BUYER S ACQUISITION OUTLINE Preliminary Copyright 1997 by Maryann A. Waryjas Presented February, 1998 1. This outline assumes that management has engaged in a comprehensive, in depth study of the needs of the business, that it has determined that such needs cannot be accomplished solely by internal growth and that the Board of Directors has approved the conclusion that an acquisition should be sought. 2. Basic Questions The following basic questions are of the utmost importance from the inception to the closing of every acquisition: (d) What are the buyer s principal objectives in this acquisition (for example, increasing earnings per share, buying to resell, acquiring patents or other intellectual property rights, hiring superior management, or acquiring plant, equipment and work force)? Does the target company really fulfill the objectives? To what degree? What are the shortcomings? Is there another (better) alternative at a different (better) price? What is a fair price for what will be acquired and the risks that will be undertaken? Review these basic questions frequently during the acquisition process, as more information is obtained and the terms of the acquisition agreement are being negotiated. 3. Formation of Acquisition Team After identifying the target company (and before talking to them, if possible) the buyer should form its acquisition team. The buyer should inform the team of the buyer s principal objectives and give them ready access to all available information. The team should include individuals with experience in the following areas: Management Financial Accounting Tax Legal
One management person should be clearly in charge and should be responsible for the rapid and complete flow of information, the timely completion of work and the appropriate making of decisions. 4. Responsibilities Management Evaluation of the Target (viii) People - the ability and depth of the target s management; which people are necessary or even crucial to the continued success of the target s business following the closing; and redundancies; Business and products - future value for each one, considering the industry as a whole and each product individually; Plant and equipment - adequacy; status of technology; need for additions or replacements; redundancies; Engineering, research, patent and licensing matters; Sales and marketing abilities and problems; Post-acquisition changes that would achieve economies and maximize synergies; Appropriate price; and Preferred structure Financial Evaluation of the Target (viii) Strength and trend of earnings; Asset values; Debt and terms thereof; Cash flow and cash needs forecast; Contingent liabilities; Probable post-acquisition earnings, taking into account all probable changes (including anticipated cash flow and cash needs forecasts) and accounting requirements; Appropriate price; and Preferred structure
Accounting Evaluation of the Target Reliability of target s accounting procedures (particularly if privately held); Difference in results if accounted for in the same manner as buyer; Pro forma past financials for the combined businesses; Desirability of pooling vs. purchase; Adequacy of reserves; and Probable post-acquisition earnings, taking into account all probable changes (including anticipated cash flow and cash needs forecasts) and accounting requirements (d) Tax Evaluation of the Target and the Proposed Acquisition (viii) Taxable vs. tax free - use of securities, debt, cash; Adequacy of tax reserve - prior audits; Structure. There are four principal tax structures for an acquisition: (A) taxable purchase of the target s stock; (B) taxable purchase of the target s assets; (C) acquisition of the target s stock in a tax-free exchange; and (D) acquisition of the target s assets in a tax-free exchange; Will the transaction be structured so that the buyer obtains a new basis (either stepped-up or stepped-down basis) in the target s assets (generally the purchase price, plus the target s liabilities assumed by the buyer, plus the buyer s acquisition expenses)? Or will the buyer take a carryover basis in the target s assets (generally the target s much lower historical asset basis)? Will the transaction cause the target to pay corporate-level tax on all the appreciation inherent in its assets, including goodwill and other intangibles? If so, will the economic burden of this tax fall on the buyer, or on the target s stockholders? Will the target s stockholders pay tax on the appreciation inherent in their stock? Can that gain be deferred by the installment method, a tax-free reorganization, or other means? If the target has a net operating loss ( NOL ) or other tax attributes, will the buyer inherit these tax attributes, or will there be restrictions imposed on the buyer s ability to use the NOL or other tax attribute? Review of the target s history of compliance regarding state sales/use taxes and other state or local taxes
(e) Legal Analysis of the Target Antitrust considerations - Hart-Scott-Rodino; SEC analysis; State law analysis; Pending litigation; Environmental due diligence investigation; ERISA analysis; Preferred structure 5. Preliminary Negotiation and Investigation Period Ultimate goal is to use all information generated during the due diligence process in order to: Decide if the acquisition is worth pursuing or should be abandoned; Bargain for an appropriate price; and Protect the buyer against possible damages and unknown liabilities by allowing buyer to be able to get out of the purchase at any time before the closing and (if possible) to be indemnified if damaged after closing (d) The buyer s acquisition team obtains access to the target s business records and people, with the goal of finding out as much as possible before the buyer has agreed on price or terms. This time period and investigatory phase is also often used to educate the seller that the buyer will realistically expect contract protection as set forth in above. Difficulty in obtaining access often arises with publicly held companies because of their duty to disclose if an agreement is reached, or if information concerning the possible acquisition becomes public, or if there is unusual trading in the company s securities. Both publicly held and privately held companies may also take the posture that the buyer s team should not be allowed access to information until a price is agreed because of possible damage to employee morale or customers. It is essential that one person be in charge of negotiations with seller. A buyer should never allow the seller to be able to go around or over the buyer s person in charge. This person in charge must keep his or her team informed and should consult with appropriate members of the team before making any concessions to be sure they will not adversely impact tax, legal, accounting, or other matters.
6. Price Determination and Agreement Negotiations Ideally, the buyer should not agree on a firm price until the entire investigatory period is ended and the agreement is in final form. Because this usually cannot be done, buyers sometimes make a tentative agreement on price after some investigation (usually limited to financial statements) and attempt to condition the ultimate price on the consummation of the investigation and a final agreement. The goal is to achieve a fair and reasonable agreement, not one that is outrageously tough on the seller or gives the buyer no protection. At the same time, one of the best tools for negotiation of price is the negotiation of the agreement. First, negotiation of the agreement actually sets forth hidden price terms in many instances. For example, an agreement to indemnify the buyer if audited financials as of the closing date show less than a designated net worth is actually a price term. Second, after the agreement is drafted and has been presented to seller, the difficult problems often emerge and their solution involves price terms. For example, a publicly held company seldom will agree to give any indemnification after the closing. But if litigation is pending against the seller which could have a serious adverse financial effect and its outcome will not be known until long after the closing, a buyer will often make its own analysis and then ask for a price reduction in the bargaining process because the buyer will be taking the risk. 7. Post-Closing Purchase Price Adjustments. The most effective form of price adjustment depends on the type of business involved. For a business in which tangible assets, such as physical plant and inventory are key, a balance sheet adjustment is useful. It might operate as follows: There will be a post-closing audit of the target s balance sheet as of the closing date. To the extent the closing date balance sheet differs from a previously agreed upon balance sheet, there will be a post-closing payment by the buyer or the seller to the other to reflect the difference in the target s net worth. In a business that requires a significant amount of working capital, there me be a requirement that the business have, at closing, a specified amount of working capital. 8. Handling the Target s Liabilities Stock Acquisition Where the buyer acquires the target s stock, the buyer remains liable for all of the target s fixed and contingent liabilities. If the parties intend that the seller retain some of the target s liabilities, then the seller can agree to indemnify and hold harmless the buyer against such liabilities. However, if the seller falls upon financial hard times, the seller s indemnification may be worthless and the buyer may nevertheless bear the liability. Asset Acquisition Where the buyer acquires the target s assets, the parties can tailor the asset
purchase agreement so that the buyer assumes only specified liabilities and leaves all other liabilities behind. However, even in this case, there are several legal doctrines under which the buyer may inherit the target s liability if the target falls on financial hard times and is unable to satisfy its liabilities. Thus, the asset purchase agreement should obligate the seller to guarantee payment of those liabilities of the target not assumed by the buyer. However, if both the seller and the target fall on financial hard times and are unable to satisfy the target s retained liabilities, the buyer may be held responsible for such liabilities if one of the following legal doctrines applies; a. Merger. If the buyer acquired the target s assets by a cash merger, buyer automatically becomes liable for all of the target s liabilities; b. Bulk Sales Act. In certain states, a buyer of the target s assets in bulk is automatically liable for all of the target s liabilities if the creditor sues the buyer within six months after the acquisition, unless notice was given to all of the target s creditors within a specified period of time before the sale and certain other procedures were followed; and c. De Facto Merger and Successor Liability. Courts increasingly have held a bulk asset buyer responsible for tort liabilities for defective products and certain underfunded pension liabilities under the common law doctrine of de facto merger and successor liability where the target s business is transferred to the buyer as a going concern and the target goes out of existence (especially in situations where the seller receives an equity interest in the buyer). Some Alternatives for Protecting the Buyer Against the Target s Liabilities Tough, detailed representations and warranties tied to detailed disclosure schedules are probably the most helpful. Indemnification provisions should survive for as long as possible (A) forever, with respect tot title; (B) for the applicable statute of limitations for tax, environmental, ERISA and product liability matters; and (C) at least for three months after the completion of the first full fiscal year s audit by the buyer s auditors; Escrow arrangements for a portion of the purchase price; Seller notes which allow for recoupment by the buyer for any breach of a representation, warranty or Covenant; and Continent purchase price payments
9. Special Employee Liabilities Existing Management. If the buyer intends to retain the target s existing management, the agreement should provide as one of the buyer s closing conditions that the buyer will have entered into satisfactory employment agreements with specified members of the target s management. Inactive Employees. The agreement should address what happens to employees of the target who are on temporary or long-term disability leave at the time of the closing, and pipeline cases (for example, the employee who is diagnosed with cancer the day before closing and is in the hospital and absent for the next six weeks). Severance Costs. The agreement should specify who will pay the termination costs of the target s employees that the buyer does not need and that the seller will not employ elsewhere. Counsel should be consulted so that all applicable labor laws are complied with and that the process is not discriminatory. In some cases, severance costs may be triggered by the transaction, even if the employees are hired by the buyer. www.kmzr.com 525 West Monroe Street Suite 1600 Chicago, IL 60661-3693 Tel 312.902.5200 Fax 312.902.1061 575 Madison Avenue New York, NY 10022-2585 Tel 212.940.8800 Fax 212.940.8776 2029 Century Park East Suite 2600 Los Angeles, CA 90067-3012 Tel 310.788.4400 Fax 310.788.4471 1025 Thomas Jefferson St., N.W. East Lobby, Suite 700 Washington, DC 20007-5201 Tel 202.625.3500 Fax 202.298.7570 401 South Tryon Street Suite 2600 Charlotte, NC 28202-1935 Tel 704.444.2000 Fax 704.444.2050 260 Sheridan Avenue Suite 450 Palo Alto, CA 94306-2047 Tel 650.330.3652 Fax 650.321.4746 One Gateway Center Suite 2600 Newark, NJ 07102-5397 Tel 973.645.0572 Fax 973.645.0573 06/28/2002 8