What’s on tap for 2018 M&A? A recap of 2017 trends and the Cooley outlook on this year’s dealmaking:
Buying Innovation: Retention and Non-Competes. For both old-line companies and tech giants, innovation is the name of the game. It is often difficult for large companies to foster innovation organically for various reasons, including internal organizational challenges and historical cultural expectations. As a result, we are in a pocket of deal momentum strongly motivated by “buying” innovation. No longer just “acquihires,” today’s innovation-driven acquisition is focused on talent retention. One familiar technique used by sophisticated tech buyers is a holdback structure that subjects a portion of key employees’ merger consideration to revesting. The typical revesting period for these arrangements is 24 to 36 months. Ideally, the revesting provisions are structured to provide key employees long-term capital gains treatment on any deferred payments (compared to the ordinary income attributed to vested options or restricted stock units cashed out at closing). In addition to revesting provisions, buyers often request non-compete agreements from sellers or employees. This mechanism protects the business or value of the innovation purchased. Buyers should be mindful of potential enforceability issues when structuring non-compete agreements with stockholder employees. Countervailing public policy interests that favor employee mobility and individuals’ ability to earn livelihood can be surprisingly protective. State laws differ in many respects, and structuring non-compete agreements often requires complex jurisdiction questions regarding which law governs particular people and/or activity.
280G Gross-Ups in Public Company Sales. Despite the “say on pay” environment and the elimination of virtually all 280G gross-ups in executive employment arrangements, we continue to see target boards approving full or partial 280G gross-ups for executives in connection with public company sales. Where possible, parties generally seek to minimize the change of control payments potentially subject to excise taxes under the Internal Revenue Code, making gross-ups unnecessary. However, avoiding excise taxes may not be possible when executives have relatively low parachute base amounts (due to short tenures or compensation arrangements) or where a target’s stock has appreciated sharply within a short period. Approval of gross-ups in connection with a transaction typically involves a prior negotiation with the buyer. In our experience, buyers in competitive transactions appear willing to allow gross-ups (and further loss of tax deductions) as a cost to get the deal done. We find this practice particularly highlighted in the healthcare sector. According to a September 2017 Equilar study of gross-up practices for 107 mergers in the healthcare sector since 2013, 10% of the relevant companies had existing gross-ups and 15% added new gross-ups in connection with M&A transactions. For the remaining companies in the study, we cannot determine whether the executives received any payments that would have triggered material excise taxes and, thus it is impossible to conclude whether the parties addressed 280G gross-ups in the deal negotiations. Accordingly, the fact that only 25% of the studied deals included these gross-ups may underreport the percentage relative to the number of studied companies with meaningful 280G issues. Nevertheless, as gross-up arrangements are typically negotiated after the deal price is negotiated, we do not believe that these arrangements are impacting overall stockholder consideration. Buyers generally treat gross-ups as a transaction expense separate from deal price.
We also note that while institutional stockholders and proxy advisory firms remain opposed to gross-ups as a matter of policy, the inclusion of deal specific gross-ups has not appeared to have any practical impact on the outcome of transactions to date. In one-step mergers, where there is a so-called golden parachute advisory vote, inclusion of a gross-up may increase the percentage of shares voting “no” on change of control arrangements, but these are only advisory votes and shareholders generally still approve these arrangements, albeit by smaller margins. To date, we have not seen ISS or Glass Lewis recommend against sale transactions solely because of the inclusion of gross-ups. We caution that ISS, Glass Lewis or institutional shareholders could change their views on this issue, and buyers and target boards need to remain appropriately nimble in this space.
Appraisal Closing Conditions in Private Deals. While the inclusion of any appraisal rights condition remains uncommon in public deals, we commonly negotiate these conditions in private sales of venture-backed companies. Commonly accepted conditions take one of two forms: the absence of available appraisal rights altogether or appraisal rights not having been exercised by a certain percentage of shares. Often, these closing thresholds are set so high that, as a practical matter, the target must obtain the affirmative deal approval from 90% to 95% of outstanding company shares. Targets with a diffuse or large shareholder base are often troubled by the practical implications of rounding up the vote and/or giving minority shareholders (including former employees) potential leverage to extract deal concessions. In these situations, target companies that have well-drafted drag rights in existing voting or shareholder agreements have been able to help satisfy the appraisal condition by deploying the power of the drag. The legality of advance waivers of appraisal rights has not been resolved by the courts. In drafting drag rights in anticipation of a potential future change of control, we recommend following the National Venture Capital Association model voting agreement but not including the optional board approval requirement because of the risk of shareholder challenges to a board’s actions on fiduciary duty grounds. In connection with a merger involving a target with drag rights, the parties need to be mindful of the precise requirements for triggering the drag rights. The parties may alternatively conclude that drag rights technically should not be used, but rather deployed as a reminder of the prior vote agreement and any related pre-agreed mechanics.
M&A Deal Litigation: Increase in Private Deal Litigation. The Trulia decision (in January 2016) significantly changed the landscape of public M&A litigation, and we continue to observe a decline in public M&A litigation, particularly in Delaware. However, incidences of private M&A deal litigation relating to post-closing claims (e.g., indemnification, earn-out, fraud, etc.) and claims alleging breach of fiduciary duties by the board or controlling stockholders in conflicted transactions are each on the rise. Most private, venture-backed companies do not have boards comprised of a majority of independent directors, and some do not have any independent directors at all! Although Delaware courts generally apply the business judgment rule in breach of fiduciary duty cases, in conflicted transactions the court will apply the entire fairness standard. A transaction may be viewed as conflicted where a controlling stockholder is on both sides of the transaction or is receiving something that the other stockholders are not (e.g., disparate consideration, side deals, etc.) or where the board is conflicted (see Trados, Nine Systems, Good Technology, ODN Holdings). For venture-back boards where all or virtually all directors have a significant financial interest in the sale transaction and where cleansing the transaction in order to qualify for the business judgment rule may be practically impossible, we recommend that parties focus on process (including consideration of strategic alternatives, market checks and other mechanics typically followed more rigorously in the sales of public companies) and providing full disclosure to the stockholders (these are not the deals for which disclosure light is appropriate).
M&A Closing Certainty – Antitrust and CFIUS Trends: In both public and private deals, the parties need to be mindful of issues that impact the certainty of completing the transaction. We continue to focus on antitrust- and CFIUS-related conditions:
Antitrust Trends: Three points are worth noting. First, while antitrust scrutiny most frequently focuses on the horizontal aspects of transactions involving the combination of competitors, we are also seeing a focus on vertical mergers, as we have noted in a recent blog post. For instance, the DOJ is challenging the proposed acquisition of Time Warner by AT&T, a transaction involving an upstream supplier and a downstream distributor. Historically, in order to resolve antitrust concerns raised by such mergers, parties have agreed to behavioral remedies requiring non-discriminatory treatment of customers. The DOJ has recently indicated that it will not accept behavioral remedies and will instead require structural relief, typically requiring companies to divest product lines or business units, as it almost always does when resolving horizontal mergers. The outcome of the AT&T/Time Warner merger challenge, now set for trial starting March 19, may therefore significantly impact vertical merger antitrust law. Second, the FTC continues to aggressively target pharmaceutical companies in connection with mergers and acquisitions. As we have noted in our recent blog post, the agency has recently required divestitures of two generic pharmaceutical products to resolve antitrust concerns, including “imminent future competition,” in connection with Baxter’s $625 million acquisition of Claris’ injectable drugs. The agency also required divestiture of two point of care medical testing device product lines to resolve concerns raised by Abbott’s $8.3 billion acquisition of Alere. Third, the FTC has recently announced new higher HSR thresholds, to take effect in February, increasing the minimum size-of-transaction threshold from $80.8 million to $84.4 million. The larger size-of-transaction threshold, which is applicable even if the HSR size-of-person test is not met, will also increase from $323 million to $337.6 million, so that acquisitions valued at more than $337.6 million will be reportable regardless of whether the size-of-person threshold is met (unless an exemption applies).
CFIUS: The Committee on Foreign Investment in the United States has received much attention over the past year for its role in blocking or altering the terms of proposed foreign acquisitions of and investments in US companies. CFIUS’ actions in this regard have led parties to other transactions to abandon their proposed investments. CFIUS is an interagency committee of the US government that was created to review foreign investments in US businesses for potential national security concerns. A CFIUS review can take months to complete and may result in a mandate for the parties to a transaction to mitigate perceived national security concerns or in the outright prohibition of the proposed transaction. Where a transaction has already closed, CFIUS can recommend that the President retroactively order the transaction be unwound.
When engaged in a buy- or sell-side transaction involving an acquisition of a US business by a foreign entity, CFIUS should be one of the first issues addressed. Key considerations include whether the acquisition involves sensitive government contracts, critical infrastructure, export-controlled technology or potential foreign access to other sensitive information (e.g., personally identifiable information). Where national security issues are implicated, the parties should work with their respective CFIUS counsel to create a strategy with regard to obtaining CFIUS clearance of the transaction and account for this strategy in the transaction timeline. Do not postpone these issues until closing.
Use of Earn-Outs in Life Sciences Deals. We continue to see earn-outs used as a mechanism to bridge valuation gaps between parties in a significant number (approximately 77%) (2017 SRS Acquiom Life Sciences M&A Study) of private development-stage life sciences deals where parties share the risks and rewards of clinical and regulatory development through earn-out payments. Of the life sciences deals surveyed in the SRS Acquiom study, only 31% saw a successful payout of earn-outs. As a result of the low rate of success associated with earn-outs, disputes often arise in the context of the interpretation of successful achievement of an earn-out. A recent case in the Delaware Chancery Court (Fortis Advisors v. Shire) highlighted the importance, in this context, of specificity in the drafting of earn-out provisions. In this case, the court agreed with Shire based upon a plain reading of the earn-out provision as set forth in the merger agreement. Drafting earn-out provisions is complex as they are heavily negotiated, fact-specific and based on multiple factors. Where buyers’ earn-outs are based upon the successful outcome of clinical trials, sellers are advised to consult with business, legal and technical experts on the definition of success in light of the fact that the court will not blue-pencil the earn-out provisions or look beyond the plain words of the acquisition agreement