In addition, shareholders of emerging businesses are finding that strategic mergers or acquisitions result in earlier liquidity with less uncertainty than public offerings. The operations of the emerging business often jump forward in a merger or acquisition by an established enterprise having a ready sales, warehousing, distribution or manufacturing infrastructure. A strategic merger or acquisition of an emerging business often allows an established enterprise to utilize more fully its own infrastructure, increasing return on its assets.

The purpose of this white paper is to offer guidance to both emerging as well as established businesses in establishing a merger-and-acquisition (or “M&A”) strategy.

Requisite Steps: Plan and Protect

The requisite steps before any consideration of a merger or acquisition are to “plan and protect.” The first step in any M&A strategy of either an emerging or established business is to protect the resources of that business.

Protecting resources

The two most important resources of either a business seeking to make an acquisition or a business seeking to be acquired are (i) the human resources of their management team and other key personnel, and (ii) the intellectual property of their business, products, and services.

Employment terms. With respect to the human resources, a detriment to an acquisition is not having key members of management and other key personnel obligated to the venture through employment contracts. The two most important provisions of an employment contract are:

• Notice provisions which require an employee to give advance notice (typically thirty days to six months) before resigning or quitting; and

• Discharge provisions authorizing someone, typically the CEO with respect to non-officers or the board with respect to officers, to remove an individual from his or her authority and responsibilities as an officer and employee for any reason, with or without cause.

Often these notice and discharge provisions provide different levels of compensation through either continuation of salary and bonus or payment of separate severance benefits based on whether there is cause for discharge or good reason for quitting.

Restrictive covenants. Other provisions, typically referred to as “restrictive covenants,” are also important considerations. The most common of these covenants place restrictions on:

• Outside activities. These provisions are typically provided either in the affirmative, requiring employment “on a full-time basis,” or in the negative, prohibiting any other employment or activity that impairs the person’s ability to exercise his or her authority and to meet his or her responsibilities fully.

• Ideas developed. Usually an affirmative covenant, this provision states that any idea or invention developed by the employee for the business of the venture belongs to the venture and often includes an assignment of any such ideas, including inventions, to the venture.

• Use of confidential information. Typically a negative covenant, this provision prevents the use of business or trade secrets and other confidential information, except as authorized, in the course of the venture’s business.

• Solicitations of resources. These provisions are generally a negative covenant prohibiting the solicitation of any employee, customer or client, vender or supplier, or similar resources of your venture to cease their relations with your business.

• Competition with business. Typically a negative covenant, this provision prevents competition with the business of your venture during, and often for a period after, employment.

Third-Party nondisclosure agreements. In addition to protecting the human resources of the management team and other key personnel, any business should protect its business and trade secrets and other confidential information, including technology and inventions. In addition to affirmative covenants and assignment by employees of ideas or inventions developed for the business, third parties, including potential acquirers or targets of an acquisition, should sign a nondisclosure agreement before being given access to any such business or trade secrets and confidential information.

Trademark, trade name, and domain name protection. Other deterrents are not having adequate protection of its entity name, often including exclusive rights to an Internet domain name identifying the business, as well as trade and service mark protection of the business’ products or services.

Identifying What It Wants

Also before undertaking consideration of any merger or acquisition and as one of the first steps in adopting an M&A strategy, a business must identify what it wants from a merger or acquisition. The principal reasons that an emerging business considers acquiring or being acquired are:

• Liquidity for founders and investors.

• Access to resources, including financial resources such as working capital; infrastructure such as a ready sales force or warehousing, distribution, or manufacturing facilities; addition of strategic products or services; and expansion of markets.

The principal reason that an established business would consider acquiring an emerging business is greater utilization of its resources including its sales force or warehousing, distribution, or manufacturing facilities. Other reasons include:

• Acquisition of key technology;

• Addition of new products or services;

• Entry in a new market;

• Elimination of competition;

• Acquisition of creative talent.

Describing Itself

After determining what it wants from a merger or acquisition, the next step for either an emerging business or an established business is to describe itself. This is easier for publicly held businesses, which describe in detail their operations, assets and liabilities in annual reports to their security holders and SEC reports.

An emerging business may start with its business plan. The description should include: the business description; management expertise and experience; security ownership; management’s discussion and analysis of the plan of operation; financial statements; and projected financial information which are discussed in the paragraphs below. Securities and Exchange Commission (SEC) Regulation S-B provides helpful guidelines detailing the issues to consider for each of these sections. Regulation S-B is available on the SEC’s Internet website.

Retaining a Business Broker or Investment Bank

Any business that is about to consider acquiring or being acquired may want to have the help of business broker or investment banker with merger and acquisition experience in the applicable industry. A business broker or investment banker can help evaluate enhancing and detracting factors of the business itself as well as of candidates to acquire or be acquired, but also help offer and evaluate alternatives.

The business broker or investment banker often takes the lead in planning an acquisition strategy for a business seeking to be acquired. In addition to evaluating the businesses own strengths and weaknesses as well as its relative industry position, the business broker or investment banker will lead in finalizing the presentation description materials discussed under “Describing Itself” and then in identifying, contacting, and qualifying potential candidates.

Finally, a business broker or investment banker can help with the most critical business term: valuation. See “The Principal Business – Valuation of the Business Being Acquired.” Business brokers and investment bankers typically require an exclusive representation agreement providing for payment of a percentage of the purchase price. These agreements can and should be negotiated by someone familiar with trade practice in this area.

Contacting Candidates

Generally, a business seeking to be acquired will want to contact acquirers that are looking for either a strategic business or investment opportunity. Established businesses are generally interested in an acquisition that strategically complements or supplements their businesses as well as increasing the return on their assets.

A business broker or investment banker is invaluable in identifying and making initial contact with candidates. Potential acquirers generally view the involvement of a broker, or in larger transactions an investment banker, as advantageous because it means that some third-party due diligence has been done substantiating what is being offered. Involvement of a broker or investment banker also generally means that someone is likely to have dealt with any unrealistic expectations of management of the business seeking to be acquired.

A requisite step before any representative should have any discussions with any acquirer candidate is signing of a confidentiality agreement. The confidentiality agreement should protect not only the confidentiality of all information to be presented, but also the “novelty” of any proprietary technology information, products, and processes. Sometimes these agreements also contain prohibitions on offering employment to company personnel involved in the transaction.

Sharing of Information

No script rules the next stage of the process. Information is shared. Potential acquirers will want to meet management of the business that may be acquired. Often, they will want to visit or “walk through” the other’s offices or facilities. A knowledgeable company will provide disclosure in stages, withholding the most competitively sensitive information until the acquisition is near certain to occur.

Because time is not an ally to maintaining confidentiality, the business that may be acquired will want to proceed quickly to a discussion of principal business terms. Its representatives in the process as well as its management should be familiar with what the principal business terms are in any deal as well as what they want as the principal terms in theirs.

The Principal Business Terms

Structure of the Transaction

Although not the most critical term, one of the first business terms that needs to be determined is the structure of the transaction.

From a legal viewpoint, the structure is typically one of the following:

• Asset acquisition in which the acquirer acquires assets and only designated liabilities of the business being acquired. The advantage to the acquirer of an asset acquisition over a stock acquisition or a statutory merger is that the acquirer does not acquire unknown liabilities except to the extent that there are unknown adverse claims against the acquired assets. A big disadvantage to the acquired company going out of business is the potential of double taxation—once on sale of the assets and again on the distribution of proceeds to shareholders. A corresponding advantage to acquirers is the ability to increase tax basis in the assets. Another advantage of an asset acquisition to both parties is that it typically requires less than a unanimous affirmative vote of the outstanding capital stock of the business being acquired to effect the transaction. Under most corporate statutes, the required affirmative vote is from a majority to two-thirds of the outstanding capital stock of the business being acquired. As long as the requisite affirmative vote is attained, dissenting holders cannot block the asset sale, but are entitled only to dissenters’ rights to receive fair consideration determined pursuant to a statutory process typically akin to an appraisal.

• Stock acquisition in which the acquirer acquires the outstanding capital stock of the business being acquired. A disadvantage of a stock acquisition is that, unlike an asset acquisition, all of the liabilities of the selling entity are acquired. For this reason, an acquirer often will create or use a subsidiary to acquire the stock in order to shield the acquirer from unknown liabilities. Another disadvantage of a stock acquisition is that for the acquirer to acquire absolute control, all of the holders of the capital stock of the business being acquired must sell. As a result, a stock acquisition is difficult if there are many holders who have to participate or even one holder who will not participate in the transaction.

• Statutory merger in which the entity of the business being acquired becomes part of the acquirer, or more likely a subsidiary of the acquirer, whereby the successor entity succeeds by operation of law to all of the assets and liabilities of the entity of the business being acquired. As with a stock acquisition, an acquirer often will create or use a subsidiary as its constituent entity to the merger in order to shield the acquirer from unknown liabilities. An advantage of a statutory merger over a stock acquisition is that it typically requires less than a unanimous affirmative vote of the outstanding capital stock of the business being acquired to effect the transaction. Under most corporate statutes, the required affirmative vote is from a majority to two-thirds of the outstanding capital stock of the business being acquired. As long as the requisite affirmative vote is attained, dissenting holders cannot block the merger, but are entitled only to dissenters’ rights to receive fair consideration determined pursuant to a statutory process typically akin to an appraisal. Mergers may be structured as a:

• Straight merger into the acquirer as the survivor. Generally, a straight merger is used only in a merger of equals or where it is impractical to shield one entity from the liabilities of the other;

• Forward triangular merger into a subsidiary of the acquirer where the acquirer’s subsidiary is the survivor. A forward triangular merger is used where it is desired to shield the acquirer from the liabilities of the business being acquired; or

• Reverse triangular merger with a subsidiary of the acquirer where the entity whose business is being acquired is the survivor. A reverse triangular merger is used where the assets being acquired has contracts subject to termination if the entity does not survive. A reverse triangular merger is subject to more stringent requirements than a straight merger or forward triangular merger in order to constitute a tax-free reorganization.

From a federal income tax viewpoint, the transaction may be structured between corporations as a tax-free reorganization if the consideration given is capital stock of the acquirer or certain related entities resulting in a continuity after the transaction of the prior ownership of the business being acquired in the following types of transactions:

• Stock for asset acquisition in which at least 80 percent of the total consideration paid for the assets must be capital stock of the acquirer or certain related entities;

• Stock for stock acquisition in which the shareholders (other than those perfecting dissenters’ rights) of the business being acquired must exchange their shares of capital stock solely for capital stock of the acquirer or certain related entities and the acquirer must acquire at least 80 percent of the outstanding capital stock of the business being acquired; or

• Stock merger in which the consideration paid meets the following requirements depending upon the type of merger: For a straight merger, at least 50 percent of the total consideration paid must be capital stock of the acquirer; for forward triangular merger, at least 50 percent of the total consideration paid must be capital stock of the acquirer; and for a reverse triangular merger, at least 80 percent of the total consideration paid for the assets must be capital stock of the acquirer.

In the past, the accounting treatment of the transaction was an important business term for early negotiation. However, beginning in July 2001, transactions of this sort will be accounted under the purchase method of accounting under generally accepted accounting principles. Under the purchase method, past financial statements remain separate; and statements only at dates and for periods after the closing may be combined; the assets being acquired are recorded at their fair market value on the balance sheet of the acquiring entity; the excess of the fair market value over the value that such assets were recorded on the balance sheet of the business are to be recognized as goodwill; and that good will is to be amortized reducing future earnings.

Valuation of the Consideration Given

Often the consideration given in acquiring a business is stock or property other than cash. An equally critical business term is the valuation of such consideration other than cash. Often such consideration is expressed in one of the three ways:

• As a Fixed Dollar Amount of Securities. For example, the consideration is expressed as $50,000,000 of the acquirer’s capital stock. This expression favors the business being acquired if the market price of the acquirer’s capital stock decreases and favors the acquirer if the market price of its capital stock increases before the closing. A disadvantage of this expression of consideration to the business being acquired is that the business being acquired will not share in any increase in market price of the acquirer’s capital stock resulting from favorable reaction to the announcement of the acquisition. However, this expression is favored by a business being acquired if it believes that the earnings per share of the acquirer will decrease and that decrease will result in a decrease in the market price of the acquirer’s capital stock before the closing.

• As a Fixed Number of Shares. For example, the consideration is expressed as 5,000,000 shares of the acquirer’s capital stock. This expression favors the business being acquired if the market price of the acquirer’s capital stock increases and favors the acquirer if the market price of its capital stock decreases before the closing. An advantage of this expression of consideration to the business being acquired is that the business being acquired will share in any increase in market price of the acquirer’s capital stock resulting from favorable reaction to the announcement of the acquisition. This expression may result in problems if the business being acquired has preferred stock that is to receive a liquidation preference of a fixed dollar amount before any distribution to the holders of common stock. If the market price of the acquirer’s capital stock decreases, there may not be sufficient value remaining to attract the affirmative vote of the holders of the common stock.

• As a Percentage Interest of the Resulting Entity. For example, the consideration is the number of shares of the resulting entity that results in the owners of the business being acquired owning 45 percent of number of shares that the combined entity will have outstanding as a result of the acquisition. The percentage interest is based upon each constituent entity’s contribution to the future operations of the resulting entity rather than the market price of either constituent entity’s capital stock. In theory, neither constituent entity is as concerned with the market price of its or the other entity’s capital stock as it is with the future performance of the resulting entity. For this reason, this expression is used most frequently with a merger of equals or a consolidation resulting in a new entity. In practice, however, a significant divergence in the market price of the capital stock of the entities before the closing may result in difficulty in obtaining the necessary shareholder vote.

Adjustments Negotiated to the Consideration

Often there are negotiated adjustments that reduce unwanted effects of a change in market prices prior to the closing. Some of the common adjustments are:

• Earn-Out Adjustment. In any transaction to be accounted for by the purchase method of accounting, the business being acquired may want to negotiate for a post-closing addition to the expressed consideration if certain earning levels are achieved after the closing. Also, the acquirer may want to offer such a future earn-out adjustment rather than agree to a more costly current expressed consideration. Problems with negotiating an earn-out adjustment are whether it should be based upon the earnings of the segment consisting of the business being acquired or the earnings of the entire acquirer. Basing the adjustment on a segment consisting of the business being acquired will require agreement as to a separate accounting of that segment’s operations for the earn-out period. Basing the adjustment on the earning of the entire acquirer may avoid separate accounting, but may not be reflective of the contribution to the acquirer of the acquired business.

• The Collar. The collar is a range or window of the market price of the acquirer’s capital stock in which the consideration, whether expressed as a fixed dollar amount or fixed number of securities, is applicable. If the market price goes above or below the range, either the consideration is automatically recalculated or the acquisition can be terminated. For example, the expressed consideration (such as $50,000,000 of the acquirer’s capital stock or 5,000,000 shares of the acquirer’s capital stock) is applicable as long as the market price of the acquirer’s capital stock is within the range or window of $25 to $30 per share at closing. If the market price is above or below the range, typically the consideration is automatically adjusted pursuant to the agreed terms or the appropriate constituent entity can terminate the transaction.

• Net Worth Adjustment. If either constituent entity expects a positive change in its net worth that is unattributable to the announced transaction, that entity may want to negotiate an adjustment to the expressed consideration pursuant to agreed terms if the net worth so changes. This is most often an adjustment negotiated by the business being acquired if there is a positive change in the working capital of the business, such as receipt of a substantial purchase order or realization of a written-off receivable the work for which was completed prior to the announcement of the transaction. At times this is an adjustment negotiated by the acquirer such as when there is a possibility of another acquisition occurring before the transaction in question.

Treatment of Stock Options and Warrants

Although this is typically not a critical business term if addressed initially, the issue of whether the expressed consideration is for all outstanding stock as well as outstanding options and warrants to purchase stock, or is for just the outstanding stock, of the business being acquired can become a stumbling block if not so addressed. Most acquirers intend that the consideration is for all outstanding stock as well as options and warrants to purchase stock, and the business being acquired will need to calculate what each holder is entitled to receive on a dilutive basis taking into account those options and warrants as if exercised.

Management of businesses being acquired need to consider options and warrants that are “under water” (those having exercise prices that are greater than the value of the consideration being received as a result of the acquisition). One solution is for the acquirer to assume these options or warrants or substitute comparable options or warrants. Often, however, the acquirer will want these options and warrants extinguished at or prior to the closing. In some cases, the options and warrants will not automatically expire by their own terms so that the business being acquired will have to offer some form of contractual consideration to the holders of these options or warrants in order to obtain their agreement to extinguish them. If so, this will generally reduce the consideration being received by holders of the outstanding stock.

Exclusivity, Non-Solicitation, and Break-up Fee Provisions

A “chicken-or-egg” problem that frequently occurs is whether the transaction is priced (that is, the consideration is expressed) before due diligence occurs. Typically, a business being acquired will want pricing to be offered and the consideration to be expressed before it will open its confidential business, financial, technology, and other proprietary information to the acquirer. In exchange, the acquirer will negotiate for an exclusivity period during which the business being acquired will not solicit competing offers. And either constituent entity may negotiate for a break-up fee as liquidated damages if the transaction is not consummated because of another constituent.

• Exclusivity and Non-Solicitation Provisions. An acquirer will not want to undertake the expenses of negotiation and then due diligence only to have the other business use the acquirer’s offer to start a bidding process. Typically, an acquirer will require the business being acquired to use its best efforts to cooperate exclusively with the acquirer, ceasing all negotiations with others and agreeing not to solicit competing offers. Terms to negotiate include the length of the exclusivity and non-solicitation period and the right of the business being acquired to respond to unsolicited inquiries or offers. The business being acquired should seek the advice of legal counsel as to its fiduciary obligations to shareholders before agreeing to a “no talk” provision preventing it from responding to an unsolicited inquiry by another person for information that would enable it to make a competing offer to shareholders.

• Break-up Fees. Either constituent entity (most often the acquirer) may negotiate for a break-up fee as liquidated damages if the transaction is not consummated because of another constituent. The business being acquired may fear that it will suffer such damage such as lost opportunities if the transaction is announced and not consummated that it may not survive without some form of liquidated damages. Likewise, the acquirer may want to impose such liquidated damages that will deter competing offers or a bidding war.

Risk of Loss Provisions

Provisions regarding pre- and post-closing risks of loss typically are not discussed until the negotiation of a definitive agreement unless the transaction is intended by the business being acquire to be “as is” such that either any pre-closing or post-closing risk of loss incurred by the business to be acquired is assumed by the acquirer. Typically, representations are made about the business being acquired that are warranted to also be true at closing so that the risk of any loss that is incurred prior to the closing is assumed wholly by the initial owners of the business being acquired. Sometimes, especially if the business being acquired is publicly held and has a history of reporting of its operations with audited financial statements, the transaction may be “as is” with respect to liabilities that surface after the closing. Typically, however, if the business being acquired is closely held or does not have a history of reporting its operations or audited financial statements that have withstood scrutiny after public dissemination, the representations and warranties will survive the closing so that the acquirer has recourse if a loss is incurred contrary to those representations and warranties.

There are a number of terms to be negotiated regarding this recourse. An acquirer would have recourse both in contract and for tort if a loss is incurred contrary to a representation or warranty that survives the closing; however, absent any provisions facilitating that recourse, the acquirer would have the burden of initiating and then prosecuting appropriate legal proceedings against the appropriate parties in an appropriate venue and jurisdiction, typically at the acquirer’s expense. To facilitate its recourse, an acquirer generally will negotiate for the following:

• Indemnification. Either the entity or the owners of the business being acquired agree to indemnify the acquirer not only against any loss that is incurred contrary to any representation or warranty, but also against any expenses incurred by acquirer in dealing with such losses, so that the acquirer can proceed against the entity or owners of the business being acquired without having to initiate such legal proceedings.

• Escrow. A portion of the consideration to be paid for the business being acquired, or other property of the entity or owners of that business, will be deposited and held in escrow against which the acquirer may proceed to recover any indemnified losses and expenses without having to proceed against the entity or owners. If the acquirer wants the accounting treatment of the transaction as a “pooling” of interests, the escrow may not include more than 10 percent of the capital stock issued as consideration in the transaction.

There are a number of limitations on these indemnification and escrow provisions that the business being acquired may negotiate. These include:

• Basket Clause. A basket clause requires that the aggregate losses incurred must exceed a certain “basket” or threshold amount before the acquirer may seek indemnification. The assumption underlying a basket clause is that every business incurs in its ordinary course certain unintended losses and, until the aggregate of such losses exceed what would be considered ordinary under the circumstances, there should not be liability to the entity or owners of the business being acquired.

• Cap. A cap is a limit on the maximum amount of indemnification that may be sought. The assumption underlying a cap is that the exposure to the entity or owners of the business being acquired should not exceed that maximum exposure that the entity or owners would have incurred if the business had been liquidated rather than acquired by the acquirer. At a minimum, where there is joint and several liability for indemnification, it will be capped at the amount actually received by the indemnifying party.

• Time Limit. Almost every indemnification or escrow provision limits the time during which the acquirer may seek indemnification or proceed against the escrowed assets. The assumption underlying a time limit is that at some point the prior owners should be able to put potential liability behind them.

Registration or Registration Rights

If all or any portion of the consideration for the transaction consists of securities, another fundamental business term is whether the securities will be restricted or “lettered” stock when issued to the business being acquired or its owners. Restricted or lettered securities do not offer liquidity to owners of the business being acquired unless accompanied by registration rights. The business being acquired will want to negotiate at a minimum for “piggyback” registration rights which entitle their shareholders to join a registration if one is initiated by the issuer or other security holders. More valuable are “demand” registration rights which entitle their shareholders to demand registration.

Human Resource Issues

At some point representatives of both the business being acquired and the acquirer will need to discuss who will be retained and how and what will happen to those who will not. This is an important issue to both sides because the business being acquired will want to retain everyone in order to keep the wheels from coming off during the acquisition process and especially if the acquisition is not consummated. This should be important to the potential acquirer because it often needs everyone's institutional knowledge initially in order to effect a successful transition, and it is often better to evaluate performance before judging who to retain or discharge.

The stress of a potential acquisition often lowers morale. First, there is often an increase in workload in providing information for the acquisition process and responding to the potential acquirer’s due diligence requests. Second, there is uncertainty in whether jobs will continue if the business is acquired or can continue if the business is not. Third, if the acquisition becomes public knowledge, the best people will be deluged by employment offers from competitors. As a result, many businesses when announcing to employees that they will be going through a due diligence process with a potential acquirer will offer those employees a retention bonus if they stay through the process.

Important issues that must be dealt with include resolution of differences between acquirer's and acquired company's employment terms, compensation plans, qualified retirement and deferred compensation plans, stock option and equity plans, non-competition and other employee restrictions, and employee policies. Typically, these are not dealt with initially, but after other principal business terms are resolved.

Evidencing the Deal

Once there is accord as to the principal business terms, the next step is evidencing that accord and working out the details of the deal. Typically, a letter of intent or commitment evidencing the principal business terms precedes negotiating and preparation of a definitive agreement detailing those terms.

Letter of Intent

A letter of intent is typically a short (three-to-five page) outline of the principal business terms of the proposed acquisition. Its primary purpose is to assure accord on the principal business terms before time and resources become committed to due diligence and negotiation of a more definitive agreement. The other purpose is the extent that the parties have any legal obligation to the acquisition. A letter is legally binding to the extent that it includes any confidentiality covenant, non-solicitation obligation or a break-up fee. See “The Principal Business Terms – Exclusivity, Non-Solicitation, and Break-up Fee Provisions.” Except for such provisions, a letter of intent is typically not detailed enough to otherwise legally bind any party to the proposed acquisition. For this reason it is important to proceed to the definitive agreement.

At times a party that has publicly traded securities may avoid executing a letter of intent so that there is no agreement that may trigger a public disclosure requirement. More typically, however, parties having publicly traded securities will impose restrictions on other parties preventing an unwanted early disclosure of the transaction. See “The ‘Process’ of the Deal – Public Disclosure.”

Definitive Agreement

The definitive agreement will generally have a name to reflect the structure of the transaction. It is generally an “asset purchase agreement” if the transaction is structured as a purchase of assets; a “stock purchase” agreement if structured as a purchase of stock; an “agreement and plan of reorganization” if structured as a form of a merger. However, the provisions of any of these definitive agreements follow the same traditional form:

• Description of the transaction, detailing most of the principal business terms in the letter of intent, including what is being acquired, the consideration being paid, and when and how it will be paid, and when the transaction will close;

• Representations and warranties on behalf of the business being acquired;

• Representations and warranties on behalf of the acquirer;

• Covenants or promises of what is to be done prior to closing on behalf of the business being acquired;

• Covenants or promises of what is to be done prior to closing on behalf of the acquirer;

• Conditions that must be satisfied before the business being acquired is obligated to close;

• Conditions that must be satisfied before the acquirer is obligated to close;

• Termination provisions detailing circumstances and consequences of abandoning the proposed acquisition;

• Indemnification and escrow provisions protecting one party if it does not received what it bargained for;

• Miscellaneous, but important, provisions regarding giving of notices, governing law, resolutions of disputes, and construction of the agreement.

One of the common clauses that is often overlooked by business representatives of the acquirer and the business being acquired is the provision that the definitive agreement supersedes and replaces all prior agreements, whether oral or in writing, between the parties regarding the transaction. Accordingly, it is important that any issues discussed and agreed to between the business representatives are expressly covered or referenced in the definitive agreement and not by a side handshake.

The business representatives will want to focus initially on two sets of provisions. The first is the description of the transaction. This should describe the principal business terms of what has been bargained for. The second are the conditions to closing. These will control if and when the transaction will close.

There will likely be additional agreements typically attached as exhibits or appendices. These include forms of employment agreements, non-competition and other employee restrictive covenants, escrow agreements for any closing into escrow as well as security for any indemnification.

The ‘Process’ of the Deal

The deal “process” begins with the letter of intent or accord as to the principal business terms of the transaction. A number of activities generally go on concurrently after there is accord on the principal business terms. In order to establish some order over what could otherwise result in chaos, identifying each party’s designated representatives and a schedule of who will do what and when is one of the first steps of the process.

List of Participants

The list of participants is simply a list, with respect to each party, of the representatives of:

• The party’s management team;

• Legal counsel;

• Auditing firm;

• Business broker or investment banker; and

• Other advisers

who have a need to know what is happening. The list gives mailing and email addresses and telephone and fax numbers for communicating with each person listed. The list should include the home addresses and telephone number of key representatives in case of emergencies.

Time and Responsibility Schedule

Typically, the time and responsibility schedule is prepared by the acquirer; however, if time is of an essence to the business being acquired, especially if it is subject to restrictive non-solicitation and break-up provisions, the entity being acquired may propose the schedule. The schedule lists each anticipated step in the process to complete the transaction, the party and its representatives responsible for each step and a proposed date for completion of the step.

Steps typically included are:

• Exchange of documents for due diligence;

• Preparation and circulation of the definitive agreement;

• Preparation and circulation of Hart-Scott-Rodino filings (see “The ‘Process’ of the Deal – Government Filings and Consents”);

• Scheduling of any on-site due diligence visits, including review of records by auditors;

• Preparation and circulation of any disclosure documents or reports to shareholders;

• Preparation and circulation of the first draft of any fairness opinions;

• Board meeting for review of the definitive agreement and related matters such as fairness opinions;

• Execution and delivery of the definitive agreement;

• Calling a meeting of shareholders or other owners whose approval is required;

• Scheduling the closing.

Public Disclosure

Often neither the business being acquired nor the acquirer desires to make an early public disclosure of a proposed transaction. Other than Hart-Scott-Rodino filings, there is no required time at which disclosure to the public has to be made unless any party is aware that someone who has knowledge of the transaction is trading securities. For this reason, parties that have publicly traded securities will impose restrictions on all participants. These restrictions prohibit disclosure except to those who have a need to know and an obligation to maintain the confidence of what is disclosed; and trading or tipping others to trade in that party’s securities.

Government Filings and Consents

The number and nature of governmental filings and consents depends upon the structure of the transactions as well as the jurisdictions involved. Two of the most common are:

• Hart-Scott-Rodino Filing. One of the early determinations that legal counsel for both parties must make is whether a pre-merger filing is required with the Federal Trade Commission and Department of Justice under the Hart-Scott-Rodino Antitrust Improvements Act. This filing generally is required if the acquirer has assets or annual net sales of at least $100 million, the business being acquired has more than $10 million of assets or sales, and the acquirer is paying consideration of more than $50 million for the transaction. The filing, if required, also requires a minimum $45,000 filing fee, and the parties must wait 30 days after the filing before the transaction can close. During that period, the Federal Trade Commission or Department of Justice will determine if the effect of the proposed acquisition is likely to be anticompetitive. During this waiting period, the acquirer and business being acquired must maintain their separate operations. Either the Federal Trade Commission or the Department of Justice may request additional information if there is a preliminary conclusion based on the initial filing that the transaction may be anticompetitive. If there is a “second request,” the closing may be substantially delayed or the acquirer may be required to divest itself of certain assets to obtain approval of the transaction.

• Securities Filings. If the consideration being paid in the transaction consists in any part of securities, the acquirer will need to comply with registration requirements under both federal and state securities laws. The method of compliance which is least expensive to the acquirer is to structure the issuance to fall within an available exemption, if any, from registration under the federal securities laws; however, this typically results in restricted or “lettered” stock being issued which is of the least value to the owners of the business being acquired. If the acquirer can structure the issuance to fall within either the accredited investor or private offering exemption can avoid filings under state securities or “blue sky” laws. In order for the securities issued as consideration not to be restricted or “lettered,” the acquirer will need to register the issuance with the Securities and Exchange Commission. The expense of a registration is substantially more than the expense of an exemption, if available. Another possible method is to invoke a fairness hearing under an applicable state securities or blue sky law and rely on a related exemptions under section 3(a)(10) of the Securities Act of 1933. Unlike the other exemptions or the registration process which focus solely on whether there is adequate disclosure, a fairness hearing requires a substantive determination as to the fairness of the transactions in addition to the adequacy of disclosure. In absence of registration or a 3(a)(10) exemption, the business being acquired will likely want to negotiate for registration rights as one of its fundamental business terms. See “The Principal Business Terms – Registration or Registration Rights.”

Director Authorizations and Shareholder Approvals

Board of the Business Being Acquired. Generally, unless the transactions are structured as an offer to the shareholders or other owners of the business being acquired, the board of directors of the business being acquired is required to authorize and its shareholders or other owners are required to approve the transaction. Typically, the acquired entity’s board must authorize the definitive agreement before it is executed and often, if there is much intervening time or any material intervening event, the board will authorize going forward with the transaction immediately prior to the closing. A Board of Directors has a fiduciary obligation to try to negotiate the best deal for its shareholders. The board has a fiduciary duty under most state laws to exercise the skill and prudence customary under the circumstance in a manner believed to be in the best interest of the entity. Accordingly, the board will want to assure that due diligence has been done. Typically, it will delegate this to management and oversee management’s investigation and reports. Often the board is required by state law or federal securities laws to determine that the transaction is fair to the shareholders of the entity being acquired. A board will often consult an investment banker for its opinion regarding the “fairness” of the proposed transaction.

Shareholders of the Business Being Acquired. If the transactions are structured as an offer to the shareholders or other owners of the business being acquired, then each shareholder or owner has its own, separate decision whether or not to sell. This is often referred to as a “tender offer.” Typically, any other disposition, whether in the form of a merger of sale of assets and even a sale of the stock of a subsidiary, requires approval of the shareholders or other owners of the business being acquired. Sometimes a supra-majority vote of the shareholders is required. Obtaining shareholder or other owner approval typically requires detailed disclosure to shareholders in the form of a proxy statement.

Board of the Acquirer. Unless the acquisition is de minimis, the board of the acquirer must authorize the definitive agreement. If a vote of the acquirer’s shareholders or other owners is required or if there is much intervening time or any material intervening event, the board may subsequently authorize the transaction before it is closed.

Shareholders of the Acquirer. In absence of a merger directly into the acquirer (which is infrequent except for a merger of equals) or an issuance of a substantial consideration amounting to substantially all of the assets or a substantial amount of equity, approval of the acquirer’s shareholders if often not required.

Closing

The closing typically takes place at the offices of legal counsel to facilitate last minute document changes. The closing consists of the execution and delivery of the definitive agreement and all ancillary agreements and documents, as well as delivery of the consideration for the transaction.

Post-Closing Restrictions

A number of rules must be observed following the closing including:

• Rule 145 Resale Restrictions. In any transaction in which the consideration is shares or securities, at least those persons who are “affiliates” within the meaning of federal securities after the transaction may only resell their securities in compliance with Rule 144. Rule 144 generally requires that the issuer must make available information to the public regarding the securities and that the securities may be resold only in unsolicited brokers’ transactions subject to volume limitations.

• Pooling Lockups. In the past for transactions accounted for as a “pooling,” affiliates of both the acquirer and business acquired may not sell or resell securities for a lockup period that begins 30 days before the closing of the transaction until publication of at least 30 days of combined post-closing financial results. This should not continue to be a requirement after June 30, 2001 because the pooling accounting method is no longer permitted.

• Federal Tax Continuity of Interest Rules. For transactions structured as a tax-free reorganization for federal income tax purposes, the holders who received acquirer securities in the transaction must continue to maintain their interest in at least a majority of the securities issued.

• Rule 16(b) Limitations. The transaction will be treated as a “purchase” for Section 16(b) under the Securities Exchange Act of 1934 for affiliates of the acquiring business who become officers, directors, or 10-percent shareholders of an acquirer having publicly traded securities. As a result, these affiliates may not sell the securities received for at least six months after the closing because an earlier sale will require them to disgorge any profit on the sale.

Conclusion

Historically, a business is more likely going through a merger or acquisition than a public offering of its securities. The trend is increasingly toward a merger or acquisition as the most likely for obtaining liquidity for the owners of the business being acquired.