Exits: Legal and Practical Aspects

Technion Institute of Technology:

Legal and Financial Aspects of Technology

Entrepreneurship

Exits: Legal and Practical

Aspects

Adv. Barry Levenfeld, Yigal Arnon & Co. [email protected]

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Outline

 The Exit – Possible Structures

◦ Initial Public Offering (IPO)

◦ Asset Sale

◦ Share Sale

◦ Reverse Triangular Merger

◦ Court Approved Merger

 Legal and Regulatory Issues

◦ Antitrust

◦ Securities Laws

◦ Tax

◦ OCS

 Ten Commandments for Running Your Company and

Preparing for Exit

The Exit – Possible Structures



Initial Public Offering



Asset Sale



Share Sale



Reverse Triangular Merger



Court Approved Merger

IPO

Shareholders ShareholdersInvestor ShareholdersInvestor

$ [Underwriter] Shares Issuer _Public 6 Issuer Public

IPO

Pro

 Preserves the “Dream”

 Preserves control, autonomy  Lends credibility

 If done on the right exchange

and right valuation, adds cash resources and liquidity

Con

 Very expensive and time

consuming; monopolizes management resources

 High annual maintenance

costs

 Public scrutiny on earnings,

etc.

 Dealing with public

shareholders, external directors

 Approving certain

Asset Acquisition

Acquirer

1. Start:

2. Transaction:

Acquirer Target Assets

3. Finish: Assets Target Consideration

Shareholders _ShareholdersTarget ShareholdersTarget

$ and/or shares

Assets of Target

Acquirer _Target

Asset Acquisition

Pro

 Can be fastest

 Easier decision making

process in target and acquirer (often no shareholder

approval is needed)

 Acquirer can avoid unknown

liabilities

Con

 Two levels of tax on selling

shareholders – company and shareholder

 Non-Israeli shareholders of

target pay more tax

 Target may be left with

unwanted liabilities

 May have OCS complications  Need to assign contracts,

Share Acquisition

Shareholders Target Shareholders (only if consideration was in shares of Acquirer)

Acquirer Shareholders Acquirer

Shareholders

Acquirer Target Acquirer

Target

Acquirer Target

Shareholders

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Share Purchase – Private Target

Con

 If not all shareholders agree,

need contractual or statutory bring-along

 Bring-along may require 80%

or 90%, sometimes less, and may take up to 90 days

 Questions regarding

enforceability if:

◦ differs from statute

◦ consideration allocated according to liquidation preferences

◦ often excluded from legal opinions

Pro

 If all shareholders agree,

can be very fast

 Only capital gains taxes –

foreign shareholders often exempt

Share Purchase – Public Target

(tender offer)

Pro

 No target board approval

required

 In theory, can be very fast  Relatively simple

documentation

Con

 Tender offer rules apply

 Need 95% positive response! –

not practical

◦ Also need majority of disinterested shareholders (unless 98% positive response)

 Right to appraisal for 6 months

following – even if you agreed!

1. Start: Acquirer Shareholders Acquirer Acquisition Subsidiary Target Shareholders Target 2. Transaction: $ and/or shares Acquirer Acquisition Subsidiary ) דעי ( Target Shareholders Target ) תטלוק ( merger 3. Finish: Acquirer Shareholders

Target Shareholders (if consideration includes

Acquirer shares)

Acquirer

Target (survives merger)

Reverse Triangular Merger

Reverse Triangular Merger

Pro

 Certainty, if you have majority (50% or

75%) of target shareholders

◦ May require class vote

◦ Can substitute court approval

 US companies/lawyers understand it

better

 All agreements, etc. of target remain –

no assignments needed

 Only capital gains taxes – foreign

shareholders often exempt

 Only viable option for public targets

Con

 Originally, some uncertainty

regarding reverse mergers, but now the courts have “blessed” this structure

 Can close only on latter of 50

days from signing or 30 days from shareholder approval

Court Approved Plan Of Arrangement

 Companies may adopt a “Plan of Arrangement” which is

basically a court-approved merger

 Application made to the District Court to convene a

meeting of Target’s shareholders.

 Transaction must be approved by the shareholders (and

possibly the creditors)

 Vote required is 51% of the voters that are present and

that represent 75% of shares present (for each class)

 Court must then approve the transaction and find it to

When you need a “Plan of Arrangement”?

 Where stock is used as consideration

 Where different consideration is provided to

different classes of shares

 In “going private” transactions or any transaction

where some shareholders remain in the company

 Anywhere the statutory merger might not be

Regulatory Concerns



Antitrust



Israel Securities Authority



Taxation

Antitrust

 Restrictive Trade Practices (Antitrust/HSR) approval

required depending on:

◦ Minimum of turnover in Israel (NIS 150 M aggregate; NIS 10 M each)

◦ Either party is a declared monopoly

◦ Merged entity will control over 50% of product or service in Israel

 “Short Form” Pre-Merger Notification Can be Used

◦ Commission has 30 days to respond

 Not needed if acquirer has no Israeli presence

◦ Not a “company” for purposes of the law

Securities Law Issues – Option Grants

 Background: Exemption from Israel Securities Authority (ISA)

required for offering securities to more than 35 Israeli residents in any rolling 12 month period (excluding

“qualified investors”)

◦ Qualified Investors include most financial institutions and VC funds, but not high net worth individuals

 Option substitution constitutes an offering, but an

exemption is available under Section 15D if applied for in advance

 New ISA policies impose monetary sanctions if target

company has previously granted options without complying with Section 15D

Securities Law Issues – Stock Deals

 Complications in receiving ISA approvals where U.S.

listed purchaser uses stock to make acquisition (where there are more than 35 Israeli resident selling

shareholders).

 Possible solutions:

◦ Court approved arrangement

◦ Dual listing on the Tel Aviv Stock Exchange – often not practical

◦ Israeli prospectus – never practical

Taxation – Capital Gains Tax and Purchaser

Withholding Obligations

 If the sellers are subject to Israeli capital gains tax,

then the purchaser (even if not Israeli) may be subject to Israeli tax withholding obligations

 Withholding obligation may apply to purchase of

Delaware corporation if:

◦ Management and control exercised from Israel

◦ Significant assets (IP) held by Israeli subsidiary

 Result – a US acquirer buying a Delaware corporation

Solutions for Purchaser

 Apply to ITA for withholding tax pre-ruling

◦ Clarity as to who pays how much

◦ Clear instructions to paying agent

 Insist on personal withholding exemptions (or

reductions) for Israeli and non-Israeli shareholders

 For some shareholders, declarations of residency may

suffice to determine that no withholding is required

 Can be handled in merger agreement, or in letter of

Taxation – Option Cash-Out or Substitution

 Background: virtually all Israeli employees hold

options through an incentive stock option plan

qualified under the “capital gains track” of Section 102 of the Israel Tax Ordinance

◦ Section 102 options taxed at 25% on sale of underlying security; otherwise tax can be as high as 44%

◦ To qualify, options must be held by a qualified Section 102 Trustee for at least 2 years from the date of grant

 Issue: cash out or substitution of options breaks the 2

year holding period and can result in loss of tax benefits

Tax Ruling for Treatment of Options

 “Roll-Over” or Substitution of Options

◦ To ensure no deemed tax event (sale and purchase)

◦ To ensure that the 2-year 102 clock does not restart

 Cash Out

◦ Escrow of funds for vesting and/or 102 compliance

◦ Maintain 25% tax rate

◦ To prevent an “early” tax event if the consideration is held in trust

 Interim Rulings: to allow closing prior to finalizing the

Office of the Chief Scientist (“OCS”)

 Background: many Israeli companies receive OCS

funding for R&D

 No such thing as a free lunch: OCS funding comes

with royalty obligations and other strings attached

 Some restrictions may apply to getting the

acquisition done

◦ Sometimes OCS consent will be required for the change in

ownership resulting from the acquisition of the Israeli or Israeli-Related company

◦ Other times notice alone will suffice

Post-Closing OCS Restrictions

 OCS approval required:

◦ to transfer OCS-supported technology outside of Israel (even to affiliated companies)

◦ to manufacture products based on OCS-supported technology outside of Israel in excess of agreed percentages

 To transfer IP out of Israel – must pay the greater of:

◦ Amount of grant, plus interest

◦ Sale Price multiplied by (amount of all OCS grants / total investment in the IP), and then depreciated

◦ Payment capped at 6X, or 3X if R&D operations maintained

 To manufacture outside of Israel – may be required to pay

royalties equal to three times the original grant

Th

e Ten Commandments

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6. Position the Company

7. Be Your Shareholders’ Best Friend

8. Know When to Say Yes

9. Don’t Drag Out the Process

10. Don’t Do It Alone 1. Keep the Company

Structure Simple

2. Love Your Cap Table

3. Don’t Delay –

Solve Problems Early

4. Keep Your Due Diligence Ready at All Times

1. Keep the Company Structure Simple

 Underwriters and potential acquirers are familiar with

and prefer standard structures and documentation

 “Creative” structures/documents risk raising time

consuming and expensive problems and may result in unintended consequences

 Standard documents “work”

◦ Many have been vetted by U.S. courts

◦ They are drafted to anticipate and prevent problems

 Save time, money and headaches!

 Save innovation and creativity for your business!!

2. Love Your Cap Table



Keep it complete, accurate and up-to-date



Clean-up shareholder ownership and transfer

records; establish option plans



Make sure your options and share grants have

clear numbers of shares; not percentages!



Remember: a confused cap table can kill deals

◦ Shareholders fight over dividing up the proceeds

◦ Cannot determine price per share

◦ Cannot get an opinion of counsel

Sample Cap Table

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Stockholder/ Option Holder Ordinary Shares

Options/Warrants to Purchase Common Stock

Preferred A

Stock Total I&O % I&O Total FD % FD

Investor A 500,000 500,000 9.62% 500,000.00 8.62% Investor B 1,000,000 1,000,000 19.23% 1,000,000.00 17.24% Ivnestor C 1,500,000 1,500,000 28.85% 1,500,000.00 25.86% Investor D 200,000 200,000 3.85% 200,000.00 3.45% Founder A 1,000,000 1,000,000 19.23% 1,000,000.00 17.24% Founder B 1,000,000 1,000,000 19.23% 1,000,000.00 17.24%

Total ESOP Reservation 0 600,000 0 0 0.00% 600,000.00 10.34%

Total : 2,000,000 600,000 3,200,000 5,200,000 100.00% 5,800,000.00 100.00% Sampe Cap Table

3. Don’t Delay – Solve Problems Early

 Agreements with Employees

◦ Best practice - separate the IP provisions from employment terms

◦ Make sure you have clear IP assignments (Section 134 issues)

◦ Beware of problems with prior employers – IP and non-competition

 Agreements with Consultants

◦ IP Assignments Mandatory – IP Ownership at Risk

◦ Other affiliations? – academic, medical, government??

 Don’t accidentally give away your IP to Third Parties

◦ Check NDAs, MTA’s and License Agreements; fix if needed

◦ Best Practice: do an “IP Audit” now

 Obtain all waivers, consents, etc. early, while there are no “big bucks” on

the table

 Install clear IP policies (no open source, no unidentified IP incorporated,

no transfer of IP out of company, etc.)

4. Keep Your Due Diligence

Ready at All Times

 Be ready at all times! Prompt and organized document

production increases credibility

 Simply get a copy of any standard “Due Diligence

Request” and use that to organize documents

 All Due Diligence these days is done virtually – emails

and virtual data rooms

 This makes it easy to be organized and up-to-date –

establish virtual filing based on due diligence request

5. Build the Best Team

 Make sure management includes at least one person

(CEO, CFO or COO) who has “done it before”, someone with real exit experience

 Remember – the CEO for the start-up may not be the

best CEO for the exit

 Make sure some directors and scientific advisory board

members have established relationships or

unimpeachable credibility with potential buyers or underwriters

 Select VC’s with added value (do your own due

diligence!)

6. Position the Company

◦ Trade Shows, Exhibits and Investor Conferences

◦ Professional Articles and Press Releases

◦ Social Media

◦ For Biotech, hard to generate interest without human clinical data

 Create a Management Presentation that clearly conveys

product and market potential

 Engage in Dialogue with Potential Buyers and Bankers

◦ Be prepared to learn as well as to educate

◦ Locate the decision maker within a company; don’t blindly call contacts from a web site

7. Be Your Shareholders’

Best Friend



Remember: you need their approval to close

the deal



Keep good relations – turn them into your good

will ambassadors



Every investor is a potential resource



Don’t surprise them!

8. Know When to Say “Yes”



Consider the deal negotiations as the beginning

of a long term partnership



Keep a positive atmosphere



Keep the deal moving – a good dynamic is key



Identify your red lines and be prepared to

compromise on other issues

9. Don’t Drag Out the Process



Increases direct costs



Increases opportunity costs if no deal



Don’t give events beyond your control more

time to kill the deal:

◦ Market crash

◦ Competitive product

◦ Technological/clinical failures

Initial

Contacts SheetTerm “No Sleep” _Period Contract _Signing

Post

Closing Closing Pre-ClosingPeriod

M&A: The Process



Business and technical contacts, possibly with

multiple potential purchasers



Target needs to be sure sensitive technical and

fiscal information is protected



Broad outlines of transaction are discussed



Bankers (if any) involved; lawyers and

accountants in background

Initial Contacts



Not legally binding, but morally binding and hard to

escape

◦ Need good reason or new facts to change terms

◦ Almost always contains binding “no shop”



Don’t sign without lawyer and accountant

involvement



Different schools of thought regarding level of detail

Only select few should know about the deal

Term Sheet

 Lawyers and business people transform term sheet into full

blown agreement: intense negotiations and exchanging of drafts

 Due diligence proceeds in parallel

◦ Legal/IP

◦ Accounting/Tax

◦ Business

 Intense management involvement – hard to run the company

at the same time

 Circle of knowledge expands; need to keep confidentiality

◦ Use of Code Names

“No Sleep” Period



Binding Legal Obligation



Remembers signing is not closing (although they

may be simultaneous)



Deal usually becomes public knowledge

◦ Press releases

◦ TASE and SEC filings



No champagne yet!

Contract Signing



Obtain regulatory approvals

◦ SEC/ISA

◦ OCS

◦ Tax Rulings

◦ Antitrust



Convene shareholders meeting to obtain

shareholder approvals



Restrictions on target’s actions



Mandatory waiting periods before closing

Pre-Closing Period



Money changes hands; shares issued

◦ Public deals use payment agents or exchange agents

◦ Sometimes some funds deposited in escrow

◦ Trust company involved for option issues



Deal is “done”



Usually virtual – no meetings in big conference

rooms

Closing



Paying Agent pays target shareholders



Escrow Agent holds funds for escrow period



Filings with Registrar of Companies, etc.



Integration: Now the real work begins

◦ Employees

◦ IT systems

◦ Corporate culture

Post-Closing

10. Don’t Do It Alone



Select patent counsel with strategic outlook

◦ Don’t let your tech geniuses draft patents



Select a leading accounting firm



Use a law firm with proven experience



Consider taking on an investment banker

◦ At a minimum – talk to them even if you don’t need them

Barry Levenfeld

 Harvard College, AB 1976; Harvard Law School, JD 1979  Senior Partner in Yigal Arnon & Co.’s Technology

Practice Group

 International clients include Computer Associates,

Medtronic, Oracle, eBay, IBM, Boston Scientific, EMC

 Representation of venture funds, technology start-ups,

IPO’s of Israeli companies, and technology/life science M&A transactions

 Senior Lecturer, Hebrew University Law Faculty, in high

tech corporate finance

Thank You!