I.TRANSACTION BASICS
There are three basic types of merger and acquisition transaction: (1) asset purchase, (2) stock purchase and (3) merger. Consideration paid for the acquisition may include cash, stock of the buyer, assumption of seller liabilities or a combination of them. Factors including tax and financial accounting considerations, impact on earnings and cash flow, risk management, transaction mechanics and required corporate, governmental and third-party approvals are taken into account in determining transaction structure and form of consideration. The tax treatment of the transaction is often the most important factor. If the selling shareholders are key persons (whether continuing as employees or not), a portion of the consideration may be allocated to future employment compensation, covenants not to compete, or “Stay-Put” arrangements.
A.Asset Purchase. In an asset purchase, the buyer acquires only identified assets and liabilities of a company, not the company itself. With successful negotiation, the purchaser can select which of the seller’s assets to acquire (such as inventory, equipment, contract rights and intellectual property) and which not to acquire (such as contaminated real estate or obsolete inventory). Within limits, the buyer can also negotiate which outstanding or contingent liabilities to assume and not to assume. Buyer need to assess applicable state laws and determine if “successor liability” may apply – a common law doctrine applied by some states and in certain conditions which imposes upon the buyer of a business liability for certain obligations of the seller, even in the case of an asset purchase.
For tax and liability reasons, it is often said that buyers prefer to buy assets and sellers prefer to sell stock. As a practical matter, in most cases the substantial tax disadvantages of an asset deal to stockholders of the seller (likely double taxation at the corporate and stockholder levels) lead to a stock or merger transaction. As a result, asset purchases are most common in the acquisition of divisions of companies or specific contracts via novation, rather than entire companies.
B.Stock Purchase. In a stock purchase, the purchaser buys the outstanding stock of a corporation directly from the corporation’s stockholders. The corporation need not be a party to the transaction and remains unchanged after the closing (other than having different ownership), retaining all of its assets and liabilities. Existing employment agreements and non compete agreements remain in place (though buyers often require that these be renegotiated to ensure the retention of key persons). Stock purchases are typically preferred by sellers because all liabilities are transferred along with the company, there is no double taxation, and there is no need to liquidate the company after the transaction.
C.Merger. In a merger, one corporation merges with another to become a single ongoing corporation. One company is designated the “surviving,” and the other the “disappearing” corporation. By operation of law, the surviving corporation acquires all of the assets and succeeds to all of the liabilities of the disappearing corporation, and the disappearing corporation ceases to exist as a separate legal entity.
As with the other types of transactions, in a merger, the stockholders of the acquired corporation typically receive cash, stock of the surviving corporation, or some combination of stock and cash. A merger may be taxable or non-taxable to the acquired corporation’s stockholders, depending on the mix of consideration received by such stockholders.
In most cases the merger must be approved by the boards of directors and stockholders of both corporations. While rarely exercised, stockholders of the acquired corporation who formally oppose the merger may “perfect dissenters’ rights” to have value of their stock determined by a judicial procedure involving an appraisal rather than accept the value negotiated as part of the transaction. As a result, many merger agreements give the buyer an “out” if more than a small percentage of the seller’s stockholders perfect their dissenters’ rights.
D.Variations. There are numerous variations on these structures, such as
•reverse triangular mergers, in which the buyer incorporates a subsidiary that merges into the target company, and
•two-step transactions, in which the buyer acquires a controlling interest in the target by a stock purchase, and follows that transaction with a merger in order to eliminate or “freeze out” the remaining minority stockholders.
E.Transaction Stages and Timing. The typical acquisition of a substantial business involves two preparatory stages from the seller’s perspective, followed by three key events for both buyer and seller. For a selling corporation, the preparatory stages are: (I) positioning for possible sale, and (II) marketing the company. For both buyer and seller, the three key events are: (1) a letter of intent or term sheet; (2) a binding definitive purchase or merger agreement; and (3) closing. In some cases, particularly those involving public companies or smaller targets, there may be no letter of intent, and the signing of the agreement and the closing may be simultaneous.
In most cases, completing a substantial transaction from LOI to closing in two months would be considered lightning speed, while a transaction completed in a heavily negotiated or regulated context may take six months or longer.


II.STAGE 1: THROUGH THE LETTER OF INTENT
A.The Business Transaction. The first step in an acquisition for the seller is, in an ideal world, the preparatory phase. This process is generally aided by investment bankers, lawyers, accountants, technical experts, and others. While a cold “out of the blue” proposal can be originated by a buyer, in the government contracting sector, transactions generally begin when the shareholders of the seller determine that they desire to sell and gain liquidity. In the optimum scenario, the seller engages an investment banking firm and explores the market, the realistic range of pricing that the seller can expect, and may involve strategic positioning such as spin-off or divestiture of unattractive contracts and lines of business to position the company for the best possible valuation in the eyes of buyers. Other preparatory phase tasks such as obtaining audited financial statements, legal structure clean-up, and implementation of other desirable “best practices” may be undertaken if time permits. Buyers generally value a company based upon expected future earnings, discounted for perceived risk, and accomplishment of this preparatory task can significantly reduce perceived risk. Because the value of many government contractors, particularly in the services sector, is in the people, goodwill, contracts and customer relationships that the seller has in place, it is desirable to have in place contractual incentives that ensure key personnel will remain in place. This is generally accomplished by identifying key persons and entering into agreements such as “stay-put agreements” and “change in control severance agreements.” These are of significant importance in the case of persons whose knowledge and expertise will be needed to consummate the deal, persons whose retention is essential to maintain the business pending the deal (and afterwards if a transaction is not consummated), and individuals whom the buyer will view as essential for post-transaction operations and success. The company should also evaluate the tax position of the sellers and determine which types of transaction structures maximize the after-tax proceeds to the sellers.
The next active stage is for the buyer and seller to define their respective goals in the transaction and to find one another. Once the company and its investment banker determine that the time is right to “go to market” (which may occur without much preparatory phase work if the market is hot and the seller decides that taking advantage of a hot market outweighs the value to be gained by completion of preparatory positioning and clean-up), the next phase usually involves the preparation of a “Book” which provides key summary information of sufficient detail to gain the interest of potential buyers and yet which can be circulated by the investment bankers to would be buyers without unduly jeopardizing company assets and proprietary information. Concurrently, the company will work with its investment banker, counsel, auditors and other advisors to collect and have available for diligence key documents, contracts and other information that a buyer will require be reviewed as a part of diligence. The seller will also want to prepare a form “non-disclosure/confidentiality agreement” that it will require prospective purchasers to execute prior to gaining access to the diligence material and key personnel. A “No-hire” or “non-solicitation” provision is also an important part of this agreement to prevent an interested buyer from identifying key people and then simply recruiting those individuals rather than buying the company. Would be buyers generally undertake preliminary “due diligence” investigation of the seller before any discussions of terms or negotiation of a letter of intent begins. Although due diligence at this stage is light compared to diligence post execution of an letter of intent, the quality and completeness of information disclosed at this stage can influence the buyer’s perception of “perceived risk” which in turn impacts price offers; thus, the seller should seek to put their best foot forward with respect to verifying reliable accounting and records to minimize perceived risk. The existence of multiple years of audited financials, demonstrable sound internal controls, and a strong compliance program can often persuade a potential buyer to raise a purchase price bid based upon lower perceived risk. Investment bankers play a key role in helping a company identify and screen potential buyers and narrow the field to a limited number for whom the company is a likely acquisition at a price range that will be acceptable. Often, investment bankers will conduct one or more rounds of an ad hoc auction among a group of interested buyers to select a single buyer for serious negotiations. This decision involves more than a mere price comparison, since individual sellers will have often have different preferences for transaction structure depending upon their own tax and business situation, and some of these may increase taxes for the sellers and produce a lower “net price” after tax. Once a buyer and seller are satisfied that the other is a good “match,” they begin to discuss the terms of the transaction, generally with a view to signing a letter of intent. We recommend that each party consult with counsel before committing to any specific form of transaction, and certainly before signing a letter of intent, for the reasons discussed below.
B.The Documentation. If an investment banker is retained, a preliminary step will be the negotiation and execution of the banker’s engagement letter. In addition, the parties will almost always sign a nondisclosure agreement before they exchange confidential information.
The parties’ first major step in the transaction is typically the execution of a letter of intent (or, in some cases, agreement on a signed or unsigned memorandum of understanding or term sheet). The letter of intent is a short document that is signed after the business people have reached an agreement in principle. In some cases an unsigned term sheet with similar content is used.
The letter of intent describes the most important elements of the transaction, including the type and structure of the transaction, price and form of consideration, payment terms and any key contingencies, such as the availability of buyer financing. The letter of intent does not obligate the parties to complete the transaction, though most letters of intent do include some additional terms that are binding. Those may include exclusivity agreements in which the seller agrees not to negotiate a sale with third parties for an agreed period of time, confidentiality agreements, and agreements that each party will be responsible for its transaction expenses. For government contractors in the service sector, the treatment of employees is also an important factor. Often a
buyer conditions an offer upon identified key employees' commitment to remain with the company for an extended period post closing or will require that shareholders and key personnel enter into non-compete, non-solicitation, employment or consulting agreements. If these people do not hold sufficiently large interest in the equity of the seller, then additional financial incentives may be required to induce them to make these commitments. In these situations, the buyer and seller should agree which party will bear the cost of securing these agreements as often buyers regard the cost to secure these agreements as part of the purchase price and subtract these amounts from the payment for shares. In rare cases, the letter of intent may call for the buyer to pay the seller a nonrefundable deposit or to put earnest money into escrow. A seller may receive a nonrefundable deposit (1) for granting an exclusivity period to the purchaser, during which period the seller will not negotiate with any other potential buyer, or (2) if the seller is in a particularly strong bargaining position, for the purposes of covering some of the seller’s costs in the transaction.
From both the business and the legal standpoint, the letter of intent should be taken almost as seriously as the definitive purchase agreement because it outlines the key elements of the transaction. Because the basic structure and terms of the transaction are established at this stage, it is essential that each party have a full understanding of the business, tax and legal ramifications of the proposed transaction before finalizing the letter of intent. Binding or not, the letter of intent tends to be viewed as “sacred” by the parties, who will be unlikely to agree to the modification of a basic provision set forth in the letter of intent, or to the addition of a new provision that is so basic that it would have been included in the letter of intent. Further, in some circumstances courts have held that even non-binding letters of intent create a binding obligation to negotiate in good faith based on the terms set forth in the letter. For the selling corporation, it is important to establish an outside date by which a definitive agreement is executed, after which date the seller is free to seek other buyers or to abandon the transaction. Failure to include such a provision can create an uncertainty as to contractual obligations that can hinder subsequent efforts to seek an alternative buyer if the transaction is not closed with the first identified buyer on the anticipated schedule.
To the extent that key third parties will be required to negotiate agreements (such as noncompete or employment agreements) as part of the transaction, the seller and buyer may want to negotiate their agreement to key terms and joinder at this stage to lessen the likelihood of a strong-arm “holdout demand” for additional consideration in the final stages.
Perhaps the most important impact of a well prepared letter of intent is psychological. Because the parties have signed their names to a proposed transaction, they tend to be committed to its conclusion. The letter of intent gives them the confidence needed for them to invest the substantial time and money involved in pursuing the transaction. It helps maintain the parties’ commitment during the ensuing detailed negotiations and establishes the broad context in which the details can be put in proper perspective. For these reasons the letter of intent generally should be confined to the true essentials of the transaction.
C.Regulatory Matters. Regulatory contacts with the transaction may be (1) affirmative, (2) negative, or (3) informational.
Affirmative regulatory contacts require agency approval prior to closing. For example, a buyer may not purchase or operate a bank, radio station or nuclear power plant without having the relevant government agency issue the necessary approvals. Similarly, prior government approval may be required before governmental permits may be transferred or government contracts may be novated (in an asset sale).
A negative regulatory contract requires a filing with the relevant agency, with the closing permitted if the agency does not act to delay or stop the transaction within a specified time period. The most common example is the Hart-Scott-Rodino pre-merger notification requirement, which requires notice to both the U.S. Federal Trade Commission (FTC) and the U.S. Department of Justice (DOJ) of proposed acquisitions of businesses valued in excess of $63 million (amount is adjusted annually for inflation). The filing provides extensive information designed to enable the antitrust enforcement agencies to evaluate any anti-competitive implications of the acquisition. If neither the FTC nor the DOJ requests additional information or attempts to stop the acquisition within the specified time period (usually 30 days or 15 days in the case of a tender offer), then the transaction may proceed, with the closing occurring after the waiting period is over or is terminated early.
The Exxon-Florio amendment to the Defense Production Act operates similarly. It provides for a voluntary filing made by non-U.S. companies acquiring control of U.S. assets or voting securities when the acquisition could have an adverse effect on U.S. national security. If cleared, the transaction may proceed without concern for its national security implications.
Finally “informational” regulatory contacts are illustrated by examples such as (1) the filing of notices of the issuance of unregistered securities with the SEC, (2) appropriate notifications under NISPOM if the company has a facility security clearance, performs classified contracts or employees cleared personnel, and (3) the Department of Commerce survey of foreign investments in the United States (administered by the Bureau of Economic Analysis), which requires the submission of rather detailed and ongoing reports of foreign investment over a certain size in U.S. business enterprises.
These are only a few examples of the many regulatory contacts that may affect an acquisition. Even those contacts that are “informational” should be taken seriously, however, since failure to comply may constitute a civil or even criminal offense.
Typically, regulatory approvals are not sought until after the letter of intent or definitive agreement is signed. However, to the extent that a waiting period is involved, the parties may wish to make the required regulatory filings as soon as the letter of intent is signed so as to get the waiting period to start running. Most sellers, however, will resist any public filings until the definitive agreement is signed, in order to avoid publicity and the resulting uncertainty among customers, suppliers, employees and others. To the extent that regulatory approvals will be difficult to obtain, the parties should work closely together to establish an approval strategy, and may wish to provide in the letter of intent for the eventuality of a failure to obtain, or delays in obtaining, the necessary approvals.

III.STAGE 2: THROUGH THE DEFINITIVE PURCHASE AGREEMENT
A.The Business Transaction. After the letter of intent is signed, the buyer usually commits substantial additional resources to its business, legal, accounting, and other “due diligence” investigation of the target company. This investigation serves two purposes. First, it should satisfy the buyer that the target company has the desired attributes. Second, it should develop facts sufficient to enable (1) the buyer to negotiate the definitive purchase agreement (such as the seller’s representations and warranties), and (2) both parties to agree on any important terms not detailed in the letter of intent. If the company has unaudited financials, weak accounting policies and practices, lacks solid internal controls or a quality compliance program, the buyer will often undertake extraordinary diligence to reduce risk since legal recourse to the sellers or an indemnification fund, while providing a means of compensation, is always an undesirable outcome and, if the sellers are continuing in employment, can sour a relationship and ultimately cost far more than any indemnification recovery.
Due diligence is usually multi-faceted and tailored to the particular situation of the seller. The buyer may commission a valuation of the seller or certain key assets. The lawyers will review minute books and charter documents, the issuance of securities, key contracts and loan documentation, governmental permits, employment and benefit practices and matters, pending litigation, environmental proceedings, and other fundamental legal matters affecting the seller’s business. The accountants will investigate the target’s financial statements, accounting practices, federal, state and local tax compliance, inventories, receivables, billing and time keeping practices, cost allocation practices, internal controls, etc. Other experts, such as environmental engineers or technical specialists, may make inquiries appropriate to the particular transaction. To the extent that the company is responsible for valuable government furnished equipment, the buyer may want to reconcile records with actual inventory. The buyer will also want to review the company’s contracts with its existing contracts to identify any potential organizational conflicts of interest that might arise post closing.
Most of the due diligence is performed by the buyer because, especially in a cash deal, the seller’s only due diligence is likely to be an evaluation of the buyer’s ability to pay the purchase price and to fulfill any ongoing commitments made to the seller. If the seller will receive stock or purchase money debt of the buyer as consideration in the transaction, the seller will likely choose to perform due diligence on the buyer, which could be as extensive as the buyer’s due diligence investigation of the seller.
In parallel with the due diligence process, during this stage the parties also fine-tune the structure of the transaction, negotiate and draft the purchase agreement and any ancillary agreements, and prepare to file any required regulatory filing that will be a part of the transaction.
B.The Documentation. The definitive agreement sets forth in binding form the full terms of the acquisition. When it is signed, the parties are obligated to complete the transaction, subject to various conditions to closing, such as obtaining any required stockholder, regulatory or third party approvals. Most definitive agreements also provide for a number of other, ancillary agreements and documents. These may include promissory notes, security agreements, bills of sale, noncompetition and employment agreements, escrow instructions, officers’ certificates, legal opinions and others. Generally, the forms of these ancillary agreements are negotiated and attached to the definitive agreement, but they are not signed until closing.
The negotiation and drafting of the purchase agreement is substantially affected by the due diligence investigations. For example, if the buyer discovers a material contingent liability not previously disclosed, it may negotiate a reduction in purchase price or a specific indemnity to cover the liability.
The content of the definitive agreement will vary greatly with the transaction, but the basic elements of a typical agreement include: (1) the specific identities of the parties (including any new companies formed for purposes of the transaction), (2) an exact description of what is being sold, (3) an exact description of the price, payment terms, possible provisions for contingent or earnout components of the purchase price, and usually provisions for a post closing audit and reconciliation of closing financial status with a target value (net equity, net working capital, or another negotiated benchmark or benchmarks), (4) lengthy and detailed representations and warranties of the parties (such as accuracy of financial statements, condition of assets, payment of taxes and many others), accompanied by a series of detailed disclosure schedules, (5) each party’s agreement as to its conduct up to and beyond the closing (such as the seller’s agreement to conduct its business in the ordinary course without unusual transactions), (6) conditions that must be fulfilled before either party is obligated to close, (7) details as to the time and mechanics of closing, provisions for possible extension if required to satisfy delineated conditions to closing, and the terms under which either party may opt out and terminate the agreement rather than close, (8) indemnities related to breaches of the agreement or the representations and warranties, (9) dispute resolution provisions, and (10) miscellaneous clauses relating to various aspects of the parties’ legal relationship.
At the signing of a definitive purchase agreement that provides for a later closing, executed copies of the agreement are exchanged by the parties together with any other documents agreed to be signed at that time. Such documents might include an escrow agreement and signed escrow instructions that govern the conduct of the closing.
C.Regulatory Matters. Depending upon the type of regulatory matters involved and the time required for each (some approvals may take several months), work begins in earnest in this area. It is typically after the execution of the definitive agreement that the agencies involved will be contacted and the regulatory applications will be prepared and filed.
IV.STAGE 3: TO THE CLOSING
The closing is the consummation of the transaction – the purchase price is paid, ownership is transferred to the buyer, and final versions of the various ancillary agreements and documents are signed. Closings often involve numerous steps, not only including the exchange of paperwork but also wire transfers, governmental filings, issuance of press releases, and others. Asset acquisition closings tend to be especially detail oriented – for example, an asset acquisition of a company owning facilities and vehicles would involve a separate instrument of transfer for each of them, with a deed recorded for each parcel of owned real estate and the title to each vehicle transferred.
A.The Business Transaction. At this stage, the buyer performs its final due diligence on the seller. A typical condition of closing is that all representations and warranties are true at the time of closing and that no “material adverse event” has occurred. In the event the buyer discovers a material problem in the course of its investigation, it may have an “out” and refuse to close. In many cases, however, when a substantial deviation from the representations and warranties or an “MAE” occurs, the buyer will threaten to abandon the transaction only to provide the necessary leverage to negotiate a reduction in price or some other concession.
In addition to completing its due diligence, the buyer will become progressively more knowledgeable about the operations of the target company with a view to conducting a smooth closing and management transition – substantial preparation will be required in numerous areas from HR to IT. That said, for risk management purposes, in most cases the buyer should carefully avoid actively taking operational control pre-closing. The buyer may also make final arrangements for its financing and attend to other closing matters.
B.The Documentation. Any unfinished documents necessary for closing will be negotiated and prepared, such as title documents and officers’ certificates. All of the details of closing will be addressed. Final director or stockholder approval, as appropriate, will be sought at this time, and preparations will be made for the provision of tax opinions, legal opinions, “bring down” certificates, and other documents to be delivered at closing. The seller will also be arranging for any necessary third-party consents to the transaction (such as landlord or lender consents) at this time – often a detailed and time-consuming exercise.
At the closing, the parties will exchange all cash, stock and documents required under the agreement, such as notes, stock certificates, financing statements, bills of sale, deeds, etc. Legal opinions may be presented and any other conditions to closing satisfied, such as proof of necessary regulatory approvals, or a certification that the applicable waiting period has expired.
C.Regulatory Matters. If not already undertaken, regulatory contacts are now actively pursued, since closing is typically conditioned on the receipt of the necessary approvals and/or the expiration of the appropriate time periods. The date of closing itself is frequently set as the day after final regulatory approval is received, or the day after the expiration of a waiting period.
V.STAGE 4: AFTER THE CLOSING
Promptly upon closing, all security interests should be perfected by filing or recording, and any after-the-fact informational filings, such as those required by the Department of Commerce, Defense Security Service under the NISPOM, or the SEC, should be made. Thereafter, the parties will monitor any ongoing obligations under the various agreements, such as performance under commercial agreements, earn out results and payments, interest or principal payments, and covenants not to compete. Should a claim for indemnification or of a breach of contract arise, the parties will resort to any dispute resolution provisions included in the agreements or, if necessary, to the courts.
Most importantly, the hard work of integrating the businesses of the buyer and the seller will begin in earnest. Experienced buyers know well that the real work of making the deal a success has just begun!

Robert Webb
rwebb@ssd.com
+1.703.720.7855