This newsletter highlights common issues affecting technology companies which are considering a potential sale to or merger of their company with a larger company.  A privately technology company often owns new technology or products in a high growth market.  The company may undergo rapid growth in its market or cash flow, but may lack infrastructure and capital.  In an acquisition, both the seller and buyer must keep in mind a variety of critical economic and legal issues and, at the same time, each needs to meet its own objectives in entering a transaction.
It is important to recognize the crucial ingredients of a successful acquisition.  The selling party should identify the reasons why it desires to be merged or sold and keep these in mind in forming responses to a buyer's proposals. 

Surveys reveal that in the field of M&A and initial public offerings (IPO's) of technology companies, roughly 75-80% of all transactions involve a form of M&A.  There are several reasons why companies prefer acquisitions instead of going public.  Acquisitions provide strategic, operating and financial benefits to both the buying and selling parties.  A strategic acquisition may provide selling parties with liquidity with reduced risk and dilution.  It may allow the company to obtain the leverage of the buyer's production and distribution systems and avoid the time and risks involved in independently developing these systems.  At the same time, the buyer obtains new products and technologies to maintain its competitive advantage and growth rate.  However, a poorly structured acquisition may create unnecessary costs and disruption to both businesses, the loss of desirable technology and products, employee disharmony and resignations as well as financial losses by the surviving company.

Reasons for Acquisitions
An IPO may provide the shareholders with liquidity, but may not generate any immediate product synergy or provide an established infrastructure.  These needs may be achieved instead by locating a strategic buyer.
The seller should determine the buyer's strategic objectives.  For example, the buyer may be seeking a product line or key technology, or looking for creative, technical or management talent, or in quest of reduced competition.  The buyer will make an acquisition that meets its objectives and increases its shareholder value more readily than internal development.  If the seller understands the strategic objectives of both parties, it can concentrate on parties that are likely to meet the needs and covet the seller's assets.

Enhancing Value and Loss of Value
The seller should initially be aware of key strategic objectives for merger prospects and focus on developing these features.  Certain features will enhance seller's worth.  For example, seller's unique proprietary technology and highly competitive products will boost seller's value.  Leadership in a growing market will increase seller's value.  Companies having high market shares are ordinarily more profitable than companies with small market shares.  High quality management will enhance the credibility of seller's growth projections.  Exceptional staff and infrastructure and strong customer relationships add to seller's value because the buyer will not need to terminate superfluous personnel or wind down undesirable contracts.

The most impressive enhancement to value will clearly be strong financial performance and collective growth anticipated from the combined company.  If a small technology company reached a reasonable sales level in a high growth market without a large sales and marketing presence, the buyer's sales organization, brand name recognition and established customer base presumably should generate impressive sales after the merger at minimal cost.

Certain characteristics may reduce value.  Poor financial results or high volatility may cause the buyer to doubt the credibility of strong future performance.  Disproportionate liabilities and pending or threatened litigation may cause the buyer to discount seller's value, unless selling shareholders agree to indemnify the buyer against such risks.  If key managers are not enthusiastic to remain with the buyer after the acquisition, the buyer will be apprehensive about the ability to function.  If substantial additional capital after closing is required, the sellers must convince the buyer that its targets are realistic and that the company is worth the selling price and the commitment of additional capital.

If the company has many non-core businesses, the buyer may be concerned about the lack of focus.  A buyer will not want to pay for undesirable assets, although sellers will want to be compensated for them.  Otherwise, the unwanted assets may need to be removed from the company before the sale.  A seller should not enter negotiations with limited operating capital because the buyer may offer bridge financing in exchange for compromises to seller's position.  A seller which has a divided board of directors, shareholders or management team will encounter negotiating difficulties.  Dissenting groups will spend more time bargaining internally than in negotiating with the buyer.  If the seller has entertained many prospective buyers, a buyer may be nervous and be unwilling to pay seller's requested price due to its belief that other parties have already examined and rejected seller.

Initial Steps
There are a number of steps in an acquisition.  The most important step in preparing a company for an acquisition or IPO is to establish consistent revenue and earnings growth and ownership of a growing technology, customer and market base.  The company should avoid excessive product or market diversification because creation of multiple products or entry into multiple markets simultaneously will burden the resources of an emerging company and reduces the likelihood of sound execution.  Further, diverse product or market focus reduces the prospect of a strategic bond with a buyer and increases the probability that certain assets will have limited value to a buyer.

The company may market its products through its partners instead of establishing a costly sales and distribution force.  Using such venture relationships may allow the company to avoid the high cost and time of establishing its own production, sales or marketing infrastructure, which will duplicate that of the buyer.

The seller should ensure that it owns legal title to its intellectual property resources and should avoid non-assignable or burdensome contracts.  To avoid accounting disputes with a buyer, the seller should maintain financial statements in accordance with GAAP and undergo annual audits.  Since pooling accounting is essential to most prospective buyers, the seller should understand pooling requirements and avoid any actions that would preclude seller from selling through a pooling of interests transaction.

Timing of an Acquisition
The seller obviously desires the best valuation in an acquisition.  In certain cases, the seller may be an attractive acquisition prospect even at a relatively early stage.  For instance, the seller may be a potential merger candidate if it has: 
(a)  developed a product which is critically acclaimed in its industry, is highly endorsed by good customers and is a strategic match with a buyer's products and distribution channels;
(b)  has a strong development team;
(c)  does not have conflicting or overlapping products or infrastructure;  and
(d)  is profitable and is poised to continue its revenue and profit growth.
This relatively early phase is advantageous because seller may reach these targets swiftly with relatively minimum capital, personnel and risk.

Key Deal Points
If the buyer and seller reach agreement in principal, the next step is to settle the terms of the merger.  The buyer’s goals will be to minimize its expenditures by structuring the deal to gain the most favorable tax, accounting and risk positions and to reach agreements with key personnel.  The selling parties should be aware of various objectives in evaluating the buyer’s proposals.
The selling shareholders optimally seek the highest possible price to be paid in a liquid, but tax-free manner. 

They will want to limit their personal liability for indemnities and avoid or minimize the amount of any escrowed monies as security for indemnities.  Seller's management will want the buyer to retain the largest number of the company's employees on advantageous terms and to deal fairly with any terminated employees.  Seller's executives will want to avoid lengthy non-compete agreements in the event that their relationship with the buyer fails.  Most importantly, seller's management will want to avoid the prospect of an abortive deal.  Seller's employees will be concerned about their job security, their reporting relationships and uncertainties caused by the acquisition.

Acquisition negotiations must be kept confidential until buyer and seller have executed the definitive agreements and are primed to answer questions that arise during the public announcement of the deal.  The number of people aware of the transaction should be minimized and the confidentiality period should be curtailed in order to avoid premature leaks.  In order to maintain confidentiality, each party should utilize code names instead of the other party’s real identity on internal documents.  Meetings should be held off-site at locations where the possibility of exposure of the principals is diminished.  Extensive due diligence involving buyer’s staff attending at seller’s premises should be avoided until the signing of the agreement is certain in order to avoid premature leaks and employee distractions.

The primary components of a successful deal should be always kept in mind.  Both parties need to accommodate the perspectives and needs of the other party.  In particular, the seller should adhere to the strategic purposes of the transaction.  These often include the following:
1) liquidity for its founders and investors;
2) synergies from complementary assets;  and
3) access to the infrastructure of a major corporation.
There are a variety of other important issues that are beyond the scope of this Newsletter, including investment banking questions, as well as various other legal and accounting issues.  The small technology company will realize more favorable terms and increase the odds of success by making use of sound professional advice at the earliest stage in the process.

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