Disgusting greed alert!!

Periodically, a business headline will start me thinking. That happened last week, when we learned that several senior Skype executives were being fired before Microsoft acquired Skype from its current owners, an investor group led by Silver Lake Partners.

Okay, shit happens, and senior managers often bite the dust for legitimate business reasons when their company is acquired: perhaps their work duplicates what the acquirer already has people doing, that sort of thing. Business is aware of this risk, and has learned to make provision for it, so that senior managers don't look elsewhere or lose interest whenever a rumor surfaces that their company may be acquired.

This headline was noteworthy because of one key way that businesses typically keep their managers involved when their company is being acquired: acceleration of their options. Unfortunately, the headline is noteworthy for all the wrong reasons.

Companies keep their managers motivated when a company is acquired by:

(1) having the acquisition itself trigger accelerated vesting, meaning that all options can be exercised on the day of the acquisition, or

(2) having any termination of the manager after the acquisition trigger accelerated vesting, meaning that all options can be exercised and the resulting shares sold if the manager is fired in the year (normally) or two after the acquisition is consummated.

The common thread is acceleration of the options, which accelerates the employee's realizing any gain in them. Either the acquisition itself triggers the acceleration (single trigger), or the termination of an employee after the acquisition triggers the acceleration (double trigger). 

It looks as if these Skype managers had a better deal than double trigger acceleration, if not as good as single trigger. According to Skype's now withdrawn S-1A (an SEC filing for its abandoned IPO), more "than two-thirds of (employees' unvested) shares (will) vest by the first anniversary of the change in control and all of the (employees' unvested) shares (will vest) by the second anniversary of the change in control."


In other words, the average Skype employee who is still employed when the acquisition occurs and stays will make good money out of the acceleration of his or her options.

Back to this week's headline. By firing several senior managers, Skype was depriving them of the benefits of any acceleration that the Skype option plan provides for them. Before accelerated vesting kicks in, an employee gets nothing out of an acquisition, and accelerated vesting only kicks in when the deal closes.

So someone in this scenario is depriving managers of a decent benefit that they had been led to expect they would receive in the event of an acquisition. Who, and why?

A quick reminder: the Silver Lake investment group picked up 70% of Skype from eBay (which retained the other 30%) in 2009 for about $1.9 billion. Microsoft is paying about $5.95 billion for that 70%. A pretty good profit in two years. (The other roughly $2.55 billion of Microsoft's $8.5 million purchase price goes to eBay.)

So why screw a few senior managers out of maybe a few million max? And who is doing the screwing? Isn't there enough to go around here?

It looks like Microsoft.

But I must say that without reviewing the various contracts (which are not publicly available) that is not a sure thing. Or maybe it is eBay and the Silver Lake investor group that might lose a few bucks if these senior managers were not fired. Unlikely. For one thing, Niklas Zennström and Janus Friis, the renegade founders of Skype, are still in the current ownership group. I can't believe that they would have let this happen to their own senior managers.

But on some level they did, because these firings happened on their watch. eBay and The Silver Lake investment group still owned and controlled Skype when these senior managers were let go.

The investors would likely claim that the firings were nothing to do with them, because Skype was already being run for Microsoft's benefit. But that reasoning doesn't work, at least not if this was a normal M&A deal in transition matters. In a normal deal, the sellers agree to run the company in the normal course, and not to do anything out of the ordinary, during the pre-closing period. Firing a bunch of senior executives is out of the ordinary.

If this is a normal deal, the Silver Lake investor group had no duty to allow these executives to be fired. My guess is that they allowed Microsoft to do so as an accommodation to the software giant, to stay in its good graces. In short, they likely shared responsibility here.

With Tony Bates, Skype's CEO, of course, the manager implementing other people's desires here with an impressive display of butt-kissing. If you work for Tony, watch out! This story suggests that his loyalty to his people is fickle, to say the least.

And guess what? According to Skype's now withdrawn S-1A, if Tony's "employment is terminated without 'cause' or if he resigns for 'good reason,' any . . . options that would have . . . . vested had he remained employed with us for the 12-month period following the date of termination will be vested as of the date of termination." Which means that Tony gets accelerated vesting of a chunk of his options if he is fired or quits because of bad treatment even if Skype is not acquired! 

In any event, a few of the senior people whose efforts expanded Skype's subscriber base over the years and helped make the company's owners a fortune have now been screwed, just when it was looking as if their chips had come in.

Thanks to some unspecifiable combination of Microsoft, with its obscene quantity of balance sheet cash, Tony Bates, their own CEO, and the Silver Lake investor group, with their obscene profits out of the deal.

Shame on all of them!

Big SVLFs, another bad acronym

An astonishing thing happened the other day over coffee with a potential client: he brought up this blog, and asked me questions about it.

Good grief! I didn’t think that anyone ever read this, which is one of the reasons that I’ve been writing so little. Now I’ve discovered that there actually is an audience, I’m going to try to post more regularly.

This particular potential client ended up going to a big Silicon Valley law firm (SVLF), which many do, in the same way as many people go to McDonalds and Pizza Hut and the like. What is familiar offers comfort.

Of course, there the analogy ends, because big SVLFs are not exactly the discount players in any market! But many people, like this engaging and erudite potential client, despite their obvious entrepreneurial skills, meaning their ability to take calculated risks, end up fueling the absurd profits of these big law firms.

Why would an entrepreneur go to a big Silicon Valley law firm?

In part, a big SVLF does give a client security, in the same way as wearing Brooks Brothers clothes or staying at a Hilton hotel or drinking coffee at Starbucks gives you security. Everybody does it, the market has validated it, the content is going to be pretty much what you expect and are accustomed to: we’re OK, they’re OK, we’re all people like us doing what we do.

But entrepreneurs by their nature don’t need much of that security. They live and work outside of the security given by the corporate world. They can handle the lack of a pre-existing employment framework to fit themselves into. That’s their job, creating their own worlds.

Founders of start-ups are not like the managers of publicly-traded corporations, who need to be able to justify their corporate actions and decisions in the face of plaintiffs’ lawyers and financial analysts and the other hawks circling their businesses. Then, a name-brand big SVLF can be as important to feelings of comfort as a name-brand accounting firm or investment bank. Start-ups don’t have these worries.

So why do entrepreneurs go to big SVLFs? Because they hope to locate VCs or other sources of finance through the law firm, that’s the basic reason.

There’s also a sense, fueled by what can only be described as brilliant marketing, that being taken on as a client by a big SVLF validates your entrepreneurial vision. So the willingness to pay triple what they are worth for a big SVLF’s legal services means that the SLVF is validating you as an entrepeneur? Right! Think about it: by signing on, you’re validating their ability to market themselves, not the reverse.

How big Silicon Valley law firms help entrepreneurs locate financing.

It’s a relationship thing. Some of the partners in SVLFs have an extensive network of relationships among VCs, and they do introduce new clients to the VCs. I saw it happen when I brought in an entrepreneurial client to a big SVLF where I was working. The VC even thanked the SVLF partner for the referral.

That was back in the glory days before the slump of 2001, when referrals were anybody’s and the VCs were throwing money at anybody who could articulate a web idea. Nowadays, there is much less early-stage VC money.

But it is true, I suspect, that a big SVLF can still help an entrepreneur locate VC financing.

But this help comes at a price. The SVLFs may “defer” (one of their favorite phrases) a portion of their excessive legal fees ($25K was a number I was hearing for a while there, which sounds like a lot). But they cost a fortune, and first-time founders typically don’t have the money. If $25K is deferred, you can bet the firm will be up to $75K in billings for the start-up in a few months.

The cost to Entrepreneurs of the Relationship between big Silicon Valley law firms and VCs.

The excessive legal fees charged by big SVLFs are far from the most significant price paid by entrepreneurs for the SVLFs connection with VC and other financing.

The real cost is in the deal terms for the financings.

A simple commercial insight will help you understand how the deal terms were arrived at. Your best customer, whoever you are, is a repeat customer. Founders and entrepreneurs don’t repeat very much as a big SLVF’s clients. Even the best and most unsuccessful only repeat once or twice. But VCs last for years, decades even, as repeat customers of big SVLFs.

The VCs bring clients to the big SLVFs - you know the spiel – “we’d like you to work with [insert big SVLF name] going forward. They may be expensive, but they know start-ups, and we’re sure you’ll be very happy with them.”

And of course you are, you feel special, one of the chosen ones. You secretly glow inside.

You are also the big SVLF’s client, and not the VC. You are entitled to expect that your very own big SVLF will represent your interests to the best of its considerable abilities. And it will, sort of.

But when it comes to VC financings, are the big SVLFs really going to bite the hand that feeds them? How hard are they going to work at reducing the VCs’ share of any pie relative to the entrepreneurs’ share? All you need to answer that question is a little common sense.

That’s an entrepreneur’s real cost.

And the solution is not . . .

. . . me. Surprisingly enough, the solution here is not to find a lawyer who is not a big Silicon Valley law firm partner, and yet is smarter than most of them, in short someone like me, although that would certainly solve many of your legal fee problems.

Finding a smart and truly independent lawyer, a risk taker like yourself, doesn’t work as a fix for the VC financing terms, or at least doesn’t accomplish enough with respect to ameliorating those terms, because of their history. VC financing terms have been around for a very long time in Silicon Valley’s timeline.

And guess who wrote the book on the terms of VC financings, literally, and wrote it years ago? Big SVLF lawyers, of course! Here it is, in its most recent incarnation. The terms do vary a little over time, as one or other quirk or style comes to the fore. But after thousands of deals structured by big SVLF lawyers who are cultivating VCs as serial clients, the basic deal does not favor founders. Not a lot else to say.

Here is just one simple example, which is the root of many of the problems that founders have had over the years at the hands of their VCs. Why do the VCs and other investors typically obtain Board control? The normal rule of corporate practice is that majority shareholders control the Board. But VCs typically control it even when they only hold a minority of the shares. You need to be a Facebook to avoid losing control of your company to your VCs.

And once they control your Board, you just became second fiddle in your own start-up.

And the solution is . . .

This one, oddly enough, is easy.

Remember how businesses used to be started, with a kiss and a prayer?

Put it another way, remember when starting up was all about talking customers into buying whatever you had for sale?

That’s the answer for the future as well as the past. There’s got to be a way to build a customer base for your product or service without obtaining third party financing. Or there’s got to be a way to build a customer base with help from the SBA or from friends and family. Bootstrapping is beautiful.

You stay in control, and decide whether you expand the business or sell it, and when to sell it.

Problem solved!

How not to do business . . .

Another blogging breakfast at NextSpace (www.nextspace.us)!

Today, it’s story time! As in “horror” story, sort of!

Tough negotiators, as in hard-nosed, ballsy and, oh yes, dumb!

Back when I was working for a major law firm, I was helping a start-up through its various pre-IPO funding rounds. It was that exciting period when neither profit nor revenue was needed to IPO a company if it was in the “right” field, and this company, let’s call it “Shrimp, Inc.” was smack bang in the middle of the hottest field of the moment.

The “A” round went well, smooth sailing, the angel investors were feeling smart and the company was feeling lucky. The “B” round went well, smooth sailing, some of the biggest marquee VCs came in, and everybody gushed their appreciation. The “C” round went well, and the “D” round went well, more of the same, money pouring in, product development advancing apace: the stars were beautifully aligned.

The bankers had told Shrimp that they could IPO Shrimp if it had not yet made a profit. They could even IPO Shrimp if it did not yet have too much revenue. But Shrimp needed a few customers in order to succeed in its IPO, and one of those customers needed to be a marquee customer. That was the important thing.

Obtaining that marquee customer became Shrimp’s number one priority, and not just for revenue generation purposes. That customer was the key to the IPO, and you must remember how much money was in IPOs in those days for all involved.

There were about five or six possible marquee customers in this field, and one of them stepped up. I was given the unenviable task of negotiating for Shrimp with this marquee customer, let’s call them “Megamax.” They were the 500 pound gorilla, and they knew it, and Shrimp’s senior management knew it.

Hard-nosed . . .

Megamax was completely overbearing and insisted upon hopelessly draconian terms, terms that no-one with half a brain could agree with. I would debate with them and push back, and then word would trickle down that Shrimp’s senior management were a little concerned that I wasn’t seeing the big picture . . . This was probably an accurate statement. The only big picture that I saw was Megamax telling Shrimp’s senior management to bend over, and Shrimp’s senior management asking “how far?” This was probably not the big picture that Shrimp’s senior management was hoping that I would see.

It was tough going, but we got the deal done. Megamax bought millions of dollars worth of Shrimp products and, yet again, everyone was happy and smiling. The marquee customer was hooked, and the future was assured.

Somebody told Megamax management, and the proverbial shit hit the fan.

Ballsy . . .

Megamax management decided that they too wanted to share in the windfall that the IPO was expected to bring all participants. After all, they were playing a major part in setting Shrimp up for its IPO, everyone could see that, and so they wanted to invest in Shrimp and share in the profit that the IPO was expected to bring all existing Shrimp shareholders.

They personally demanded the right to invest in Shrimp, and on very favorable terms. There was some resistance from Shrimp’s VCs, because Megamax management was insisting on better terms than the VCs themselves had obtained. As we all know, VCs are very understanding people, but not that understanding! Things paused while everyone reflected . . . .

Then came the voicemail: Megamax management were becoming frustrated. Forwarded on to their lawyers by Shrimp’ senior management, the voicemail said something like that there would never be another order from Megamax unless Megamax management was permitted to invest on favorable terms. So be it! The writing was on the wall!

That deal too got done. Megamax management invested, on favorable terms but no more favorable than the VCs’ terms. I protected Shrimp and its management from being implicated in Megamax management’s sleaze. The IPO happened, and the rest is history.

And dumb!

So why, you may ask, did I start this post by describing Megamax’s negotiating as being dumb?

Well, I’ve omitted parts of the story, so as not to breach any confidence. But it should be clear that Megamax and its shareholders had a legitimate claim to share in the profits of Shrimp’s IPO, because Megamax (and hence its shareholders) had spent good money on Shrimp products. Megamax management had not spent a penny of their money . . . .

This little anecdote ended for me the day, years later, when a Federal prosecutor (a US Attorney) called and asked me to act as a witness in a federal prosecution of, you guessed it, Megamax management!!

Of course, I agreed to do so - you don’t exactly say no to these people – but you must have some idea of how I felt! It doesn’t matter how much they tell you that you are not a subject of the investigation when the FBI agents who accompany them are visibly armed!

Accidental Breach of License

Back at NextSpace (www.nextspace.us) for another blogging breakfast!

A few weeks ago, we looked at the problems that confront a licensor seeking to collect royalties from its licensee. Oddly enough, even payment by a licensee can become problematic over time.

Royalty Payment by the Licensee

Licensee payment sounds like a non-issue, right? You’re the licensee, you need to pay royalties, you have a member of the Finance team on the case, and you can sit back.

Tilt!

There are definite risks, even from a diligent licensee’s point of view.

Royalties are normally paid based on sales of products using the licensed technology or know-how. When the licensee starts out, the first such product is easy to identify. The license was likely entered into to enable this product, and the engineers, business people and finance are all on the same page. All were involved on some level in negotiating the license, and the initial period of its use builds on that joint effort.

Over time, that changes. The licensee is a normal company, after all. Different projects occupy the collective attention. Individuals follow the itinerary of their own particular groups, and attention is no longer paid to the license.

But engineers and marketing people love the licensed technology, and happily incorporate it into new and revised product offerings. They know that their company has obtained the needed license, and off they go.

Nobody tells the finance person tracking sales of licensed products. The royalties that s/he pays drop relative to sales of products including the licensed technology, and the licensee has fallen into an accidental breach of the license.

The remedy is establishing a process for ensuring that the engineers and marketing people introducing new or revised products for the licensee keep Finance in the loop. Enterprise software vendors sometimes have an appropriate functionality (e.g. SAP’s Rights and Royalty Management module), but the right people need to be trained to apply it.

I know, I know, this is dry, very dry, but hopefully also useful!!

Audits of royalties paid

Here we are again: another blogging breakfast Thursday at NextSpace (www.nextspace.us)!

Royalty Collection for the Licensor

Bill Gates famously (maybe that means it never happened!) wrote an open letter to the software community early in Microsoft’s life imploring people to pay royalties on MS-DOS (and Windows?).

Microsoft has since solved that problem, at least in the US and EU, but the rest of us have an increasingly difficult time collecting royalties that are due. We’ll look into some of the reasons why next week, when we point out some of the pitfalls that a licensee can fall into that result in insufficient payments of royalties.

But for today, we’ll look at royalties from the point of view of the licensor, which depends on being paid all the royalties due. It’s no exaggeration to say that for the licensor, like Microsoft in its early days, receipt of royalties is a life or death matter. And licensee payments of royalties feel to me as if they are at an all-time low.

It’s not just the economy. It may not be the economy at all.

In many cases, it is cheating! As simple as that.

Several years ago, a client sued an Asian competitor for infringing on the client’s patents. The suit settled with my client becoming the licensor of its patents and the Asian competitor agreeing to pay past-due and continuing royalties. The amounts paid by the Asian licensee at the moment of settlement and during the license term were in the tens of millions of dollars.

As the agreed license term drew to a close, my client’s corporate controller scratched his head, weighed the odds, and decided to conduct an audit of the licensee’s sales and royalties. Nothing had alerted him, as licensor, that there may be a problem: royalties were being timely paid in amounts that appeared appropriate based on his business people’s estimates of the licensee’s sales.

But this is a guy with that great commercial asset, good instincts. He looked at the audit cost, in the tens of thousands if the licensee had paid everything, and decided that the cost was worth it.

One of the big five accounting firms duly took a look at the licensee’s books, and what do you know? The licensee was treating parts of its products as being excluded from the definition of “gross sales” under the license. This reduced the sale price of their products, and proportionately reduced the royalties being paid. But the excluded parts were sold as included in the products, and not even sold separately except as spares!

In short, there was no justification for unilaterally reducing the actual sales price to make the royalty calculation. None at all.

We know that there was none at all because the licensee paid all amounts that the accounting firm said were due without our even filing a lawsuit! The licensee paid several million dollars in underpaid royalties uncovered by the audit. They even paid the audit costs, because the License Agreement obliged them to if they had seriously underpaid royalties. The licensor’s corporate controller was the hero of the hour.

The moral to the story: if you’re a licensor, audit, audit and audit some more!

If you audited last year, audit this year as well. Even if the external signs suggest that your licensee is paying correct royalties, audit. It won’t cost you a lot, and it may give you a welcome boost to the bottom line.

Blogging breakfast Thursdays!

LOIs and MOUs

I work in NextSpace (www.nextspace.us), which its CEO Jeremy Neuner calls the “awesome, mind-blowing, global“ co-working space here in Santa Cruz, California. NextSpace is the creation of and a catalyst for the “vibrant, sustainable, dynamic” Santa Cruz economy. Jeremy says that too. He’s a quotable kind of guy.

In less flowery terms, NextSpace is a great place to work, not the least because of the regular and creative activities that the “members” come up with. Today is the first day of the most recent creative idea, a blogging breakfast for all of those who have not blogged since “we only had white Presidents.” Thank you, Ellen DeGeneres!

And thank you Manesh Grossman and Margaret Rosas for coming up with the idea and supplying great muffins and bagels!

Manesh suggested that my post from this first blogging breakfast address one of those areas where clients most often do something wrong. That way, the post can offer helpful practical advice. Sounds good: here we go!

Clients often defer as long as possible engaging a lawyer for their commercial transactions. This is an understandable impulse. Why incur the expense before you’re more or less sure that the deal will be done?

But not bringing in your lawyer carries risks, especially if the other side has involved its lawyer, even in the background.

Take Letters of Intent (LOI), sometimes called Memoranda of Understanding (MOU). They are a preliminary step in the deal-making process. Clients rarely bring in their lawyers before signing them, because in their minds the LOI or MOU is not binding, and as such can be adjusted or fixed later.

Be careful!!

Something happens when people approach a writing. For example, a client may realize that it does not want the other party to the MOU or LOI to disclose the client’s confidential information. So an NDA will creep into the LOI or MOU. All well and good, except that the NDA includes obligations, or it would not bind the other party to secrecy. And so the MOU or LOI is turned at least in part into a binding contract. Whoops: that wasn’t the plan.

Try to keep obligations out of the LOI or MOU. Signing a separate NDA at the beginning of negotiations is always a smart move. If you catch yourself thinking that you need to be sure that the other side is committed in some other way, consider putting that commitment in a side letter. Keep it out of the non-binding MOU or LOI. Or you’ll change its nature, and become a party to a binding contract.

Here is the sort of language that you should include in every LOI and MOU:

• The principal terms of these understandings as set forth herein are not intended to and will not create a binding obligation on the parties.

• The parties intend to enter a separately executed, legally binding, definitive agreement in the future incorporating the general terms and conditions contained in this MOU (“Definitive Agreement”). Although the parties intend to negotiate and finalize a Definitive Agreement embodying the terms described in this MOU within a reasonable period of time, this MOU does not presuppose any such agreements, and if the parties fail to finalize a Definitive Agreement, no liability will be incurred by either party as a result of such failure.

• This document is a memorandum of understanding only, and is not intended to be, and will not constitute in any way, a binding or legal agreement.

• This LOI will not impose any legal obligation or duty on either party.

M&A due diligence

My web designer has been telling me that an unused blog is worse than no blog at all.

And she should know: it's her business!

So after 21 months of inactivity, here is a Memorandum on that extraordinarily stimulating topic, due diligence for an M&A purchaser. Okay, so it may not be the most stimulating topic, but if you are in-house counsel asked to do it for your company, it's worth knowing something about.

What follows is a common sense summary of the due diligence of an M&A purchaser. It is set up as a list of FAQs. And yes, it does go on a bit, but we're catching up on 21 months here!


What is due diligence?

Put simply, due diligence is fact checking and elaboration.

Here we examine it in the context of a particular kind of transaction, M&A, where extensive due diligence is a baseline without which no purchaser should go forward.

But due diligence underlies every commercial transaction, even those such as product sales and purchases of supplies which in most companies attract significantly less attention from lawyers.

No lawyer should sign off on a contract without relating it to the underlying facts.
Due diligence is deal-specific and contract-specific, meaning that if you’re doing it right, you never do quite the same thing. Both the factual circumstances of the deal (e.g. the commercial domain or domains involved), and the legal structure and terms (e.g. asset or share purchase) need to be taken into account in pursuing your due diligence.

Although obviously related in its fact-checking role, the extensive due diligence that also goes into filings under the securities laws is beyond the scope of these FAQ.

What is the purpose of due diligence?

An M&A purchaser’s legal due diligence serves to clarify and elaborate on what is being purchased.

When a company is sold, its financial statements give the buyer a picture of what the company looks like from an accounting point of view. Legal due diligence should give the buyer a corresponding picture of what the company looks like from the point of view of “legal” assets and liabilities, many of which may not appear in the financial statements. Such legal assets may include, for example, trade secrets, and such legal liabilities may include, for example, guarantees.

In an asset sale, the same need applies for clarification and elaboration. It is common for asset sales to be described as including only specified liabilities, giving the impression that here the due diligence role of identifying legal liabilities is reduced. Not so. Due diligence here needs to focus on the liabilities linked to the purchased assets.

For example, the legal assets may include sales contracts which have great value for the buyer because of the customer relations that they bring over. But these same contracts may also bring over serious liabilities, such as a risk of cancellation upon assignment of the contract to the buyer or even built-in unsustainable pricing.

Another example involves employees in certain foreign countries where employees have extensive rights. A company I knew (not then a client, I hasten to add!) was delighted to purchase “for a song” manufacturing facilities in Europe, including all the needed up-to-date equipment and well-trained employees, with only a few specified liabilities. But unknown to that company, those same employees brought with them substantial liabilities whenever the inevitable rationalization or reorganization of the business occurred.

What is the utility (or otherwise) of a Due Diligence Checklist?

When you first bring your outside lawyers into a proposed M&A deal, they will likely send you a “Due Diligence Checklist” for you to send to the lawyers for the seller. Typically encyclopedic in content, such a checklist is a useful roadmap of potential issues as well as of the basic material to review.

It is important to remember that a Due Diligence Checklist, however well prepared (and they typically are very well prepared), is no more than a preliminary roadmap. Once the basic material underlying every deal has been covered (see below), the focus of your due diligence will as ever depend on the circumstances of the deal.

Portions of the Due Dilgence Checklist will likely turn out to be irrelevant or warranting very little of your time time, and other portions will turn out to need more detailed review than they suggest. This is not a failing of the Checklist: if due diligence was a mechanical and purely repetitive process, there would be no need for lawyers to perform it!

How do I initially orient a due diligence review?

By far the most important step is to obtain from your own clients their goals and expectations for the proposed deal. It is a step frequently neglected, and more often accorded too little time and energy on the lawyer’s part. This step is elaborated under the heading “What should I ask my client?”

If the target is a public corporation or a division of a public corporation, review its most recent securities filings on EDGAR (http://www.sec.gov/edgar/searchedgar/webusers.htm). Not only will these filings discuss in some depth the business or corporation that you are acquiring (in the “Management’s Discussion & Analysis” portion of the Form 10-K, for example), they will also highlight certain recent material events (in Forms 8-K) and commercial and financial risk factors (in the “Risk Factors” portion of the Form 10-K).

The most recent published financials are typically in a recent Form 8-K (including the Press Release of the most recent fiscal quarter’s results) or Form 10-Q (including complete quarterly financials).

Review the target’s website, in particular any press releases or other bulletins to be found there, and perform searches on the company and the names of the people and products identified on its web site. This may not be a very fruitful path, but is often a good orientation in the absence of securities laws filings.

Last but not least comes what is classically referred to as legal due diligence, reviewing from a legal perspective the various documents and contracts of the business to be acquired. The Due Diligence Checklist is the basis of this review, subject to the modifications learned as you move forward working with your clients and from the documentation.

What should I ask my client?

The great advantage of being an in-house lawyer is your ready access to the various individuals who comprise and lead your client. Not only are you seated right down the hall or in a neighboring cubicle, but also your colleagues in management know that your time any particular deal will not cost them anything additional. Make use of this access!

It is a good idea to meet with three or four different individuals or groups within a corporate buyer to get a feel for their respective issues in the deal BEFORE doing due diligence of the seller. If time constraints preclude such meetings before you are on a plane to visit the target, catch up with them as the deal progresses.

Meet with:

(1) the VP of business development (or CEO: whoever is driving the deal), in order to understand what is really going on here and what the corporation is really looking to buy. You may need to remind the Officer concerned of your duty of confidentiality, because there are at times more or less hidden goals underlying the deal which the Officer does not yet want to share widely, even within the corporation. Yet if the lawyer on the deal does not know these hidden goal, she cannot help assure that it is accomplished in the deal as consummated;

(2) the head of the product group, operating division or subsidiary which will digest or operate jointly with the target business, in order to understand how she sees the acquisition, and where she has concerns. Do the acquired product lines complement or overlap each other? What are her priorities within the various product lines, technologies and employees being acquired? Will integrating the acquired business’s IT systems pose problems? Will the product lines be integrated or run as a separate subsidiary? Are there technological aspects of the target that warrant special attention? How do the target’s customers complement each other? The list goes on.

(3) the Controller or Finance VP who will be handling the accounting due diligence, in order to get a feel for the potential hotspots in the target’s financial statements. As he goes through the financial statements line by line with his opposite numbers on the seller’s side, you will need to be parallel processing on the legal side. The target being (hopefully) in a business that both of you have some familiarity with will facilitate your joint effort to identify issues in advance; and

(4) depending on the nature of the target, the Officer responsible for a domain particularly impacted by the acquisition, so as to orient yourself in that domain. This is more difficult to identify in advance. If the acquisition involves patents, work with your client’s Officer responsible for IP. The HR Officer often fits under this heading, as does the GM of any local sales office or other facility in a location near a key location of the target.

As you discuss the deal with each of these individuals, issues will inevitably arise, and they need to shape the focus of your legal due diligence going forward.

What do the seller’s organizational documents tell me?

The starting point for a thorough legal due diligence review of the documents and contracts of a corporation or other going business is the various corporate records. Here is a sample section of a Due Diligence Checklist covering these documents. It is phrased as request of the target:

“1.1.1 Organizational Documents. Provide a copy of the following with respect to Company and each of its Subsidiaries:

1.1.1.1 certificate of incorporation and bylaws (or their equivalents, and other constitutional documents for non-corporate entities), and all amendments and restatements thereto.

1.1.1.2 a list of jurisdictions in which Company and each of its Subsidiaries is qualified to do business or is otherwise doing business, certificates of good standing or qualifications to do business in each state or locality where such certification or equivalent qualification is required, and a list of all jurisdictions in which such certification or qualification is required but has not been obtained;

1.1.1.3 minutes of all meetings and materials presented (including financial projections) at such meetings (and all actions taken by written consent without a meeting) of the stockholders and the Board of Directors of the Company and its Subsidiaries;

1.1.1.4 all stock books, stock ledgers and forms of stock certificates of Company and each of its Subsidiaries.”

These documents are to be reviewed first for what is included in them. They comprise the broad lines of a corporate history of the target. The minute books (of Shareholders, Board and Committee meetings) can be long, and do not need to be read word for word, but if they have been prepared correctly they will give you a roadmap of the significant deals in the target’s life.

The most significant transactions involving any company will likely be authorized by Board action. The Board minutes should show you the most significant deals that you may need to review as part of your due diligence. Of course, if your client is buying a division, transactions involving other divisions in the corporation may not need to be reviewed. Prior acquisitions of the target are particularly significant.

Based on information that you have received from your own client, as well your review of available sources concerning the target (e.g. its filings under the securities laws or the results of your web searches), you may find significant matters not dealt with in the minute books. This could be a sign of incomplete minute books or even a (more unusual) red flag.

How should due diligence be organized?

Very carefully. However well you review what you find, its utility to your clients depends more on how well you organize it and present it to them.

As soon as materials that you review (not just the legal materials: see How do you orient your due diligence review?) give insight into what your client is buying, print and classify them. Initial organization should be centered around the Due Diligence Checklist. Most Checklists nowadays incorporate columns for noting the status of review of each line of the Checklist. Use them!

Your filing system for due diligence materials should initially track the Checklist, by headings or line depending on how much material you have accumulated. There will ultimately be lots of material, even in a smaller deal. Smaller rarely means less complicated.

As you delve deeper into the deal, you will find that certain areas of the Checklist demand greater attention than others because of the circumstances of the deal. Subclassify those sections as your review progresses, and develop a sub-filing system that tracks the Checklist.

What is a Virtual Data Room?

A virtual data room is a great improvement in the due diligence process, but a trap for the unwary. It brings the internet into service for the due diligence practitioner.

When the target begins to respond to your admittedly wide-ranging due diligence request (the Checklist), you begin to get into the meat of your due diligence. In the not-so-distant past, this meant trip after trip to the target’s offices or its lawyers’ or banker’s offices to review materials that had been pulled together in a “Data Room” in response to your due diligence request.

I remember days that accumulated into weeks shut in a windowless Data Room somewhere in Idaho with a group of lawyers painfully reading through file cabinets full of documents conscientiously provided by the seller.

The Virtual Data Room improves the Data Room process tremendously. The seller’s banker or its lawyers prepare the seller’s responses to your due diligence request and upload them online. You will be given a password, and can access the Virtual Data Room wherever you have internet access. Hopefully, the online documents will be organized congruently (or close to it) with your Due Diligence Checklist.

The principal downside is the absence of a human interlocutor. In an old-fashioned Data Room, the seller’s representatives were normally down the hall or even in the Data Room with you. As questions came up, they could be addressed in real time. You need to write down all questions arising out of a Virtual Data Room, and email them to the appropriate Seller’s representative, and follow up until you receive answers. That can be a time-consuming process.

In addition, Virtual Data Room contracts and documents are regularly incomplete in some manner. Exhibits and Schedules are omitted, or amendments missing. Again, follow up is the key. No review of a contract is complete until the complete contract has been reviewed.

The Virtual Data Room can trap the unwary by lulling you into a false sense of completion. When you have finished reviewing the broad selection of documents in the Virtual Data Room, you can be excused for feeling that you are done. Not so. There is almost always a lot more to do.

How do I communicate the results of my due diligence?

The classic answer to that question is the “Due Diligence Memorandum,” a detailed summary of the results of your review. Normally tracking the Due Diligence Checklist, this Memorandum can grow into a monster, especially if you are asked to include certain key information for each reviewed contract, like its assignability in an asset sale.

A thorough Due Diligence Memorandum is a requirement of complete reporting to the client, but its highlights should have been reported already.

Two other means of communication are to my mind of more value for your clients.

The first again reflects the advantages of your role as in-house counsel. As things progress and you identify issues that will be of interest to particular groups within the corporation, tell them promptly. These groups will principally be those whom you have already met to learn their itineraries in the deal (see What should I ask my client?), but should include whoever is responsible for key issues as they are uncovered.

The second complementary means of communication that I like to use is a shorter memo headlining major discoveries or summarizing a key domain of legal due diligence. A long or complicated deal can benefit from several such memos. Each can be addressed to the corporate officer responsible for the area covered, or to the client team if it covers a variety of issues.

“Headline” memos are of particular value to clients because they obviate for many individuals a review of all the detail of the complete Due Diligence Memorandum. Clients typically have a strong preference for headlines!

In my files is a sample “Headline” memorandum prepared after an initial visit to a target company earlier in 2008. It focuses on the areas of particular concern to the VP in charge of the deal. Feel free to ask if you'd like to review it, by emailing me at istock@entreprelaw.com.

How are the results of due diligence incorporated in the contracts for the deal?

The reps and warranties in the (Stock or Asset) Purchase Agreement are intimately linked with the Disclosure Schedule or Exhibits, which are based on the results of due diligence. This is the key interaction between the contracts and the results of due diligence, and others may exist in related or complementary agreements.

Reps and warranties are the portion of the Purchase Agreement which delineate and confirm what the seller is selling. Often long-winded, they are the meat of any M&A deal. Not as sexy as the earn-out, indemnification or break-up fees, for example, they remain fundamental.

There are essentially two types of Disclosure Schedule or Exhibits:

(1) detail of assets, for example lists of contracts or of patents and applications; and

(2) exceptions to the reps and warranties.

The first type of Schedule is a simple compilation. If the contract calls for an all-inclusive list of patents and applications worldwide, the target’s patent counsel will typically supply a print-out to be inserted. One issue here is whether to include the list as a part of the contract or refer to is as an outside document. The latter is useful for reducing the length of a contract. I have worked on a 2000+ page Stock Purchase Agreement, when for various reasons several lists of assets were required to be included.

The second type of Schedule interacts more sensitively with the Purchase Agreement. To illustrate, an Asset Purchase Agreement will usually rep. that all the contracts of the business to be acquired are assignable to the purchaser, except as set forth in the Disclosure Schedule. What is then disclosed in that portion of the Schedule is a not a list of all the contracts assigned to the purchaser, but only those whose assignability is in question. (All of certain types of contract will likely be listed pursuant to other reps.) Identifying which contracts fit that description is a part of your due diligence.

What should the final results of legal due diligence look like?

Ultimately, you will share responsibility for being the guardian of this acquisition for your client. It is a responsibility that you will share with finance and probably HR, IP and other functional departments, as well as the operating division or product group that made the acquisition.

You may not be given the resources needed to enable to adequately fulfill this guardianship role: the modern corporation tends to rush through its acquisitions with an emphasis on the speed of income accretion.

But this haste is one of the principal reasons that so many acquisitions do not fulfill the hopes of their proponents within your client. There is nothing like insufficient attention to detail and to cultural blending to ruin the logic of an acquisition. Synergies need more than a good idea: they need careful execution.

Your client will be best served by thorough and complete documentation organized around the Due Diligence Checklist or your Due Diligence Memoranda. The organization needs to be transparent to others in your corporation, both those there now and those who will come later.

One low-tech device which I miss and was very useful with this organization was the deal binder. Remember those leather-bound volumes that the law firms produced after M&A deals? They produce them less frequently now, especially in smaller deals, but their guiding principles are as useful as ever:

all documents, including indices and memoranda, need to be numbered;

the numbering system should bear some relation with the organization that has been applied; and

complete copies of all documents should be carefully collated and included.