Erich Merrill, Miller Nash LLP and Justin Monahan, Otak
The overall volume and valuations in merger and acquisition activity in the U.S. have increased in 2024 from some lower activity in 2022 and 2023. We have seen industry publications reporting that in the architecture and engineering industry, for example, target firms are achieving valuations at EBITDA multiples of 11.4x, 13.8x, and higher—well above historical medians in the 6x–7x range. Mergers and acquisitions that generate inorganic growth remain a key maneuver for firms looking to incorporate specific resources from smaller firms, augment specific capabilities, scale new growth platforms through geographic and capability expansion, and in some cases transform both firms by reshaping service offerings with transactions of scale. In this article, we are going to review several issues that have been significant deal and drafting points in recent transactions to flag approaches for buyers and sellers alike.
Considerations for potential buyers
We will begin by looking at preparations for a potential acquisition from the perspective of potential buyers.
- Intellectual property
Based on transactions with which the authors have recently been involved, intellectual property of the target business continues to be of major interest to buyers. Buyers typically are looking for one of two opportunities in an acquisition: the ability to extend an already successful or potentially successful business platform into a new area or onto a larger scale, or the addition of operations that expand the sectors in which the buyer’s business operates. In each case, obtaining the ability to offer a product or service that others cannot is a key factor to a successful acquisition.
Intellectual property can provide this exclusivity. Buyers should spend significant time reviewing intellectual property assets of the seller’s operations in the due diligence phase of acquisitions. Diligence should go well beyond confirming that the seller holds patents, registered trademarks, or trade secrets that appear to offer value to the buyer. Buyers need to verify that key employees have assigned rights to the seller, that trade secrets have been protected in practice, and that third parties do not hold patents or other intellectual property rights that pose a risk of infringement claims against the seller (and, after the transaction, against the buyer). In addition, buyers need to assess the degree of competitive protection actually provided by the intellectual property held by the seller. Analysis of patent scope and possible invalidity are critical as part of the diligence process.
- Non-competition agreements between parties and with employees
Much has been written about the FTC’s April 23, 2024, rule potentially affecting non-compete agreements. (See the most recent coverage from the Oregon Business Lawyer in this issue’s article, “Federal Trade Commission Non-Compete Ban: December 2024 Update.”) However, that rule is in limbo following the August 20, 2024, ruling by Judge Ada Brown of the Northern District of Texas that blocked it, pending potential appeal. At the state level, ORS 653.295 and applicable case law have set criteria for the enforceability of non-compete agreements between employers and employees. It is generally clear that non-competes are permissible in the bona fide sale of a business. These are important tools for acquiring firms: target firms may have valuable relationships with clients, customers, suppliers, and subconsultants. The economic benefit of a successful transaction generally provides reasonable consideration to make an owner’s non-competes enforceable. There are additional requirements on non-competes under state law which are worthy of addressing in a future article; anyone needing guidance on this should seek experienced transaction counsel.
In the context of professional services, protection against seller competition may also take the form of non-solicitation provisions for clients and staff. When considering mid-level management, federal and state rules are trending toward invalidating and limiting non-competes. Non-solicitation agreements may continue to be enforceable, although there are circumstances where certain clients may effectively hold a “monopoly” over a business sector, and affected employees may argue that a non-solicitation agreement is effectively a non-compete that frustrates their ability to earn a living. This may be true of, for example, certain government clients such as Departments of Transportation that simply govern an entire field of work. In these cases, counsel should pay careful attention to other restrictive details, such as the duration of the non-solicitation following an employee’s exit, to improve the likelihood that a court might enforce the agreement.
- Larger deals: HSR reporting and clearance—new FTC rules
Buyers in larger transactions need to consider whether a filing under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 will be required. When such a filing is required, both parties must spend significant time and money gathering and submitting detailed information about their operations, the proposed transaction, competitive overlap, the market in which the companies compete, and other required information. The parties submit the required information and must then wait for agency review and clearance to proceed. Not only can the process significantly delay the transaction, but the filing fees alone constitute a major expense.
The Federal Trade Commission recently adopted a final rule, which is estimated to triple the time and effort needed to complete the required filings. The good news is that filings are generally not required for transactions having a value of less than $119.5 million. If you are involved with a transaction above that amount, it is always wise to consult with experienced counsel who can help guide you through the HSR process.
- Diligence process
Once some basic concepts and intents begin to be shared and agreed between the parties, due diligence can begin in earnest. The overall assessment of strengths and weaknesses of a business or business line will take many forms: financial condition, succession planning, contract rights and restrictions, and intellectual property that will be part of the deal all need to be evaluated.
A critical piece of due diligence will be the risk assessment associated with potential claims against the target that the buyer will need to evaluate. These include employment-related claims, tax underpayment/reporting, participation in multi-employer pension/welfare plans, and claims related to privacy and data security. The risk profile of each business will be different, and subject matter experts should be used within given market sectors to inform the decision making of the buyer. Although parties this far along in the process may be less and less likely to find true “no-go” risks, the sum of risks and items requiring workouts and attention may start to affect the deal valuation. If the buyer is interested in the transaction because they are picking up a piece of intellectual property or a specific customer base, the due diligence process may become particularly focused. A broad acquisition of a large performing firm, on the other hand, may span out across a broad range of potential topics and risks.
For any transaction to be successful—something the parties look back on after the dust settles to see the acquired assets performing well in the context of the buyer’s business—it is critical that risks are assessed and valued appropriately at this stage of the process. Most practitioners will maintain a detailed log and checklist of items that will be evaluated as part of their process.
Considerations for potential sellers
The process of selling a business is frequently completely new to sellers. We list below several key considerations that sellers should be aware of when preparing to sell a business.
- Orderly records; due diligence production
Although orderly records by themselves may not define the success or failure of a transaction, it is wise for sellers to insulate themselves from claims by having orderly records that support the buyer’s due diligence. If there are unwelcome surprises for the buyer after due diligence, a buyer may insist that the very format of the due diligence production from the target thwarted proper due diligence and that the buyer is entitled to (a) a reduction of the purchase price prior to closing or (b) a remedy or indemnification after closing. Attractive acquisition targets can also demonstrate orderly record-keeping and the consistent use of best practices throughout their business.
- Protection of intellectual property
As noted above, patents, strong trademarks, and trade secrets are usually ascribed significant value by buyers. Sellers considering a business sale should therefore spend the time and resources to ensure that any intellectual property they may have is appropriately protected and documented.
Potential sellers should expect that buyers will require extensive warranties regarding intellectual property in the acquisition agreement. These warranties virtually always place the risk of infringement claims on the seller. Potential sellers should therefore obtain freedom-to-operate opinions or other advice from intellectual property counsel to assure themselves that infringement risk is minimized or can be accurately disclosed to the extent it exists.
Sellers sometimes believe that it is helpful to obtain a valuation of their intellectual property assets. Our experience is that such valuations do not facilitate the sale of the business and are not worth obtaining. Most buyers put little stock in valuations of intellectual property. Their lack of faith in valuations appears to be well placed. With the exception of valuations of patents or other intellectual property that has a history of earning royalties, valuations of intellectual property vary widely, appear to have little correlation to business advantage, and are often highly speculative.
- Transition process during and after sale
Attractive acquisition targets can demonstrate a focus on succession and transition planning within their organizations. Too often, acquiring firms find themselves disappointed when they pay significant amounts to current company leaders, only to find those leaders promptly transitioning out of the company business and handing the reins, along with all the accompanying learning curves, to emerging leaders.
Another thing an acquiring firm does not want is to be the savior to a company whose leadership is looking to exit amid a floundering, late-stage effort. Rather, attractive acquisition targets can demonstrate both immediate and durable value-add propositions for acquiring firms that mirror the motivations of the acquiring firms in the first place: adding specific capabilities while giving the target firm access to broader platforms and resources. There are many transition-planning strategies available to companies wishing to make themselves attractive targets, which we may explore further in a subsequent article.
- Earnout terms
Frequently, sellers and buyers resolve disagreement over acquisition price by agreeing that part of the price will be paid after closing based on how the business performs—commonly called an “earn-out.” Sellers can find earn-outs attractive because they potentially increase the purchase price.
Sellers should know several things about earn-outs. First, the buyer, not the seller, will be in control of the business after closing, which is the period during which performance of the business will be measured for the earn-out. Second, it is critical that the earn-out criteria be carefully and completely defined in the purchase agreement. Close coordination between the seller’s financial teams and legal teams is critical in this regard to avoid disagreements over whether an earn-out has been earned and how much the seller is entitled to receive. Third, sellers need to assess whether they will continue to work for the buyer for the time that is often required in order to earn the earn-out. We often see sellers decide that they are ready to move on, leave the business before the end of the earn-out period, and negotiate a compromise amount to be paid rather than the full potential earn-out.
- Rollover equity—liquidity; control over the process
Buyers will often insist that sellers take part of the purchase price in the form of stock issued by the buyer, rather than being paid the entire purchase price in cash. Sellers need to consider these facts when faced with such an offer:
- Unless publicly traded, stock in the buyer is not liquid. Sellers must consider whether they are willing to hold the buyer’s stock indefinitely, without the ability to convert it to cash, or what alternative exit mechanisms may be available under the relevant stock plan.
- A seller willing to take buyer’s stock as part payment of the purchase price should usually negotiate a right to require the buyer to purchase the stock from the seller on a future date. Such a right will often involve a formula price since there is no market price for the buyer’s stock. Sellers should make sure that the formula is reasonably predictable and verifiable, and that the seller retains a reasonable right to challenge a calculated price that the seller believes to be incorrect.
- As with an earn-out, sellers who agree to take buyer stock as part of the purchase price should attempt to negotiate some degree of control over the buyer’s operations post-closing. For example, the buyer should not be able to sell key components of its business or incur unreasonable levels of debt without the seller’s consent.
- A seller willing to take buyer’s stock as partial consideration should also insist that a tag-along clause be included in the acquisition documents. This clause gives the seller a right to sell a proportional amount of stock, if the buyer’s major shareholders in the future sell a significant portion of their stock to a third party. A buyer will likely impose a companion clause—the drag-along clause—on the seller, so that the buyer is able to require that the seller sell stock if the buyer or its major shareholders want to sell the whole company.
- Areas of focus for buyers
As mentioned above in the discussion of the due diligence process, buyers are likely to spend significant time on evaluating possible employment-related claims, tax underpayment/reporting, participation in multi-employer pension/welfare plans, and claims related to privacy and data security. Sellers should keep these areas in mind well prior to a proposed sale of the business and adopt business practices meant to minimize the potential for claims or liability in these areas. In recent transactions the authors have handled, some of the most contentious negotiations of transaction terms have focused on these areas.
- Involving an investment banker/broker
Sellers should give serious consideration to retaining an investment banker or business broker to assist with the sale of their business. Potential sellers are sometimes tempted to sell their businesses on their own, wanting to avoid the expense of a banker’s or broker’s commission.
Our experience is that retaining a skilled business broker or banker is worth the expense. These professionals typically bring a larger number of potential buyers to the table, resulting in a higher price for the business. In addition, we have been involved in numerous acquisitions where a skilled banker or broker is able to effectively act as a mediator when the parties seem unable to agree on a crucial transaction term. In these situations, the deal often proceeds toward closing with the help of the broker or banker’s shuttle diplomacy to keep the parties at the bargaining table and resolve the key issue.
- Involving M&A counsel
As with retaining a business broker or investment banker, potential sellers sometimes question the benefit of hiring counsel experienced in merger and acquisition transactions. Just as physicians have different specialties, attorneys have varying levels of expertise in different areas of law and business. Counsel that has served well for routine contract, corporate, and litigation matters may or may not also have the experience to provide efficient representation for a sale of the client’s business. Potential sellers should consider contacting and interviewing counsel with significant merger and acquisition experience. Such counsel can work in full cooperation with existing company general counsel, if requested to do so, so that the background knowledge and experience of the company’s general counsel is available for the seller’s benefit in the sale transaction.
Conclusion
Signs suggest that mergers and acquisitions will continue at a significant pace in 2025 and beyond. As is clear from the issues raised in this article, the topic touches many different areas of the law, implicating intellectual property, employment law, corporate law, and regulatory schemes. Careful preparation before an acquisition occurs will be beneficial to both buyers and sellers in the transaction and the operation of the ongoing business.
