Having been an active participant as legal counsel in over 100 mergers and acquisitions, I am often asked how hard is it to attract, negotiate and close an acquisition especially during tough economic times. Surprisingly, mergers and acquisitions are still quite active in the knowledge based economy as various verticals continue to be in consolidation mode whether among direct competitors or entities which are diverse in size but complimentary in technology, customers, revenue or other strategic values. It is more important than ever to ensure that negotiations are carried out in a manner which increases the probability of success of a transaction rather than programming it for failure. We have all heard that most mergers fail to deliver value. The same can be said for joint ventures, strategic alliances, outsourcing deals and to a lesser extent supply contracts. Fundamentally, it is mainly because parties tend to enter negotiations with tactics that focus on winning the negotiation and closing at any cost, rather than also focusing on achieving value for the transaction. In the context of mergers and acquisitions, where earnouts have become a focal point for bridging the gap in the purchase price offered and accepted between the parties, it is more important than ever to ensure that negotiations are not only balanced but are carried out in a manner which provides maximum potential for value creation after the transaction is closed.

The Best Ways to Negotiate

The fundamental gap that leads to a break down in negotiations is proper communication. Too often clients and, yes, lawyers are focused on avoiding disclosing information, keeping the other side off balance, treating the negotiating process as distinct and separate from implementation and creating an atmosphere of "must close" or "walk away".

Instead of focusing on what information should not be disclosed, it is far more useful, especially when your company is the target, to focus on disclosing information in a manner that also elicits more information from the buyer as to their intentions, strategies and objectives surrounding the transaction. This information is highly valuable when negotiating the terms of any transaction, especially value, indemnity and earnout, especially where financial factors come into play in achieving the earnout.

When economic conditions are difficult, negotiators are often under even more pressure to deliver results. For this reason those acting for acquirors, especially large company acquirors, focus on the quality of the deals and the value of capital being deployed. As a target, if you can recognize that the purpose of negotiation is to accomplish something more than closing the deal, then working backwards from that objective can allow you to ensure that you maximize not only the deal points but also the likelihood of success for the buyer. Even where an earnout is not involved, it is far more gratifying for founders, management and shareholders of target companies to know that their company has gone on to play a pivotal role in the future success of the buyer regardless of the relative size.

Eliciting the framework for the buyer's goals, objectives and strategies is essential. Is the acquisition being done for a particular technology purpose and, if so, what is the purpose? What is the impact and expectation of the future revenue from such acquisition by the buyer? This is typically very different than the forecasted revenue the target company would continue to enjoy if it remained a stand-alone.

Often the principal selling shareholders are also key members of the acquired team. If this is the case, it is essential that negotiations be as collaborative as possible. Sometimes it is best to delegate to your advisors most of the non-substantive points to the greatest degree possible and only dealing directly with the most senior person on the other side of the negotiating table for the key business points. This may shift as the deal process goes through the normal spikes and valleys. Setting expectations from the outset assists in bridging gaps during these key negotiations. Do not allow animosity or bad feelings to play into the negotiation. As the leader of the organization, set the tone from the outset as to the expectation of how the parties will deal with each other. Negotiators take their direction from the organization's leadership and regardless of the size of an organization; a transaction team should treat negotiations like any other critical business function. Like any other outcome, a good process or roadmap is likely to lead to a better outcome. It is for this reason that planning of each step of the process, key terms, key potential roadblocks, issues and other nuances need to be continually strategized and revamped where necessary among the team. It is also very critical that various parties on a team understand their respective roles, with key players not micromanaging the negotiation concession by concession.

In a recent transaction that I was involved in, TEG (The Electric Company of Hunan Province - China) acquired 75% of the shares of Dynex Semiconductor Ltd. (TSX-V). The due diligence process provided a unique opportunity for collaborative process between the Chinese acquirer and the British management team which resulted in much more robust integration and business plan for Dynex going forward. While we have only just completed the acquisition, all parties involved were of the unanimous view that the collaborative nature of the due diligence was one of the most constructive processes we had encountered. We deliberately split the negotiating team from the due diligence team and while there were many key issues that needed to be resolved in three different time zones, the goodwill demonstrated through the entire process made the key issues relatively easy to agree upon as they arose.

Earnout

While there are many critical components to the deal terms on an M&A, by far the most complex comes into play when part of the purchase price is contingent on the future success of the business. These "earnouts" are often glossed over by a purchaser once the mechanism to bridge the imbalance in the purchase price is agreed to. The art of negotiation and eliciting information with respect to the buyer's intended plans is absolutely essential in ensuring that an earnout is properly structured so as to achieve success for both vendor and purchaser. If parties to the negotiation use dirty tactics or traditional win-lose strategies in negotiation, the likelihood of an earnout achieving its goal is greatly diminished. On the other hand where a target has open negotiations and discussions about its business and setting appropriate expectations, then the likelihood of earnout is much greater. Too often buyers initially place very little emphasis on details of the earnout and merely focus on the thresholds that need to be achieved for the earnout to succeed. It traditionally falls on the seller's shoulders and that of its legal counsel to properly contemplate and draft the pages of contingencies, conditions and rules that are put in place to allow the parties to determine whether an earnout has been achieved or whether more importantly the purchaser has met its obligations to allow the business to be properly operated, accounted for to achieve its goals.

Because so many factors invariably change regarding a target's business after an acquisition, it is important that the obligations of the buyer to continue to operate the business in substantially its then current form and that structure be embedded into the agreement. It is also important to have a business plan or forecast which the parties agree on and which may not be changed without the vendor's consent.

Where feasible, it is also important to enunciate those changes to operations that may be made and those changes that may not be made. For example, on acquisitions by large companies, often the financial and other back office operations and support move to the head office. Conversely, there are also many other attributes of large companies that add expense to an independent business unit that need to be taken into account and preferably excluded in determining the earnout. These may include inter-company loans, overhead for corporate head office, overhead for being a public company, increased accounting costs due to the size of the audit of public companies, third party agreements where the corporate level may receive rebates or preferential pricing without same flowing down to the business unit which all affect the earnout.

It is also equally important to set out the roles and responsibilities for current management of the target and the continued leadership of the team on a go forward basis. In many cases, one should attempt to negotiate a early trigger or payout to the earnout whether or not financial thresholds have been met, if and when certain key members of the team are terminated without cause after the acquisition. As well where selling shareholders have during the negotiations assumed that certain additional resources, capital or business units are to be supplied in order to maximize the earnout, those specific obligations should be built into the definitive agreement.

Employment Matters Post-Acquisition

Whether an earnout exists or not, typically new employment agreements are negotiated for executives which set out not only the responsibilities and compensation but ramifications of severance. It is a common experience during the negotiations that these agreements are left to the last minute by the buyer and often shifted to the human resources department. It is incumbent upon the seller and legal counsel to ensure that these agreements arrive on a timely basis to allow proper negotiation and thoughtful process for the continuing employees. It is also critical that the key restrictive provisions surrounding employment agreements be thought through carefully. Unfortunately, as is the case with lack of successes in integration and unsuccessful transactions, most founders and management teams are surprised to learn just how short-lived most employment arrangements are after an acquisition. Whether an earnout is involved or not, attention should be paid to the length of the non-competition provision especially where termination occurs without cause by the employer after the acquisition. Often if one does not focus on all of the negative variables that may come into play, shareholders may be left with an unduly long but yet enforceable non-competition provision, even where no earnout exists or is likely.

As is the case in the industry as a whole, legal counsel need to work even more diligently through difficult economic times on mergers and acquisitions as well as other strategic transactions. It is imperative however that the right tone, strategy process and deal experience be brought to any negotiation regardless of the economic environment we find ourselves in.

By Debbie Weinstein

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