M&A Considerations for Serial Acquirers

Transcript

Justin:
My name's Justin Yi, I'm a partner in the M&A Group in our Orange County office.

Josh:
And I'm Josh Pollick, I'm a partner in the Tech Companies Group based in Santa Monica.

Justin:
Today, we're gonna have a conversation about considerations for serial acquirers. So Josh, you represent a lot of companies from inception to exit. What are some of the key common themes around clients of yours that do lots of acquisitions?

Josh: Yeah, that's a good question. We have some clients that are very acquisitive, and for those companies that tend to be later stage private companies, we've helped them set up a sort of M&A playbook. It goes through the different stages of the transaction from pre-term sheet diligence to the term sheet process itself, to tax considerations and structural issues, and then negotiating the deal. At the pre-term sheet stage, what we tend to focus on in terms of diligence is understanding the cap table, so liquidation preference, vesting schedules for the key employees who are typically a core part of the acquisition. Looking at whether there's any material litigation or liabilities, understanding that pre-term sheet is important. Assessing the product, we're not involved in the product diligence, but making sure that the product, which will now be integrated into your business, is consistent with the quality and values that your company represents. Doing diligence on the customers, things of that nature. That's the pre-term sheet side of things. I think another key issue is the structure and tax implications, and it'd be great to get your perspective on those issues.

Justin:
Yeah, structure is very important, especially when you're gonna do multiple rounds of acquisitions because if you start doing it wrong, it's really hard to fix it after you've done your second or third one. So I would say it's important to involve tax advisors early and often because they'll help you think through the best way to structure. And again, this is all about creating a playbook, creating economies of scale, you can do it over and over again. And especially when you're thinking about using stock as a form of consideration, oftentimes you have to worry about, hey, is this gonna allow me to use the tax-free reorg rules? Because sellers are always gonna be very interested in that as well. The other thing to think about is what is the form of the acquisition or the form of the transaction, right? So we've done a lot of full acquisitions through mergers, we've also done asset sales, but a lot of times buyers don't necessarily want to buy the entire company. What they really want is the team. So acqui-hires have become a common acquisition structure where you make offers to the team, maybe you get a license to the IP, maybe some limited assets, and otherwise you leave the rest of it behind, the seller can wind up the company, and otherwise the team joins you and becomes part of your team working on the product for you going forward. So that's an attractive structure, not only because it gets you what you want, you can cherry-pick it without having to take over the legacy liabilities of a company, but also it streamlines the documentation, the diligence, and allows you to execute on it much quicker. I would say you can do an acqui-hire in weeks as opposed to in a full M&A transaction, which takes many months to execute on.

Josh:
So you mentioned stock consideration, and a lot of our acquires would prefer to pay in stock rather than cash. How do you typically advise companies on how to value the stock and the deal?

Justin:
Yeah, that's a great question, and it's a question we often get from our clients. I would say there's a number of common methodologies that people use. A lot of times buyers will use their last preferred price from the last price round that they've done. Obviously, that's beneficial to the buyer because it allows them to use a higher price which results in less dilution for their existing stockholders. From a seller's perspective, they wanna use the lower value, often that's the 409A, but I would say more often than not, parties do not use that methodology because it's really not an appropriate value of the shares for purposes of an M&A transaction. And then there's everything in between. People can determine something in between or maybe there's a forward valuation that they're using based on a multiple, but I've seen the gamut of it. But it is a key factor because the per-share price will determine how many shares are issued. And that's also something that goes back to the tax aspect of, and something that a lot of clients aren't aware of. Under the tax-free reorg rules, there are certain percentages of cash stock that you can have in order to have the stock portion deferred, which is important for a seller. They're not gonna wanna have to pay out-of-pocket cash taxes on stock consideration, that's illiquid, right? And so a key consideration is when you set the split of cash and stock to conform to the tax-free reorg rules, you gotta think about, hey, is the value of the stock going to be respected by the IRS? Or if it's later challenged, will the stock be deemed to have a discounted value like the 409A, and then you end up blowing your tax-free reorg. So that's definitely something that we always assist our clients with and can help through the planning process. And I would say the earlier the better because if we're able to get in it and think about how the numbers work, think about the valuations at the term sheet stage, then that would allow you to kind of present an offer that the seller would be able to accept as opposed to going through many iterations of negotiation based on difficulties they have with accepting a package that doesn't work for them from a tax perspective.

Josh:
Yeah, that makes sense. And you mentioned acqui-hires. I mean, in any deal, whether it's an acqui-hire or not, the team is a core part of what they're acquiring. How do you think about it? And how do you advise your clients on structuring the deal in terms of what's paid at closing versus sort of, you know, what's paid over time based on milestones or time or other kinds of earn-out considerations?

Justin:
Yeah, I mean, the obvious answer is you want to create the right incentives for the team to stick around. And you do that through a combination of revesting the consideration they get in the deal if the team is getting a large portion of the deal. Usually that's limited to founders or early employees that have a large stake in the company, but also to make sure that you're providing the appropriate level of new go-forward incentives to ensure that people want to stay, help you grow the company, because if they're not going to stick around, more often than not, that will kind of lead to risk of an unsuccessful M&A outcome. And that's something that you got to think about kind of more broadly in terms of when you're buying founder-backed companies, you know, you got to think about not as the marriage, but the divorce, right? These are companies that have been built by founders. They think of them as their baby and they're giving it to you as part of a sale process when they exit. And, you know, founders have many different objectives when they sell and you got to be prepared, not just for the success, but also what happens if it doesn't work out. And so in that sense, we often counsel clients to not only include vesting provisions or incentives, but also to think ahead, to create a way to have a clean exit that works for both your company as well as for the founder if things don't work out.

Josh:
That makes sense. And I guess if you're advising, let's say, an early stage company versus a later stage company on a potential buy-side acquisition, are there different considerations that you think about at different stages of the business? Is the advice that you're giving the same? How do you think about, you know, in terms of the client that you're advising, you know, on the buy side, does the stage impact your guidance?

Justin:
Absolutely. I mean, as you know, like stage has a critical role in terms of determining the culture of a company. And so when you're early stage and you've got 10 employees and you're trying to absorb another company that has five employees or 10 employees, that's going to drastically alter the makeup and culture of your company once you integrate. And that integration is frankly the hardest part of the M&A. What we do is the easy part. We're just execution. Once you close that deal, you got to find a way to have everyone rowing in the same direction. And so what I would say is, yeah, yes, that the advice that we give early on for early-stage companies is much more focused around ensuring that there are good structures in place to integrate the teams, to make sure that there's a good fit organizationally from a product, from an IP perspective. For our later stage clients, as we know, like they already have all their policies, they have their structures, they have the way of doing things. And so it's a lot easier to bring in a company or two or three or four or five, you hand them the handbook, you give them the t-shirt and the email address, and they're on their way because you've done it so many times. And this goes back to what you're talking about with the playbook. That's why it works so well. I mean, in terms of the playbook, I mean, I think one of the benefits of it is that it enables you to, you know, with a straight face, go to targets and say, "Hey, this is the way that we do things." You know, and we're really not going to change it for you. And we found that that is a very effective negotiation tool because it's born out of reality, right? Like for a large late-stage company, they're not going to be able to bend over backwards for every single target. They're going to have to have a system in place to enable them to be able to do many acquisitions successfully and quickly, which increases execution certainty and success.

Josh:
Yeah. You know, and speaking of divorce and sort of future disagreements, you know, when we're on the sell side, we often advise our clients not to agree to any sort of earn-out, you know, that earn-outs just are a recipe for future disagreements. When you're on the buy side though, how do you think about earn-outs, you know, from that perspective?

Justin:
Well, I think, you know, my view on that. I think earn-outs are often used as a last resort because there is a valuation gap. And so certainly we understand the business rationale for it, but you always have to be aware of the risks. It's, you know, earn-outs tend to lead to disputes, to litigation. And so if you're going to use an earn-out, you want to be very specific in terms of how it's calculated. And from a buyer's perspective, right, like you're going to want to make sure that you're protected. You're not going to want to give them rights beyond just here, here's what your financial entitlements are if the earn-out's met. But other than that, I think, you know, it's something that people need to think about carefully.

Josh:
Yeah. You know, our clients always want to move quickly. There's a desire to close ASAP. Everybody wants to get the deal done, move forward, you know, but you also want to do the right level of diligence. And in your experience, particularly on the buy side, you know, what are the types of diligence issues that can come up and, you know, that companies should really be focused on in terms of IP versus data privacy versus other issues that come up?

Justin:
Yeah, I mean, look, I think every company is different, right? But I'd say there are themes that you see over and over again, right? The themes are proper documentation around ownership of IP, right, for tech companies. You gotta think of where are these people located? Oftentimes they're in foreign jurisdictions. You got to make sure that you're complying with the local laws around their employment, but also in terms of their ownership and creation of the IP. Things of that nature, I think, pop up quite often. And then, you know, as you have in your practice, a lot of times the capitalization records are not correct and it takes quite a lot of time to correct them or to figure out what went wrong. And so that's something we always focus on because you want to make sure that you know what you're buying.

Josh:
Well, Justin, I appreciate your time today and thanks for all your insights on the buy side M&A process.

Justin:
Yeah, likewise.