In This Issue

BEST PRACTICES
Just Whose Lawyer Are You?
Stockholders may have to scramble to engage new counsel
if disputes arise after a merger.

FINANCIAL TIP
When Buyers Get Free Money
at the Expense of Stockholders
Beware of accounting for non-cash items that can cost you
real money.

INDUSTRY INTEREST
The Key to Maximizing Fund Performance
Savvy investors know that success often depends on focusing
on what you do best and getting everything else off your plate.
Why is this sometimes forgotten?

Just Whose Lawyer Are You?

If you sell your company, you'd assume the lawyers who helped you with the deal would still be able to assist you with any issues that might come up after closing, right?

Not so fast. The analysis may surprise you.

In most mergers, the law firm technically represents the target company rather than the selling stockholders. That company gets merged into the buyer, which means the target company (the "client") is now a part of the buyer. Therefore, the buyer typically becomes the client at closing, and your lawyers may be prevented from taking any positions adverse to its interests. That means the buyer may have the right to force the selling stockholders to use a different firm after closing, which can place them at an obvious disadvantage in negotiations. Many investors do not see that coming.

Making matters worse, if the buyer becomes the "client" after closing, it may suddenly own rights to some or all of the pre-closing communications with the target's law firm. That's definitely not something the average stockholder or manager thinks about when speaking with the attorney. The general assumption is that you can have candid communications with your lawyer, and the opposing side will never hear anything about it. In the merger context, that assumption may be on shaky ground. The limited case law on this contains a somewhat convoluted analysis that tries to make a distinction between whether pre-closing communications relate to the merger transaction itself or to the general operations of the business, with buyers owning general communications but not communications that are specific to the deal. The problem is that those issues are heavily intertwined, which makes it pretty hard to accurately predict whether a court would put certain communications in the "general ops" bucket or the "deal" bucket. Also remember that the buyer generally takes all the target's assets in the merger, including the files and servers on which company emails likely exist. Therefore, even if the buyer cannot get what it's looking for from the target's law firm, the correspondence may be readily available to it anyway. For all these reasons, you'll want to think hard about the form of communications you have with your counsel on deal points and may want to pick up the phone rather than emailing.

Our view is that the applicable court decisions we've seen come to the wrong outcome on the attorney-client relationship issues in the context of a merger. There are clear problems inherent in concluding that the sell-side law firm effectively switches loyalties at closing. Each party should get the benefit of having access to, and candid communications with, their attorney throughout the entire merger process. It does not seem fundamentally fair that the buyer gets their lawyers for the whole transaction but the sell-side gets thrown into a pool of uncertainty. Once a company has made the decision to be acquired, the stockholders are the parties with the primary economic interest in the deal and with exposure to related liabilities. Therefore, the sell-side law firm is really representing the stockholders' interests when negotiating the deal. The target company is just a conduit for all of this and effectively becomes the opposing party upon closing.

Unfortunately, given the current state of the law, there are a few things we would suggest stockholders consider doing when consummating a merger:

1. Talk to your lawyers about putting conflict waiver language in the merger agreement.

2. Discuss with your lawyers their understanding of who will own communications and what their disclosure obligations may be after closing.

3. Discuss communications policies related to what should be in writing, including attorney's notes. Be careful with written communications that you may not want the buyer to see.

Originally published on peHUB 06/03/10

When Buyers Get Free Money
at the Expense of Stockholders

Net working capital is supposed to represent those assets and liabilities that are expected to have a short-term impact on cash and equity. Current assets are generally those that are expected to generate cash within twelve months. Current liabilities are generally those that are expected to use cash within the same time frame.

Looking at the name alone, most people think that deferred tax assets and liabilities refer to expected tax refunds or taxes due. However, deferred tax assets and liabilities are not the actual taxes, but simply an accounting concept. They refer to "timing differences," an accounting term used to describe a situation in which certain revenue and expenses are recognized differently for tax purposes and book purposes, and are non-cash in nature. Even though they may be classified as short-term on the balance sheet, the calculation is derived from the classification of the underlying asset or liability that has the timing difference for tax purposes. It does not necessarily follow that the deferred tax asset or liability will have any impact on cash within twelve months, or ever.

SRS recommends that non-cash items, such as deferred tax assets and liabilities, be specifically excluded from the definition of working capital in merger agreements. If they are not excluded in your transaction, pay special attention to their anticipated impact on determining the estimated balance sheet or any target level of net working capital. Otherwise, one of the parties might find itself writing checks for unexpected amounts and reasons. We have seen large adjustments made to the purchase price for reasons that will never affect the combined company's actual cash position or value. This result can be hard for selling stockholders to countenance, especially if they realize the impact after it's too late to change.

The Key to Maximizing Fund Performance   —
Effective Time Management

Time is the most precious resource to the typical VC. It seems like there is never enough time to get through everything you want to do personally and professionally. Maintaining the current portfolio is a full time job. Sourcing new deals is a second full time job. Add to that LP communications, financing and exit transactions, and general operational matters and it's no surprise that VCs find themselves stretched very thin. In addition to all your job requirements, it seems everyone wants a piece of you. Charities want you to serve on their boards. Business schools and law schools want you to teach classes. Organizations want you to sit on panels.

The good news is that you already know where to find more time. You just may not have looked recently. VCs urge their portfolio companies to identify their core strengths and outsource or delegate most everything else. But, when it comes to managing their own businesses, the lesson is sometimes forgotten.

Despite the severe constraints on your time, you're probably still doing some things that may not be the best use of that very limited resource. For example, some VCs are still signing up to serve as the stockholder representative after the sale of their portfolio companies. While there are obviously circumstances in which this may make sense, taking the role means committing to a volunteer job that has unknown time requirements. It's also not a VC's core business. Is working through balance sheets to determine the final working capital adjustment amount or helping other stockholders who have lost their stock certificates really the best use of your time? Of course, not. LPs didn't invest in you because of your ability to manage post-closing administrative work and disputes. They invested in you because you're really good at identifying great companies and helping them grow.

This is one example of many things you may be doing that you could get off your plate. It just happens to be significant because of the unknown and often substantial time commitments required (and the job keeps getting harder with increased usage of earnouts, longer escrow periods, larger escrows and other similar complicating terms). While you and your team could do jobs such as being a shareholder representative (and probably do them pretty well), that doesn't mean you should. The real analysis should not be whether you can do these sorts of tasks, but rather whether that is what is the optimal use of your limited time. Analyze the costs and benefits of alternatives and think hard about what use of your time is really in the best interests of your fund and its investors. LPs want you to maximize returns on the fund. Taking you away from focusing on finding and growing companies is working against your LPs' best interests.

So, consider taking a different approach. Protect your time. Instead of using lots of hours on post-closing administrative work, use that time to read an extra hundred business plans increasing your chances of finding that next great company. Practice what you preach to your portfolio companies by focusing on your core competencies and delegating or outsourcing the rest.

Originally published in NVCA Today Second Quarter 2010

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Pre-Closing Practices
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The SRS Newsletter is intended to provide information of general interest to the public and is not intended to offer legal or tax advice about specific situations or problems. You should consult a lawyer or accountant if you have a legal or tax matter requiring attention.