Counsel Urged To Prepare As M&As, IPOs Increase

With signs pointing to an imminent surge in mergers and acquisitions and initial public offerings, experts say in-house counsel should be well-prepared far in advance to play a lead role in preparing their companies for these transactions.

This means not only organizing documents for an eventual due diligence review months, if not years, in advance, but also constant assessment of how deals made with investors or business partners can affect a future acquisition or IPO, and knowing the possible impact of Sarbanes-Oxley, even for privately held companies.

Careful preparation – which occurs prior to the time an acquisition or IPO begins to dominate the day-to-day work of the legal department – will enable in-house counsel to pounce on the important negotiation tasks instead of holding up the deal while gathering documents, permissions and signatures.

While preparing for either an IPO or acquisition involves many elements, experts indicated the take-home message is simple: Act like a public company years before you are one.

“The phone will ring at one point,” said Douglas Reynolds, partner in charge of professional standards at the Boston office of accounting firm Grant Thornton, “and they’ll say, ‘We’re buying your company and we are public. What have you done to prepare for the possibility that you will be acquired by a public company?’ If you say, ‘Well, I haven’t considered that at all,’ you might lose that opportunity.”

And while small businesses are allowed some relief under Securities and Exchange Commission rules and Sarbanes-Oxley, the reality is that their auditors are not.

“They have to meet their standards anyway,” said Peter Sugar of Detroit-based Jaffe Raitt Heuer & Weiss.

Added Mark Sides of Faegre & Benson in Minneapolis: “You still have to provide for the auditor sufficient analysis to get through the audit. It really is a pay-me-now or pay-me-later kind of thing. And if you pay me later, it really is more expensive.”

Market Trends

In the first three months of 2004, there were 41 IPOs nationwide, according to IPOVitalSigns.com. This compares to a total of just 73 IPOs in 2003, 81 in 2002, and 83 in 2001, according to Thomson Venture Economics and the National Venture Capital Association. In the last quarter of 2003 alone there were 43 IPOs – 13 more than there had been in the first nine months of the year.

Analysts are predicting the expected IPO of Internet search engine Google this spring will inject the market with even more adrenaline.

While the stock market makes a come back, the IPO and M&A markets aren’t far behind, at least in New England.

“Prior to the past few months, the IPO vision might not have been on the radar screen,” said Steven London, a corporate lawyer at Brown Rudnick in Boston. “In the past two quarters there have been reasonably successful IPOs reported. After-market activity has been attractive [and that creates] increasing activity in the IPO market.”

And all that is good for M&A activity, as well, he continued.

“I think what you’re now starting to see is a leveling-off of expectations on the part of sellers as to what a reasonable price for their company will be. And, this is kind of the end of the bottom-feeders for purchasers. They’re starting to realize they’re not going to get bargain-basement prices,” London said.

Comparing the beginning of 2004 against the same period last year shows that more IPOs have been filed, according to Mark Sides of Faegre & Benson in Minneapolis. “We’ve seen that in our office already as compared to a year ago,” he said.

The M&A market is becoming stronger as well, Sides said. “Acquisition work started getting stronger late last year and it seems to be carrying through. Is it 1999 again? Probably not, but definitely on both fronts it is stronger than it was last year.”

Sources contacted by New England In-House indicated that M&A activity would likely surpass the volume of IPOs this year.

Preparing For An Acquisition

By far the most important action in-house counsel can take in the period before an acquisition may take place is to gather and organize into one place all corporate documents – in hardcopy or digital format – that would be reviewed under due diligence, experts agreed. This enables a prospective buyer to perform due diligence easily, thus taking it off the table as quickly as possible.

It’s a mistake to wait until a potential acquisition is imminent to begin organizing documents, experts stressed.

“When I acquire companies, I am concerned when I go in and the comptroller of the corporation is my contact for legal due diligence and then that comptroller points me to a file cabinet and wishes me luck,” said Gant Redmon, corporate counsel Arbor Networks, Inc., in Lexington, Mass. “That immediately erases any benefit of the doubt that they have a sound legal strategy.

“Whenever I’ve done due diligence on a company that has a counsel in-house, my fears are generally put to rest because they know what I’m looking for and that I want to see it well-organized and I want them to know what questions I’m going to ask,” he noted.

In anticipation of his company being acquired, Redmon scans, indexes and describes all company documents in a Microsoft Excel spreadsheet. He includes hyperlinks between the spreadsheet and each document, and then he copies it all to a disk.

“I organize my work as if I had to answer those questions tomorrow,” he said. “When someone comes to do due diligence on me, I hand them a disk and say everything we’ve ever done is on this disk.” (Redmon provided to Midwest In-House a sample “due diligence” checklist, which can be found in the “important documents” section of Midwest In-House’s website, www.midwestinhouse.com.)

Auditors have been pleased with the simplicity of the approach and the company saves money on the audit, he noted.

Alternatively, in-house counsel can fill three-ring binders with hardcopies of the documents. This approach “conveys a sense of organization and gives a lot of comfort to buyers,” said Sides of Minneapolis. “These buyers and their advisors have so much information coming at them on a daily basis, to the extent you can eliminate noise, you can focus on the deal.”

The more comfortable a prospective buyer will be “translates into a better price for your business,” London noted.

Last year Andrew Myers at Davis, Malm & D’Agostine in Boston worked on the negotiating team for the acquisition of a privately held high technology manufacturing company. The company sold for $60 million in a mix of stock and cash.

“One thing the company did very well was get all their records in order so the due diligence process of the buyer [went smoothly],” Myers said. “That’s very important now as Sarbanes-Oxley is taking effect. Buyers are now really looking at the corporate governance of sellers and they are scrutinizing it. As a seller, you really want to give the buyer a level of comfort.”

Sarbanes-Oxley, Myers noted, “did not apply to them, but as a public company, a buyer wanted to see the seller had its records in order and had its corporate house in order.”

Another bonus for the acquired company was good communication with its stockholders.

“When the buyer was looking for signed releases, it was no problem to get it. This company had over 50 [stockholders], and that’s a lot for a private company,” Myers said. If not done ahead of time, he suggested, the process of gathering signatures can hold up the deal unnecessarily.

Perhaps the next most important check for in-house attorneys is ensuring the company really does own the intellectual property it assumes it owns, experts emphasized. Buyers want to know which patents a seller owns, and which patents or other intellectual property is in the marketplace the company could potentially infringe.

A good approach is to consistently ensure through employment agreements and other contracts that the company clearly owns intellectual property, Redmon said.

“It’s surprising how many people don’t have proper transfer of ownership to the employers of what is being created,” Redmon said. “In an employer-employee relationship, it’s generally assumed that anything they create is the employer’s, but I like to leave no doubt. That goes for consultants, too. That’s where work-made-for-hire is more important. That’s not assumed at all in a consultant relationship.”

IP problems can result in a discount being taken off the purchase price, Sides warned.

Other acquisition preparations should be considered on a day-to-day basis.

For example, every contract or agreement should be evaluated for how a prospective buyer of the company might react to taking it on, which means in-house attorneys should negotiate terms in anticipation of a potential sale of the company.

“I keep in mind what acquirers are sensitive to as I go about my daily life of negotiating agreements,” Redmon explained. “I know they’re going to want caps in liability. I know they’re going to want to limit exposure. I know they’re going to want to limit who can use the product. I know they’re going to want agreements assignable to a successor. These are things you can keep in mind as you do your day-to-day work.”

Further, when negotiating contracts or equity deals with investors, avoid tying the company’s hands in a future acquisition, Sides suggested.

“On a contract, avoid having to get their permission to do the deal. If it’s a customer that’s 30 percent of your business or more, that may prove difficult, but in agreements, you want to avoid having to get their consent, whether its an asset deal or merger,” he noted. “Avoid having to give them notice. Deals are done quickly and parties don’t want to [wait for customers to be notified before closing],” he said.

Another important item to consider early on in an acquisition is how it will impact employees. Taking proactive steps early to lessen employee angst can prevent them from leaving before the acquisition is final or taking other action that can negatively affect the deal

“Make sure that the human resources and labor aspects of the acquisition are addressed in the very earliest stages of the planning process,” said Lyncheski of Cohen & Grigsby in Pittsburgh. “Too often – and I’ve been there – the people in charge of the transaction are the CEO and often the CFO. They’re focused on the business aspects of the deal and they get far along before they ever consider the human resources and labor aspects of the transaction.”

In-house counsel should determine whether the surviving entities want to be single or joint employers after the acquisition, which affects labor negotiation issues, Lyncheski said. They should also call for a complete audit of the human resources policies, benefits, functions and procedures of both companies involved in the transaction.

Also, considering what exactly is to be sold is something many companies, particularly those that are closely held family businesses, sometimes forget, according to Joswick of Miller Canfield.

“What is it you want to sell? You’ve got to think about getting it into one place because typically a buyer is going to say, ‘I want the whole thing,’ and they’re not going to buy the building under a 25-year sweetheart lease to the owner of the company,” Joswick noted.

“The other big area to think about is where do you want the money to go if you’re selling the company,” he continued. “If it’s time for the inside guy to move into that condo in Florida, then does he want to get all the money or, for estate planning purposes, are there other things you want to do upfront to restructure the company so many parts of the money goes to the kids as opposed to dad or mom? Or maybe the insiders have some great vision of an endowment with their name on it at a favorite university. It’s probably a good idea to, at the time, put that agreement in place before you sell it so the money goes directly to that.”

Preparing For An IPO

Before an IPO, in-house counsel must become intimately familiar with the rules that will govern the corporation after the fact, and they also must get management to start complying with them pre-IPO, according to Joswick.

Under Sarbanes-Oxley, the most important preparatory steps to an IPO involve the variety of boards that oversee a corporation and the independence of the members of those boards. Here is where the refrain “start acting like a public company before you’re a public company” becomes imperative, according to London.

Falling short of the law’s mandates could effectively kill the deal, he stressed.

Under the act, companies must have audit, finance and compensation committees and all of the members of these committees must be independent. Many private companies do not have these boards in place, and if they do, they may be filled with family members or others who have a financial interest in the company. It is up to the in-house counsel to explain to current board members why independence is important and to be the driving force in finding the right people to sit on the committees, experts said.

“Getting real people that will stand up and do the job of monitoring for shareholders, that’s not easy,” Sugar said.

In-house counsel also must direct the corporation in how to comply with the rules of whatever stock exchange on which it will be listed.

The cardinal rule of prepping for an acquisition also applies to preparing for an IPO: Have your business documents gathered and well organized so due diligence becomes a non-issue. The same goes for IP.

“Make sure you really do own the intellectual property you think you own, they are held in the correct party’s name, and any licenses are in the correct name. In some cases, those are your crown jewels,” London said.

In-house counsel also should be aware of the requirement that the financial documents of privately held companies purchased in the past by a pre-IPO company must comply with SEC accounting rules. “This could be a very significant lead time item,” London said. “There could be several acquisitions prior to the IPO. All need to be audited in compliance with SEC rules.”

In most privately held companies, an auditor won’t have to look far before finding something that runs afoul of the rules under which public companies operate, Joswick said. The most common of those violations is loans to executive officers.

“It’s not unusual for someone who owns a closely held company to have outstanding loans from the company,” he said. And while that’s not illegal for a private company, it is forbidden for a public company, Joswick noted.

Similarly, if a private company is sold to a public company and the former owner becomes an executive officer of the public company, that loan becomes illegal as well. Thus, officers must find a way to get those loans off the books before an IPO will be allowed, according to Joswick.

Another step for in-house attorneys is to encourage management to issue press releases as part of its normal business plan as a way to avoid problems with the SEC.

“There’s a concept called ‘gun-jumping,’” London explained. “You can’t, within the registration period when you’re preparing for an IPO, prime the market or promote in the marketplace in a way that is different than what you’ve done historically.”

The solution is to start a regular and coordinated plan for routine press releases about developments in business, new markets, new products, any events in the company, he continued.

“If you have set up something that could be viewed in hindsight as ordinary and routine, you can continue doing ordinary and routine press releases while preparing for an IPO. If you don’t have that historic record, the SEC might say that ‘you’re attempting to prime the market, you’re ‘gun-jumping,’ and we’re going to delay until the market cools down.’ That could kill an IPO.”

Choosing reliable and well respected outside law firms and accountants is more important than you might think.

“For pre-IPO companies, working with reputable outside lawyers and accountants helps give the business stability and takes issues off the table. I see a lot of companies that are pre-IPO and the law firms they’ve got are really more mom-and-pop. That is concerning to underwriters and concerning to venture capitalists,” Sides said.

Accounting Considerations

Whether negotiating an acquisition or preparing an IPO, in-house counsel must meet early and often with anyone involved with company numbers. “Accounting areas are proving to be more problematic and more expensive for a company to comply with,” Joswick said.

“The audit requirements are fairly rigorous. You may not have to implement them now, but you ought to talk with auditors about how to migrate to that point and make it as painless as possible,” Sides offered.

Reynolds suggested in-house counsel act as a liaison between auditors and senior management on Sarbanes-Oxley: “In-house attorneys should be more proactive in dealing with the auditors and making sure management understands the law. Work with management and the auditors to make sure everything is in place that needs to be there for the transaction.”

Dealing closely with auditors may be a new role for some in-house counsel. Historically, attorneys and auditors cross paths at many points along the way, but Sarbanes-Oxley really does require a joint effort, “and that’s a big difference,” Reynolds said.

In-house counsel should also bring these two sides together early in the company’s organization, particularly because stock issuance can be problematic later.

“When management is coming up with stock compensation ideas,” Reynolds said, “they typically work with attorneys to prepare legal documents. The in-house lawyers could try to make sure the auditors are brought into the planning phase because everybody has had trouble with stock compensation – how the options are valued and who has what rights. It happens all the time. It’s a very common problem.”

Questions or comments can be directed to the editor at: [email protected].