Tech Tuck-Ins (Part 2)

Here’s how to craft a tech deal purchase agreement to align expectations all around

IN MY LAST column I imagined that you were a large financial institution in the process of buying a small tech company (the “Target”) that was in the artificial intelligence (AI) space. We call this a “tech tuck-in.” You are particularly keen to have the Target’s top-flight team of AI engineers and data scientists join your organization, but the Target also had developed some software that would advance your own CRM efforts significantly.

   You’ve agreed in a non-binding Letter of Intent on a price (or at least a formula on how to subsequently determine a price once your due diligence review of the Target is complete), settled a Non-Disclosure Agreement (under which you have mutually exchanged non-public information), and you have completed your due diligence. Now you’re ready to negotiate a sensible and even-handed purchase agreement (PA).

PAs are fairly complex documents that take time and care to draft, negotiate and settle. What follows are highlights of what needs to be considered early on in the process. While the legal aspects of tech company M&A — both for tuck-ins and more complex tech acquisition deals — can be quite involved, some of the basics can be reduced and considered in fairly business-oriented terms, as follows.

A Win-Win Structure

An important issue to work out collaboratively with the selling shareholders of the Target (referred to here as the “sellers”) is whether you will be buying their shares of the Target, or whether you will purchase the assets of the Target, and the Target will then distribute to the sellers the proceeds of the sale, either by dividend or some other means. This will typically involve a fairly involved negotiation before the resolution can be reflected in the PA.

As a general rule, the sellers will want to sell their shares of the Target, particularly if the Target qualifies as a Canadian Controlled Private Corporation, in which case each seller may be able to claim a capital-gain tax exemption on the first roughly $800,000 of proceeds received by each of them if they have held the shares of the Target for more than two years and haven’t already claimed this exemption in the past. On the other hand, you may well prefer to be buying assets, particularly in respect of the Target`s software products, because under Canadian tax law you may have an accelerated write-off of the purchase price paid for that asset.

In essence, you, the sellers and tax advisors will negotiate an optimum structure for the deal. Sometimes the compromise will involve a hybrid deal in which the buyer acquires the software asset first, and directly afterward acquires the shares from the sellers. The objective is to craft an approach in the PA that works well for both parties in a mutually tax-effective manner.

Promises, Promises

Whatever the final structure for the acquisition, what will not vary is that the sellers will be required to make a long series of representations and warranties (collectively, “Reps”) in the PA about their Target company, including the fact that it owns its proprietary software. The Reps are essentially a series of promises that the sellers make about various aspects of the Target, which will result, if any one or more of them proves to be inaccurate, in you getting back some of the purchase price you paid for the business. For example, particularly if you’re buying the shares of the Target, you will want the sellers to confirm in the PA that the only liabilities of the Target are those that are listed in a schedule to the PA.

In my last column I discussed how in the due diligence process you confirmed, as best you could, that the Target owned its proprietary software. Now, you get a contractual confirmation to the same effect in the Reps. In another section of the PA, the sellers give you an indemnity confirming that if one or more of the Reps proves to be untrue, they will reimburse you for the resulting damages on a dollar-for-dollar basis.

For instance, if after the deal closes a third party appears and argues (successfully) that they own a portion of the software code used by the Target, then it will be up to the sellers to pay some amount of the purchase price to this third party to settle their ownership claim. In short, the overall result of the Reps and the indemnity regime is that the sellers are responsible for any problems with the Target’s business that arose prior to the time you purchased it. That would include claims related to the title to the software (as in the example given above), but it would also cover any tax or errors in the Target’s financial statements.

In short, the sellers are responsible for all problems or issues that arose in the Target company prior to the date you purchased the Target, while your responsibility commences on the closing date. The PA therefore keeps the sellers responsible for adverse matters that arose while they ran the Target.

Crafting a Reasonable Non-Compete Provision

It is very typical that the sellers — or at least those who are active in the management of the Target — agree to a covenant in the PA not to compete with the Target after the sale for a specified period of time (the “non-compete period”). The rationale for this non-compete clause is fairly straightforward: buyers wouldn’t pay good money for the shares or assets of another company if the persons receiving the purchase price proceeds could simply turn around the day after closing and start a competing company. In other words, by paying the seller a bunch of money, the buyer is purchasing a period of exclusivity during which it can expect the seller not to show up in the marketplace competing against the buyer.

Courts generally uphold these sale-of-business non-competes as long as they are crafted within reasonable constraints, including the restriction’s scope not extending beyond the business of the Target at closing — in terms of type of activities and geographic scope of the Target’s customers — and that the duration of the non-compete is in the range of two to five years.

Drafting enforceable sale-of-business non-compete clauses in the digital era is getting trickier. Say, for example, you are buying a Target that is in the fintech (short for “financial technology”) space, and so your initial inclination in the non-compete clause is to have the sellers not compete in the fintech space for a certain period of time. In popular usage, fintech refers to a broad range of activities that financial institutions and others engage in digitally. You may therefore be advised to get quite granular in your specific definition of the particular restricted submarket within fintech, in order to increase the likelihood that your non-compete will stand up in court if it is ever challenged.

As for duration of the non-compete, it can make sense for differently placed sellers to agree to different terms of duration: namely, shareholders who get more purchase price proceeds would sign up for longer non-competes.

So, a shareholder who gets only $500,000 of the purchase price signs a non-compete of a shorter duration than one who gets $5 million. In effect, one size doesn’t necessarily fit all.

From Sticks to Carrots

While a non-compete clause may keep a particular selling shareholder who joins your organization from pulling up stakes to go to the competition for a certain period of time after the closing, it won’t stop them from leaving you altogether (and thereafter engaging in some sort of non-competitive activity). In other words, in order to keep high-performance people gainfully engaged after the closing, you have to create a very attractive work environment for them (and I don’t just mean by offering lots of perks at the office). That means that the quality of work and nature of the projects they work on have to be sufficiently exciting to ensure that they will stick around.

This is true of just about everybody who joins your organization nowadays who has impressive digital credentials, because they have so many employment options in Canada and around the world (especially in the United States). But this scenario is amplified after you have just paid several million dollars to someone because you bought their business; now they are able to become quite selective about where and with whom they work.

This means you must create an environment for these software engineers and data scientists that is both engaging and rewarding financially. They need to be constantly working on state-of-the-art projects that are leading edge — projects that give them significant “psychic income.” But then don’t forget to give them financial incentives that are appropriate for people of their stature and potential impact. If they can drive very significant increases in value for your organization, you have to figure out how they can share in a meaningful way in that increase in value.

In short, buying the tech tuck-in company is the easy part in many respects. As with all acquisitions, the challenging part is keeping and motivating the key staff who came along with the deal to ensure that they drive value to your organization long after the closing of the initial transaction.

George Takach is a senior partner at McCarthy Tétrault LLP and the author of Computer Law.