What will be written in the M&A documents in 2023 in IT sector
Based on the M&A transactions of 2022 in IT sector, the lawyers of the M&A in the IT practice of REVERA law group have summed up below the most popular legal provisions of 2022 which are going to be widespread in 2023 as well.
The new investment rounds represent a fundamentally important issue for both parties and, therefore, are problematic for negotiation. On the one hand, the first investor is afraid that his share will be diluted and he will lose his initial corporate rights due to the entry of a new investor. Therefore, the first investor wants to control the attraction of new financing. On the other hand, the founders are afraid that the first investor may block a new investment round and, consequently, the growth of the business.
Anti-dilution protection can be a solution to this problem. Anti-dilution is used in down rounds when a new investor enters the company at a valuation lower than the previous investor. This provision does not give the investor the right to block the new financing, but in the case of a down-round, the previous investor will be able to "adjust" the size of his share to the company's new valuation.
There are two ways to recalculate the previous investor's share:
- (a) On a weighted average basis. This method is more favourable for the founders. The new price for 1% of the previous investor's share will be calculated as the arithmetic average between the price for 1% in the old and new rounds.
- (b) On a full rachet basis. This method is more favourable for the investor. The new price for 1% of the previous investor's share will be the same as for the new investor. That is, the shareholding of the previous investor will increase significantly.
Antidilution provision was widely used in 2022 M&A transactions because many investors expect a future decline in the company's valuation, taking into account the general recession. That is, the risk of a down-round has increased. Therefore, investors now require a mechanism for recalculating their shares to be included in transaction documents.
Another provision that investors frequently use is liquidation preference. Despite its name, it is intended rather not for liquidation (although this one, too) but for the company's sale. This provision gives the investor the right to a priority return of their investment upon certain conditions. It guarantees that the investor will not lose his financing and receive the investments back.
The following points shall be negotiated if the liquidation preference is included in the transaction documents:
- (a) What is considered the liquidation events, that is - the cases when the investor may exercise his right to receive liquidation preference. For example, liquidation, reorganization, sale of the company, sale of its main assets, and change of control.
- (b) Which sums are included in liquidation preference (e.g., cash-in investments only, cash-in and cash-out investments, unpaid dividends). It is often argued that only cash-in (that is – the money that goes specifically to the company) shall be included in liquidation preference, however, this is a debatable issue, so it is important to clearly establish this in the transaction documents.
- (c) How is the initial investment sum multiplied? For example, 1x multiple means the investor will receive the same sum he invested in the company. But there are also other multiples: 0.5x, 1.5x, 2x, and higher.
- (d) Is liquidation preference non-participating or participating? With non-participating liquidation preference, the investor shall choose one option: either receive the amount of his initial investment sum back or participate in the distribution of profits from the sale of the business with other shareholders on a pro-rata basis. With participating liquidation preference, the investor does not have to choose: he has the right to receive both sums simultaneously
Put-option and call-option
Investors are generally ready to invest but provided the founders will be held responsible for certain violations. Usually, penalty fines are used for this. For example, the investor may include in the transaction documents provisions that in the event of a violation of the lock-up (obligation not to alienate shares), non-competition or non-solicitation, the founders will have to pay a fine to the investor. Fine’s size, as a rule, depends on the amount of investment - the higher the investment, the higher the penalties, respectively. According to the experience of 2022, investors demanded rather high fines.
Alternatively or additionally to the fines, penalty options may be used.
Put-option: Put-option allows the shareholder to fully exit from the company under predetermined unfavourable circumstances. Upon such circumstances, the shareholder exercises the right to "sell back" his shares to the other shareholders (or a specific shareholder) at an agreed price. For example, an investor can use this right if the company loses intellectual property rights (for software, game, trademark, etc.). In this case, the business may lose its attractiveness to the investor, and he will want to exit it, demanding that the founders buy out his shares.
Call-option: A call option gives the shareholder the right to acquire shares of another shareholder, that is, to demand that another shareholder sells him his shares. For example, the investor can use this right as a "penalty" for a violation by a founder of non-competition or non-solicitation obligations. If the founder violates these obligations, the investor can demand that the founder sells his shares (or part of the share) to the investor.
This provision obliges founders to indemnify investors for property losses when certain events occur. For example, when the company receives claims from third parties for violating intellectual property rights.
Losses typically include:
- costs for solving the problem;
- negotiation costs;
- consultancy costs;
- litigation costs;
- decrease in the value of the investor's shareholding in the company.
The following points shall be negotiated if the indemnification is included in the transaction documents:
- (a) The limited time period during which compensation claims can be brought.
- (b) The minimum threshold from which an investor can claim an indemnification. This limit serves as a filter against minor claims from the investor.
- (c) The maximum threshold of indemnification amounts. There may be several such thresholds at once. For example, the parties may agree that if the claims are related to tax issues, the seller's liability limit for them will be 20% of the transaction amount, and in the case of claims from third parties regarding intellectual property rights – 100%.
In summary, despite the recession, the tech industry actively attracts investment. At the same time, investors pay great attention to the provisions allowing them to protect their investments and secure the responsibility of the founders for possible violations. The founders should remember that almost all M&A provisions can be balanced for both sides. In response to the investor's requests, it is usually possible to negotiate restrictions, limits, exceptions, and mirror mechanisms to achieve win-win solutions and feel relatively free and comfortable in relations with the investor.