Boilerplate clauses – usually tucked away at the back of the contract – can seem dry and legalistic. But for high-tech companies, the wrong boilerplate clause in an IP contract can affect the valuation of the company. Two clauses – assignment, and change of control – are of particular significance.
Young, technology-based companies have a habit of running out of money. For financial and strategic reasons, a company may need to be able to react quickly to corporate opportunities, including mergers, acquisition, joint ventures, trade sales and stock market flotations. When doing so, it will need to demonstrate its market value.
The value of such a company may be based largely on the products that it has in development. In turn, this value can depend on two main assets: (1) intellectual property (IP), and (2) contracts affecting the development of the IP, including R&D agreements, consultancies, IP licences, option agreements, and so on.
If the IP contracts do not “survive” a corporate transaction such as an acquisition, they have no value to the acquirer. If the IP contracts are central to the value of the company, this may mean that the company has no value. When the acquirer’s lawyers conduct due diligence on the target company’s important contracts, the assignment and change of control clauses will be scrutinised closely.
There are two main ways in which a business can be sold. Either the shares in the company are sold, or the assets of the company are sold. The practical effect of each of these routes may be similar; which route is chosen may be based partly on an assessment of tax and liability issues.
In the case of an asset sale, the company’s IP contracts may need to be transferred to the buyer. An assignment clause in a contract states whether a party has the right to assign or novate the contract to a third party. Sometimes, the clause will permit transfer of the contract to a purchaser of the business. The acquirer in an asset sale will hope to see such a clause. In the absence of such a clause, and depending on the law of the contract, it may not be possible to transfer the contract to the acquirer.
Some form of assignment clause is often seen in a detailed commercial contract. Less commonly seen, but just as important, are change of control clauses. Typically, a change of control clause will state that a party may terminate the contract if there is a change of control of the other party. “Change of control” is usually defined in such circumstances, and typically will include the situation where a person acquires a majority of the shares of one of the contracting parties.
The presence of a change of control clause in a valuable contract may act as a “poison pill” in the event of an acquisition of the shares of a contracting party. In other words, the contract may have no value to the acquirer, if it can be terminated on a change of control.
At the time of negotiating important IP contracts, it is not always easy to persuade the other party to include a suitable assignment clause and to omit an undesirable change of control clause. In this blogger’s experience, the negotiating discussion is different, depending on the type of counterparty one is dealing with:
- If the other party is a young, high-tech company, it may understand the issue and readily accept the need for appropriate provisions.
- If the other party is a large, multinational company, it may understand the issue but its sympathy for the issue may be unpredictable. Sometimes it will be concerned about the IP contract being acquired by one of its competitors. We have been involved in negotiations where a change of control clause has been included but limited to situations involving another multinational company
- If the other party is a family-owned business, whose ownership has stayed in one family for generations (this type is encountered in some parts of Europe), there may be little understanding of the issue, and a lengthy discussion may be required
- If the other party is a Government body or charity, it may be concerned about transfers to an “undesirable” company. For example, cancer research charities are unwilling to allow transfers to a company that has tobacco interests.
Parties sometimes leave discussion of boilerplate clauses to the final stages of their negotiations, and they are sometimes surprised at the amount of effort that is required to reach agreement on seemingly innocuous boilerplate provisions.
After a posting of this kind, there is inevitably a plug: readers who wish to be well-prepared for such discussions will have read our book, A-Z Guide to Boilerplate and Commercial Clauses(Bloomsbury, 2nd edn, 2006). The book includes discussion of legal, drafting and negotiating issues in respect of a wide range of boilerplate clauses.
A company’s key contracts represent a valuable business asset. Thus, it’s crucial that the contracts remain in force as a business changes hands from the seller to the buyer when the business is sold.
Asset Sales and Equity Sales
Although deal lawyers generally describe their practice as involving “mergers and acquisitions,” the sale of a small or medium-sized business is usually structured as either an equity sale or an asset sale. In an equity sale, the buyer buys the equity from the owner(s) of the target company — stock in the case of a corporation and membership interests in the case of a limited liability company. The business is transferred to the new owners, corporate or limited liability company entity and all, and the target becomes a wholly-owned subsidiary of the buyer. There is no change in the status of the target entity itself, and its contracts, assets, and liabilities remain with the entity.
In an asset sale, specified assets are transferred from the target company to the buyer, while the corporate or limited liability company entity remains in place and continues to be owned by its equity holders. The assets transferred might be all or substantially all of the target’s assets, or they might be more limited in scope. Similarly, some or all of the target’s liabilities might be transferred to the buyer or retained by the target company, although most of the liabilities often stay with the target. The contracts of the target company are transferred to the buyer by assigning the contracts to the buyer.
It is common for commercial contracts, leases, and other agreements to include anti-assignment provisions. In addition, bank credit agreements, distribution agreements, and other agreements often contain change of control provisions. It is important for the buyer and seller to review the target’s material contracts early in the transaction process to determine whether such provisions exist.
In an asset sale the target’s contracts are transferred to the buyer by means of assigning the contracts to the buyer. The default rule is generally that a party to a contract has the right to assign the agreement to a third party (although the assigning party remains liable to the counter-party under the agreement). However, contracting parties often want to have the right to control who they do business with, so they include a clause in their contracts that prohibits the counter-party from assigning its rights or delegating its responsibilities under the agreement absent prior written consent.
These provisions pose a problem in the context of an asset sale. Because the target doesn’t have the right to assign a contract containing an anti-assignment clause absent its counter-party’s agreement to permit the assignment, the target is dependent on the counter-party’s willingness to agree to the assignment. The failure to obtain consent to assign a material agreement could jeopardize the transaction as the buyer is likely to refuse to close if it won’t receive the benefit of a contract that is important to the business.
The process of obtaining consents can be time-consuming and should be started at the earliest practical moment. It’s not unusual for a counter-party to extract some value in exchange for agreeing to the assignment. Sometimes the counter-party is somewhat opportunistic and sees an opportunity for a windfall. In other cases, the need for the target to obtain consent for assignment is an opportunity for relief from a disadvantageous agreement. In such cases where the contract is advantageous to the target (e.g., if the target is able to purchase products from a supplier at prices below market under a long-term supply agreement because it locked in low prices and the market prices have subsequently risen), the counter-party will often be unwilling to consent to the assignment of the agreement absent concessions.
The need for obtaining consents from counter-parties is often obviated in the context of an equity sale, because equity sales don’t require the assignment of contracts to the buyer. In an equity sale the target’s assets, including its contracts, are not transferred to the buyer; rather, the entire corporate or limited liability company shell is transferred to the buyer with its assets and liabilities remaining intact. Sometimes the only way to accomplish a transaction is to structure it as an equity sale if it’s not possible to obtain agreement to assign a crucial contract.
Change of Control Provisions
The target’s material contracts should be reviewed early in the process even when the transaction is structured as an equity sale, because change of control provisions, which have the same effect as anti-assignment provisions, are triggered by an equity sale. Such provisions are common in contracts where the counter-party requires a great deal of control over who its does business with. Change of control provisions are common in credit agreements, where the borrower’s financial wherewithal is crucial to the lender; commercial leases, where the tenant’s financial stability is an important aspect of its ability to pay rent over the course of the lease; and distribution agreements, where a manufacturer is dependent upon the skills of current ownership and management to distribute its products in a particular territory.
Material contracts that contain change of control provisions require the parties to deal with the counter-party to the contract because the provisions will be implicated in both asset sales and equity sales.
Due Diligence Implications of Anti-assignment and Change of Control Provisions
Sellers should review their important contracts for anti-assignment and change of control provisions before taking their company to market. If an important contract contains such a provision and the counter-party is not willing to agree to the transaction on reasonable terms, the deal will look much different — and less attractive — to the buyer. It’s good to know early in the process that there’s a problem so the seller can plan accordingly, and so it can devise a strategy for overcoming the challenge.
Buyers should review the target’s material contracts to identify anti-assignment and change of control provisions as part of its due diligence efforts. It would be imprudent to hand over the purchase consideration when the buyer would not have the benefit of one or more crucial contracts.
Whether a transaction is structured as an asset sale or an equity sale, the buyer and seller should pay close attention to anti-assignment and change of control restrictions in the target company’s important contracts. Failure to do so could delay or endanger the closing of the transaction or even leave the buyer with less of the business than expected. That’s a recipe for trouble.