Best Practices in Mergers & Acquisitions ACC-America, San Diego Chapter Presented by: Otto E. Sorensen Luce, Forward, Hamilton & Scripps LLP July 20, 2006

© Otto Sorensen Use earn outs supported by escrows to bridge the gap between the value expectations of sellers and the reality of their historical performance. Put cash, rather than shares, in escrow. Assure that the deal in principle is clearly understood before documentation while still being cognizant of the need to avoid an enforceable deal prior to documentation. While contingently issuable shares are registrable, shares underlying contingently issuable options or warrants are not. Note: I still think the SEC is wrong about this.

July 20, 2006© Otto Sorensen Assure that the target has adequate financial controls and reporting that the acquiror will not have difficulty satisfying the 8- KA financial statement requirements and that the principal officers of the acquiror will not have difficulty with their certification requirements post merger. Keep the target in a separate subsidiary, regardless of form of acquisition. Get the transaction team together early and make them part of the negotiation of the deal in principle. Particularly make sure that the auditors are involved and that it is clear exactly how they are going to treat all aspects of the acquisition upon audit. Do not issue resettable derivatives.

July 20, 2006© Otto Sorensen Many sellers believe that the value of their enterprise as reflected in its financial performance should be enhanced by possible post merger synergies, such as the ability to cross-sell and cost savings occasioned by the elimination of duplicative overhead. The seller must be made to understand that these intangible benefits will at best be realized at a significantly later stage and are at worst speculative and therefore cannot be part of the valuation of the seller’s business. Many sellers form an expectation as to the value of their business by reviewing multiples realized in the significantly larger transactions. Historically, it has been true that smaller transactions generally reflect smaller multiples. Demonstrating this fact to a seller can enhance the likelihood of completing a transaction.

July 20, 2006© Otto Sorensen When acquiring a company, the sales of which are enhanced by preferences or set asides (such as those for minority owned firms or small businesses), remember to discount those revenues to reflect the probable loss of that preference or set aside. Establish your acquisition team at the earliest possible time and give each member of that team input into not only the transaction documentation but also the creation of the letter of intent. This is particularly true with regard to your auditors, in that accounting rules, particularly those related to acquisitions, have become less intuitive. It is critical that management understand how the auditors will treat an acquisition prior to agreeing to the final letter of intent.

July 20, 2006© Otto Sorensen If bank debt is used to finance a portion of the acquisition, explore with the bank the ability to convert all or part of that debt to term debt with a term reflecting probable returns from the acquisition. This will have the salutary effect of improving short- term liquidity and enhancing the likelihood that the acquiror’s balance sheet will remain within bank covenants. At the risk of sounding New Age, it is important that a bond of trust be established as soon as possible between the principal shareholder of the target and the most senior officer of the acquiror who has deal responsibility. That bond is often strongest when the senior officer of the acquiror and the principal owner of the target establish it outside of the negotiation arena.

July 20, 2006© Otto Sorensen Very early in the acquisition process, determine whether contract or charter provisions create possible obstructions to the acquisition. For example, one or more shareholders may have preemptive rights or a creditor may have acceleration rights in the event of an unapproved change of ownership. Preferred stockholders may have a right to approve a merger transaction or to compel a redemption of their preferred stock in the event of the merger. I have even seen instances in which a holder of derivative securities had the right to compel a redemption of those derivative securities in the event of an unapproved change of control.

July 20, 2006© Otto Sorensen Obtain a representation from the target and its principal stockholders that no person, particularly no employee, has been promised any benefit upon a change of control. We have seen instances in which employees have received dangerous and non-specific assurances that they will “be taken care of” in the event of a sale of the company. If the employment of such an employee is terminated post-acquisition, such non-specific claims can be adjudicated in front of a notably unfriendly labor commissioner. If the target recently reacquired certain of its shares, assure that it did not grant claw back rights in connection with those repurchases.

July 20, 2006© Otto Sorensen Assure that the key employees of the target are committed, both contractually and spiritually, to continued employment with the target following the change in control. Ideally, document any changes in employment relationships when the definitive agreement is signed rather than in satisfaction of a closing condition so that the deal cannot be held hostage to employment agreements. Transaction termination fees. In its most recent transaction termination fee study, conducted in 2004, Houlihan Lokey Howard & Zukin reports that 22% of all transactions included reciprocal termination fees. In the vast majority of such cases, the termination fees were equal for the target and the acquiror. The median size of the termination fee was 2.9% of transaction value.

July 20, 2006© Otto Sorensen Prior to the preparation of definitive documents and even prior to the conduct of any significant diligence, the parties should agree to a summary of terms or a letter of intent or memorandum of understanding. These should cover such terms as the price to be paid for the target, the nature of the consideration (e.g., cash, equity, or debt), transaction structure, basic employment terms for those employees of the target who are deemed to be of critical importance by the acquiror, the scope and timing of due diligence by each party, conditions to closing, preclosing covenants, stand still provisions, and nondisclosure provisions. However, it may be preferable to have those elements of a preclosing agreement which are intended to be binding to be set forth in a separate document.

July 20, 2006© Otto Sorensen The active and enthusiastic participation of key managers of the target company can be critical to completing a transaction. Their enthusiasm will be enhanced to the extent that they believe they will prosper under the new regime. An effective technique for instilling this belief is to cause them to have contacts, during the due diligence process, with satisfied employees of the acquiror who themselves were previously employees of earlier target companies.

July 20, 2006© Otto Sorensen Various studies have concluded that indemnification obligations in acquisition transactions are subject to caps approximately 85% of the time, earnouts based on the target’s post-closing performance are used in approximately 25% of transactions, the most frequent escrow period supporting an indemnification provision is 12 months and the most common escrow amount is approximately 15% of the transaction price. These studies also conclude that a slight majority of the transactions providing for indemnification also provide for baskets with regard to that indemnification.

July 20, 2006© Otto Sorensen As a practical matter, public valuations in an industry provide a cap, rather than an estimate, of private valuations in that industry. The market will generally not tolerate a public company which apparently overpays for a target based on public company valuations. Private targets should understand that private company valuations are generally lower than public company valuations as a consequence of many factors, including generally smaller size and lack of access to public capital markets.

July 20, 2006© Otto Sorensen Target companies sometimes propose a downstream issuance of shares in the event that the shares issued at the initial closing do not maintain or increase their value by a specified amount. An acceptance of such a proposal is inadvisable from a buyer’s perspective, in that its stock price could frequently be affected by factors far beyond its control. An effective counterproposal is to provide for a claw back of stock issued at closing in the event that the value of such stock increases.

July 20, 2006© Otto Sorensen The buyer’s integration plan should be evaluated to determine its probable effect on the assets and operations of the target, in part because that analysis can reveal errors in the valuation model being applied to the target. For example, if the integration plan calls for replacing the target’s commission based sales structure with the acquiror’s non-commission based sales structure, the revenue and cost of sales projections for the target should reflect that change in structure. This is one of the many reasons that the integration plan should be created early on and be part of the due diligence process.

July 20, 2006© Otto Sorensen The integration plan can also impact the documentation. For example, if an integration plan calls for a significant reduction in force, legal due diligence should focus on the labor laws and regulations of the jurisdiction in which the reduction of the force is to occur, and the documentation of the transaction should clearly have very strong representations and warranties with regard to the severance and related employment obligations. A clear communication of the integration plan to managers of both the target and the acquiror is critical. In the absence of such a clear communication, employee morale, performance, and longevity can be jeopardized.

July 20, 2006© Otto Sorensen Multiple acquisitions within a six-month period in which the acquiror issues securities to a total of more than 35 non- accredited investors can create challenging integration issues. The severity of those issues is reduced if no relationship exists between the sellers and none of the transactions are contingent upon any of the other transactions. If all of the target shareholders are not signatories to the acquisition agreement and acquiror securities are being issued as part of the acquisition consideration, a separate document to be signed by each target shareholder should include the resale restrictions required by applicable securities registration exemptions.

July 20, 2006© Otto Sorensen Especially if the target is a public company the shares of which are widely held, the buyer should obtain unanimous Board of Director agreements to recommend a vote in favor of the deal (without affecting the “fiduciary out”), and non-compete agreements, at the time the definitive agreement is signed. An independent investor advisor retained to counsel unsophisticated shareholders of a target company can be very helpful in satisfying the private placement requirement that only sophisticated people or people advised by sophisticated advisors are to be issued stock in an exempt offering.

July 20, 2006© Otto Sorensen Acquirors often neglect their disclosure obligations when engaged in M&A transactions. Both the Ralston-Purina case and Regulation D contemplate that significant disclosures be made to shareholders of a target company. This requirement is generally easily satisfied by a public company. Private acquirors have more difficulty satisfying this requirement. Public companies should avoid closing an acquisition or even signing a letter of intent while in registration with regard to a previous acquisition or financing.

July 20, 2006© Otto Sorensen The evergreen period for a resale registration statement should never exceed that period of time after which the registrable securities could be sold under Rule 144, either without any volume limitation or subject to a volume limitation that would nevertheless permit the sale of all remaining shares in a three- month period. A buyer should obtain the right to impose blackout periods in the use of a resale registration statement to assure that the buyer has the ability to halt the use of that resale registration statement when it becomes materially misleading. Sellers will of course seek to limit the number and duration of blackout periods that can be imposed and may attempt to negotiate penalties for blackout periods that exceed those limits.

July 20, 2006© Otto Sorensen If a buyer anticipates that Regulation D may not be available with regard to shares issued in a transaction, either because of a possible integration with other acquisitions or because the target has a large number of shareholders, a buyer can register the issuance of its shares on Form S-4. If it anticipates that it will be making a number of such acquisitions, it can use a shelf registration under Rule 415 on Form S-4. The requirements for a Form S-4 acquisition shelf are set forth in the Service Corporation International No Action Letter (Pub. Avail. Dec. 2, 1985).

July 20, 2006© Otto Sorensen Issuers with small market capitalizations may find the filing of an acquisition shelf registration to be disadvantageous, in that the market may consider the potential overhang effects of the shelf when valuing the securities of the issuing company. The filing of an acquisition shelf can also sometimes prompt questions from regulators with regard to the appropriateness of disclosing the filing company’s acquisition program and strategy.

July 20, 2006© Otto Sorensen Another alternative for acquisitions in which Regulation D is not available is the exemption from registration found in Section 3(a)(10) of the 33 Act, which exempts from registration securities issued in acquisition transactions following a fairness hearing by an appropriate state authority. California is one of several states that provide for such fairness hearings. Shares issued under Section 3(a)(10) are freely tradable, except those which are issued to former affiliates of the acquired company or to persons who become affiliates of the buyer, which shares must be resold pursuant to Rule 145. Although some issuers fear the delay which may be occasioned by the fairness hearing process, our experience has been that as little as four weeks can transpire between the filing of the application and the fairness hearing itself.

July 20, 2006© Otto Sorensen When conducting an acquisition program, remember that even insignificant acquisitions can trigger a target financial statement disclosure requirement if in aggregate any of the regulatory tests for significance exceeds the 50% threshold. In that event, financial statements covering at least a majority of the individually insignificant businesses acquired must be filed. Beware change of control vesting acceleration provisions in options held by key employees. Will that newly minted millionaire really want to continue to work for the acquired company?

July 20, 2006© Otto Sorensen Post closing working capital adjustments can be particularly important to an acquiror whose access to cash flow to support a new acquisition is not as robust as it might be. The working capital of the acquired company on the closing date should be determined as soon as possible after the closing and should be supported by post agreement pre-closing covenants and representations and warranties. The purpose of any such clause is to assure that those controlling the target prior to closing do not artificially increase the purchase price by engaging in conduct which reduces artificially either cash or other current assets. Any working capital adjustment should be paid in cash from escrow. Alternatively, it can also be structured as an offset against an earnout payment.

July 20, 2006© Otto Sorensen In crafting a working capital adjustment provision, thought must be given to historical seasonal fluctuations in cash flow. When crafting an earnout provision, exculpatory language with regard to the operation of the target post-merger should be included. Earnout provisions can create some of the most contentious post-closing disputes, and such exculpatory language can increase the likelihood that the buyer will prevail in any such dispute.

July 20, 2006© Otto Sorensen Notes with regard to the care and feeding of investment bankers: 1.An investment banker’s tail period should not exceed six months and it should apply only to companies identified by the investment banker upon termination of the engagement and with whom the investment banker has had substantive discussions. 2.A company should always negotiate strongly for a right to terminate the engagement prior to its scheduled expiration period. This is particularly important in instances in which a monthly fee is being paid to the investment banker.

July 20, 2006© Otto Sorensen Investment bankers sometimes seek to obtain an additional fee upon the signing of a letter of intent. Such provisions are unacceptable. An investment banker is being paid to help you win the war, not a battle. 4.If a fee to be paid to an investment banker is based in part on downstream transaction consideration, the investment banker should receive his fee applicable to the downstream payment when that downstream payment is actually made. If the investment banker is not willing to agree to such provision, he should agree that the downstream payment should be discounted to its net present value for purposes of determining the amount of his fee. 5.Fees should be earned upon closing, not upon entry into an agreement in principal or even a definitive agreement.

July 20, 2006© Otto Sorensen Reasonable non-compete provisions which are entered into in connection with a sale of a business are enforceable under California law. They can also be controversial. A buyer will rightly claim that he is paying for a business, including its goodwill, and has no wish to see that goodwill diluted through competition with the former owners of the target. The owners of the target will argue that they are willing to refrain from competition as long as they are employed, but that, if their employment is terminated, they will have to put food on the table in some fashion. Such an argument can be refuted by pointing out that the shareholder, if he is terminated, will still have the proceeds of sale with which to provide for himself and his family. If necessary, a severance package can also help address these issues. A buyer should never rely solely upon a non-compete provision. The conditions to closing should include the delivery of confidentiality and non-disclosure agreements by each selling shareholder.

July 20, 2006© Otto Sorensen From a buyer’s point of view, letters of intent should be as non-specific as possible for two reasons. First, a buyer’s negotiating power tends to increase during the course of a transaction and delaying the negotiation of contentious provisions can therefore inure to a buyer’s benefit. Second, the execution of a letter of intent which is too specific can be a disclosable event under federal securities laws.

July 20, 2006© Otto Sorensen Merger and acquisition techniques occasioned by the Sarbanes-Oxley Act. 1.The acquisition agreement should contain a representation with regard to the target’s internal controls and disclosure controls. An acquiror should independently verify the effectiveness of those controls. 2.Buyers may wish to perform a pro forma corporate governance audit to verify compliance with the Sarbanes- Oxley Act and any applicable listing standards on the part of the buyer after giving effect to the acquisition.

July 20, 2006© Otto Sorensen Determine whether the acquisition will have any impact on the independence of the directors of the buyer. 4.If the target uses the same auditor as the buyer, the audit committee of the buyer should approve in advance any non-audit services that will be performed by the auditor after the closing date to preserve the independence of the auditor. Any non-audit services that are not approved or which are prohibited should be terminated on or before closing.

July 20, 2006© Otto Sorensen Sarbanes-Oxley generally prohibits the extension of credit to directors and executive officers. If an owner or employee of the target is to become a director or executive officer of the buyer, his compensatory arrangements, including benefit plans and perquisites, with the target should be reviewed to assure that they will not result in an extension of credit subsequent to his becoming a director or executive officer of buyer. 6.Disclosures of pro forma financial information, whether on a Form 8-K report or otherwise, made with regard to an acquisition should be evaluated to assure that they comply with Sarbanes-Oxley mandated rules regarding the use of non-GAAP financial measures.

July 20, 2006© Otto Sorensen

July 20, 2006© Otto Sorensen