Private M&A Transactions: Summary and Review (Weeks 3/4 ) John D. Wilson Mergers & Acquisitions Spring 2016

Overview 2 Nature of a private M&A transaction:  Buyer negotiates directly with the owner(s) of the target business  Does not involve the solicitation of the stockholders of a publicly traded entity  Purchase price is not disbursed to the general public so that partial “refunds” or post-closing adjustments are possible in the form of indemnities, escrows and purchase price adjustments SF01/310018

Overview 3 Potential issues:  Absence of publicly available information on the target  Potential for more complicated structuring issues  Separation issues in cases where target is not a stand- alone entity Preliminary Agreements (use varies):  Confidentiality Agreement  Exclusivity Agreement  Letter of Intent  Term Sheet SF01/310018

Due Diligence 4 Areas of particular focus vary depending on the facts:  Contingent and third party liabilities  Environmental (if applicable)  Intellectual property (if applicable)  Real property (if applicable)  Employee compensation and benefits  Tax liabilities  Regulatory compliance (if applicable)  “Certain business practices” (if applicable) SF01/310018

Due Diligence 5 Depending on the structure of the transaction, careful review should be made of:  Restrictions on transfer/anti-assignment provisions in the target’s existing agreements  Change of control provisions, in particular in financings, employment agreements  Event of default/termination provisions in existing agreements  Third party potential reactions generally  Regulatory approvals or concerns (antitrust, CFIUS) SF01/310018

Acquisition Agreement Overview 6 Types of acquisition agreements include stock purchase, asset purchase and merger Deciding between the stock transaction and the asset sale:  Usually depends on corporate goals, tax benefits and/or liability concerns  Benefits of a stock purchase:  Generally less complicated  Lower closing costs SF01/310018

Acquisition Agreement Overview 7  Benefits of an asset purchase:  Allows for the purchase of a division or business segment that is not an organized legal entity  Allows for the purchase of only specific assets and for the assumption of only specific liabilities SF01/310018

Acquisition Agreement Overview 8 Description of what is being sold is a key difference between stock and asset deals:  Conveyance provisions in a stock purchase agreement merely describe the nature and number of the shares to be sold  Specifying assets and liabilities in an asset purchase agreement can be a substantive issue and require long schedules of assets and liabilities  If assets are scattered in different countries or states, can require significant preparation just to convey the assets effectively under local law (for example real estate) SF01/310018

Asset Deals – Describing Assets and Liabilities 9 Need to specify assets in as much detail as possible:  Importance of defining the “Business”  Specify assets reflected on balance sheet or statement of net assets  Schedule various categories of assets such as real property, intellectual property and contracts  Include intangible assets such as goodwill, permits and licenses, potential claims related to the assets being purchased and other contractual rights (including insurance) SF01/310018

Asset Deals – Describing Assets and Liabilities 10 Need to determine how to deal with shared assets:  Standard for basic transfer: “primarily” or “exclusively” used in business or related to business  Consider need for services agreements, transition agreements or other arrangements SF01/310018

Asset Deals – Describing Assets and Liabilities 11 Asset deal allows buyer and seller flexibility to divide liabilities, subject to successor liability issues:  Especially if representing buyer, need to negotiate specific liabilities to be assumed and liabilities to be excluded  Exclude liabilities not associated with assets or business being purchased  Buyers often seek to exclude all liabilities arising prior to closing (“our watch vs. your watch”)  Buyer may seek to exclude large, unusual liabilities  Key issue: negotiations over unknown or “unmatured” liabilities—who bears the risk of these post-closing SF01/310018

Asset Deals – Describing Assets and Liabilities 12 Important to deal specifically with following types of pre-closing liabilities:  Taxes  Environmental liabilities  Employee/benefit liabilities; including pensions and other post-retirement liabilities  Liabilities or obligations under assumed contracts  Product liability/product warranty issues  Outstanding litigation SF01/310018

Purchase Price – Overview 13 Types of consideration:  Cash  Stock  Notes or other deferred consideration  Earn-outs, milestones and other contingent consideration Must decide what is being bought when setting the price  Cash-free, debt-free? SF01/310018

Purchase Price – Adjustments 14 Generally designed to deal with performance of the business between when transaction was priced and closing The parties will estimate the amount of the purchase price to be paid at closing based on historical financial figures or projected future earnings SF01/310018

Purchase Price – Adjustments 15 After closing, adjustments may be made, usually based on one of the following:  Working capital  Equals current assets (e.g., cash, accounts receivable and inventory) minus current liabilities (e.g., debt or obligations due within one year)  Net assets  Equals total assets minus total liabilities  Net worth  Same as “Net Assets” for corporation  Net debt  Equals short and long-term debt minus cash and cash equivalents SF01/310018

Purchase Price – Adjustments 16 Mechanism:  Pre-closing estimate  Post-closing audit  Need to define items constituting adjustment with specificity (accountants should review language)  Need to define basis for disputes  Dispute mechanism  Threshold for adjustment Preparation of closing balance sheet or other adjustment statement  Who prepares? SF01/310018

Purchase Price – Earn-Outs and Milestones 17 An earn-out provides for future payments to the seller of additional purchase price contingent upon the acquired business achieving certain predefined financial or operating objectives after closing Usefulness of earn-out provisions:  Method of “bridging the gap” between the buyer and the seller when views on value diverge  Situations where the target business is thought to be on the brink of significant financial improvement SF01/310018

Purchase Price – Earn-Outs and Milestones 18 Measurement of performance may be based on: revenue, profit, income, cash flow, sales or cost savings During the earn-out period, the seller will want to retain some control over the business and may request certain contractual protections to ensure that the seller can meet the milestones Milestone payments are triggered by specified events (e.g., receipt of approval for a new drug, specific revenue targets, etc.) SF01/310018

Escrows, Holdbacks and Other Security 19 To support post-closing purchase price adjustments and indemnities in favor of buyer Alternatives:  Third party escrow of portion of consideration  Holdback of consideration by buyer  Letter of credit or other security posted by the seller  Each alternative has advantages and disadvantages and their use depends on the specifics and preferences of the parties (including the level of trust between buyer and seller) SF01/310018

Escrows, Holdbacks and Other Security 20 Security is most often utilized in following situations:  Multiple sellers, so “refund” would be difficult to collect  Financial sellers (proceeds to be distributed)  Individuals  Troubled sellers  Liquidating entities The termination of the escrow agreement should be tied to the indemnity survival period SF01/310018

Representations and Warranties 21 Common types of representations and warranties given by the seller:  Basic representations and warranties:  Organization and good standing  Authority  Enforceability  No conflict  Title SF01/310018

Representations and Warranties 22  For a stock purchase:  Subsidiaries  Capitalization  Books and records  Financial information  Absence of undisclosed liabilities  Government consents  Conduct of business  Material contracts  Customers/suppliers SF01/310018

Representations and Warranties 23  Employee benefit matters  Labor matters  Intellectual property  Real property  Environmental matters  Compliance with law  Certain business practices  Litigation  Assets SF01/310018

Representations and Warranties 24  Receivables  Taxes  Insurance  Full Disclosure  Brokers Key related issue – definition of “Knowledge”—which persons are included and what level of knowledge must they have (actual, reasonable, etc). Sometimes the sellers don’t know the business that well (management does). How should this be addressed? What if management is on the buy-side? SF01/310018

Representations and Warranties 25 Common types of representations and warranties given by the buyer:  Basic representations and warranties:  Organization and good standing  Authority  Enforceability  No conflict  Government consents  Litigation  Financing  Brokers SF01/310018

Disclosure Schedules 26 Purpose:  Disclose exceptions to representations and warranties  Provide information about which seller (or buyer) will represent and warrant  Buyer “smokes out” information from seller and confirms results of due diligence SF01/310018

Disclosure Schedules 27 Content:  Common categories of information include: subsidiaries, capitalization, conflicts, governmental consents and approvals, financial information, liabilities, conduct not in the ordinary course of business, litigation, compliance with law, environmental matters, material contracts, intellectual property, real property, employment matters, taxes, insurance, brokers and others specific to a transaction  In an asset deal, may also include categories of excluded assets, excluded liabilities and/or shared assets  Seller prefers to be over-inclusive or vague and thereby avoid indemnification; buyer seeks specificity and to delete items SF01/310018

Disclosure Schedules 28 Introductory Language Issue of updating before closing  Closing certificate Mechanics:  Create template based on provisions of acquisition agreement  Allocate responsibility for collection of information  Management “blood” letters SF01/310018

Covenants 29 Pre-closing Covenants:  Access  Confidentiality  Conduct of business  Notice of developments  Consents and approvals  “Hell or high-water” provisions SF01/310018

Covenants 30 Post-closing Covenants:  Non-competes  Non-solicitation and no-hire  Treatment of employees  Access to information/Maintenance of records  Further assurances / “wrong pocket” SF01/310018

Conditions to Closing 31 Mutual conditions:  Representations, warranties and covenants  Buyer’s condition Timing aspects of the bring-down “in all material respects”/Material Adverse Effect Buyer will want to avoid double materiality  Seller’s condition  No orders (or no actions)  HSR, EU, China, CFIUS and other regulatory clearances  Ancillary agreements SF01/310018

Conditions to Closing 32 Additional conditions to buyer’s obligation to close:  Consents and approvals  No MAE  Others: financing, due diligence, legal opinion  Query: should the availability of financing be a condition to closing? Why would the seller allow this?  Should additional due diligence also be an out?  Legal opinions—not customary except for specific issues unique to the deal or the industry SF01/310018

Material Adverse Effect/Change 33 Role in acquisition agreement:  Grounds for termination (directly through an explicit closing condition or indirectly through bring-down of a representation or warranty)  Qualifies certain representations and warranties and covenants Buyer prefers broad definition of MAE; seller prefers to limit scope of MAE SF01/310018

Material Adverse Effect/Change 34 Typical carve-outs (sought by seller):  Changes in general economic conditions or securities markets  Geographic regions  Events or circumstances that affect the industry in which seller’s business operates  No material/significant disproportionate effect  Changes arising from announcement or consummation of the deal  War, hostilities, terrorism SF01/310018

Material Adverse Effect/Change 35 Sample points of negotiation:  “Taken as a whole”  “Would”/ “could”  “Prospects”/ “is or is reasonably likely to be”  “as of the closing date”  Quantification SF01/310018

Material Adverse Effect/Change 36 Litigation:  Fact-intensive, case-by-case analysis with no bright lines—but there are few precedents on point  MAE clause applies only if adverse events are unknown to the buyer and threaten the overall earnings potential of the target in a dramatically significant manner. Huntsmann illustrates how reluctant DE courts are to apply MAE provisions to preclude a closing, although the buyer lacked clean hands in that case  Courts consider the MAE in the context of the entire acquisition agreement, including the disclosure schedule and other information made available to the buyer; SF01/310018

Indemnification – Overview 37 Events giving rise to indemnification of by a seller:  Breach of representations or warranties  Breach of covenants  Excluded Liabilities (if an asset deal)  Other (specific agreed-upon items) Financial sellers typically resist any indemnification, recognizing that this will likely result in a lower sale price—they distribute the “profits” to their investors Therefore, the dynamic is very different depending on the nature of the sellers SF01/310018

Indemnification – Overview 38 Events giving rise to indemnification by a buyer:  Breach of representations or warranties  Breach of covenants (post-closing obligations important)  Assumed Liabilities (in an asset deal)  Post-closing operation of business  In general indemnification of buyers is much more limited, as the subject of the transaction is the business or assets being sold/purchased SF01/310018

Indemnification – Survival Period 39 Representations and warranties (and indemnification rights relating thereto) should survive for a period of time that would be sufficient to allow discovery The typical survival period is 12 to 24 months (should be at least one full audit cycle after closing) Certain representations survive for longer periods:  Indefinite survival: title to shares or assets and authority  Survival until expiration of applicable statute of limitations: tax and product liability  Longer specified period: environmental, intellectual property and ERISA SF01/310018

Indemnification – Responsibility 40 In stock transactions, it may be appropriate to subject different selling stockholders to different levels of responsibility for indemnifying the buyer Joint and several liability:  More than one seller  If indemnifying parties resist, consider a hold-back or escrow arrangement or suggesting that the sellers enter into a contribution agreement among themselves  These can become very complicated SF01/310018

Indemnification – Limitations 41 Sellers will seek to limit liability on indemnity Limitations on indemnity should apply only to breaches of representations and warranties - not covenants Types of limitations:  “De minimis” per item thresholds  Baskets v. Deductibles  Caps SF01/310018

Indemnification – Limitations 42 Other factors often included that may reduce the seller’s indemnification obligations:  Reduction to take account of insurance recoveries received by the buyer - but buyer beware of resulting premium increases  Reduction to take account of benefits to the buyer in the form of tax deductions as a result of the loss  Limitation on consequential, incidental, punitive and other damages SF01/310018

Indemnification – Limitations 43 A less common seller-oriented provision is the “actual knowledge” or “anti-sandbagging” defense, which prohibits the buyer from recovering for breach of representation or warranty if the buyer had actual knowledge of the breach at or before the closing SF01/310018

Procedure for Claims 44 The indemnifying party typically has right to control proceedings with third parties The indemnified party typically has a right to participate in proceedings with third parties It is important for the indemnified party to retain control if other than monetary damages are sought (e.g., injunction, remediation) The acquisition agreement should include procedures for claims between the parties that do not involve third party claims SF01/310018

Termination 45 Grounds for termination:  Mutual agreement  Drop-dead date (deadline for deal to close)  Extension for regulatory conditions  Impossibility of conditions  Permanent injunction or other prohibition  Incurable breach or breach uncured after specified time period  Financing out (discuss)  Due diligence out (discuss)  Can limit to certain time period, or on specific issues SF01/310018

Effect of Termination 46 Each party generally remains responsible for its own costs (unless otherwise agreed) Each party is still liable for its breaches Termination/break-up fees; expense reimbursement  Reverse break-up fees payable by buyer Some provisions (e.g., confidentiality) should survive SF01/310018

General Provisions 47 Expenses Notices Public announcements Severability Entire agreement Assignment No third party beneficiaries Governing law SF01/310018

General Provisions 48 Arbitration/submission to jurisdiction Waiver of jury trial Headings Counterparts SF01/310018

Closing 49 Closing versus signing Importance of understanding the closing mechanics, being organized and aware of any open issues early SF01/310018

Closing 50 Officers’ certificates, secretary’s certificates, incumbency certificates and receipts Pre-closing  Verify all documents present and in order as they appear on closing checklist  Signature tabs Signatures Wire transfers SF01/310018

Closing 51 Differences between stock deal and asset deal:  In asset deal, conveyance documents include bill of sale, assignment and assumption agreement, intellectual property assignment and deeds of transfer for real estate  Certain conveyance documents need to be recorded  In stock deal, conveyance document is stock power  Buyer may require submission of letters of resignations from certain directors or officers  May be transfer taxes SF01/310018