One of our themes was that selling business owners must continually focus on “after tax proceeds,” and Tim Tikalsky did a terrific job of reviewing many of the factors that can make understanding “after tax proceeds” so difficult.

Most business owners expect to receive long term capital gains treatment on most of their proceeds, which in recent years typically meant being taxed at 15%. Today the tax environment is more complicated, the potential applicable tax likely higher, and the importance of tax planning even greater. A reminder of the changes effective this year, and how complicated the calculations can become, was reflected in a recent Wall Street Journal article: “The New Capital-Gains Maze” which can be found here. Some of the considerations noted are not related to a sale of a business, but many of its comments are directly on point. In addition to adding a third tax tier for capital gains at 20% to the previous two tiers of 0% and 15%, there are three “backdoor” tax increases that can push the effective tax rate to nearly 25% for some tax payers. (And Tim has also noted to me that many overlook the newly instituted 3.8% Medicare tax on investment income.) It is complicated.

At the conclusion of our recent presentation, we emphasized that, among other things, sellers should “plan early, hire a key advisory team (including an M&A advisor, and M&A attorney and a tax advisor) and never lose sight of “after tax proceeds.” This years changes of the capital gains rates, and the related tax considerations noted in the WSJ article, further emphasizes the importance of our recommendations.

“Seller shall indemnify buyer against any and all claims, demands, losses, and liabilities respecting the business or otherwise, including interest, penalties, and reasonable attorney’s fees, that buyer shall incur or suffer by reason of seller’s breach of any representation, warranty, covenant, promise, or agreement covered by this agreement or in any exhibit, schedule, or other instrument attached to this agreement or furnished, or to be furnished, by seller under this agreement.”

(The Buyer may also agree to indemnify the Seller, but it is the Seller’s indemnification which typically results in the more difficult negotiations, including in many instances, establishing both “minimum” and “maximum” dollar limitations.)

A recent post by attorney Keith Paul Bishop was a reminder to me that California Sellers should be mindful of several provisions of the California Civil Code in interpreting indemnity obligations.  Specifically, Section 2778 provides that, unless the parties have otherwise agreed in writing:

• First, subsection (3) provides that the indemnity obligation “…embraces the cost of defense against such claims…” (italics mine). (I should note that the example provision provided above does specifically addresses and includes attorney’s fees; presumably 2778(3) would be of most significant in those instances in which the indemnity provision does not specifically address the duty to defend / cost of defense issue.)
• Second, subsection (4) provides that, in our sale of a business scenario, the Seller is bound to provide the defense if the Buyer so requests. (Many Sale Agreements go into some detail about the process of demanding and providing a defense; again, this provision would apply if the parties have not addressed the issue in writing.)
• Third, and again applying the provision to our sale of a business sale scenario, if the Seller, after receiving adequate notice of the claim, neglects to defend the Buyer, a judgement against the Buyer would be “conclusive” as against the Seller (see 2778(5)).

The take-aways for a California Seller negotiating a sale:

• Expect to be bound by an indemnity obligation; and,
• Negotiate and document specific provisions if you intend to: (i) limit your obligation to an amount in excess of a minimum threshold, or to a maximum total; (ii) shift the duty to defend from the presumptions established by the Civil Code; and (iii) require specific notification or other process provisions.

If, post-closing, you the Seller are contacted about a claim, contact your attorney immediately. The indemnity provisions can be complicated and confusing, and you may have obligations and rights which are not immediately apparent. You may also prejudice your rights if you do not act timely.

Most Sellers attempt to structure the sale of their businesses to maximize capital gains treatment, and today that rate is 15%. It is currently scheduled to go to 23.8% next year, at least for most higher income individuals. Even if the 15% rate is extended, many believe that the effective rate would be at least 18.8% because of the health-care law changes for higher-income individuals.

Governor Romney has proposed to eliminate all taxes on capital gains for taxpayers with incomes below $200,000, and to maintain the 15% maximum rate otherwise. He has also pledged to repeal parts of the health-care law.

So what does this mean if you are a Seller? Many suggest that Sellers are attempting to sell before year’s end, because of the expectation that taxes will rise. (See, for example, yesterday’s Wall Street Journal article, “Looming Tax Hike Motivates Owners to Sell“), but sales of privately held companies through the third quarter do not appear to have increased over that in prior years (see, for example this Insight Report by BizBuySell).

The uncertainty, I believe, means that Sellers remain understandably cautious. Nevertheless, if you are a Seller and do in fact believe that capital gains rate are going to increase substantially, you should be in the market right now. With less than two months before the end of the year, there is not much time to identify a Buyer and both negotiate and close a transaction.

Since that time, there have been several key related developments of importance to purchase and sale transactions. First, the UK passed the UK Bribery Act, which is similar to the FCPA, but it is both broader and can result in more serious penalties. Second, the DOJ has increased its FCPA focus, resulting in a significant increase in the number of prosecutions. Third, and perhaps most importantly for potential Buyers, the DOJ has shown a willingness to impose successor liability on acquirers. In other words, the buying company can be heavily penalized for FCPA violations which occurred before it made its purchase, whether or not it knew of such practices.

What does this mean if you are a Seller with international operations?

• First, without regard to whether you are planning to sell your company, you should have FCPA compliance procedures in place as part of any good compliance program.
• Second, you should expect any multinational Buyer to conduct significant due diligence on your FCPA compliance programs.
• Third, you should expect that the Buyer will insist on representations and warranties concerning your FCPA compliance in the Purchase Agreement.
• Fourth, if violations are uncovered or if the compliance program is found to be inadequate, you should anticipate an adverse impact on your purchase price, your indemnity obligations, and perhaps your escrow.

Be proactive. Compliance is costly, but becomes even more costly if you wait until the date of sale. If you have any international operations the time to insure that your compliance programs are up to speed is before you go to market.

Well, the Ohio Supreme Court has now reconsidered, and has essentially ruled that the merger company…”has stepped into the shoes of the absorbed company,” and that the absence of the “successors and assigns” language did NOT prevent the company from enforcing the covenants. (See Acordia of Ohio, L.L.C. v. Fishel, 2012 Ohio LEXIS 2454.) (The reconsideration by the Ohio Supreme Court was brought to my attention by the excellent article by Thomas Metzger and Melanie Houghton of Littler Mendelson’s Columbus office: the full article can be found here.)

I view that as good news… not because it favors employers, but because it is consistent with the law of most jurisdictions, and, I believe, is probably consistent with the intent of the parties. Nevertheless, this case reminds us that: (i) the enforceability of such covenants turns on state law; and (ii) it remains prudent to include in the original agreements concerning such covenants that the obligations will survive an assignment, merger, consolidation, sale of shares or other change in control of the company.

Thompson Hine, a highly respected Ohio law firm (that I hired in a previous life as a General Counsel), has brought to our attention, in it’s “Business Law Update” for the Summer 2012, the case of Accordia of Ohio LLC v. Fishel. In that case, the Ohio Supreme Court has ruled that a merger resulted in the termination of the acquired company, thereby terminating its noncompetition agreements, and causing the two-year non-competition period to begin running. As the agreements apparently did not have a “successors and assigns” clause, and as more than two years had passed following the merger, the passage of time resulted in the release of the employees from their obligations.

That result is surprising to me because the “general rule” – which apparently is also set forth in Ohio statutes – is that the surviving entity in a merger continues to possess, by operation of law, all interests and obligations of the parties to the merger. In other words, the “acquired” company in a merger is generally thought to continue to exist.

Nevertheless, as a California lawyer, I am very familiar with the public policy considerations disfavoring covenants not to compete (and I have previously commented on here), so I should not be all that surprised.

Key takeaways:

• Too often “successors and assigns” language is viewed as unimportant “boilerplate”… but it may have made a difference here (the court found its absence “significant”).
• As Thompson Hine notes, the prudent approach, if you do in fact want to insure that such covenants are enforceable post merger, would be to include language that specifically provides that the rights and restrictions would survive an assignment, merger consolidation, sale of shares or other change in control of the company.

The Wall Street Journal has an article in today’s paper indicating that  Silicon Valley bankers and entrepreneurs are predicting an acceleration in tech mergers and acquisitions. And they point to increased cash on the balance sheets of potential acquirers, some vc’s reluctance to continue to prop up later stage companies, and the sluggish tech-IPO market as key factors. (Interestingly, they also note that a heated IPO market will often result in more aggressive acquirers.)

Unfortunately, I have seen and heard these kinds of comments for several quarters. There is no doubt in my mind that there will be a turnaround – these trends are always cyclical – the question is when. And, as is reflected in the article, there is no precise data to correlate deal activity to, for example, cash on the balance sheet. Psychology continues to be a – perhaps the –  key factor. As the article notes after mentioning the recent Salesforce and Microsoft deals: “…such deals often spur others as Silicon Valley firms follow their peers in a race for assets.” Let’s hope they do.

But if you need a reminder that this is serious stuff, the Department of Justice just gave us one. In a press release issued earlier this month, it noted that a senior officer of a South Korean company had agreed to plead guilty to altering, and ordering subordinates to alter, company documents that were submitted to the government as part of HSR compliance. The company has now paid a $200,000 fine, and the officer has agreed to a FIVE MONTH PRISON TERM! The full press release can be found here.

A recent survey of Merrill Datasite and Pitchbook, however, sheds some light on the size of PE transactions during 2012. (To review the entire report, go the Pitchbook website here. And I should note that Merrill Datasite is one of a number of virtual data rooms providers that I have recommended to clients. My comment on virtual data rooms can be found here.)

Among the data that is provided:

• In the first quarter of 2012 there were 187 completed U.S. private equity investments.
• Of those deals, 108, or 58% were for $50M or less!
• Interestingly, and perhaps related, the number of add-ons also went up, accounting for more than half of all buyout activity.
• And the IT industry – where I have spent much of my time doing deals – accounted for the most invested capital in 2012, with $10.8 billion of capital invested through 55 deals.

As I noted in a prior post, PE transactions can be among the most lucrative exits for sellers, and should not be ignored under any circumstances.  And, as the above data suggests, a company value in the tens of millions – not billions, and not hundreds of millions – is clearly attractive to a number of PE investors.

• During due diligence, most Buyers will want to gather as much intelligence and meet with or speak with as many of your customers as they can.  BE CAREFUL. Insure that, before a binding purchase agreement is signed, you have an enforceable confidentiality agreement, and consider including non-solicitation protections. While it is not unusual for Buyers to insist on speaking with some key customers as part of due diligence, make sure that: (i) no such discussion occurs before the the 11th hour – i.e. just before the signing if there is a simultaneous signing and closing, and, if possible, after the signing but just before the closing (my post on “staging” due diligence”); (ii) you use a “cover” for the discussion – tell the customer that the Buyer is interested in investing in your company, or something to that effect, as you will need to be able to explain what the discussion was for should the transaction fail; (iii) you or one of your key employees participate in every discussion – DO NOT allow the Buyer to have one-on-one’s. The deal is not done until it is done.
• If the parties decide to begin integration planning prior to the closing – which is very common if there is to be a signing followed by a lengthy interim period during which third party consents are obtained – make sure you consult with your attorney concerning anti-trust and Hart-Scott-Rodino (“HSR”) compliance. There are real limitations on how much information you can share, how much you and the Buyer can agree to do, and how much is in fact done prior to the closing, and, among other things, you must have a plan in mind on how to “unscramble” the egg should the transaction fail.
• Do focus on your key employees responsible for customer relationships. Keeping them informed – to the extent possible – and insuring they are motivated during any interim and immediately following the closing will be key to their and your success. Among other things, insure that you have programs and policies in place that insure that key employees are confident about their future – stay pay, change of control payments, etc. (see my post here).
• If the Buyer is insisting on an earn-out, which typically will include metrics tied to either customer retention or some proxy for it (like recurring revenue), consider the extent to which you can build into Company programs or individual compensation plans metrics that are consistent with your interests as a Seller.

Customers are obviously the key to any business, and a poorly managed merger will jeopardize those relationships for both the Buyer and the Seller. Many Buyers will build into their analysis an assumption that a certain percentage of customers will be lost as a result of the merger, but, if both Buyers and Sellers manage the process appropriately,  it is a real opportunity for the parties to improve customer relationships… 2 plus 2 can = 5!