M&A, Antitrust and The Board Room in 2017: Challenges and Conundrums for the West Coast
January 30, 2017
We were glad to see over 195 of you in San Francisco a month ago for the lively discussions on “M&A, Antitrust and The Board Room in 2017: Challenges and Conundrums for the West Coast.”
The event included senior personnel from in-house corporate development and legal teams, law firms, financial advisory and investment banking firms, proxy solicitors, and shareholder engagement consultants, as well as the Chief Justice of the Delaware Supreme Court, the Chief Economist of Google, the investment director at CalPERS, former senior officials from Federal Trade Commission and the U.S. Department of Justice, the author of the bestseller Chaos Monkeys, and professors from a number of graduate programs, including the University of California, Berkeley School of Law and the Berkeley Center for Law, Business and the Economy, the event’s co-sponsor with Cleary Gottlieb.
Below are images and key takeaways from the day’s discussions.
Session 1: The Future of Competition in the Tech Industry
The first session featured contributions from:
- Richard Gilbert, Professor at the University of California, Berkeley and Former Deputy Assistant Attorney General for Economics at the DOJ-Antitrust Division;
- Nancy Rose, Professor at the Massachusetts Institute of Technology and Former Deputy Assistant Attorney General for Economics at the DOJ-Antitrust Division;
- Carl Shapiro, Professor at the University of California, Berkeley and Former Deputy Assistant Attorney General for Economics at the DOJ-Antitrust Division;
- Howard Shelanksi, Administrator of the U.S. Office of Information & Regulatory Affairs and Former Director of the Bureau of Economics at the FTC; and
- Hal Varian, Chief Economist at Google, Inc. and Former Dean of the School of Information Management and Systems at the University of California, Berkeley.
Facilitated by Cleary partner George Cary, a former Deputy Director at the FTC, the session focused on future trends in technology and what those trends mean for competition, the U.S. antitrust enforcement regime, and deal-making going forward.
The session kicked off with a discussion of the trends and mega-trends in technology. The panel discussed the advent of multiple data centers and cloud computing, “micro-multinational” small firms with access to the vast computing structure, outsourcing, and recent breakthroughs in machine learning, including voice recognition and interaction, accurate image recognition, deep learning, and real-time translation services. The panel discussed how the world of fantasy is quickly becoming reality. The panel also noted the impact of non-humanoid robots on job productivity, with ten of the top job categories in the U.S. capable of being enhanced by the provision of computer services and advances in technology. The panel discussed the intense level of competition amongst large internet platforms, such as Google, Amazon, and Apple.
The panel then turned to the issue of automation in pricing and “virtual competition”—where pricing algorithms gather information online and make decisions—and what it means for competition under the antitrust laws. Two questions were posed: Does virtual competition result in more competitive outcomes or to more coordination among rivals in a way that the Sherman Act did not anticipate? What does automated pricing mean for consumers?
The panel discussed that in the online world, firms have the ability to move faster than consumers. As soon as one firm cuts its price, competitors quickly follow, which reduces incentives for cutting price. Similarly, incentives for raising price have been enhanced because interaction with competitors is ongoing.
The panel also discussed price discrimination within the context of pricing algorithms. Price discrimination may be advantageous to consumers if it expands output for consumers unwilling to pay the profit maximizing price, if the seller were only able to provide a single price to the market. Price discrimination may also disrupt the tacit collusion among firms that otherwise might emerge from greater transparency in pricing as a result of online shopping platforms. The panel also noted that the underlying structure of the platform affects whether pricing algorithms and price discrimination will undermine consumer welfare. The number of platforms in the market will make a difference in how well these mechanisms work. Lastly, the panel discussed versioning, which allows firms to create product lines that appeal to different market segments. With versioning, many, if not most, consumers are better off.
The panel next discussed the role of innovation concerns in competition and enforcement analyses. One panelist expressed surprise that innovation has been so slow to earn a place in merger enforcement under the antitrust laws. In the past two decades, harm to innovation has become a significant antitrust concern. The panel debated the role of innovation in merger challenges and expressed differing views on whether innovation should be addressed as a merger “efficiency” or as a (pro)competitive effect. The panel noted that the key question is whether the two firms are likely to produce competitive products or compete with one another in the future. In the technology sector, it can be challenging to define what is happening in the pipeline, making it difficult to assess whether two companies are going to compete in the future. The panel expressed a need for more research into empirical evidence of the impact of industry consolidation on innovation, rather than broad, and often ambiguous, economic theory.
The panel discussed the competitive implications of acquisitions of small tech companies by large platform companies with strong positions and high market shares. The panel discussed advice for companies in this situation. The panel noted the importance of not disincentivizing large companies from “jumping into” new spaces by precluding them from acquiring start-ups thereafter. These procompetitive incentives must be balanced against the concerns of the DOJ and FTC that large companies will acquire small competitors, along with their disruptive technology, to keep them from becoming future threats. When the acquisition is vertical with respect to the acquirer’s main line of business, the deal usually is approved. However, in an area where the large tech company may eventually be able to enter, the agencies may express more concern about the elimination of potential competition. The key question posed by the agencies is how many other entrants are there into the market that are equally well positioned to compete. One panelist suggested that the concern is more with potential competition and foreclosing vertical markets than about innovation. The panel mentioned that we are seeing intense competition in areas of disruptive technology, for example with Amazon Echo, Alexa, and other “smart home” technologies.
Lastly, the panel addressed their predictions for the next 5-10 years. One panelist responded: “technology changes, but economics does not.”
Session 2: Evolution of Start-up M&A
The second session featured contributions from:
- George Boutros, CEO, Qatalyst Partners;
- Stephanie Brecher, General Counsel, New Enterprise Associates (NEA);
- Antonio García Martínez, author of New York Times bestseller Chaos Monkeys: Obscene Fortune and Random Failure in Silicon Valley;
- Don Harrison, Head of Corporate Development, Google, Inc.; and
- Doug Parker, Senior Vice President, Corporate Development, OpenText Corp.
Facilitated by Cleary M&A partner Ethan Klingsberg, the panel discussed key issues in the evolution of tech M&A.
A candid discussion of the rationale and irrationalities of the acqui-hire eco-system
The session commenced with a discussion of the acqui-hire eco-system. Using a baseball analogy, the panel explored how the prospect of acqui-hires have created a structure akin to a minor league farm system of prospective talent funded by VC and angel money. When the big league teams want to bring minor league prospects up to the majors, rather than just signing up the individuals, they pay a fee to the sponsors of the minor league system – i.e., the VC and angel investors – and the structure used for this payment is an M&A transaction where the equity of the start-up company is purchased even though, in many instances, the target company has negligible historical net income and no contracts guaranteeing future cash flow and may well be barely solvent. The panel discussed with candor the concept of M&A as a talent scouting mechanism that is an extension of the HR function.
The session then engaged in debate over the benefits and justifications of paying high purchase prices in M&A transactions for start-up teams who purportedly allow large and mid-cap public companies to reinvigorate themselves on an accelerated basis. The session questioned whether M&A transactions were the optimal way to nurture and develop talent, and explored how some large companies may have more success taking their own developers from within who already know their current products and the culture.
The session went on to discuss various ways to evaluate acquired the benefits of a potential acqui-hire and the tactics employed by private technology companies to get the attention of strategic acquirors.
The session discussed the fact that retention is a challenge after acquisition, with most talent leaving in less than two years, and discussed a number of ways to build bespoke compensation packages to incentivize retention.
Allocation of consideration among different constituencies
The session next turned away from acqui-hires to discussing issues pervasive for all acquisitions of private tech targets. First up, was a discussion of how to allocate the enterprise value among stay bonus pools, single trigger ‘sale of business’ bonuses, post-closing milestone payments, and closing date merger consideration to equity holders. , The panel emphasized how and why different venture capital funds and angel investors have different levels of tolerance for different terms for sales of their portfolio companies, including the extent to which merger consideration to the VC sellers may be tied to the execution of offer letters by an extended list of key employees by the closing date and their continued employment through the subsequent anniversaries of the closing date. The panel engaged in a nuanced and frank exploration of the role of social capital and relationships on determining the allocation of the enterprise value.
In addition, the session explored how the growing number of investors in common stock of private tech companies has led to a growing tension with boards of these companies that are typically dominated by VC holders of preferred stock. The panel delved into the subject of the waterfalls of rights to merger consideration contained within charters and how to navigate these tensions in a manner that minimizes legal exposures while not impeding transactions.
Valuation of tech targets
The session then turned to a discussion about how to approach valuation and what valuations metrics make the most sense. The financial advisor experts on valuation and Delaware cases regularly rely on two paradigms for determining what price is fair: 1) DCF and variations on DCF through multiple analyses, sum of the parts analyses and future share price analyses, and 2) prices determined by a market check. But neither of these approaches may make sense for the boards of either a strategic tech acquiror or a private tech target when evaluating whether the purchase price is fair, because future cash flows are highly speculative with all of the value in the far-out terminal year and there is rarely a meaningful market check.
The session tackled this issue by first recognizing the disconnect between how the buyer and seller value the target company. The seller, in theory, is looking at the value of what the company can deliver and achieve if it does not sell and what can be delivered to stockholders on risk adjusted basis. This exercise for sellers regularly gets bogged down in out-year speculation, although the panel did explore ways for the management and boards of private tech companies to evaluate their business model and ability to execute in ways to make this approach to valuation have a thoughtful foundation. By contrast, the big league tech company acquiror is typically looking at what that value will be based on the buyer’s unique ability to integrate, accelerate and realize the promise of the target company’s business as part of buyer’s existing, relatively short-term business plan. Against this background, where the buyer’s vision for value may well be more precise and well-grounded, the session ended up focusing on the importance for private tech targets to focus on precedent transactions as an indication of value. The session acknowledged the challenges of this approach. The session explored the difficulties and variables relevant to the determination of what metrics and multiples to use in a precedent transactions analysis and whether any of these former transactions really are comparable. At the very least, it was noted, the precedent transactions analysis can provide a nice sanity check or, put more cynically, a justification for continued irrationality.
The session then explored further the acquiror’s dilemma of buying vs. building a new tech product and the relevancy of timing. The session shed helpful light on the frequency with which buyer’s underestimate how much it will cost and how long it will take to turn a target’s product into what buyer envisions and the difficulty of being able to properly diligence this risk.
M&A vs. another round of financing
The session concluded by discussing when a private tech company should decide to forego a sale of the company and opt for another round of financing or an IPO instead. The session quickly moved beyond a discussion of the immediate value of an M&A exit vs. the longer term prospects of another IPO or financing round and delved into how the decision is typically driven not just by appetite for risk, but by pure economics of the investors. The session explored in particular how some of the extremely high valuations for some financing rounds in recent years has led to situations where these later round investors are forcing companies to continue to go-it-alone based on questionable long-term forecast rather than accept what would have otherwise been a very attractive and certain-value in an M&A exit.
The session addressed further the degree to which the M&A exit for start-ups helps vs. hinders the development of competition and long-termism relative to further rounds of equity financing and concluded with an interesting discussion of the current state of the relationships between VC funds and large-cap tech companies in coordinating sales of private companies.
Session 3: M&A in the Board Room and the Courts
The third session featured contributions from:
- Randy Baron, Partner at Robbins Geller Rudman & Dowd LLP and the lead counsel on Del Monte and Rural Metro and in the pending Good Technologies lawsuit;
- Lisa Coar, Managing Director, M&A Group, Goldman, Sachs & Co.;
- Steven Davidoff Solomon, New York Times “Deal Professor,” Professor of Law and Faculty Director of Berkeley Center for Law, Business and the Economy;
- Jill E. Fisch, Professor of Law and Co-Director of the Institute for Law & Economics at the University of Pennsylvania Law School;
- The Honorable Chief Justice Leo E. Strine, Jr. of the Delaware Supreme Court.
Facilitated by Cleary litigation partner Meredith Kotler, the panel focused on director independence and good special committee processes.
The session began by reviewing case law regarding director independence, including the implications of the Delaware Supreme Court’s recent opinion in Sandys v. Pincus, where the court determined that certain directors of Zynga Inc. were not independent for the purposes of considering a demand because of personal and professional connections to the controlling stockholder, including, in one instance, shared ownership of an airplane. The session agreed that owning an airplane is an unusual tie, and acknowledged that generally these determinations will not be so clear cut. The session emphasized that the inquiry into director independence under Delaware law is fact- and context-specific. The session encouraged advisors to be skeptical, and view these potential conflicts as if reading about them in a newspaper article about another company.
After discussion of the latest thinking about director independence, the following practice points emerged:
- At least annually, have directors complete questionnaires drafted in manner that is sufficient to permit an objective assessment of director independence, and consider re-circulating these questionnaires off-cycle if the company has a material transaction on the horizon.
- If these questionnaires reveal relationships and interests that may implicate independence, the inhouse legal department should be asking follow up questions to determine more information about these relationships and interests. It will be important to be obtain information that will permit the board’s evaluation of independence to be sensitive to nuances – e.g., going golfing a few times a year is a different relationship than renting vacation homes together.
- Expect plaintiffs’ counsel to use internet search engines to check for indicia of a lack of independence. Corporations should do the same as a secondary way to check whether directors have relationships and interests that merit further consideration.
- Be willing to have hard conversations with people who have been on the board together a long time to determine whether they can still be independent.
- Consider whether it might be appropriate to set up a standing litigation committee consisting of independent directors to avoid the situation faced in Sandys v. Pincus.
The session recognized that there are many instances where directors will have relationships or interests in connection with the matter before the board that differ from stockholders generally, but these directors may nonetheless have knowledge or expertise that is important to the matter being considered by the board and how in such situations the key is to assure that these directors are not dominating the process.
The session explored how the dynamic nature of the scope of technology companies and their strategic plans often leads to overlaps between entities that were not foreseeable only a short time earlier. The session highlighted the importance of disclosing these relationships to the full board as far in advance as possible so that the legal department at the corporation may take appropriate action to assure these conflicts are managed in a way that preserves the integrity of the board processes and disclosed to stockholders where material. The session then discussed the interplay between the need to discover and disclose this information to stockholders and the developing jurisprudence in the Delaware courts that permits claim extinguishment as a result of a fully informed, uncoerced stockholder vote.
The session continued with a discussion about the ways in which capital structures associated with start-ups and venture capital funding can create conflicts of interest. Members of the panel debated protections for equity from prior rounds that might be squeezed out later in a down round.
The session concluded by discussing the criteria for good special committee processes and how these criteria vary depending on the nature of the conflict that the special committee process is formed to avoid or overcome and the type of transaction or determination that the special committee will be addressing. The session deliberated about:
- the appropriate timing for putting a special committee in place,
- how to evaluate the adequacy of the independence of the directors appointed to the committee,
- the proper scope of the mandate of a special committee in different situations,
- the role of the financial advisor to the special committee,
- the role of inhouse counsel in connection with a special committee,
- the potential differences between in-person and telephonic meetings from a fiduciary duty perspective, and
- the optimal approach to the preparation of minutes.