18 Key Issues in Negotiating Merger and Acquisition Agreements for Technology Companies

By Richard D. Harroch, David A. Lipkin, and Richard V. Smith

Effectively negotiating merger and acquisition agreements for a privately held technology company involves addressing and resolving a number of key business, legal, tax, intellectual property, employment, and liability issues. Such agreements are often heavily negotiated, and a poorly negotiated transaction can result in significant risks to the selling company and its shareholders, including with respect to the certainty of closing the deal and potential post-closing indemnification liabilities to the buyer.

This article discusses a number of the hotly contested key issues in acquisitions of privately held technology companies. The ability to achieve success in any negotiation depends on a number of factors: the leverage a party has in the negotiation, the price and other key terms the parties may have already agreed upon at the letter of intent stage, the risks a party is willing to take with respect to closing conditions and post-closing liability exposure, whether there is competition among bidders for the target company, the quality of the lawyers involved, and the skill of the negotiating team.

1. Price/Consideration Issues

The price and type of consideration are issues that will need to be addressed early in the process, preferably in the letter of intent, and these go beyond agreeing on the “headline” price. Here are some of these issues:

• Whether the purchase price will be paid all cash up front.
• If the stock of the buyer is to represent part or all of the consideration, the terms of the stock (common or preferred), liquidation preferences, dividend rights, redemption rights, voting and Board rights, restrictions on transferability (if any), and registration rights. In addition, if the buyer is a public company, it will be important to consider whether that stock should be valued at signing or valued at closing, and whether a “collar” arrangement that limits upside and downside risk may be appropriate.
• If a promissory note is to be part of the buyer’s consideration, what the interest and principal payments will be, whether the promissory note will be secured or unsecured, whether the note will be guaranteed by a third party, what the key events of default will be, and the extent to which the seller has the right to accelerate payment of the note upon a breach by the buyer.
• Whether the price will be calculated on an “indebtedness free and cash free” basis at the closing (enterprise value) or whether the buyer will assume or take subject to the seller’s indebtedness and be entitled to the seller’s cash (equity value).
• Whether there will be a working capital adjustment to the purchase price, and if so, how working capital will be calculated. This is ultimately just an adjustment up or down to the purchase price. The buyer may argue that it should get the business with a “normalized working capital” and the seller will argue that if there is a working capital adjustment clause, the target working capital should be low or zero. This working capital mechanism, if not properly drafted or if the target amounts are improperly calculated, could result in a significant adjustment in the final purchase price to the detriment and surprise of the adversely affected party.
• If part of the consideration is an earnout, how the earnout will work, the milestones to be met (such as revenues or EBITDA and over what period of time), what payments are to be made if milestones are met, what protections (such as acceleration of payment of the earnout if the business is sold again by the buyer) will be offered the seller to enhance the likelihood of the earnout being paid, information and inspection rights, and more. Earnouts are complex to negotiate and tend to be the source of frequent post-closing disputes and sometimes litigation. Precision in drafting these provisions and agreeing on suitable dispute resolution processes are essential, although also difficult to accomplish.

2. Escrow/Holdback Issues

In many acquisitions of privately held technology companies, an escrow or holdback of a portion of the purchase price is negotiated to protect the buyer from losses due to breaches of the seller’s representations and warranties or covenants or specified contingencies (such as a shareholder’s exercise of dissenters’ rights). Sometimes there is a second escrow or holdback to help protect the buyer in the event of a post-closing price reduction based on a working capital adjustment provision. In certain transactions there may also be a special escrow/holdback to protect the buyer from specific matters, such as pending or threatened litigation. It is rare that a company can be sold on an “as is” basis without post-closing indemnities, in which case there would be no escrow/holdback. Here are some of the key issues associated with escrow/holdbacks:

• The amount of the general escrow/holdback for indemnification claims by the buyer and the period of the escrow/holdback (the typical negotiated outcome is a 5% to 15% escrow that is held by a third party for a minimum period of 9 to 18 months).
• With increasing frequency, in transactions with private equity bidders, it is becoming the norm for the majority of the escrow/holdback to be replaced with a provision that relegates the buyer to pursuing claims against a policy of “representations and warranties insurance” procured by the buyer or the seller for post-closing indemnification claims. Although this is not seen often in deals with strategic acquirers, if they are competing against private equity firms for an attractive target, strategic acquirers may feel compelled to agree to this structure as well.
• The seller will attempt to negotiate that the escrow will be the exclusive remedy for breaches of the acquisition agreement (except perhaps for breaches of certain defined “fundamental representations,” such as with respect to capitalization and organization of the seller, and for breaches of pre-closing covenants). Buyers who are willing to agree to this limitation typically will seek an exception for losses due to “fraud” or “actual fraud.”
• If a portion of the consideration paid in the transaction consists of the buyer’s stock, the buyer and seller will need to agree on whether the escrow will be all cash, all stock, or some combination of both, and how and when the stock will be valued for purposes of the indemnity. The negotiation on this topic becomes more complicated if the buyer’s stock is not publicly traded or if the escrow will include both preferred stock and common stock.
• In target companies with multiple (sometimes hundreds of) shareholders, it will be important for there to be a “shareholder representative” who post-closing represents on a unified basis the interests of the former shareholders with respect to indemnity and escrow/holdback issues. Traditionally this role was filled by one of the seller’s significant shareholders, but more frequently in recent years sellers have found it attractive to hire professional outside firms (such as Shareholder Representative Services or Fortis) that specialize in fulfilling this role.

3. Representations and Warranties of Seller

The representations and warranties of the seller can be all-encompassing, covering all elements of a seller and the business operations of the seller, including financial statements, corporate authorization, liabilities, contracts, title to assets, employee matters, compliance with law, and much more. For the sale of a privately held technology company, the representations and warranties relating to its intellectual property will also be particularly important.

• The representations and warranties in the definitive acquisition agreement typically serve three buyer-driven purposes. First, the buyer uses the representations and warranties to confirm its due diligence findings, and what it has learned about the seller. Second, if, after signing, the buyer determines that the representations and warranties were untrue when made (or would be untrue as of the proposed closing date), the buyer may not be required to consummate the acquisition (and may be entitled to terminate the agreement). Third, if the representations and warranties are untrue at either of such times, the buyer may be entitled to be indemnified post-closing for any losses the buyer suffers arising from such misrepresentation by the seller.
• The seller should make sure that representations about the selling company are only made by the selling company. Occasionally, a buyer will argue that a major selling shareholder who controls the selling company or owns a major stake in the selling company should join the selling company in making representations.
• For this reason, careful M&A lawyers representing sellers negotiate materiality qualifiers, knowledge qualifiers, and thresholds for disclosure so that immaterial violations do not result in breach of the acquisition agreement. They also work closely with the seller to prepare a schedule of exceptions to the seller’s representations and warranties (commonly referred to as the “Disclosure Schedule”) which, if accurate and complete, will protect the seller and its shareholders from indemnification liability for inaccuracies in such representations and warranties. A similar negotiation takes place around the closing conditions and the terms of indemnification.
• The seller’s representations and warranties regarding its financial statements, intellectual property, contracts, and liabilities merit particular attention and are discussed in the following sections.

4. Financial Statement Representations and Warranties of the Seller

For the buyer, representations of the seller as to its financial statements are critical. The buyer will expect that the acquisition agreement will include, at minimum, the following representations and warranties related to the seller’s financial statements:

• That the audited and unaudited statements of income, cash flow, and shareholders’ equity for specified periods and as of specified dates (the “Financials”) have been prepared in accordance with generally accepted accounting principles (“GAAP”), or international financial reporting standards in some cases, consistently applied throughout the time periods indicated and consistent with each other.
• That the Financials present fairly in all material respects the seller’s financial condition, operating results, and cash flows as of the dates and for the periods indicated in the Financials.
• That there has been an absence of recent changes in the seller’s accounting policies.
• That the seller’s internal controls have been adequate in connection with the preparation of financial statements by the seller.

The seller’s M&A attorney will attempt to limit the scope of these representations and warranties by the time period covered (such as only for the current year (or portion thereof) and the past one or two years), and by specific exceptions that may be set forth in the Disclosure Schedule. The representations regarding unaudited financial statements are typically qualified to the effect that footnotes required by GAAP have not been included in the unaudited financial statements, and that there may be immaterial changes resulting from normal year‑end adjustments in a manner consistent with past practice.

Buyers that are public companies can be expected to insist that the seller prepare audited financials for certain time periods, which will satisfy these buyers’ SEC reporting duties. The seller needs to appreciate the risks associated with this demand, especially if the seller has not previously prepared audited financial statements (a common situation for many technology startups and emerging growth companies).

5. Representations and Warranties Related to Intellectual Property

The seller’s representations and warranties as to its intellectual property (“IP”) are among the most significant representations and warranties in the acquisition agreement. The buyer wants comfort that the seller is the sole and exclusive owner of each item of IP purported to be owned by it, and that such IP is not subject to any encumbrances or limitations that unduly restrict the seller’s ability to exploit such IP (or that reduce the value of that IP in the hands of the buyer), or give third parties rights to such IP (currently or as a result of the M&A transaction) that are inappropriate or materially detract from its value. The buyer will also want to know that the seller has the appropriate right, through a license (exclusive or otherwise) or other contractual arrangement, to use any IP owned by third parties that is material to the seller’s business. Finally, the buyer will want to know if the seller is subject to any pending or threatened legal proceedings challenging its IP or exposing the seller to significant damages or loss of its IP, including in particular patent infringement claims or litigation, as discussed in more detail below.

However, the seller will seek to narrow its IP representations in important respects. For example, the seller will seek to “knowledge qualify” representations related to its ownership of its IP and whether or not its activities infringe upon the IP of third parties. The seller will want to ensure that it is not required to make any representations and warranties as to its ownership of IP that speak to the period following the closing, when there may be factors beyond its control (including prior agreements entered into by the buyer) that give rights to third parties or otherwise limit the right of the seller or the buyer to exploit the IP.

The following are several examples of matters that may encumber or limit the seller’s ability to exploit its owned IP following the closing of an acquisition:

• Claims by third parties that patents are invalid (as a result of the existence of “prior art” or otherwise)
• Liens on the IP in favor of banks or other lending institutions
• Claims by third parties that the IP or activities of the seller infringe their patents or other IP rights
• Inadequate evidence that the employees or contractors who contributed to the creation of the IP have assigned all of their rights in the IP to the seller
• Rights of first refusal, exclusivity, or similar rights in favor of third parties with respect to the IP
• The failure to have obtained any third-party consents necessary for the IP to have been transferred to the seller (if not originally developed by the seller)
• Broad licenses to the IP in favor of third parties that compete or may compete with the seller
• Open source issues (including the risk of IP that purports to be proprietary in nature but is actually in the public domain)
• The failure of the seller to have appropriately registered the IP with the applicable governmental body

See also 13 Key Intellectual Property Issues in Mergers and Acquisitions

6. Representations and Warranties Related to Intellectual Property Infringement

The buyer typically wants the seller to represent and warrant that:

• The seller’s operation of its business does not infringe, misappropriate, or violate any other parties’ patents or other IP rights.
• No other party is infringing, misappropriating, or violating the seller’s IP rights.
• There is no litigation and there are no claims covering any of the above that is pending or threatened, or that could be reasonably expected to be brought following the closing.

The scope and limitations of these representations and warranties are often heavily negotiated. The buyer is concerned about the risk of large unknown infringement claims that third parties may bring against the seller or the buyer after the signing or the closing. When an M&A transaction is publicly announced at signing (and there is a deferred closing that may be weeks or months later), it is not uncommon that third parties that are unhappy with the seller from an IP perspective may bring claims or lawsuits during this interim period to try to maximize their leverage (believing that the seller may fear that the buyer will “walk away” from the deal if the claim or litigation is not settled).

The seller often negotiates to limit the scope of the non-infringement representations and warranties by:

• Materiality qualifiers
• Knowledge qualifiers
• Representations being limited to infringement of issued patents (and not all other IP rights)
• Eliminating any ambiguous representations (such as that no third party is “diluting” the seller’s IP)

Here is an example of a pro-seller form of representation and warranty regarding IP non-infringement:

Intellectual Property. To the Company’s knowledge, as of the date hereof, the Company owns or possesses sufficient legal rights to all Intellectual Property (as defined below) that is necessary to the conduct of the Company’s business (the “Company Intellectual Property”) without any known violation or known infringement of the rights of others. To the Company’s knowledge, as of the date hereof, no product or service marketed or sold by the Company violates any license or infringes any rights to any patents, patent applications, trademarks, trademark applications, service marks, trade names, copyrights, trade secrets, licenses, domain names, mask works, information and proprietary rights and processes (collectively, “Intellectual Property”) of any other person. Since [date], the Company has not received any written communications alleging that the Company has violated or, by conducting its business, would violate any of the Intellectual Property rights of any other person.

The scope of the seller’s exposure for breaches of representations and warranties relating to IP infringement can also be limited by including protective language in the indemnification provisions of the acquisition agreement, including thresholds/deductibles, right to control the defense and settlement of third-party claims, and the limitation for recovery of IP infringement claims to the portion of the purchase price placed in escrow or some lesser amount (see item 14 below).

Often, a buyer may seek to lengthen the period post-closing in which it may bring claims relating to breaches of these IP representations and warranties (beyond the “survival” period applicable to other representations and warranties), and may seek to negotiate a remedy for breach of the IP representations and warranties that goes beyond the standard escrow/holdback that applies to other indemnifiable matters. The buyer may take the position in the acquisition of a technology company that “substantially all it is buying is the IP,” and thus that it is entitled to these broader protections. Conversely, the seller will want the IP representations and warranties to be treated just like the others in the acquisition agreement.

7. Representations and Warranties as to the Seller’s Liabilities

Buyers in acquisitions of technology companies typically ask for a broad representation and warranty that the seller has no liability, indebtedness, obligations, expense, claim, deficiency, or guaranty, whether or not accrued, absolute, contingent, matured, unmatured, known, or unknown, except as specifically disclosed to the buyer. The seller’s counsel will argue that the following should be excluded from this liability representation and warranty:

• Any items currently reflected in the seller’s current balance sheet
• Any items arising since the date of the current balance sheet and arising in the ordinary course of business consistent with past practice
• Any items arising pursuant to the seller’s contracts or employee plans
• Any items set forth in the Disclosure Schedule
• Any items that are the subject of any other representation or warranty contained in the acquisition agreement
• Any items arising from actions taken by the seller at the request of the buyer
• Any item
  
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