Five Key Securities Issues in Due Diligence of M&A Deals
In business acquisitions, and especially in business acquisitions structured as stock purchases, there are a number of securities issues you’ll want to be on the lookout for. For the purposes of this post, you can think of a security as the stock or other equity interest in a company like an option or warrant. (You can check out this post for a more detailed discussion of what a security is.) Below I’ve listed 5 key securities-related due diligence issues for you to consider when purchasing a business.
We’ll start with the two key issues that are important for acquisitions of both stock and assets; we’ll finish with three key issues that primarily affect stock acquisitions:
Issues for acquisitions of either stock or assets
Two issues are of primary concern for acquisitions of both stock and assets, as they determine whether your purchase is effective–you don’t want to complete the transaction and put a few months of effort into making your new acquisition successful, only to find out that your acquisition was void. To know whether a transaction was sufficiently approved, you need to know who owns stock and whether any stock has special voting or approval rights.
- Verify past stock issuances were valid and that you have accurate information about the current ownership
Generally, a merger or acquisition (even an acquisition of only a portion of a company’s assets) needs to be approved by a certain percentage of the company’s shareholders or members. The target company will generally have a “cap table” they present you. (A cap table is a spreadsheet listing the ownership interest of each shareholder or member, including options and warrants). But don’t rely on the cap table they give you. Cap tables can be complicated and may have important errors. The way to confirm that a cap table is accurate is to rebuild the cap table from the legal documents provided to you by the target company. Review the stock authorizations and issuances, and track them on a spreadsheet until you have a clear picture of the company ownership. Then match your cap table to the one provided to you. Once you’ve got the two reconciled, you should have a clear picture of the ownership of the company.When you create the cap table, you should pay special attention to unexercised options and warrants, both of which allow individuals to increase their ownership interest in the company. Treat the unexercised options and warrants as having been exercised already to understand what your ownership interest will be if these options and warrants are exercised, as your interest in the company will become diluted as a result.
- Determine whether any shareholders have approval rights for key transactions or other special voting rights
You’ll want to review the company stock agreements to make sure no individual or subset of shareholders have rights to approve the sale or other key transactions–sometimes these types of approval rights are granted to preferred shareholders. You’ll also want to review the voting rights that come with each share of stock–sometimes preferred stock has super-voting rights. Along similar lines, you’ll want to make sure that there were no voting proxies in place. A voting proxy is an agreement to let someone else control the vote that comes with your shares. The company may not have records of all the voting proxies, if it doesn’t require proxies to be filed with the company to be effective. But you could get a representation from shareholders, or at least the major shareholders.
Once you know who owns what shares, and what voting and approval rights those shares come with, you can determine whether the transaction is adequately approved. And for stock acquisitions where you’re purchasing a majority of the stock, but not all of the stock, you’ll know the rights of your fellow shareholders and the extent of your control post-acquisition.
Issues for acquisitions of stock
I’m not saying you wouldn’t want to look into these issues if you’re only purchasing assets (successor liability can be nuanced), but these are much more important issues if you’re acquiring a company by purchasing its stock:
- Review past security offerings for compliance with regulations
If your newly acquired company raised money from investors without complying with securities regulations, those investors may be entitled to get their money back, with interest. You’ll want to have a securities attorney review these transactions to see what your company’s liability is. Also, you don’t want to take over a company that has violated securities regulations, as those violations could be a hinderance to your company’s future efforts to raise capital.
- Investigate the rights of preferred shareholders
The preferred shareholders may have special rights, including a liquidation preferenceand a right to nominate one or more directors. Liquidation preferences can give investors superior financial rights upon the sale or dissolution of the company. And your ability to control your newly acquired company may hinge on whether or not preferred holders can separately elect board members. Similarly, you’ll want to see when preferred holders can convert their shares into common shares. Depending on the liquidation preference and voting rights, it may be advantageous for preferred holders to convert their shares into common shares. When you’re equipped with an understanding of the conversion rights, you have a more fully developed picture of the preferred holders’ rights and your rights as an acquirer.
- Take another look at the vesting and acceleration provisions in the company’s stock agreementsWhen you were reviewing the company’s cap table, you should have already gotten a picture of (A) whether certain shareholders’ interests are subject to vesting provisions, and (B) when the vesting rights are accelerated. But you should take a fresh look at those terms to see if key employees are subject to vesting provisions, and, if so, whether your acquisition will trigger an acceleration provision. Ideally, the employees you want to stick around after your acquisition would have a significant economic incentive to keep working for your company, including stock subject to vesting.
This is certainly not an exhaustive list of securities issues you’ll want to consider, as the potential issues are too numerous to fully cover here in any sort of readable length, but these are some of the most important issues you’ll want to consider.
If you’d like to learn more about due diligence in the purchase or sale of a business or other key considerations when buying or selling a business, please feel free to contact us today.