Gone are the days when those buying companies rushed to wrap up deals and wrest hot companies from their competitors' grasp. In today's market, buyer due diligence is thorough and can easily lead to renegotiating terms. Increasingly those deals hinge on the value of patents, and firms are responding by creating IP "swat teams" to handle the load. Our panel from Northern and Southern California discussed these issues as well as strategies for bridging valuation gaps, cross-border deals, and the market's impact on M&A. They included Doug Cogen of Fenwick & West; Eric McCrath of Morrison & Foerster; Ed Wes of Perkins Coie; Marc Empey of Slovak, Baron & Empey; and Joe Wyatt and Dan Zimmerman of WilmerHale. The roundtable was moderated by California Lawyer and reported by Paula Shi of Barkley Court Reporters.

Moderator: How are transaction terms evolving in acquisitions of private companies, particularly when it comes to earnouts and breakup fees?

Empey: In middle market transactions we're seeing a pretty significant increase in earnout provisions. There's a widening gap in the perception of value between the buyers and sellers. It's become a pretty good tool to bridge that gap. It's also a tool that we're using with companies that have short operating histories or are asset-light service-based companies so that you can get the financing.

The problem is that it adds significant complexity to documenting the transactions and includes serious risk post-closing for dispute. But we've seen a lot of them and we're going to continue to see more. Typically sellers see revenues as the most objective measure for the earnouts. But even using GAPP - this year is not the same as next year, and revenue recognition can be a problem. Because of FAS 141(R), we've also seen heartburn over booking the earnout payments.

Cogen: You're seeing them a fair bit, particularly in situations where value is binary, like in biotech. For a pre-FDA approved pharma company, it can be difficult to put a deal together without an earnout. The trick is finding deals where you don't expect too much of an evolution in the alignment between buyer and seller in term of the metrics. Sometimes the buyer has a competing or an adjacent product set that creates issues as you get into the earnout period about whether the sales force is appropriately focused on the earnout-measured product versus the buyers' other products. Earnouts are rife with potential for disputes. The great saying is: "Rarely earned, often litigated, sometimes paid!"

Wes: As a practical matter, I often see an earnout being "paid" if an acquired company continues to be operated post-M&A by the former management team, and they are valued by the buyer. But if there's a hiccup and the buyer is displeased with management, or else the acquisition was motivated by a desire for efficiencies, so that the former management team was largely laid off, there is a lot of potential for disputes. Unfortunately, such disputes regularly lead to litigation.

Wyatt: It's really difficult to align the interest if you have an extended period for your earnout. I'm seeing earnouts as more acceptable to sellers as a way to bridge the valuation gap. But they want them very short and well defined, in order to mitigate a lot of the risk that's inherent in earnouts.

McCrath: Managing risk is a significant challenge for earnouts - particularly for companies without a significant track record where the valuation is inherently based on projected EBITDA. Trying to diminish the possibility of litigation and account for likely outcomes often creates the needs for extensive earnout related covenants. As a client reviews long covenants, they see the potential pitfalls in an earnout and the tone can change from "this is going to be a great deal" to a more defensive mode as you negotiate the covenant terms.

Zimmermann: Recently we have been experiencing quite a bit of pushback from target company investors on earnouts. Most of them have been burned in past deals. We are hearing that the bundling of products is a big problem in situations where such products can be thrown in for free. Production-based earnouts are also hugely problematic because management often does not get the means to perform at a level to which it would like or is accustomed.

I've also seen a bit of horse-trading with earnouts. The first offer often contains a nice valuation of the business but may also contain a big earnout. In those situation we often see folks come back with the offer to do an all-cash deal albeit at a lower valuation. Sometimes the initial term sheet from buy-side counsel specifically allows mixing and matching of cash and stock, which complicates a deal tremendously. So on two recent deals everyone ended up agreeing on all-cash deals without an earnout, at a lower valuation than the initially proposed deals that contained earnout portions to the purchase price.

Wyatt: I've done a couple of deals recently where the economics weren't rich enough to incentivize management, and there was concern on management's part about their responsibilities to stick around for the full earnout. They felt a responsibility to their investors to continue to try to achieve the earnout, but they didn't want to have continuing obligations for a year or two.

On a related issue, I have seen more of the purchase price reallocated to back-end incentives to the management team, the people that the buyer really wants to bring over. That structure can create tax issues, but there seems to be incentive on the buyer's part to make sure management is happy. It can sometimes work to the economic detriment of the investors. This can create tension between the management team, who the buyer really wants to make happy and ensure that they stay with the company for a long period post closing, versus the investors' interest in a solid return on their investment.

Cogen: We're also seeing where a portion of what might have been the purchase price is set aside for new RSUs or a cash bonus plan. The investors think that this money could have been theirs, but in the view of acquirer it never could have been theirs. Although it is part of the deal, it really is compensation to incentivize management to stick around.

If a management team, is "too vested" to ensure sufficient retention and a successful integration, they can be requested to revest some equity, and in this case, it can often stay as capital gains as opposed to ordinary income. This, however, is always controversial, but sometimes it's the only way to make it work for the acquirer.

Wes: Management carve-outs are almost always used when the company valuations are down, so that employee stock options have very little or no value. Before negotiating terms for companies where this is the case, it is best practice for the board and management to reach an agreement on what kind of carve out may be appropriate. For companies where stock options have no value, we're often seeing ten percent of the consideration being set aside for management carve-outs. From an investor's perspective, this is very expensive, but they often have no realistic alternative except to agree. Investors need management to sell the company.

McCrath: We are seeing a lot of deals with a post-close deferred compensation arrangement. This arrangement can take the form of rolling over options to ensure that management still has skin in the game post-closing and valuing the company on a fully diluted basis to include unvested options. The VCs wonder what's in it for them and assume it has a dilutive effect on the overall purchase price, but it is a necessary expenditure to ensure the purchaser is keeping a key asset of the deal: the target's employees. This is the stickiness that will keep management from moving off into the sunset and the VC needs to understand that they agreed to the issuance of these options.

Zimmermann: You hear time and again that integration is one of the biggest issues. The fear is that the combination is not going to work from a business perspective. Acquirers need to make sure the negotiations over these incentives don't get so acrimonious that the target's management is really ticked off and looks for any opportunity to get out after the deal is closed.

Creating proportionally large incentive structures really only works where those same people are also the major stakeholders who are still running the company. Otherwise you're creating such a disincentive for investors who need to approve the deal. Why would they agree to a deal where half of the purchase price is back-ended through stay bonuses?

McCrath: A couple of companies we've looked at on the buy side have been subject to a longer incubation period than planned given conditions in '08'09. This often requires some pre-sale modifications to the payment of equity holders. As additional rounds of financing have occurred, it can significantly reduce payments to the common and early series of equity. When you look at the distribution waterfall, on the sell side we've had to restructure the payments to the equity holders for California corporations to ensure we had sufficient funds being paid to the common and early series of equity so that there is sufficient shareholder support in each class of equity. On the buy side, we've had to due diligence on how payments to the equity holders have been restructured.

Wyatt: Likewise. If the economics are not such that the cash will flow down to the lower stockholders, and if it's a California corporation, there can be a very intense and sometimes acrimonious discussion among the stockholders regarding the allocation of the purchase price. It can get fairly complicated especially if you're going to have a management carve out.

Wes: Adding to the acrimony is the VantagePoint case (VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108 (Del. 2005)), where the Delaware Chancery Court ruled, and the Delaware Supreme Court affirmed, that Delaware law applies to the internal affairs of Delaware corporations that may be located in California. The California Supreme Court has not yet ruled on whether the Vantage Point Chancery Court holding will be respected.

Moderator: What impact is the IPO and stock market having on M&A transactions?

Cogen: Roughly 95 percent of the exits for a private venture backed company are M&A as compared to an IPO. While that's varied somewhat with the stock market over the last 15 years, the likelihood of an IPO for a private company these days is probably in the high single digits. But when you're in a market where companies really can go public, it certainly changes the dynamic for the strong ones.

Wyatt: If there are bankers on the deal, they will point to public companies as a valuation metric for a private company. Depending which side you are on, that can work for or against you. Even though the M&A market is the typical exit, you still see IPOs and public company valuations having an impact.

McCrath: In the first half of 2011 there was a more robust stock market, and sellers suggested that an IPO was a possible stalking horse. There was a notion that many deals could be dual tracked and that an IPO was still a likely exit strategy. In the summer, the volatility of the market increased and the attractiveness of an IPO alternative had diminished.

Wes: I counsel my start-up clients to aim for an IPO, as it's the only exit that they can control. A lot of the same governance and strategic decisions that will result in a successful IPO will also prepare a company for a successful M&A exit. Acquirers in M&A are motivated by fear and greed to move quickest and pay the highest valuations. A realistic prospect of an IPO will force a prospective acquirer to move quickly before the company goes public and gets more expensive.

Zimmermann: IPOs give you huge bumps in valuations because IPOs are still considered the king's exit. These days, the companies that make it to go public usually get great valuations in the IPO markets, and VCs certainly prefer these exits. But at the same time to run a real dual track? I'm sure most serial acquirers just listen to this and go, "yeah, right." The regulatory environment has put a huge damper on this and most management teams today are not capable of running a public company. That was different 15 years ago.

Cogen: Well, there are dual tracks and there are dual tracks. If you've filed an S-1 and you have a ready-for-prime time management team, that's one thing. But to simply - as Eric [McCrath] was alluding to - say there's a dual track with nothing to back it up, that isn't very powerful. The capital and effort involved to actually file an S-1 is significant and few companies are going to step up just to have the added argument in an M&A deal. You can see it with a private equity seller who's taken the company private and now wants to take it back out. They're sometimes willing to spend the money, and the company is of a scale that it's more plausible.

McCrath: The trophy IPO concept has in many ways been reduced by Sarbanes-Oxley. That, together with management appreciating what an underwriter lockup entails, makes an M&A exit often more appealing than an IPO.

Wyatt: The shift has occurred because investors are often willing to take a sale of the company, especially if there's a good solid return on it, versus taking the risk in the IPO market. Anything can happen with an IPO, especially in the last few years, even when the IPO window has been open, so to speak, the market has been volatile. I did two IPOs last year in which the open window was literally just a few weeks. Then the lockup kicks in, and they automatically have to take in the IPO context: another six months of risk on their investment versus all cash now in an acquisition.

Wes: Another disadvantage to liquidity from an IPO is that if things go wrong and the valuation of the company takes a nosedive, management will probably be constrained by the securities laws from buying or selling stock. They are saying, "This is a good opportunity. We can sell to an established, high-quality company. We may be leaving some money on the table, but on the other hand, how much do we need?"

Wyatt: It obviously depends on the economics, but there's some risk involved with the investors, especially if they sit on the board of a public company. In an M&A context, they get to walk away with the deal versus potential additional liability if the VCs have a representative on the public company board.

Wes: We all saw how M&A activity did a nosedive in 2008 as the stock market plummeted. The only people doing M&A were strategic investors. A strategic investor may continue to make investments in products or technology that are instrumental to its business. However, financial buyers generally left the market for the year.

Empey: I saw tack on after tack on. Same guys over and over that were willing to take that as an added tuck into what they were already doing but definitely not the financial buyers.

Cogen: In a volatile or down market, the strong get stronger for that reason. They usually have the cash to pursue acquisitions regardless of what the stock market is doing. If you look at the balance sheet of all the big tech acquirers, they're very strong right now. And for the truly solid buyers, there's virtually no limit on the amount of cash that can be borrowed in this environment. But volatility is the enemy of M&A - on the target side, it's very hard to know your company's worth when the market is swinging whole percentage points on a daily basis.

Empey: We like that on the buyer's side. For the serial acquirers, we saw valuations that looked like 2008 to us. We really looked at companies and thought, "We're going to do a series of these in a row. Just on a pure EBITDA basis, they look cheap to us." But none of them were financial buyers, they were all strategic, and the gap between the companies they were buying and the size of the buyer was huge.

Cogen: Which has also led more buyer-favorable terms almost across the board in deals. The recent evolution has been solidly pro-buyer in deal terms.

Empey: We've ratcheted it up on the reps and warranties. Our survival periods have gone way up. We used to fight over one year and now I see them going - especially for environmental reps - more like five years. I've seen the same thing for baskets and caps.

Zimmermann: We've recently seen buyers say, "If there's a situation where we would be indemnified under the agreement due to a breach and we also have an earnout, we'll have the right to grab that out of the earnout if we need to." We look at a lot of deal point studies, and they're a little skewed. Many deals that we do in the Silicon Valley are not necessarily reported, so when it comes to relying on or pointing to deal point studies, it's a bit of a free-for-all.

Empey: We even saw some hold backs this year, which have been off the table for a few years. They were a way to say, "We're catching you on the upswing in your company. We believe you that we're on the right part of the curve, but you're going to take some risk with us." It really came back to where we started with earnouts. It was more of a valuation deal than it was an indemnity comfort piece for us.

Wyatt: I've seen a number of deals where the LOI [Letter of Intent] was already executed, and then you do a little IP due diligence and issues you thought were resolved all come back into play again because the buyer will assert that things have changed.

Cogen: Whether the intellectual property rep goes beyond the escrow and what the cap is for it, is an issue that you try to frame out when you're having that first discussion. Sellers and VCs feel very strongly about it. A lot of VCs take the view they can distribute to their LPs if the tax, capitalization and authorization reps go beyond the escrow but not IP. So it becomes a huge issue for the seller.

Moderator: Are you seeing many cross-border deals, and what are key issues to look for in such deals?

Wes: When it comes to privacy law, it's important to understand how the laws affecting an offshore company can apply post-acquisition. For example, if you are dealing with employee or customer information, you'll find that what's a permissible use of the information in the United States is completely different from what's permissible in Europe. A lot of companies will unwittingly submit themselves to unfamiliar regulatory schemes.

McCrath: In many countries there are government subsidies involved that are often tied to employee retention. If there is a change of control or a change in the geography in which the employee is working, you may be jeopardizing a government subsidy that may have retroactive affect on the business. The balance sheet of the target may be significantly affected by the subsidies, and the cutoff of those subsidies may have a real impact on the purchase price.

Cogen: If you want to remove IP developed in Canada, it's either going to get taxed or it's going to result in a royalty. Similar issues can apply in Israel where the Office of Chief Scientist funds so much IP development, which will restrict the transfer of that IP out of the country, or it dramatically increases the royalty.

Zimmermann: The lack of transparent financials creates a huge burden on the deal team and their ability to run good models. For all intents and purposes, it's going to be very difficult to do a proper analysis of what's happening in the target company if the financials are not prepared under the same rules. A foreign target is not necessarily willing to incur the expense of getting their financials prepared in U.S. GAAP. Nevertheless, in those instances the buyer can of course insist and say, "We're a public company. We actually need you to do that."

Wyatt: Even if you have a full set of reps and warranties, and you think you're covering all your bases with the disclosure schedule, new issues often arise - issues that you would think the reps and warranties would flush out but often they don't.

McCrath: Sometimes it works the other way around. We have advised on inbound acquisitions as well, and many relatively new U.S. technology companies don't have audited financials themselves, and inevitably those financials are prepared on a U.S. GAAP basis. Foreign purchasers need to take these financials and conform them to their own jurisdiction's filing requirements, which can be time consuming.

Cogen: In foreign-target deals, you need to carefully diligence true defined benefit plans, which are far more common, especially in Europe, as opposed to defined contribution plans. These plans can have significant unfunded liabilities - truly deal-moving sorts of numbers.

McCrath: That's also apropos to Japan-based acquisitions. A concern on the buy side is to ensure that the demographics of the employees fall into a typical bell curve on age and experience. In a carve-out asset transaction, sellers may be trying to fix their own internal demographics. Part of that are unfunded pension liabilities, one of the more significant carrying costs.

Another issue is that a lot of other countries are taking on larger regulatory roles. For example, China has increased its profile in conducting competition reviews and this increase in activity has made the time periods involved in completing a review by the Chinese regulators more extensive.

Empey: The Canadian regulators have been significantly more aggressive than in the past. It seems like every time the economy is rougher everywhere, regulators step up everywhere and people get a little more protective.

Moderator: What other recent decisions or trends are affecting your practice?

McCrath: IP-driven deals and patent-driven transactions. Starting with Nortel, there's been a very significant number of very high-value deals. In many cases, there's an exclusionary value premium paid as opposed to an enabling value. It's a hallmark of 2011.

Cogen: With the unsettled situation in Europe, it's hard to know if this is a good time to be doing deals abroad or not. And in the Internet and social media spaces, many companies are focused on talent acquisitions. We're solidly in the million dollars-per-engineer when you look across tech-focused deals.

Zimmermann: There are going to be more cross-border deals, and they will be coming from other countries, especially China, because acquirers there have a lot of cash and need to get it out of the country in order to be able to expand. Another trend that we have been following is the use and proliferation of professional shareholder services. We are seeing a useful cottage industry grow that is capable of handling almost everything imaginable post closing.

Wyatt: Buyers are very cautious these days. Even if it's a hot company, they're very deliberate, especially in the due diligence process. They take a lot of time and effort, especially if IP and patent portfolios are important. There's little hesitation to go back and negotiate price and other terms after they've signed the LOI.

Empey: On the upswing last year and continuing are a lot of spinoff type transactions as a way to unlock some shareholder value. We're going to see a more aggressive stance among antitrust regulators.

Wes: Far more attention is being given to IP. Some law firms, including ours, have created IP "swat teams" that specialize in reviewing IP portfolios for M&A. Huge value is being attributed to patents. Increasingly it seems that at least half of the negotiation in our M&A deals involve IP issues.