In This Issue
LIFE SCIENCES FOCUS
Focus on Earnout Outcomes Rather than Milestones Envisioned Today
Setting milestones based on value inflection points can help align buyers and sellers to achieve strategic goals.
TAX TIP
Sellers Beware of Israeli Tax Withholding
Dr. Ayal Shenhav explains one of the most complex matters in transactions involving the sale of Israeli-related companies.
INDUSTRY INTEREST
Understanding the Post-Closing Implications of Talent-Based Acquisitions
Navigating post-closing issues on deals primarily focused on human capital may be more challenging than parties expect.
LIFE SCIENCES FOCUS
Focus on Earnout Outcomes Rather than Milestones Envisioned Today
When companies develop products or services, there tend to be many unpredictable turns in the road. Companies start down one path, figure out that a different strategy makes more sense, and adjust appropriately. While this seems obvious, it is surprisingly difficult to account for when the parties negotiate and define the terms of M&A earnouts. We often see earnout provisions with deadlines or specific requirements that appear to be one way, but not the only way, to reflect the value of the business acquired. The result is that earnouts are sometimes technically missed for reasons that are caused by changes in business strategy, while the buyer may still be getting the value sought from the company purchased.
 This is especially true in life sciences transactions, because the earnouts in those deals tend to be long and complex, and often development and regulatory plans change over time rather than play out as planned. For instance, the parties might determine at the time of closing that a milestone payment should be made upon the first patient dosing in a phase II study in Europe, provided it starts by a certain target date. A typical provision in the merger agreement requires the buyer to use efforts that are commercially reasonable in the industry to achieve the milestones. Months or years later, however, the buyer might have determined for legitimate business reasons that it makes more sense to do a somewhat different phase II study in India rather than Europe, and the change has resulted in a delay of several months. The result is that the parties know in advance that the milestone defined at closing will not be technically achieved, even though the development of the drug or product is proceeding and value is being created.
This scenario tends to result in disputes over significant sums of money with no clear right answer. Moreover, other aspects of the buyer-seller relationship (such as an escrow release) are often impacted because this potential earnout dispute can be foreseen by both parties long before the milestone is actually missed. To avoid this, the parties could acknowledge at closing that nobody really knows how the future development will progress and avoid setting milestones tied to the plan as it exists at closing, especially for tests that will be years into the future. Instead, they could focus on the results of what would constitute "success" with respect to this acquisition, or clear value inflection points that cannot be bypassed. If the goal is to take a product to market, the buyer and seller should base the milestones on that occurring rather than worrying about how they got there. When development cycles are long and interim milestones are necessary, parties might provide for a second opportunity to receive the milestone payment (perhaps in an adjusted amount) if plans change and the first test is bypassed or delayed.
TAX TIP
Sellers Beware of Israeli Tax Withholding
By Dr. Ayal Shenhav, Shenhav & Co., Law Offices
Israel is one of the world's leading centers of innovation. Every year, hundreds of start up companies are formed by Israeli entrepreneurs and many are eventually acquired by multinational corporations. Almost every leading technology company has acquired an Israeli company, including Intel, Cisco, Microsoft, Google, IBM, and Oracle.
 While most Israeli entrepreneurs incorporate their companies under the Israeli Companies Law, it is also very common for new start ups to be incorporated in Delaware or another offshore jurisdiction. Such foreign companies then typically form a wholly-owned Israeli subsidiary where most of the enterprise's activities are performed, including R&D and management. Therefore, one of the most complex matters in a transaction involving the sale of an Israeli company or Israeli-related company is compliance with Israeli tax laws.
Israel's Income Tax Ordinance (the "Ordinance") provides that Israel may tax the worldwide capital gains of Israeli residents. In addition, the Ordinance provides that a non-Israeli resident may be subject to Israeli tax on capital gains when:
(a) the sold asset is in Israel; (b) the sold asset is outside of Israel but is predominantly a direct or indirect right to an asset in Israel in respect of the part of the consideration that is attributable to the property located in Israel; (c) a share or the right to a share in an entity which is an Israel resident; (d) a right in an entity which is a foreign resident which is predominantly the owner of a direct or indirect right to property located in Israel, in respect of that part of the consideration that is allocable to the property located in Israel. (Section 89(b)(3) of the Ordinance)
As can be inferred from above, the scope of Israeli taxation of non-Israeli residents is very broad. Israeli taxation may apply even when a non-Israeli resident sells shares in a non-Israeli company if such shares are an indirect right to property in Israel.
The non-Israeli resident can often qualify for an exemption from Israeli capital gains tax. A general exemption applies with respect to assets acquired after 2009, and other exemptions are available under Israel's tax treaties. In addition, certain venture capital funds can qualify for a special tax ruling.
In exit transactions, the purchaser typically requires each selling shareholder to prove its compliance with one of the available exemptions (typically through a formal ruling application to the Israeli Tax Authority). Absent such exemption, the Purchaser may withhold up to 30% of the gross proceeds payable to the selling shareholders. Even if the seller is subject to Israeli tax, such seller may apply for a ruling that will allow the purchaser to withhold a lesser amount based on the actual gain of the seller (the tax on actual gain is 20-25% of the net gain).
Investing in an Israeli or Israeli-related company requires careful tax planning. Consulting with an Israeli tax lawyer before the investment and during the sale is highly recommended.
INDUSTRY INTEREST
Understanding the Post-Closing Implications of Talent-Based Acquisitions
Companies are acquired for lots of different reasons. Some targets have a crown jewel asset that is critical to the buyer's strategic direction. Others have key customers that the buyer would love to add for future growth. Often, there are synergies between the companies that make the combined entity more valuable than the sum of its parts. Finally, some targets are attractive because the team they've put together has unique talents or has proven itself to be a winner.
 Each reason for doing a merger has risks. The crown jewel asset might fail or lose strategic relevance (see Cisco's acquisition of Pure Digital) or the key customer might terminate their relationship with the company. Deals done to acquire talent, however, are especially tricky. This is often counterintuitive, because the parties to these deals often think they're clean and easy because issues such as the target's financial condition or intellectual property ownership may not be as important. The challenge comes, however, because the key "asset" walks out the door at the end of each day, and neither party to the merger can fully control what team the acquirer will be able to retain following closing.
This is a growing issue because much of the recent M&A activity in Silicon Valley has been focused on the acquisition of talent. There is an endless need for smart, visionary professionals in the technology industry, especially in social media, where competition for intellectual capital is intense. Facebook is the poster child for talent-based deals, having acquired several companies largely for their employees.
To account for this, some buyers will try to put in place mechanisms that permit the transaction to close only if a certain percentage of key employees sign employment agreements. Buyers might also assert a right to make claims against the escrow, or claw back part of the purchase price, if too many key people leave too fast after closing. Typically, between 10 and 20% of the purchase price is set-aside in escrow for at least one and sometimes two years, and shareholders need to take into account that this consideration is at risk on any type of deal.
Talent acquisitions put the selling stockholders in a tough position for two main reasons. First, they have little control over whether an employee stays or goes generally. Contrast this with other business matters such as ensuring that it has good title to its assets or is not a party to outstanding litigation. Issues such as those tend to be pretty clear and fully within the control of the selling company, which makes it easier for selling stockholders to understand and to attempt to quantify any associated risks. Second, whether an employee stays or goes after closing is largely dependent on how the acquirer treats them. Even if the buyer treats them well, many employees who thrive in a start-up environment struggle with the culture of working at large public companies.
When structuring a talent-based M&A transaction, the buyer and seller, including their advisors, need to thoroughly understand the strategic reasons behind the deal and focus closely on those issues. Selling shareholders, including venture capitalists, private equity firms and corporate executives, also need to focus on understanding the implications to them if the economic deal changes based on whether employees remain with the company after closing.
In managing the risks of talent acquisitions, the buyer and seller often use some combination of retention bonuses or other incentives for employees to remain with the company through a specified period. While deal structure can help to mitigate these risks, selling stockholders should also try to understand whether the team is excited about the deal and the prospect of working for the combined company. This can be tricky because people will surprise you, or might tell you what they think you want to hear rather than what they really believe. Additionally, often it's hard to have this discussion prior to signing a merger agreement because of confidentiality concerns. The more investors can learn, however, about whether the team likes the idea and whether the companies' cultures are compatible, the better idea they are likely to have of the level of risk of departures and ensuing claims.
It would be remiss to discuss employee retention in the post-closing of an M&A deal without addressing the type of acquirer involved. The good news for selling stockholders is that most talent-based acquisitions are carried out by strategic corporate acquirers. The 2011 SRS M&A Post-Closing Claims Study shows that corporate purchasers bring fewer indemnification claims on average than financial buyers. Strategic buyers generally don't pursue an acquisition without wanting to retain the acquired company's management team or key employees and, as a result, most will try to avoid needing to bring an indemnification claim.
Many successful mergers have been primarily about acquisitions of talent. There are compelling reasons to do these deals, and there will continue to be, especially in hot industries like social media. When thinking about whether such a deal is advisable and how to structure them, the parties need to understand that the team is the primary reason behind the transaction and focus their efforts on planning for the transition. While the parties on these deals might not need to spend as much time on issues such as reviewing the financial statements, they need to think hard about the human issues.
Originally published on peHUB 07/05/11
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