Consolidation continues to increase in the technology sector, with many technology companies throughout the lifecycle acquiring or merging with similar or complementary companies. This is due to several factors, including a more challenging funding environment, the opportunity to strengthen balance sheets, improve economies of scale and accelerate the path to profitability. We’ve outlined five things these companies need to be aware of when considering consolidation opportunities.
Structure is the key to any consolidation. It should be determined whether the transaction will be a merger between equals or a takeover of one company by the other and whether a new structure will be put in place. Often these transactions are done cashless with an agreed ratio split among the shareholders of each entity. Bridge financing may be required during the negotiation of the transaction and a consolidated group financing strategy will be required.
It is critical to understand the impact of existing liquidation preferences and key terms of all equity and debt instruments. The transaction may also constitute a change of control for either or both companies and therefore the impact of the structuring on the commercial contracts of the parties must be considered.
Also, venture-backed companies often have a large shareholder base, so it may not be possible for all shareholders to subscribe to the transaction before the announcement. Some shareholders may also resist the transaction. As such, careful consideration should be given to how the transaction can be implemented from a legal perspective, including the efficiency and approach to exercising rights of entrainment. This will vary by jurisdiction and legal advice is essential.
A parallel consideration is taxation which can have a significant impact on deal structure and returns for existing investors. If shareholders move to a new Topco structure or exchange their existing shares for new shares in an acquiring entity, it will be important to consider a tax-efficient structure to minimize the impact of any taxable event on existing investors. This will depend on the diversity of the shareholder base from a tax residency perspective and whether or not there are particularly large shareholders whose position will determine the direction of travel.
Management incentives and turnover
The incentive approach of management and employees is important in any consolidation scenario. Consideration will need to be given to how existing awards are affected, whether they will accelerate or roll over to the new entity, and what post-closing arrangements should be in place to ensure that management and employees of each party are properly incentivized in the future. This is likely a complex subject that will require careful planning with legal and management advisors.
Regardless of the transaction structure chosen, the future governance arrangements of the combined entity will be a key topic. A shareholders’ agreement for the surviving entity will be required and consideration will need to be given to how investor protections in each party’s existing governance documentation (such as consent rights, liquidation preferences and -dilution) are carried over to the new governance. arrangements (if any).
Decisions will also have to be made about who from existing businesses will sit on the combined entity’s board of directors and who will take on key management and leadership roles. These negotiations will be sensitive and guided by the respective bargaining power of the parties.
Regulatory and Antitrust
In a consolidation scenario, the parties involved are likely to operate in the same or similar industries, so antitrust considerations may be important. In addition, if the companies operate in a regulated industry, the transaction may have to be conditional on obtaining change of control approvals from the relevant regulatory authorities. Foreign direct investment regimes should also be considered.
Appropriate legal advice should be sought at an early stage to understand: (i) whether the transaction is feasible from a regulatory perspective; (ii) whether approvals may be required or desirable and how long they are likely to take (which could be a critical consideration for companies with short runways); and (iii) regulatory restrictions associated with sharing business information with potential counterparties prior to an agreed transaction and whether “clean teams” should be used to assist in this.