For many start-ups, this will mean having to sell at a discount or to accept money at significant discounts to the valuations of their prior financing rounds, or suffer the ultimate ignominy of shutting down the company. The expected coronavirus-induced recession may well be the start of that period.
This article, first published on Bloomberg Law, is the first of a two-part series for buyer and investors on how to structure transactions for distressed start-ups. It will cover mergers and acquisitions transactions; the second part of this series will cover investments.
To frame the historical context, we can look at each of the two downturns since the new millennium—the dot-com crash in 2000-2001 and the Great Recession starting in 2007-2008. In the dot-com crash, while the number of M&A transactions involving U.S. venture-backed companies did not drop significantly from 2000 to 2001 (from 489 deals to 464 deals, or 5%), the median acquisition price plummeted from $100 million to $27 million (or 73%). In fact, the market would not regain the $100 million watermark until 2018.
Similarly and less dramatically in the Great Recession, the number of transactions dropped moderately from 2007 to 2008 (519 deals to 427 deals, or 18%), and even recovered slightly in 2009 to 437 deals (up 2%). However, the median acquisition price more than halved, from $58 million in 2007 to $32 million in 2008 to $25 million in 2009 (total drop of 57%). Since then, however, deal activity has been markedly up in all of the 2010’s. For example, 2018 saw 757 deals (up 55% compared to 2000, the height of the dot-com bubble) and 2019 saw an all-time high median exit value of $93 million. This is a dramatic upturn from the median exit value in 2010 of $38 million (total increase of 145%).
So while difficult to forecast the future based on the past, it should be fairly safe to say that if the coronavirus does induce a long-term recession, deals may still happen at a moderate pace, but one should expect valuations to fall significantly.
The Difference With Buying a Distressed Start-Up
Tech start-ups have characteristics that make the traditional tools of distressed M&A less relevant. First, start-ups often do not need the restructuring benefits of a bankruptcy process. They tend to be financed through preferred equity (or equity- like instruments such as convertible notes—SAFEs, or a “Simple Agreement for Future Equity,” a simplified security that in economic terms approximates the result of a convertible note but without the debt features). These are commonly held by a close-knit group of insider investors, rather than complex debt structures secured by marketable assets.
And for many start-ups, there are not significant deferred commercial liabilities that need to be satisfied, as the primary expenses for start-ups are the employees themselves and a limited set of obligations like real estate leases and cloud- server contracts, which must be kept current to continue operations. As a result, the use of the bankruptcy process to restructure significant debt and other liabilities is often unnecessary.
Second, the primary value drivers of a tech start-up are often in the people and in the “soft” assets, such as source code or process know-how or network effects. As such, the negative connotations and the extended timing and expense of a bankruptcy or restructuring process makes preserving that value challenging. (The one notable exception being start-ups that have substantial patent portfolios.) As such, for the typical start-up acquisition, the traditional tools of conventional M&A, such as mergers and asset sales, remain commonly used.
The Primary Deal Structures
The primary choice to make in most start-up M&A, distressed or not, is between purchasing the equity of the company versus purchasing the assets directly.
Equity Purchases / Mergers. The primary benefits of purchasing equity, either via a stock purchase or a merger, is speed of execution and favourable tax treatment for the sellers. On speed, with the right internal shareholder approvals, and assuming that the transaction falls below the thresholds for antitrust filings, a merger can close on the same day that it signs
(a so-called “sign-and-close”). This speed becomes an incredible advantage in the melting ice-cube situation of a distressed start-up: the management teams can negotiate without any publicity regarding the financial distress, and the transaction can be presented to the world as a fait accompli.
Employee and customer flight can both be minimized, because the buyer can take control of all communications rapidly (although for practical reasons the buyer will probably want the assurance of key stakeholders pre-signing). On the tax front, the sale of equity in a corporation is generally taxed only at the shareholder level, and at capital gains tax rates. If a shareholder’s equity in a start-up qualifies as qualified small business stock, the shareholder may be allowed to exclude all of the capital gain from the sale (up to $10 million or 10 times the stock basis, whichever is greatest) from the shareholder’s gross income. A stock purchase also tends to mitigate certain transfer taxes that could apply to an asset purchase.
The most significant downside of an equity purchase is inheriting all of the liabilities of the start-up. Of those, the more obvious liabilities are all of the ordinary course commercial liabilities, e.g., unpaid bills, taxes, and the contingent liabilities, e.g., possible lawsuits, regulatory fines (see below). The less obvious are the corporate-level liabilities created by the transaction itself (see below). And on the tax front, buyer does not get to step up the basis of the target’s assets to reflect the purchase price, and so foregoes some future tax depreciation benefits.
Asset Purchases. An asset purchase has as its main advantage the flexibility to customize the assets and liabilities to be received. Notably, an asset purchaser can opt to only take the assets and leave behind all of the legacy liabilities of the target, with some limits as described below.
On the speed dimension, asset purchases are slower to negotiate and execute. First, buyer and target need to parse the individual assets and liabilities, to determine what should transfer. Second, the transfer of those assets over to the buyer will often times require additional third party consent (e.g., contracts and employee arrangements). These disadvantages are somewhat counterbalanced by not having to heavily diligence the liabilities of the target entity, which are usually left behind.
On the tax dimension, asset purchases can be less efficient than stock acquisitions as there are ultimately two levels of taxation. The target corporation will generally be subject to income tax on the net taxable gain from the asset sale, which may be offset, in part or in whole, if the target entity has significant net operating losses. Then, if the target wishes to distribute the sale proceeds to its shareholders, the amount distributed to each shareholder will generally be subject to income tax, which may be at the capital gains tax rates or the ordinary income tax rates depending on the type of distribution made.
Because distressed sales by definition tend to have lower purchase prices and a history of operating losses, the ability to offset purchase proceeds with historical net operating losses increases the appeal of asset sales. Furthermore, buyer does get to step up the basis of the target’s assets to reflect the purchase price in an asset purchase, and may generally deduct depreciation and amortization based on the stepped-up asset basis.
The flexibility to customize the transaction is not bulletproof, because of two doctrines. First, under fraudulent conveyance (or fraudulent transfer) laws, creditors can claw back assets or unwind transfers, if they can prove that the assets were transferred for less than fair value at a time where the target was insolvent or near insolvent, with the effect of unfairly depriving creditors of assets of the entity. In assessing such risk, for the average start-up that has only ordinary commercial liabilities (e.g., lease payments, ordinary accounts payable), there is a reasonable risk assessment that ordinary commercial creditors would likely not initiate litigation to unwind a sale over smaller amounts. The concern is substantially heightened for start-ups with substantial debt. In such cases, it will likely make sense to include lenders in the negotiation in any case to ensure that any claims on the assets are properly released, or to explore the ABC or 363 options described below.
Second, successor liability laws can also offset some of the benefits of leaving legacy liabilities behind. Under such laws, under certain circumstances, if a buyer acquires the entirety of a target’s business, the liabilities of target will follow the assets notwithstanding the contractual agreement between the two parties for the seller to retain such assets. Such risk can be mitigated, for certain constituents such as employees, by obtaining releases as part of the closing process.
However, careful thought should be given to the issue if the target is in a business where there is a high magnitude of risk of contingent claims: e.g., hardware companies with product liability claims, or big data companies with consumer privacy claims. The unfortunate aspect of both fraudulent conveyance and successor liability laws is that their application may be subjective and often litigated in hindsight (e.g., when the eventual bankruptcy has actually happened, or when a plaintiff
is looking for a deep pocket after the target entity itself has already dissolved), such that it is often difficult to conclusively avoid such risks by contractual drafting.
Acquihires. To take an extreme form of an asset sale, for many small target companies, one common acquisition structure is a so-called “acquihire,” where the buyer simply hires the employees from the start-up. Acquihire structures are useful where the target company’s actual products did not gain significant traction and thus are not of great value. Though there is no universal legal structure for acquihires, in one common acquihire structure, the buyer makes offers of employment to the target’s employees that it wants, and simultaneously pays a relatively nominal amount of consideration to the target entity itself (usually an amount sufficient to satisfy some portion of debt and pay for the liquidation itself), in exchange for which it receives a release of claims.
The key benefit of this particular acquihire structure is an almost complete insulation from the liabilities of the target: because neither assets nor liabilities were transferred, the risk of a fraudulent conveyance claim or a successor liability claim are minimized. And execution time can be minimal, as the buyer need not diligence the target’s assets and liabilities or negotiate a full purchase agreement. As a note, it will be helpful, even where the intellectual property is not desired, to obtain a non-exclusive, perpetual license to the intellectual property to avoid future owners of those assets making infringement claims.
ABCs and 363’s. In truly distressed situations, a so-called “ABC,” or assignment for the benefit of creditors, or a 363 pre- packaged bankruptcy sale, are also potential tools. Such structures are primarily useful where the deal proceeds are unable to clear the debt of the target, or there exists substantial concern about fraudulent conveyance or successor liability, and buyer wants fuller protection from such claims.
An “ABC” is available in certain states, including notably California. In an ABC, the target entity agrees to transfer all of its assets to a liquidator (called an assignee), which is typically a private-sector service provider. The assignee conducts a solicitation process for such assets (unless a satisfactory one was done pre-ABC), and if it finds no better bids, then sells the assets to the buyer and remits the proceeds to the target’s creditors.
An ABC can be appropriate in situations where the buyer values the ability to cleanse historical liability but still wants a relatively predictable and fast deal execution process. Because the assignee is a private company, it is able to move fairly quickly and, if the target has already engaged in a fulsome solicitation process prior to entering into the ABC, the assignee may also be willing to waive an additional solicitation process.
The downside is that because the technical sale occurs between the assignee and the buyer, the buyer is often stuck with very limited representations to the assets and little if no post-closing recourse. As such, ABCs are likely best reserved for extreme situations where the purchase price is so low as to be unable to satisfy a fairly large number of lenders and/or trade creditors.
Similar to an ABC, a 363 sale refers to a procedure in bankruptcy whereby a buyer and seller can pre-negotiate a purchase agreement, which is then submitted to approval by the bankruptcy court. Much like in an ABC, but this time in the context of a formal judicial process, the court will oversee an auction process. The winning bidder will buy the assets free and clear of unwanted liabilities. The primary downsides of a 363 sale in the context of most start-ups is the time and expense necessary to navigate the bankruptcy process, and for the buyer, the attendant uncertainties of the court-governed auction process.
For most buyers, both structures have downsides that make them viable only in truly distressed cases. Both structures offer little mitigation of the key concerns of employee retention and customer flight, though ABCs are incrementally better than 363s because the process is less visibly publicized.
Mitigating Liability Risks
It is probably obvious that a distressed start-up likely has more potential for liability than average. As such, the normal tools of risk mitigation for M&A should be amplified.
To start, it is much more likely that distressed start-ups will have above-average amounts of unpaid bills. Sufficient financial due diligence should be performed to ensure that known liabilities are accounted for in the upfront purchase price. Buyers should generally use purchase price adjustment mechanisms (e.g., cash-free, debt-free, with a target level of working capital), rather than opting for fixed price or lock-box approaches.
