Mergers and Acquisitions of hindalco and novelis

7/27/2019 Mergers and Acquisitions of hindalco and novelis

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Best Practices inMergers & Acquisitions

ACC-America, San Diego Chapter

Presented by: Otto E. Sorensen

Luce, Forward, Hamilton & Scripps LLP

July 20, 2006


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July 20, 2006 Otto Sorensen 2006 2

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.


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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 ofacquisition.

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.


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Many sellers believe that the value of their enterprise as

reflected in its financial performance should be enhanced bypossible post merger synergies, such as the ability to cross-selland cost savings occasioned by the elimination of duplicativeoverhead. The seller must be made to understand that theseintangible benefits will at best be realized at a significantly laterstage and are at worst speculative and therefore cannot be partof the valuation of the sellers business.

Many sellers form an expectation as to the value of theirbusiness by reviewing multiples realized in the significantlylarger transactions. Historically, it has been true that smallertransactions generally reflect smaller multiples. Demonstrating

this fact to a seller can enhance the likelihood of completing atransaction.


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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 andgive 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.


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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 acquirors

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.


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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 ofthe 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.


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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-specificclaims 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.


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Assure that the key employees of the target are committed, both

contractually and spiritually, to continued employment with thetarget following the change in control. Ideally, document anychanges in employment relationships when the definitiveagreement is signed rather than in satisfaction of a closingcondition so that the deal cannot be held hostage toemployment agreements.

Transaction termination fees. In its most recent transactiontermination fee study, conducted in 2004, Houlihan LokeyHoward & Zukin reports that 22% of all transactions includedreciprocal 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 transactionvalue.


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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 ofcritical 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 setforth in a separate document.


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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 previouslyemployees of earlier target companies.


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Various studies have concluded that indemnification obligations

in acquisition transactions are subject to caps approximately

85% of the time, earnouts based on the targets 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 alsoconclude that a slight majority of the transactions providing for

indemnification also provide for baskets with regard to that

indemnification.


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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.


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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 buyers

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 eventthat the value of such stock increases.


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The buyers 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 targets commission

based sales structure with the acquirors non-commission based

sales structure, the revenue and cost of sales projections for thetarget 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.


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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.


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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.


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Especially if the target is a public company the shares of which

are widely held, the buyer should obtain unanimous Board ofDirector 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 counselunsophisticated 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.


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Acquirors often neglect their disclosure obligations when

engaged in M&A transactions. Both the Ralston-Purina caseand 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.


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The evergreen period for a resale registration statement should

never exceed that period of time after which the registrablesecurities could be sold under Rule 144, either without anyvolume limitation or subject to a volume limitation that wouldnevertheless permit the sale of all remaining shares in a three-month period.

A buyer should obtain the right to impose blackout periods in theuse of a resale registration statement to assure that the buyerhas the ability to halt the use of that resale registrationstatement when it becomes materially misleading. Sellers will ofcourse seek to limit the number and duration of blackout periods

that can be imposed and may attempt to negotiate penalties forblackout periods that exceed those limits.


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If a buyer anticipates that Regulation D may not be available

with regard to shares issued in a transaction, either because ofa 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. Therequirements for a Form S-4 acquisition shelf are set forth in

the Service Corporation International No Action Letter (Pub.

Avail. Dec. 2, 1985).


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Issuers with small market capitalizations may find the filing of an

acquisition shelf registration to be disadvantageous, in that themarket 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 companys acquisition program and strategy.


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Another alternative for acquisitions in which Regulation D is not

available is the exemption from registration found in Section3(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 thosewhich 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 weekscan transpire between the filing of the application and the

fairness hearing itself.


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When conducting an acquisition program, remember that even

insignificant acquisitions can trigger a target financial statementdisclosure 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?


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Post closing working capital adjustments can be particularly

important to an acquiror whose access to cash flow to support anew 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 suchclause 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 structuredas an offset against an earnout payment.


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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 exculpatorylanguage can increase the likelihood that the buyer will prevail in

any such dispute.


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Notes with regard to the care and feeding of investment

bankers:

1. An investment bankers 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.


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3. Investment bankers sometimes seek to obtain an additional fee

upon the signing of a letter of intent. Such provisions areunacceptable. 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 paymentwhen 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 anagreement in principal or even a definitive agreement.


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Reasonable non-compete provisions which are entered into in

connection with a sale of a business are enforceable underCalifornia law. They can also be controversial. A buyer will rightlyclaim that he is paying for a business, including its goodwill, andhas no wish to see that goodwill diluted through competition withthe former owners of the target. The owners of the target will arguethat they are willing to refrain from competition as long as they areemployed, but that, if their employment is terminated, they will haveto put food on the table in some fashion. Such an argument can berefuted by pointing out that the shareholder, if he is terminated, willstill have the proceeds of sale with which to provide for himself andhis family. If necessary, a severance package can also helpaddress these issues. A buyer should never rely solely upon anon-compete provision. The conditions to closing should include

the delivery of confidentiality and non-disclosure agreements byeach selling shareholder.


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From a buyers point of view, letters of intent should be as non-specific

as possible for two reasons. First, a buyers negotiating power tends toincrease during the course of a transaction and delaying the negotiation

of contentious provisions can therefore inure to a buyers benefit.

Second, the execution of a letter of intent which is too specific can be a

disclosable event under federal securities laws.


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Merger and acquisition techniques occasioned by the

Sarbanes-Oxley Act.

1. The acquisition agreement should contain a representation

with regard to the targets 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.


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3. 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 orwhich are prohibited should be terminated on or before

closing.


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5. Sarbanes-Oxley generally prohibits the extension of credit

to directors and executive officers. If an owner oremployee 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 directoror 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 ofnon-GAAP financial measures.


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