Cleary Gottlieb Discusses the Virtues of Standardization in M&A

Standardization can be a virtue and one that M&A lawyers, likely due to self-interest and ego, sometimes resist.  If venture financing and derivatives practices can have widely accepted forms of legal documentation as a starting point, why should M&A be an exception?  Ironically, agreements for takeovers of publicly traded companies – once revered as a rarified realm that only an elite group huddled in skyscrapers in Manhattan could navigate – has evolved considerably toward standard forms thanks to enhanced attention to these publicly filed agreements and an effort by Delaware courts to draw clearer guidelines about precisely what will and will not fly in the world of “public M&A.”

However, the terms for private merger agreements, where the parties have more freedom to legislate their own rules, remain less standardized.  Enter Atlassian, a NASDAQ-listed enterprise software company that likes to play in the “serial acquiror” space alongside many cash-rich tech companies, as well as an increasing number of industrial and retail companies, with business models that include regularly acquiring privately held startups for purchase prices ranging from single digit millions to double digit billions of dollars.  Atlassian’s stated goal is to distinguish itself as more seller-friendly and rational than the bidders against whom they are competing for these targets and, to achieve this objective, their general counsel and head of corp dev have committed the company publicly to a form of term sheet.

This commendable project to promote standardization in the world of private M&A is garnering attention among M&A professionals in the tech world.  It is not inconceivable that this buzz will reach a tipping point where founders of targets and corp dev negotiators from acquirors will be reaching oral agreements on headline prices and a stay bonus pool amounts on the condition that the acquiror’s corp dev team commit then and there that their legal team will use the “Atlassian term sheet” for the balance of the terms.  What could be simpler and more efficient for the parties?

To help answer this question, here’s some commentary on the terms that a buyer and the target/sellers are taking on when they opt for the “Atlassian approach”:

  • Timing of ClosingNo closing is permitted at any time during the last month of any Atlassian fiscal quarter. For some cash-strapped start-ups, having to gut through an extra month of cash-burn may be stressful or even impractical.
  • Purchase Price Adjustments. The headline price is adjusted only by a reduction equal to the amount of the closing indebtedness, transaction expenses, change of control payments and costs of representations and warranties insurance. The absence of an adjustment based on balance items other than indebtedness leaves the buyer vulnerable to manipulative actions – e.g., if the purchase price goes up as debt is reduced but does not go down as accounts receivable go down during the pre-closing period, then the target is incentivized to accelerate collection of receivables and use the proceeds to pay down debt.  (Asserting a claim under the ordinary course covenants to recover for this kind of activity is not nearly as predictable or efficient as a purchase price adjustment mechanic.)  And what about protection of the buyer against the ballooning of liabilities (on- and off-balance sheet) before closing that are not in the categories specified above as meriting a purchase price reduction?  It is not unreasonable for acquirors of start-ups, especially those targets in the pre-revenue phase, to protect against this risk through broad adjustments based on all balance sheet liabilities and, for really early stage targets, off-balance sheet liabilities.
  • Treatment of Target Equity Awards. Unvested equity held by those who will continue to work for the target after closing rolls over into acquiror equity awards while all other unvested equity awards terminate without any consideration, and all vested equity awards are cashed out subject to a portion of this cash consideration going into escrow to secure the indemnification obligations to acquiror.
    • Receipt of equity of the acquiror may or may not be exciting to the target employees, depending on the size of target relative to the acquiror and the volatility of the acquiror’s trading price. Moreover, granting rights to acquiror equity may trigger investor pressure on the acquiror to engage in offsetting share buybacks. Another possible concern arising from the use of equity may be the dilutive impact on the voting power of acquiror insiders.  Accordingly, buyers may want to consider working around these concerns by converting unvested equity awards into rights under an “unvested payment plan” where the retention value is maintained through a vesting schedule, but the employees get certain value in cash (rather than buyer stock) upon vesting.
    • Meanwhile, participation in the escrow by holders of vested equity awards reduces slightly the pro rata exposure under the escrow of the larger (typically VC fund) selling stockholders, but can lead to unintended challenges, including:
      • administrative complexity arising from the need to track the escrow release payments to all the employees and apply appropriate withholding and payroll taxes that would not apply in the case of escrow releases to selling stockholders
      • loss of value of the escrow to buyer arising from the withholding and payroll taxes required to be skimmed off the top of any release and the cost/benefit judgment that buyer will have to go through before electing to punish its new set of employees (typically a key, and sometimes the sole, basis for the acquisition) by taking these employees’ escrowed money
      • potential conflicts with the target’s equity incentive plan – not every equity incentive plan will permit the acquiror to escrow a portion of the pay-out to the vested awards in connection with a merger and employees may be eager to enforce these rights to receive the full pay-out
    • Holding Back Merger Consideration from Key Employees. A percentage of the merger consideration payable to key employees would be held back and vest in installments over a period to be specified and, upon pay out, would be in the form of a number of shares of acquiror stock calculated using the trading price shortly before the execution of the merger agreement.  If the employee is terminated without “cause” or departs for “good reason” or due to death or disability, the vesting of these holdback shares would accelerate and, if the employee otherwise ceases employment, the employee would forfeit the unvested holdback consideration.
      • Retention is the sole purpose of this increasingly common concept of holding back a portion of the merger consideration payable to key employees who are selling stockholders. But holdback consideration in the form of acquiror stock may be sub-optimal relative to cash as the employee bears the risk of the value of the stock consideration from the date that the merger agreement is signed through the post-closing vesting dates (assuming that, at those vesting times, an exemption from the Securities Act is available to permit immediate monetization on the stock exchange, as should be the case in most instances by six months after closing).
      • Moreover, acquirors offering acceleration of vesting upon certain departures by these key employees (as opposed to a blanket, “you leave, you lose it” approach) will have to pay attention to the definitions of “cause” and “good reason.” For example, does a “#metoo” issue necessarily constitute “cause” and, if not, will the acquiror be in the awkward position of having to make a payout to a high profile employee upon his or her departure in connection with unpopular circumstances? Further consideration should be given to the fact that poor or inadequate performance often fails to constitute “cause,” thus risking an accelerated payout to someone whose inability to adequately perform duties and responsibilities led to his or her termination.  Similarly, the parameters of “good reason” can be bright lines, such as compensation thresholds and specifically mapped geographies for location of employment, or vague references to duties and responsibilities that leave the retention objective at risk.
      • Finally, buyers should expect that key employees will not react uniformly to this holdback arrangement because the tax impacts on different key employees can vary as a result of each key employee’s specific facts and circumstances.
    • Stay Bonus Pool. The form would be stock consideration. Offering a cash bonus pool may be more competitive than a stock bonus pool for an acquiror in an auction process for the target and more effective at achieving retention objectives. See also the issues flagged above under “Treatment of Equity Awards.”
    • Indemnification of the Acquiror for Breaches of Representations and Warranties. The indemnification obligations of the selling stockholders for breaches of representations and warranties would be almost entirely replaced by a representations and warranties insurance (RWI) policy, the cost of which would reduce the purchase price. (The cost for RWI is typically 3-4% of the coverage limit.) The policy would cover losses equal to only 4% of the purchase price.
      • Although indemnification claims for breaches of representations and warranties are not common and claims for more than 4% of the purchase price are even more uncommon, one factor that may contribute to this historical data is that, during most of the historical period from which this data is derived, RWI was not prevalent and therefore the sellers had much more “skin in the game” and incentive to get the representations correct.
      • In addition, while claims for material breaches of representations are not common, catastrophes do occur and a solid indemnity with a cap beyond 4% provides acquiror deal teams, as well as their officer and director supervisors, with coverage against assertions that they were being cavalier in their approach to M&A.
      • Finally, M&A teams at the acquiror need to keep in mind that RWI typically has important limitations, including:
        • no coverage of known matters (including matters that become known after the signing of the agreement and before the policy is formalized between signing and closing as is frequently the case),
        • no or limited coverage of many representations focused on specific balance sheet matters such as accounts receivable and deferred revenue, and
        • potential limitations on coverage of GDPR matters, civil and criminal fines, environmental exposures, transfer pricing matters, tax matters, and underfunding of pensions.
      • In addition, insurers may push back on the breadth of some of the IP representations that are popular in tech M&A, including on coverage of IP relating to future, not-yet-developed products, and on non-knowledge qualified “IP validity” representations. A creative and deliberate approach to negotiations by acquirors can bridge these gaps in coverage of IP representations, but acquirors need to be prepared for a potential second negotiation of these critical representations with the insurer after the negotiation with the target.
      • Furthermore, the insurers will scrutinize the level of diligence conducted by the acquiror and may not provide coverage for areas where the acquiror may have made a business judgment to conduct “due diligence-lite” and rely primarily on the representations and warranties in lieu of a deeper dive on diligence.
    • Escrow and Indemnification by the Sellers. The escrow, taken out of the merger consideration payable to the selling stockholders and equity award holders, is only 1% of the purchase price and, in the absence of unresolved claims, will be released 15 months after closing.  The acquiror may recover from the escrow not only for breaches of representations and warranties (presumably for the deductible not covered by RWI) but also for the areas of indemnity that are capped at the purchase price amount (fundamental representations, covenant breaches, and fraud). 
      • While it is not typical to have claims under the indemnity that exceed 1% of the purchase price, when these claims occur (the most common instance where this occurs in our experience is when there is a “special indemnity” for a known risk), the result is usually a settlement of the indemnification claim. Acquirors should consider that the amount of escrow money that is being held back from release while the settlement negotiations are ongoing is a material lever in determining the results of these negotiations.  A 1% escrow may be too small to contribute meaningfully to the acquiror’s leverage in these settlement discussions.
      • In addition, once the escrow is depleted or released, the ability to recover directly from the indemnifying parties is subject to serious limitations. As detailed in our blog post following Delaware Chancery’s Cigna v. Audax decision [make “blog post following the Cigna v. Audax decision” into a hyperlink to https://www.clearymawatch.com/2014/12/wake-up-call-for-private-ma-deal-structuring/], recovery from outside the escrow is not legally enforceable in the absence of express joinders being signed by the indemnifying parties (since they are not parties to the merger agreement between the acquiror and the target).  It is typically not practical to obtain joinders from all selling stockholders and equity award holders, especially as startups stay private longer and have increasingly large stockholder and equity award bases.  Moreover, the funds that are indemnifying parties will distribute promptly their proceeds from the merger and may not even be in existence (depending on the nature and life cycle of the fund) by the time the indemnification claim is asserted against them.  Finally, many of these indemnifying parties (former shareholders and equity award holders) will be valued employees of the acquiror at the time of the indemnification claim and therefore the retention and incentive costs to the acquiror of directly suing these individuals may outweigh the monetary benefits.  For all these reasons, the ability to recover from an escrow is more certain, cleaner, and less costly than reliance on recovery beyond the escrow.
      • The justification for the 15-month survival period is that such a period is sufficient to assure that the release of the escrow would be preceded by at least one annual audit, which in theory would turn up all undisclosed liabilities and other inaccuracies in the representations. Interestingly though, a survey released last week by AIG’s RWI unit indicated that approximately one quarter of all indemnity claims for breaches of representations and warranties are asserted more than 18 months after the closing.

Standardization is coming to M&A documentation.  Accordingly, Atlassian’s project is deservedly receiving growing attention.  The consequence is increased pressure on M&A actors to understand what they are actually agreeing upon when they decide to embrace the efficiency of standardization.

This post comes to us from  Cleary, Gottlieb, Steen & Hamilton LLP. It is based on the firm’s blog post, “Guidance on Navigating the Atlassian Term Sheet: Understanding the Substantive Implications Behind the Virtues of Standardization in M&A,” dated September 11, 2019, and available here.

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