, and subsequently liquidate Target, thereby avoiding taking on the liabilities of the legacy business. But what are the legal issues faced with structuring such an acquisition, and how can an effective integration be achieved?
Is an "Earn-Out" appropriate?
One pricing mechanism adopted by a buyer to ensure it does not overpay for an asset is to make part of the purchase price subject to an earn-out, conditional upon the performance or profits of Target over a given period of time. Shuttering the newly acquired company however poses an obvious obstacle: how can you measure the performance or profits of an entity that no longer exists? That’s not to say it is not possible to deploy an earn-out style structure, but careful thought needs to be had. It may be possible to use revenue based performance criteria, whereby the revenue of the purchaser's group which is directly attributable to Target's products or solutions to be sold by the purchaser's group is tracked and tested against a target threshold. If this is desirable, does the purchaser have the accounting software and systems to accurately track such revenue as distinct from revenues it would have generated in any event, and how do the parties agree what or what is not "directly attributable"?
Employees as Sellers
If the core asset being acquired is a team of skilled developers, then at the forefront of the purchaser's mind will be the retention of those staff in the purchaser's group going forwards, and incentivising them efficiently so that they stay. A number of issues can arise however where those employees have also been Sellers under the share purchase agreement, either as a result of being direct shareholders in Target from the outset (i.e. Founders), or holders of EMI options which have been exercised on completion of the purchase.
One such issue can arise where the parties are negotiating the consideration and incentive packages on offer. On the one hand, a Seller will be keen to put as much of that package into the consideration for the sale of its shares in Target (and therefore potentially taxed to CGT and Entrepreneurs Relief), and on the other hand, a purchaser will be keen not to overpay, or at least if it does agree to pay it as consideration for the sale of shares, to defer an element of it and make it contingent upon the continued employment of the relevant employee Sellers within the purchaser's group. This is likely to create tax implications for the employee Seller and tax advice should be sought by both parties to analyse whether such an approach would result in the deferred element of the consideration being treated as income and taxed to income tax and NICs, rather than capital gains. A developer is unlikely to be impressed if the consideration is structured in a manner which means they cease to be eligible for Entrepreneurs Relief at 10% when they are expecting to benefit from it. This tension can be alleviated by the parties addressing it early on in negotiations, and the purchaser considering alternative ways it can incentivise its new employees. For example, can the purchaser issue consideration shares in itself or its parent company to the employee Sellers? Does the purchaser have an option scheme it can utilise to incentivise the new team, or can one be put in place? Can it create a new bonus pool specifically for the new hires which is payable subject to performance milestones?
Completion Accounts v Locked Box
A purchaser wishing to avoid overpaying for the asset would be well advised to adopt a completion accounts mechanism, enabling it to test and ultimately adjust its valuation of the Target by reference to a set of accounts drawn up in a period following completion and prior to Target's liquidation, once the purchaser has control of the Target and is better placed to understand the finances of the business. Whether the completion accounts test the net assets of the Target, or alternatively adjust the price against a target working capital or the net debt position of the Target (or a combination thereof), will depend upon what basis the Target has been valued.
In some cases however, particularly where the Sellers are also the employees of Target being "acqui-hired", there may be a wish to avoid price uncertainty. Completion Accounts can create uncertainty and ultimately lead to disputes, and the parties should therefore take care if adopting a completion accounts mechanism that the provisions are clear and unambiguous, particularly as to the definitions of financial terms. Alternatively, if a purchaser is wishing to avoid potential disputes with its newly acquired talent, so as to maximise retention and give certainty that the amount they are paid on completion will not be chipped away, the parties may prefer instead to go for a Locked-Box mechanism: where the price paid for the Target company is agreed and fixed prior to completion by reference to a set of accounts drawn up prior to completion. Whilst adopting a Locked Box mechanism will require greater financial diligence and negotiations upfront, it avoids the need for potential escrow arrangements and any unnecessary delay in "shuttering" the Target post-completion.
Warranty & Indemnity Protection
Where a corporate acquirer is looking at an acqui-hire, early thought should be had to the shareholder make-up of the Target. What percentage of the issued share capital is held by the very people the purchaser is looking to retain? The purchaser is unlikely to want to bring a warranty or indemnity claim against its newly acquired team of developers post completion, as this would likely damage the personal relationship it is looking to build. This is likely to leave a gap in coverage as against the total purchase price paid, which can be exacerbated if the Target has been backed by venture capital: VC investors are almost certainly only going to give warranties as to title to their shares, and refuse to stand behind general warranty and tax claims. A warranty and indemnity insurance policy could bridge the gap, and should be explored as an option if the risk profile of the Target's business is thought to warrant it. Brokers and underwriters should be engaged early in the process, as they will also want to do their own due diligence on Target. Premiums nowadays for W&I policies are competitively priced and the types of products more innovative.
In addition, where a Target is to be liquidated shortly following completion, care should also be had when drafting the warranty protection in the share purchase agreement. A breach of the warranties (which are usually stated to be given for a period of between 18 months and 3 years following completion, or up to 7 years in the case of tax warranty/indemnity claims) may cease to be actionable if the Target company has been liquidated, leaving the Buyer with no ability to recover its losses.
Transfer of Employment
On a UK transaction where the Target is "shuttered" following completion, thought will need to be had to the Transfer of Undertakings (Protection of Employment) Regulations 2006 (known as TUPE) which protects the employment rights and the terms of the employment of Target's employees, and whether it applies. The purchaser should seek legal advice in respect of its consultation obligations, particularly if it is looking to make redundancies in Target's workforce or look to amend the terms of employment. An important aspect of the employee due diligence will be to understand the restrictive covenants (in particular non-competition provisions) and the notice periods of the employee contracts. The purchaser will not want to pay a large sum for the acquisition only to then find the employees are free to walk away a few months later and set up in competition with them. Non-compete provisions can be put into the share purchase agreement to bind those employees which are also Sellers, but it will need to rely on the underlying employment contracts for the others (and caution taken if it's looking to increase the duration of the covenants). Realistically in these scenarios, a carrot is better than a stick, and perhaps most importantly for the corporate acquirer, how does it on the one hand incentivise the newly acquired team, and on the other, not alienate its existing workforce by offering the new team better terms? HR integration planning will need to be done from an early stage, and thorough due diligence done on the employment terms and benefits of the team being acquired. From a practical perspective, it will need to get both workforces to buy-in to the shared mission and narrative going forwards.
Transfer of Business & Assets
When shuttering the Target's business, the purchaser should take advice on the transfer of assets and liabilities from Target to the purchaser's group, or more importantly which assets and which liabilities it wishes to leave behind in Target at the point of liquidation. A well drafted business purchase agreement should be drawn up to detail those assets which are being transferred, and those liabilities left behind. Due diligence should highlight the key or valuable assets of Target and care taken that these are not forgotten and mistakenly left with the company at the point of the company's dissolution following liquidation. Indeed, the law of bona vacantia still applies here in the UK, which states that the property, cash and any other assets owned by a company when it is dissolved automatically passes to the Crown. It can be difficult for non-UK purchasers to comprehend why the Queen now suddenly owns the Target's assets! Whilst a UK company which has been dissolved can be restored to the register and brought back to life for up to 6 years following its dissolution, bona vacantia won't be avoided where the Crown has already disposed of the asset in the intervening period.
In summary, on acqui-hires and shutterings, where a large part of the value in the corporate acquisition is the experience, skillset and certifications of the Target's employees as opposed to Target's actual products (as is often the case in the software and mobile app industry), a purchaser should have thought to the types of issues highlighted above and seek professional advice, particularly when drafting and negotiating the term sheet so that the myriad of issues can be addressed at an early stage. Careful due diligence should be undertaken not only to assist with risk allocation across the purchase agreement but also to assist with effective post-merger integration, and thought had as to what will be the real "carrot" which helps ensure the newly acquired team of developers stay loyal and committed to the purchaser's cause.
Tom Ward is Senior Associate at Fieldfisher, specialising in mergers and acquisitions, private equity and venture capital. Fieldfisher is a leading technology, media and IP focused full-service law firm, with offices across Europe and in Palo Alto.
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