SELLING
YOUR TECHNOLOGY BUSINESS
LESSONS FROM DEALS GONE AWRY
By Gavin G. Galimi, Attorney, Katten Muchin Rosenman, LLP
Every lawyer
can talk about the deals that closed. If you are selling your
technology business, you should be asking about the deals that
went bust or were renegotiated. Why did they go bust? How did
the deal terms change? What could have been done differently?
Some of these stories, and the lessons they teach, are told here.
Romeo and
Juliet
Think Montague and Capulet and the tragedy of Romeo and Juliet.
In this story, there are two companies, "Buyer" and
"Seller." Buyer and Seller are fierce competitors. They
sell into the same space and in the same territory. The competition
is so fierce that at virtually every staff and management meeting,
Seller bad mouths Buyer. For years, Seller has been telling its
people how terrible and how weak the Buyer is, how buggy Buyer's
software is, and how Buyer's development team rejects end up at
Seller.
The chief
executives of Buyer and Seller begin discussions about a possible
deal. Notwithstanding the perception of Seller's rank and file
that everything about Buyer is terrible, Buyer's acquisition of
Seller makes a great deal of sense. Seller's development pipeline
is very attractive. Seller is much further down the path than
Buyer of finishing the next generation product. As a combined
company, Buyer could cut its development expenditures and still
speed the next generation product to market. The combined sales
force would be the largest in the industry and the combined company
would be nearly ten times larger (based on revenue) than its nearest
competitor. (Some of you may be thinking there are antitrust issues
involved, but that is not what this article is about.)
Negotiations go very well. Although there is some back and forth
over price and various asset purchase agreement provisions, all
of the deal terms get ironed out. The CEOs of both companies,
with approvals from their boards of directors, sign the purchase
agreement. Both executives now turn their focus to satisfying
closing conditions. Since a key motivating factor for the acquisition
is the development pipeline at Seller, one of those conditions
is that the development team must agree to join Seller after the
acquisition. Although the Buyer can waive any condition that is
not satisfied and proceed with the closing, there really is no
deal if this condition is not met.
You may have guessed where this story goes. There is no way Seller's
development team will join Buyer. For years, this team was either
ranting about, or listening to rants about, how horrible and inferior
Buyer was. Although generous retention packages were offered to
the development team, the culture of competition - the great feud
between the Montagues and Capulets - stopped this deal from getting
done.
Buyer learned two lessons from this dead transaction. First, examine
carefully the culture of the target company. Second, be thoughtful
about the internal messages conveyed to the workforce about competitors,
anticipating the day the buyer becomes a seller.
Woops, Someone Else Owns What You Are Selling
There are many news articles about two companies involved
in a lawsuit over intellectual property ownership. These are what
we will call "Woops Problems." The story behind Woops
Problems invariably involves some variation on the theme that
the product your company is selling allegedly incorporates technology
developed and owned by another person or company.
A real example was reported in the April 4, 2005 Orange County
Business Journal. Computer Associates International Inc. alleged
that Quest Software Inc. was selling software that included code
from a company Computer Associates had purchased a few years previously.
Allegedly, four workers from the acquired company went to work
at Quest after the acquisition and supposedly used or incorporated
the original code from the acquired company into software being
sold by Quest. A lawsuit followed and a court enjoined Quest from
selling certain products which allegedly included the original
code from Computer Associates. Quest and Computer Associates subsequently
settled, with neither side admitting any fault. As part of the
settlement, Quest was to pay Computer Associates $16 million plus
royalties for a non-exclusive license to the code in dispute.
In an acquisition, when the potential problem with a target company
is so obvious because there is already a lawsuit, either the acquisition
never happens or a substantial price reduction occurs to ensure
that the substantial, anticipated expenses of the litigation are
deducted from the value the business was thought to have without
the litigation.
More typically, there is no active lawsuit and the buyers depend
on diligence and the purchase agreement's representations, warranties,
and indemnities for protection from the Woops Problem. Can the
selling company represent to the buyer that all employees, or
at least all key employees, have entered into confidentiality
and proprietary rights agreements with the company in a form that
is satisfactory to the buyer? If not, deals involving significant
intellectual property often fall apart, considering the potential
liability to the buyer easily can run into the millions of dollars.
Another scenario typical of a Woops Problem revolves around companies
that are founded in one state, but then move or expand into other
states. The risk centers on whether the documents that worked
in one state work in the other states.
In this story, a company had moved to California a few years ago
from a mid-Atlantic state. Because of changes in the industry,
the Company was now looking to be sold. Much of the company's
value was based on technology relying upon algorithms developed
by employees who had moved with the Company to California. Potential
buyers who understood the business were anxious to conduct diligence
on the ownership of the company's technology.
In the course of that diligence, the buyers discovered that an
early form of confidentiality and proprietary rights agreement
from the original founding state was still in use. There were
two big problems with the form. It prohibited competition after
employment terminated in violation of California law and the form
omitted provisions on invention assignment required by California
law.
While a few potential buyers ceased to be interested in the company,
one continued with diligence. This prospective buyer and the sellers
were able to get comfortable that this issue was manageable with
respect to the existing workforce. A number of former employees
who were instrumental in developing the algorithms had left the
company on less than favorable terms.
This story does ultimately end with a sale. In this case, the
key people among the former employees were paid a hefty sum to
enter into agreements that cleaned up the intellectual property
ownership issues and extensive indemnity and escrow protections
were implemented to get the buyer comfortable with the remaining
risk. The sale closed nine months later than had been planned
and the sellers ended up with several million dollars less, after
netting the payments and additional costs involved with cleaning
up the Woops Problem, than originally had been agreed.
Uncle Sam Takes His Cut - Taxes
A business school professor once asked his class how many
people wanted to write a check to the federal government for $3.5
million in taxes. Most people have a knee-jerk reaction at the
thought of paying taxes, especially a seven figure number. As
a result, very few students raised their hands. The professor
asked one of the students who had raised her hand to explain why
she wanted to write the check.
She explained, "Assuming an ordinary income tax rate of 35%
and that the check being written is to pay ordinary income tax,
I would have earned $10 million if I owed $3.5 million in taxes."
Another student was even happier about writing the check. "I'd
be even happier writing a $3.5 million check to the IRS if it
was for capital gains. Assuming a 15% long-term capital gains
tax rate, I would have earned $23.3 million to owe that much in
taxes."
Managing tax exposure can greatly enhance the amount of money
a seller gets to keep from a sale transaction. Volumes have been
written about tax planning. Because of the tax rate difference,
long-term capital gains are worth 20% more than ordinary income.
One of the most common ways for a seller to have long-term capital
gains treatment for a sale transaction is for a stockholder to
sell the stock of a "C" corporation owned by the stockholder
for more than one year. A stock sale, besides affording the buyer
little opportunity to avoid the liabilities of the seller, also
deprives the seller of the ability to take a tax deduction for
the amount of money paid for the stock. This is in contrast to
an asset sale in which the buyer gets a deduction for the amount
paid for the assets and the buyer generally picks and chooses
which liabilities to assume. The seller's tax treatment for an
asset sale depends on the assets being sold, the seller's basis
in those assets, and type of entity holding the assets. If the
seller is a "C" corporation, an asset sale results in
two levels of tax: first, the gain on each asset is taxable income
to the seller and second, the corporation's distribution of net,
after tax proceeds, is taxed at the stockholder's level.
All this is background for the story of a deal gone awry. The
seller had received several proposals to buy the business. Some
of the proposals were asset deals, one was a stock deal. The stock
purchase proposal was for about $10 million. After taxes, this
was roughly the equivalent of $8.5 million to the seller. The
asset purchase proposals were in the range of $20 million. After
taxes, this was roughly $11 million to the seller.
The seller was very discontented that an offer that was 200% larger
resulted in net proceeds after taxes only 30% larger. Like many
sellers with multiple offers, this seller began combining the
pro-seller features from each of the offers into a counteroffer.
The new deal terms would be $20 million in a stock deal, leaving
the seller with roughly $17 million after taxes.
This counteroffer was very expensive to the potential buyers.
The proposed stock buyer was being asked to double his bid. The
proposed asset buyers had lost the liability limitations of an
asset sale, and because they would lose the deduction for the
amounts paid for the assets, would end up paying roughly $7 million
more, after taxes, for the business in a stock deal.
At this point, the deal was dead. The asking price had gone up,
on an after-tax basis, at least $7 million. This was just too
rich a price for the proposed buyers. In this case, taxes and
perhaps a little greed, had killed the deal.
The seller quickly learned to bring the tax advisors together
much sooner in a potential transaction. He also implemented on
this strategy very quickly. After the hype over the counter-proposal
died down, the seller put his tax advisors together with those
of some of the buyers. After some thoughtful planning over several
months, the seller and a buyer were able to restructure the transaction
so net, after tax-proceeds to seller totaled approximately $15
million.
So please, when you are looking to sell your technology business,
do not let Uncle Sam, Romeo and Juliet, or a Woops Problem stand
in your way.
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Gavin
G. Galimi is an experienced corporate, technology, and healthcare
attorney who works extensively with companies across all industries,
including software, hardware, internet, search, healthcare,
and biotechnology. An entrepreneur himself, he focuses his
practice on helping entrepreneurs of large, middle market,
and emerging companies achieve their business objectives,
including venture financings, mergers, acquisitions, inbound
and outbound licensing transactions, and advising on operational
matters. He also advises clients on privacy and data security
matters. Gavin can be reached in the Los Angeles office of
Katten Muchin Rosenman, LLP, an AmLaw Global 100 and BTI Top
30 Client Service law firm. Please feel free to share your
comments and thoughts. His email is gavin.galimi@kattenlaw.com.
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©
2006 by Gavin G. Galimi. This article is not to be construed as
legal or tax advice. CIRCULAR 230 DISCLOSURE: Pursuant to regulations
governing practice before the Internal Revenue Service, any tax
advice contained herein is not intended or written to be used
and cannot be used by a taxpayer for the purpose of avoiding tax
penalties that may be imposed on the taxpayer.
