Venture capital-backed companies are becoming more prominent as targets in the M&A market as venture capital investors wrestle with the most rewarding means of exiting portfolio companies that survive start-up and reach the outer fringe of stability. A total sale seems to be an increasingly acceptable way of capturing returns at a time when the IPO market is much pickier about the size of the company it will accept and the company’s industry. However, recently released findings on acquisitions of VC-backed companies indicate that working out a deal that both acquirers and sellers will buy into can be a tough trip. For example, data compiled by WilmerHale point to a far higher incidence of earn-outs in deal structures crafted for VC-backed targets than for other types of sellers. In 2004, the law firm reported, terms for about one in four targets being sold by VC investors, or 24%, contained an earn-out. A year later, the proportion contracted to three in 20, or 15%, but remained far greater than that for the broad M&A market. By contrast, contingent payments were rarities in the broad marketplace, making only 133 appearances in 2004 and 131 in 2005, according to Thomson Financial. In both years, they were represented in less than 0.02% of all deals. The numbers reflect considerable differences in dealmaking approaches. In the orthodox M&A deal, dealmakers invariably use earn-outs as a last resort to bridge buyer/seller gaps in perceptions of value and pricing. The deal gets done because the seller is betting that its property can perform well enough post-closing to generate additional payments and win a full price. However, the entire process can turn highly problematical and turn into bitter, sometimes litigated, disputes over how the new owners or the retained management operate the target. With VC-backed targets, there’s an obvious alteration in perspective. The portfolio company being sold, which can range from a specialty retailer to an exotic high-tech operation, has outlasted its difficult early days and rounded into a shape that allows it to change ownership in viable form. But its best days apparently are ahead, suggesting that a bet on future performance is a good idea. Although the data are revealing, WilmerHale’s samples, drawn from deals valued at $25 million or more and for which terms were disclosed, are limited. The 2004 base includes 54 transactions – 23 cash deals, 22 stock deals, and nine with a combination of currencies. The 2005 base contracted to 39 deals – 27 for cash, four for stock, and eight with a package of both. In addition to the earn-outs, negotiators apparently drove hard bargains on other facets of contract terms. Indemnifications for breaches of representations and warranties and covenants were ubiquitous. The target provided indemnifications in 89% of the 2004 deals and in every one of the 39 deals in the 2005 sample. Buyer indemnifications were in 37% of the 2004 transactions and the proportion widened to 46% of the smaller base a year later. Reps and warranties’ survival most frequently were of a year’s length in the purchase contracts, WilmerHale reported. They ran as short as six months and as long as 36 months in 2004 and anywhere from nine to 24 months in 2005. Material adverse change (MAC) clauses were common, appearing in four out of every five deals in the buyer’s favor in both years. In 2004, 81% had MAC clauses in the buyer’s favor and in 2005 that figure rose slightly to 82%. Clauses in favor of the seller accounted for 30% of contracts with known terms in 2004 but only 13% the following year. Caps on indemnification obligations also were pervasive, showing up in 85% of 2004 contracts and in all of the 2005 pacts. In 2004, 72% of the caps were limited to the portion of the purchase price placed in escrow, and 7% capped recovery at the full purchase price. The following year, 79% of the contracts placed the caps at the escrow amount and 5% at the full purchase price. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com

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