This article is written by Prince Pathak, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Introduction
Merger and Acquisition activity remains robust and reached at a greater height even during the course of pandemic in India. With the COVID-19 crisis, we’ve found ourselves in yet another incredibly difficult economic situation, one that many companies are unprepared to face. Due to these economic constraints many startups have failed to survive the economic fallout. But, many giant companies and strategic buyers have used this opportunity to purchase or acquire tech companies at a discount and they still have the golden chance to strengthen and expand their own business by acquiring dying or distressed tech companies. In this article, the author has deciphered the importance of distressed tech companies, process of acquiring and at last author has also discussed the ways to mitigate the risks while acquiring a distressed tech start ups/companies.
Distressed tech companies in COVID-19
There is no doubt that pandemic has been proven as a boon for the big enterprise-technology companies and every big company is in rat race to acquire the tech companies because consumers have relied more on technologies these days. And tech companies are also preparing best to be acquired by a larger company. Businesses have a variety of valuable assets. When a company has to raise funds immediately in a tough situation (for example, a commercial debt default or unfinished business activity), it may sell these assets at a reduced price; such an asset is referred to as “distressed” and these types of tech companies are known as distressed tech companies. Finding distressed tech deals is one of the steps while acquiring distressed tech companies. Buyers must make a report and have a clear goal while acquiring any distressed assets otherwise these deals can lead to serious consequences.
Process while acquiring distressed tech companies
- Identifying distressed tech companies and decision makers– While doing the acquisition process, buyers or strategic investors must understand their goals. For a buyer, adjusting to the rules of the road in the world of distressed M&A may be the most challenging part of a transaction with an insolvent company. Hence, buyers must find the goal and calculate the risks while acquiring a distressed company.
After analyzing the risks and identifying distressed tech companies buyers should take care in identifying the real decision or policy makers. This is quite simple but if buyers don’t pay careful attention to it, it can hamper the essence of the deal. Identifying key persons or decision makers is so simple or straightforward in case of non-distressed companies because the board, management team, and key stockholders can usually negotiate and approve a deal process, while creditors are simply repaid in this process. But, these things can create complexities while acquiring distressed assets or companies because genuine creditors and decision makers will be unknown and it would be difficult to determine which creditor (or group of creditors) are needed to approve a deal.
- Selecting a structure for a distressed tech company acquisition- The next step is to formalize a structure for a distressed tech company acquisition. Generally, we see distressed tech company acquisitions are often structured as a purchase of assets, and not as a merger or equity purchase. The reasons being in the case of asset purchase, buyers can cheery pick the assets and liabilities of the seller or target company and in this way it minimizes the buyer’s assumption of unwanted liabilities of the seller. Now, we will look into the alternative acquisition structures for a distressed tech company.
Asset purchase structure- An assets purchase has many advantages. Assets purchase generally happens to take all the assets and leave behind all the liabilities associated with the assets. Asset purchase structure can be most advantageous nevertheless, assets purchase is a steady process because it is tough to negotiate and execute. First, buyers have to go through the tiring process and need to examine the individual assets and liabilities, to determine what should transfer. Second, transfer of those assets over to the buyer oftentimes requires additional third party consent which can turn into a long process. Also, from the tax perspective asset purchases can be less efficient than stock acquisitions. Asset purchase can be used as the best acquisition structure if buyers are well aware of liabilities, execution speed, and post-closing liability risk.
Equity purchase Structure- In case of equity purchase structure, target equity is acquired directly or through a merger. In this structure buyers bear or take all the risks of the target company. The main benefits of doing equity purchase, either via a stock purchase or merger, is speedy execution process and favorable tax consideration for the sellers. The speedy process of negotiation and execution in equity purchase structure becomes an incredible advantage in the melting ice-cube situation of distressed tech companies. The big disadvantage in equity purchase is inheriting all of the liabilities of the distressed company or start-up.
Acquihires- Another popular structure for the acquisition of distressed tech companies is called “acquihire,” in which the buyer actually recruits the staff from the company or start-up, this is a typical acquisition structure for many small target firms. Acquihire structures are useful in situations where the target company’s actual services haven’t gained much popularity and hence aren’t very valuable. The best thing about the acquihire structure is non-transferability of liabilities, assets and equity. Acquihire structure should be strategically and properly structured.
Assignment for the benefit of creditors– This can also be a potential tool while acquiring any distressed tech company and this type of structures are primarily useful where the deal process is unable to clear the debt of the target. In an ABC, the target company decides to hand over all of its assets to a liquidator (also known as an assignee), who is usually a private-sector service provider. The assignee performs a solicitation procedure for those properties (unless it was completed satisfactorily prior to ABC), and if no better bids are received, the assets are sold to buyers. It can be appropriate in a situation where the buyer values the ability to cleanse historical liability but still wants a relatively predictable and fast deal execution process.
- Due-diligence issues– In the case of distressed tech company acquisitions, due diligence is still needed, but it will need to be accelerated and constrained. And due to the pandemic it’s difficult to perform in-person or site visits for diligence purposes. It is preferable to avoid liabilities by discovering them through the process of due-diligence than to discover them later as a result, due diligence is indispensable. Following are key issues and buyers must pay attention to these issues while acquiring any distressed company or business.
- Buyers must calculate the supply chain risks.
- Potential employment law issues and compliance with relevant government health.
- Buyers must find out whether the target company is in compliance with all the rules & regulations of the central government or local government or not?
- Whether the seller has any deferrals of tax, customs duties, taxes or fees?
- Buyers must calculate the types of liabilities they want to be assumed and which liabilities are to be specifically excluded.
- What are the pending litigations against the target company?
- What key contracts need to be assumed and what are the odds of renegotiation.
- Is the seller in compliance with health and safety laws with respect to its workplaces and employees.
- What IT, cyber security, and data breach issues has the seller encountered?
These are issues that buyers must consider while performing the due diligence in this pandemic situation to avoid future problems. For more information on the process of due diligence during the pandemic one can refer to this link.
- Additional key issues and ways to mitigate those risks– It is obvious that a distressed tech company or startup has more potential to carry the liabilities and risks. In case of any distressed tech companies, it is much more likely that distressed tech companies or start-ups will have huge amounts of unpaid bills and in such cases sufficient financial due diligence should be performed carefully. Also, buyers of a distressed tech company run the risk that the sale is later deemed to be a “fraudulent transfer”.
Buyers must pay attention to avoid the unwanted liabilities because in case of fraudulent transfer, a creditor of an insolvent may be able to invalidate a sale of the company’s assets, or seek recourse against the buyer of the assets, in the event of a fraudulent transfer. And this type of risk can be avoided by choosing an option for assets purchase structure in the first place. Buyers must take all the consent from the third parties including board of directors, stockholders and landlord consent if any leases are to be assigned. Buyers should ask sellers to pay all the due amounts to the employee before the transaction. Finally, buyers should pay attention to ensure that the seller’s directors and officers fulfill their fiduciary duties in order to avoid creditor and stockholder claims that may hamper a deal in future time.
Conclusion and Key Takeaways
Acquiring or purchasing a distressed tech company or start-up is often a herculean task; buyers should prefer assets purchase structure while acquiring any distressed tech company and should avoid merger or equity purchase. Due diligence process is also the main concern while acquiring any distressed tech company but it needs to be accelerated and limited. Also, buyer’s objectives in terms of price, liabilities, timing, avoiding competing bids, keeping the employee and customer bases intact etc., will all have to be taken into account. In the end buyers should be aware of the changes in their own company’s situation and should be prepared for surprises.
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