Private Equity Report What’s Inside Volume 2 Number 1 Fall 2001

Covering Your Assets: The Upside and Don’t Forget Your MAC Downside of Products Liability Due Diligence page 3

Guest Column: Litigation due diligence has always been an excellent investment opportunity. A A Case for European an important part of the acquisition target’s management may have ignored Private Equity Investment process, but it has never been more crit- the company’s products liability issues, page 4 ical than it is today. Multi-million dollar focusing exclusively on maximizing oper- products liability verdicts have become ating income at the expense of minimizing What the End of Goodwill routine, and plaintiffs’ counsel have litigation-related payouts. A buyer that Amortization Means for become increasingly well-funded, aggres- properly evaluates the litigation and Finance Agreement Covenants sive and inventive. Although asbestos, develops a plan to manage it year over page 5 pharmaceuticals and tobacco have long year to a predictable and acceptable finan- been the darlings of the organized plain- cial outcome can turn a troubled target Tax Benefits for “Qualified tiffs’ bar, products liability litigation over into a winning investment. In other words, Small Business Stock” the past several years has grown to products liability due diligence can be page 6 encompass a seemingly endless list of critical not only to understanding the products that includes medical devices, exposure but to evaluating the overall Are Shareholder Agreements lead paint, tires, gasoline additives, black quality of the investment, including the Enforceable? Yes, But… mold, mercury, herbicides and many presence of unrealized value. But to do so, page 8 others. In today’s litigation environment, the buyout firm must become educated a private equity firm must be especially about the target’s litigation issues to Trendwatch: Recapture of mindful of the possibility that an acquis- determine the scope of the problem and Director’s Fees, Transaction ition target that is the apple of its eye whether some combination of better Fees and Breakup Fees does not contain a litigation worm that management and sophisticated lawyering page 10 will ruin the investment. Because buyout can release that unrealized value. Because firms typically leverage acquisitions, such a term sheet may contain terms relating to Consolidation 101 firms require a high degree of financial litigation risk, counsel should be consulted page 12 predictability on both sides of the balance early in the process to prevent the inclusion sheet. Depending on the size of the target, of terms that will be harder to unwind Alert: Good News from the a several-million-dollar-a-year swing in or work around as the negotiation of the IRS on Section 83(b) Elections litigation-related payments can make the agreement matures. and Carried Interest difference between returns that meet invest- A. What Questions Should a page 14 ment criteria and losses on the investment. Private Equity Firm Ask? The key from the buy side is fully under- The types of information that are neces- standing the actual or potential liability – sary to evaluate the risk can be broken not only the worst-case downside risk, down generally into three categories: first, but also the best-case upside potential. what is the target’s litigation history, if any, Of course, many buyers have acquired with regard to the product or products at companies with actual or potential prod- issue? It is often the case that products ucts liability problems and been glad they litigation involving multiple cases takes did. Indeed, a target with products liability on a life of its own, without a tight causal exposure may, for that reason alone, be relationship to the target’s actual past significantly undervalued and may present continued on page 15 letter from the editor We extend our deepest sympathies to all of those who have considered an opportunity rather than a danger sign for private been personally affected by the recent tragedies and turmoil equity investment. In this issue’s “Trendwatch” column, we in our world and express our concern for the personal and continue our analysis of fees by focusing on what happens to economic challenges that so many of our clients, friends and director’s, transaction and breakup fees received by private colleagues currently face. We are committed to helping face equity funds or their sponsors from third parties. these challenges in whatever ways we can. In the cover article, Mark Goodman, one of our Litigation With this issue, we mark the one-year anniversary of the partners, suggests that there may be investment opportunities Debevoise & Plimpton Private Equity Report. It has been a year for private equity firms in unlikely places. A target may be under- that has seen tremendous changes for Debevoise, including valued simply based on the perception of its products liability the opening of a new office in Frankfurt, Germany and our exposure. Mark also notes that careful products liability due move to new offices in New York. diligence is essential in assessing actual and potential liability, It has also been a year that has witnessed increasing uncer- especially in the face of recent multi-million dollar verdicts. In tainty in world markets and challenges in the private equity light of the events of this fall and notable changes in Delaware fundraising and investment environments. We do believe, case law, we also offer some insight into the current importance however, that there is still some good news in the private equity of material adverse change provisions in acquisition agreements. world. First of all, long-term private equity investors have not In our last issue we focused on how the FASB’s elimina- abandoned the market. In fact, this summer Yale University tion of pooling and changes in accounting for goodwill will decided to maintain its very high allocation of assets to private effect recapitalizations as a deal structuring tool for financial equity, and Calsters recently announced that it was increasing its sponsors. In this issue, Paul Brusiloff takes a closer look at private equity allocation. In another boost for the private equity how the end of goodwill amortization will affect financing community, Jack Welch, former Chairman and C.E.O. of General agreement covenants of existing portfolio companies. Also Electric, decided to spend part of his retirement as a special in this issue, Adele Karig, of our Tax department, reports that limited partner in a private equity firm. In explaining his decision, individual investors in private equity and venture funds may Welch noted that “the biggest thing to help America in the 1980s be entitled to special tax benefits afforded by two rarely used was the fact that we had buyout firms... that gave the capital provisions of the Internal Revenue Code. In addition, we markets a chance to get rid of entrenched and uncompetitive analyze the legal issues concerning the enforceability of businesses.” We expect the private equity community will play shareholder agreements and describe the considerations to a pivotal role in business development in this decade as well. keep in mind when using platform companies to implement We are pleased to have George Anson, Managing Director consolidation strategies with portfolio companies. of HarbourVest Partners (U.K.) Limited, an internationally We hope that this first year of the Debevoise & Plimpton recognized expert in European venture and buyout funds, as our Private Equity Report has proved a useful and informative guest columnist for this issue. George reminds us that, in light source of practical guidance on legal issues for private equity of the changes in business culture and increasingly pro-invest- funds and their investors. ment legal regimes throughout Europe, the current uncertainty Franci J. Blassberg in world stock markets and in Europe in particular should be Editor-in-Chief

Private Equity Partner/ Counsel Practice Group Members

The Debevoise & Plimpton Franci J. Blassberg The articles appearing in this Private Equity Funds Richard D. Bohm Private Equity Report is a Editor-in-Chief publication provide summary Ann G. Baker – Paris Franci J. Blassberg publication of information only and are not Woodrow W. Campbell, Jr. Geoffrey P. Burgess – London Ann Heilman Murphy Debevoise & Plimpton intended as legal advice. Sherri G. Caplan Margaret A. Davenport Managing Editor 919 Third Avenue Readers should seek specific Michael P. Harrell Michael J. Gillespie New York, New York 10022 Please address inquiries regarding legal advice before taking any Marcia L. MacHarg – Frankfurt Gregory V. Gooding (212) 909-6000 topics covered in this publication action with respect to the Andrew M. Ostrognai – Hong Kong Stephen R. Hertz to the authors or the members www.debevoise.com matters discussed herein. David J. Schwartz David F. Hickok – Frankfurt of the Practice Group. Rebecca F. Silberstein James A. Kiernan, III – London Washington, D.C. The Private Equity All other inquiries may be Antoine Kirry – Paris London Practice Group Mergers & Acquisitions/ Venture directed to Deborah Brightman Marc A. Kushner Paris All lawyers based in New Capital Farone at (212) 909-6859. Robert F. Quaintance Frankfurt York except where noted. Hans Bertram-Nothnagel – Frankfurt Thomas Schürrle – Frankfurt Moscow All contents © 2001 Debevoise E. Raman Bet Mansour Andrew L. Sommer – London Hong Kong & Plimpton. All rights reserved. Paul S. Bird James C. Swank – Paris Colin Bogie – London John M. Vasily

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 2 Don’t Forget Your MAC

Over the years, Material Adverse the business, condition (financial or Financial sponsor acquirors often Change clauses – or MACs – have otherwise), results of operations, prop- get the benefit of two MACs. Most gotten lots of attention from partici- erties, assets, liabilities or prospects of acquisition agreements between finan- pants in M&A transactions. That’s the business and its subsidiaries, taken cial sponsors and sellers of businesses because they give the buyer an impor- as a whole. The one exception is with have financing conditions that excuse tant escape hatch: if there has been a respect to the inclusion of the word the financial sponsor from closing if its MAC, the buyer can refuse to close. “prospects,” which is often heavily financing is not obtained and substi- Not surprisingly, sellers have a strong negotiated. A compromise approach tute financing on substantially similar interest in trying to keep that escape is to exclude the word “prospects” but terms cannot be arranged. As a result, hatch as narrow as possible. Recently, to expand the MAC clause to cover not the MAC condition in the sponsor’s because of a volatile stock market and only events or occurrences that have financing is incorporated in the acqui- some interesting Delaware case law, had a material adverse effect, but also sition agreement, creating another the battle over who will bear the risk of events or occurrences that are “reason- MAC condition for the seller to fret bad things happening before closing ably expected to result” in a material about. The seller to a financial sponsor has become more intense than ever. adverse effect. needs to understand the MAC clause Most of the heavy artillery is contained in the sponsor’s financing Meet the MAC. With a MAC clause, reserved for arguments over exceptions arrangements in order properly to a selling party promises the buyer that to the MAC. We frequently see excep- evaluate the risk of non-completion. there has been no material adverse tions for material adverse changes A seller may negotiate a very favorable, change to the business being sold resulting from general economic, stock narrow MAC provision in an acquisi- since a specified date – often the date market or industry conditions, not tion agreement, but it won’t provide of the business’s most recent financial specifically attributable to or dispropor- much practical benefit if a broader statements, but sometimes the date of tionately affecting the company being MAC clause in the seller’s financing the acquisition agreement. The absence sold. In M&A transactions, sellers will agreement prevents the seller from of a MAC is frequently a condition to often propose additional exceptions, obtaining financing – and the buyer closing – giving the buyer the right to depending on the business being sold is thereby excused from closing. walk if a MAC has occurred. and the identity of the buyer, such as Those negotiating MAC clauses tend Will I know a MAC when I see it? When carve-outs for material adverse effects to devote only a limited amount of fire- the dust settles after the negotiation of resulting from announcement of the power to arguing over what must be the MAC clause, notwithstanding care- transaction itself – such as loss of materially adversely affected before the fully drafted exceptions, the scope of customers or employees. buyer can walk – a typical list might the MAC clause may still be subject to a Interestingly, MAC clauses have include some or most of the following: great deal of interpretation. A “Material traditionally been narrower in M&A Adverse Change” is usually defined, agreements than in underwriting agree- rather circularly, as a material adverse ments, where force majeure concepts change. There is comparatively little Philipp von Holst Adele M. Karig are more commonplace. After the case law interpreting MAC clauses. And – Frankfurt David H. Schnabel events of this autumn, we expect that Peter F. G. Schuur parties often will disagree about what is, Acquisition/High – London exceptions for force majeure events, Yield Financing in fact, material. Context will always be including acts of terrorism and acts William B. Beekman Employee important in determining the existence Craig A. Bowman Compensation of war (both declared and undeclared), & Benefits or non-existence of a MAC – a point – London will become part of the negotiation David A. Brittenham Lawrence K. Cagney underscored in a recent Delaware case Paul D. Brusiloff David P. Mason over MAC clauses in M&A agreements, Elizabeth Pagel in which Tyson Foods, Inc. was ordered A. David Reynolds especially in certain industries. Serebransky to complete its merger with IBP, Inc. Tax Estate & Trust Andrew N. Berg continued on page 20 Planning Robert J. Cubitto Jonathan J. Rikoon Gary M. Friedman Friedrich Hey – Frankfurt The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 3 guest column A Case for European Private Equity Investment

The many advantages of venture capital and private equity investment are well documented. Besides non-correlation, this alternative asset class carries the trademarks of diversification and long term outperformance of public markets. Without straying too far from home, U.S. investors – especially those pioneers in the asset class – have done very well investing in both technology opportunities and private equity over the last few years.

Why invest in Europe? Private equity in all major economies. This is encour- firms establishing operations in the is under-funded in Europe relative to aging operating managers to take risks country. Technology companies the United States. A perhaps inexact and develop new products. There is ranging from Microsoft to Harbour- measure for the scope of growth in continued corporate restructuring, Vest’s portfolio company, Trintech, private equity markets in more devel- including divestments and consolida- have benefited from this policy oped economies is to examine the tion, in all industry sectors driven by measure that has helped create highly aggregate amounts invested in private the advent of the Euro, the focus on skilled employment and collateral equity within a given country, measured shareholder value, and a return to core economic growth in Ireland. against that country’s GDP. This corporate competencies. The improve- Some have argued that the state simplistic but relevant measurement ment in the European capital markets of the European private equity market suggests that in 2000 total private infrastructure is another positive factor, in 2000 was similar to that of the U.S. equity investments in the U.S. repre- creating opportunities for raising in the early 1990s. In any event, the sented 1.79% of 2000 GDP, while total growth capital and exit options. industry should be poised for strong private equity investments in the U.K. Governments and politicians have returns over the medium term as the only represented 0.86% of 2000 GDP. also become much more favorably pre-conditions for future success – Among the other major European disposed to the role that venture capital capital, risk takers and liquidity – are economies, Germany and France have and private equity can play in job solidly in place. economies of comparable size to the creation, reviving moribund industries, But the sector is not without its U.K., and yet have private equity markets and the redistribution of wealth. Long risks. Some of the concerns present which, in 2000 as a percentage of GDP, term tax incentives for both investors in the marketplace today center around were less than one-half the size of the and entrepreneurs alike are creating a the Atlantic drift of the U.S. technology U.K. A similar pattern exists for Europe’s more fertile environment for investment. hangover that has started to infect other larger economies, including Italy, Germany’s successful introduction Europe. Many of the nascent European the Netherlands and Spain. of changes to the capital gains tax for growth markets (Neuer Markt, Nuevo In the year 2000, $165 billion was the disposition of corporate share- Marche, etc.) are all trading well below committed to U.S. venture and buyout holdings highlights the quantum shift their highs of 2000, and more bad news funds in 2000, but only 57 was in European economic policy. This appears daily. However many European committed to European venture and measure alone is likely to initiate a venture managers have small portfolios buyout funds. Europe’s aggregate GDP wave of corporate divestitures as of investments to manage, and funds and population are greater than the companies heighten their focus on with significant uninvested cash to take United States, with an aggregate stock shareholder value. Among other advantage of buying opportunities at market capitalization falling well behind countries, France has improved laws much reduced valuations. Buyout that in the United States. Surely this sets relating to stock options, recognizing managers are still able to exit their larger the scene for a longer term investment the importance of providing strong deals through either the public markets, opportunity for the venture investor. incentives to entrepreneurs to create leveraged recapitalizations, or secondary There are a number of factors businesses and employment. Similarly, buyouts. Wherever there is change, driving the European venture and Europeans are looking to the enlight- especially brought on by uncertainty, buyout marketplaces. The entrepre- ened example of Ireland, which has then historically private equity has been neurial culture is now at last taking implemented a highly attractive ten a major beneficiary. hold, and role models are emerging percent corporate income tax rate for

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 4 Institutional investors should not perfect time to begin a commitment to — George Anson confuse the current uncertainty in the marketplace of European venture Managing Director of HarbourVest world stock markets with a reason not and private equity investment opportu- Partners (U.K.) Limited, to consider European private equity nities that will unfold over the next the London-based subsidiary of investment, but recognize it as the three to five years. HarbourVest Partners, LLC

What the End Of Goodwill Amortization Means for Finance Agreement Covenants

The end of goodwill amortization has of the financing agreement and, in Borrowers and lenders often “freeze” been heartily endorsed by the business many cases, their financing lawyers GAAP, so that the borrower calculates community, mostly because of its likely and accountants as well. Although covenants without regard to changes to effects on reported earnings and on M&A the change may not impact common GAAP. Doing so helps avoid unpleasant activity in a post-pooling environment. financing covenants which are EBITDA- surprises later. Therefore, to create more Few, however, have addressed how this based, the change may substantially certainty at the time of executing the fundamental change to the treatment of affect other types of financial covenants, financing agreement, borrowers and goodwill will affect financing agreements and even where it does not, it may well lenders alike agree to forego the possi- – primarily credit agreements and bond result in making existing agreements bility of future advantage (resulting from indentures – which use financial state- far more burdensome to administer. We a change in GAAP) and to take the risk ment measurements in a variety of ways. believe, however, that a borrower’s ability of future inconvenience (from having to We believe that all companies with such to comply with many financial covenants keep track of “old” GAAP). financing agreements should carefully should remain unaffected for the If an agreement has frozen GAAP, consider the impact of this major change following reasons: covenants keyed to financial perform- in accounting practice. • For existing agreements with “Frozen” ance are unaffected – by definition– By way of brief background, the GAAP, changes to GAAP (including even after the change takes effect. fundamental change to the treatment the end of goodwill amortization in As we noted above and discuss in of goodwill derives from SFAS 142, SFAS 142) do not apply. further detail below, the borrower will released last June, and now beginning to have to calculate financial covenants • Even before SFAS 142, many covenants take effect. More specifically, SFAS 142 under the old standard. (“Old” GAAP based on EBITDA excluded the effect changes the treatment of goodwill by for the frozen agreement, “new” GAAP of amortization and often excluded the eliminating the amortization of goodwill for everything else.) As a result, a effect of an impairment of goodwill. and replacing it with more rigorous company with frozen GAAP may be • periodic testing of goodwill for impair- Compliance with many covenants does required to maintain two sets of books ment The statement makes the change not depend on earnings or asset values. – one to track covenant compliance and applicable to fiscal years starting after Unaffected Financial Covenants one for financial reporting purposes. December 15, 2001, including unamor- Here, in more detail, is why the change Even if a credit agreement or an inden- tized goodwill from prior transactions. from amortization to periodic testing of ture does not have frozen GAAP, there In some cases, the change applies to goodwill should not affect a borrower’s are at least two additional reasons why goodwill arising from transactions obligations under many common obligations under most leveraged finan- completed after June 30, 2001. financing covenants: cing covenants could remain unaffected. In order to evaluate whether the 2. 1. For existing agreements with “Frozen” Even before the end of goodwill amor- change in accounting for goodwill GAAP, changes to GAAP (including the tization, EBITDA excluded the effect will impact a financing agreement, a end of goodwill amortization in SFAS of amortization and often excluded the borrower should consult the specifics 142) do not apply. effect of an impairment of goodwill. continued on page 18

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 5 Tax Benefits for “Qualified Small Business Stock”

There are two little-used provisions after December 31, 2000, the effective described in clause (i) above is applied of the Internal Revenue Code that can tax rate is a slightly lower 17.92%. The by taking into account the investor’s provide significant tax benefits for indi- rates are further reduced if the corpor- proportionate share of the adjusted vidual investors in venture capital and ation conducts its business within an basis of the fund in the stock. However, other funds that make portfolio invest- “empowerment zone” (designated the investor must have held his interest ments in start-ups and other small distressed urban neighborhoods and in the fund during the entire period the businesses. First, if stock in the port- rural areas). For each investor, the fund held its interest in the QSBS, and folio company meets certain “qualified amount of gain eligible for the reduced gain received from a fund is not eligible small business” requirements, certain rate is limited to the greater of (i) ten for the reduced rate to the extent that individuals and other non-corporate times the investor’s basis in stock the partner’s interest in the fund at the investors (including the members of of that issuer disposed of during the time of sale exceeded the partner’s the general partner) may be eligible taxable year and (ii) a total for all interest in the fund at the time the entity to pay tax at the rate of 14% (rather taxable years of $10 million per issuer acquired the stock. (It is unclear how than 20%) on their share of gain from of small business stock. this rule would apply to the general the sale of such stock. Second, these The Code provides for flow-through partner’s carried interest, which may investors may be able to elect to treatment in the case of QSBS held fluctuate over time.) In addition, defer some or all of their share of the by venture capital funds and other although in most cases stock is only gain from the sale of such stock by “pass-thru entities” (partnerships, S QSBS in the hands of the taxpayer who purchasing stock of another qualified corporations, regulated investment acquired the stock at original issuance, small business. companies and common trust funds). QSBS distributed in kind by a fund can Reduced Capital Gain Tax Rates In that event, the limitation of ten continue to qualify as QSBS in the hands times the investor’s basis in the stock of non-corporate investors who were Section 1202 of the Internal Revenue Code was enacted in August 1993 to encourage investments in new ventures What is Qualified Small Business Stock? and small businesses. It currently To be qualified small business stock, all of the following must be true for provides for an effective tax rate of 14% the applicable period: (in lieu of the regular 20% rate) on • The corporation had gross assets not exceeding $50 million at all times gain from the sale of qualified small after August 10, 1993 until the time of stock issuance; business stock (“QSBS”) if the investor • The corporation is a domestic “C” corporation; has held the stock for more than five • At least 80% (by value) of the corporation’s assets are used in the active years and certain other conditions are conduct of a trade or business (other than certain excluded businesses met. (When originally enacted, the including banking, insurance, financing, leasing, investing, personal capital gains rate was 28%, and the services, farming, and operating a hotel or restaurant) or is a “specialized Code provided a flat exclusion of 50% small business investment company;” of the gain from the sale. Today, the • The stock was originally issued after August 10, 1993; Code provides for the same 50% exclu- sion, but imposes the old 28% tax rate • The stock was acquired by the taxpayer at its original issue in exchange on the 50% of the gain that is recog- for money or other property (other than stock) or for services; and nized, resulting in the blended rate of • The corporation agrees to submit such reports to the IRS and to its 14% on the gain.) For investors subject shareholders as the IRS may require (to date the IRS has not required to the alternative minimum tax, the any reports). effective tax rate for gain on stock the Numerous rules and exceptions apply; for example, parent and holding period for which began before subsidiary groups are treated as one corporation with combined assets, January 1, 2001 is 19.88% (not much of and certain redemptions by the corporation of its stock can cause the a break from the regular 20% rate!); for stock to fail to qualify. taxpayers whose stock was purchased

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 6 Funds contemplating an partners at the time the fund acquired three years, removing the exclusion as the stock. a tax preference item under the alterna- investment in a company The reduced rate applies automati- tive minimum tax, increasing the $10 cally-no election need be made-but the million ceiling on excludable gain to that may be a qualified small investor must report the gain as quali- $20 million or repealing it entirely, and business may wish to consider fying for the exclusion. Generally, this even extending the exclusion to corpo- means that the fund must determine rations. Bills including these proposals asking the company to make whether any of its stock sold or distrib- have been referred to the relevant uted in kind qualifies as QSBS-which committees, and at this time no further an annual determination as requires it to get information from the legislative action has been taken. to its qualification [for the portfolio company or have the portfolio Rollover of Gain company make the determination. Enacted in August 1997 in order to reduced rate] and to agree to Unfortunately, some of the rules for make more capital available to the new, qualification are complex (in particular, comply with the QSBS small businesses important to the the active business requirement), and long-term growth of the economy, it may be difficult or costly for some reporting requirements... Section 1045 of the Internal Revenue small businesses to determine whether Code generally allows individuals to their stock qualifies (or they may not elect to “roll over” gain on the sale of have maintained the necessary records). an individual who was a partner during QSBS that was held by the individual Venture capital funds, particularly the entire period in which the partner- for at least six months if replacement those with few individual investors who ship held the QSBS and who purchases QSBS is purchased within 60 days could benefit from these rules, may replacement QSBS within 60 days of of the sale. Unlike the Section 1202 want to weigh the costs of establishing such sale may make the election with exclusion, which from the date of qualification against the benefits to be respect to the individual’s share of any enactment applied to investors holding obtained. In addition, funds may not gain on the sale that the partnership stock interests through flow-through have the right to compel their portfolio does not defer. These situations were entities, applicability of this provision companies to do the necessary analysis. given merely as examples of the appli- to individuals who held their stock Funds contemplating an investment cation of the flow-through rules, and through venture capital partnerships in a company that may be a qualified the announcement did not address and other flow-through entities was small business may wish to consider other possible situations-for example, uncertain until July 1998, when a asking the company to make an annual where an investor sells QSBS that it technical correction extended the determination as to its qualification has held for six months, and then a provision to all non-corporate and to agree to comply with the QSBS fund in which the individual is an taxpayers and incorporated by refer- reporting requirements (if and when investor purchases QSBS within 60 ence the pass-through entity rules days, or whether investors in several they become applicable). of Section 1202 into Section 1045 venture capital funds may match Several senators and congressper- (although many questions remain). up sales by one venture fund with sons, suggesting that the Section 1202 In the wake of the technical purchases by another venture fund. exclusion has not been effective because correction, the IRS announced that a To date, no regulations have been of complex and cumbersome require- partnership may make a rollover elec- issued implementing these rules. In ments and that its benefit has been tion if it sells QSBS held for more than May of 2001, several senators joined reduced due to the cut in the capital six months and purchases replacement in a letter to the Treasury Secretary gains rate from 28% to 20% and the QSBS within 60 days, and that the O’Neill urging Treasury to promptly increasing applicability of the alterna- benefit of deferral flows through to issue regulations under Section 1045 tive minimum tax, have introduced the non-corporate partners who were addressing how the rollover provisions legislation to simplify and broaden partners for the entire period during apply in the partnership context, to Section 1202. Their proposals include, which the partnership held the QSBS. permit venture capital funds and their among other things, raising the exclu- In the same announcement, the IRS investors to take advantage of these sion to 75% or even 100%, lowering the also stated that if a partnership sells provisions. stock holding period from five years to QSBS held for more than six months, continued on page 19

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 7 Are Shareholder Agreements Enforceable? Yes, But...

Documentation for many private equity investments includes an agreement among shareholders on matters such as voting of shares, transfer restrictions, tag and drag along rights, registration rights and similar matters. Although in many traditional deals the share- holders are limited to the sponsor and management, more and more transactions now have institutional mezzanine investors, strategic partners, selling shareholders and other participants having divergent interests, often resulting in complex shareholder agree- ments. Although such agreements generally are enforceable, the enforceability of some of the more esoteric provisions can’t be guaranteed. Also, there is a fair amount of law and lore on the subject, and right ways and wrong ways to document the deal.

Summary of Law corporations. The Revised Model agreements of the company, and Historically, courts have been reluctant Business Corporation Act, which is approved (or not rejected for filing) to enforce shareholder agreements, followed in whole or in part by a by the local authorities. For example, other than the most benign provi- number of states, also favors the in Brazil, shareholder arrangements sions. Many older cases strike down enforcement of shareholder agree- for one type of corporate entity, a various transfer restrictions as “unrea- ments. However, these statutes as sociedada anonima, are generally sonable restraints on alienation of well as the courts interpreting them enforceable while enforceability is less personal property” or reject special often inject uncertainty as to enforce- certain for another type of corporate voting arrangements as “vote-buying” ability by putting into the mix some entity, a limitada. Certain restrictions or “sterilizing” the board of directors. type of a “reasonableness” or “best on transfer or voting of shares may Fortunately, most modern courts take interests of the corporation” test. As a be unenforceable in certain countries, a more enlightened view and are likely result, it is hard to state with certainty although there may be other ways to to enforce typical first refusal rights, that a particular provision will be achieve the same purpose. The absence agreements on electing directors and enforced as drafted. Delaware corpor- of significant case law and the need to supermajority or veto rights. However, ation law without question provides rely on outdated statutory provisions given the checkered history of such the most protection to those parties often makes enforceability uncertain. agreements, it is not clear how a given seeking a fully enforceable shareholder In some cases, shareholders have court would react to the more exotic agreement, expressly recognizing the interposed (with the blessing of tax provisions often found in shareholder validity of many, but not all, transfer counsel) a Cayman Islands or United agreements today, particularly if a restrictions as well as the validity of States holding company in order to provision benefited a shareholder to voting and other corporate governance have a more predictable law apply. the detriment of the company or arrangements as applied to close Structuring Points harmed a minority shareholder to the corporations. (Even under Delaware Use Delaware Law. If at all possible, benefit of the majority shareholder. law, however, there is conflicting case the portfolio company ought to be Some states, most notably law as to whether even transfer restric- a close corporation incorporated Delaware, have revised their corporate tions expressly permitted by the statute under Delaware law, the shareholder laws to override the older court deci- are subject to an over-arching require- agreement ought to be governed by sions and generally to favor the ment that they be “reasonable” or in Delaware law, and exclusive jurisdic- enforcement of shareholder agree- the “best interests of the corporation.”) tion for dispute resolution ought to ments, especially with respect to close In the case of non-U.S. companies, be in a Delaware court or before enforceability issues often arise, and another panel (such as a New York it is often difficult for foreign counsel federal court) experienced in Delaware to give unqualified legal opinions on Although [shareholder] corporate governance matters. If incor- certain provisions. In many civil law poration in Delaware is not possible, agreements generally are countries, form is important and in local counsel should review the share- order to be enforceable shareholder holder agreement to point out those enforceable, the enforceability agreement provisions must be set provisions that might be of question- of some of the more esoteric forth in the corporate organizational provisions can’t be guaranteed.

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 8 Delaware corporation law able enforceability under applicable ation should be given to include key state law and to suggest ways to provisions of the shareholder agree- without question provides the strengthen their enforceability ment in the certificate of incorporation most protection to those (including, especially in the case of of the company and close corporation foreign transactions, the feasibility status should be elected. parties seeking a fully enforce- of interposing a Delaware holding Qualify as a Close Corporation. Many company). state corporate statutes have special able shareholder agreement... Use Supermajority Voting. With respect provisions for close corporations that to voting arrangements, it generally is strongly favor the enforceability of possible to work within the applicable shareholder agreements for such enti- as not applying to pledges, involuntary statutory framework to achieve the ties. Although the definition of a “close” foreclosures, bequests, inter-vivos desired result. In most cases, the corporation varies from state to state, gifts, mergers and similar transactions simplest and most direct means of it is generally defined as a corporation unless specifically provided in the providing a minority shareholder with having somewhere between 30 and shareholder agreement or charter. some measure of control over certain 50 shareholders that has no publicly (This is why the definition of “Transfer” corporate actions is to assure the offered stock and which has elected in a shareholder agreement can be shareholder adequate representation to be treated as a close corporation three lines long and contains every on the board and then to require under state law. (It should be noted synonym imaginable.) unanimity or a supermajority vote for that the limitation on number of share- Get Local Counsel Involved. Local board and often, shareholder action. holders could preclude companies counsel should be informed as early Most state corporation statutes and from qualifying if they have extensive as possible in a transaction about the Revised Model Business Corpor- management shareholdings.) the need to deliver an enforceability ation Act permit the corporation to Provide a Clear Choice of Law. opinion at closing, so that counsel can establish a vote requirement for board Questions relating to shareholder point out potential problems early in or shareholder action higher than that agreements usually have been deter- the negotiation process. It is unlikely set forth in the statute. However, a few mined under the law of the state of that counsel will give a clean legal statutes authorize such provisions incorporation of the entity pursuant opinion on enforceability. Exceptions only if placed in a particular instru- to the “internal affairs” doctrine. and qualifications in local counsel’s ment, (e.g., only in the charter or only However, if the agreement does not opinion are to be expected but never- in the bylaws), or if other technical specify a choice of law, some states theless should be reviewed closely requirements are met. (including New York) may not always and discussed with such counsel. Get the Details Right. There are a follow the internal affairs doctrine. Read the Agreement Carefully. number of technical things that can From a drafting standpoint, the share- Shareholder agreements contain long, be done to increase the likelihood holder agreement should provide for complicated and boring provisions that that a shareholder agreement will be clear choice of law. many people don’t want to read. Often enforceable. All shareholders and Draft Clearly. The shareholder agree- buried in the boilerplate are provisions their transferees must execute or agree ment should be drafted clearly, leaving that, when parsed through, can subtly to be bound by the agreement. The nothing open to interpretation by the shift the balance of power between agreement should indicate when court. Given their historical reluctance majority and minority shareholders. The it terminates, and which provisions, to embrace comprehensive shareholder best advice is also the most obvious: if any, remain effective once the arrangements, absent a statutory read the agreement carefully. company has publicly traded stock. provision a court simply could throw — John M. Vasily To ensure enforceability against third out the entire provision rather than party transferees, the share certificates try to sever the offending term and should contain a detailed legend indi- interpret the parties’ intent. A “strict cating that the shares are subject to a constructionist” approach has been shareholder agreement. Also, consider- used to interpret transfer restrictions

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 9 Consolidation 101

In highly fragmented industries with high growth potential, pursuing an industry consolidation strategy is an attractive option for financial sponsors. This may be especially true as valuations have fallen and the opportunity to build scale can be accomplished at an attractive price. Typically, the financial sponsor and a founding management team structure the consolidation, or “build-up,” by creating or acquiring a platform company that serves as a vehicle through which to pursue strategic add-on acquisitions. The creation of the platform company, and the subsequent acquisition strategy, involve many legal and practical considerations, including financing subsequent acquisitions and planning for integration and expansion.

Source of Funding for Subsequent platform company or a combination of to selling stockholders, e.g., a summary Acquisitions. Several alternatives the foregoing. Using stock as consider- term sheet with non-negotiable master exist for funding add-on acquisitions, ation raises a number of legal issues: agreements and simple joinder agree- including internally generated cash, First, the impact of federal and state ments for signature. third party borrowing in the form of securities laws is critical. For example, Fourth, if structured properly (in senior credit facilities or mezzanine it is possible that at least some of the general, at least 50% of the consid- financing, loans from the seller of the selling stockholders will be unaccredited eration in stock), stock consideration target business (“seller paper”) and investors. Perhaps in that circumstance received by the sellers will be tax additional equity from the financial there will be few enough unaccredited deferred. It is necessary to work closely sponsor or from co-investors. If the investors, and their level of sophistica- with tax lawyers to obtain a successful platform company will incur debt, the tion will be sufficient, for a valid Section “tax-free” reorganization since seem- sponsor needs to work with the lenders 4(2) private placement. If not, they ingly commonplace events, such as a to create loan documents that will will need to be cashed out, or, in the pre-closing dividend of available cash permit, and provide automatic funding absence of another available exemption, to the selling stockholders, could for, additional acquisitions. Any seller compliance with Regulation D will be destroy the “tax-free” nature of the deal. paper must be deeply subordinated to necessary, which will require, among Fifth, the platform company currency provide for flexibility on refinancings other things, delivering an offering must be valued. So long as the plat- and future mezzanine financings. If memorandum that is tantamount to form company is privately held, there additional equity from the financial a S-1 registration statement. is no alternative other than valuations sponsor will be a source of funding, Second, even if all of the selling stock- by the board or management or a third the sponsor should consider whether holders are accredited investors, if party appraisal. Since the company it wants to make a pre-commitment the platform company will be issuing has presumably made, or is consid- to contribute additional equity, perhaps shares, the selling stockholders should ering, various acquisitions, the extent at a discount from fair market value. receive an offering memorandum to which the valuation should reflect However, funding that equity for each relating to the platform company. A the prospective synergies and earnings acquisition separately, with one or properly drafted offering memorandum enhancement as a result of prior, and more co-investors is another option, is prepared on a pro forma basis, giving currently contemplated, acquisitions in which case the equityholder arrange- effect to the acquisition being consid- must be addressed. ments should allow for the flexibility ered. This creates the problem of to bring in additional co-investors. Structure of Subsequent Acquisitions. obtaining the necessary disclosure from Consideration for Subsequent In planning for add-on acquisitions, the target company before the acquisi- a decision needs to be made as to Acquisitions. The sponsor needs to tion agreement has even been signed. whether the platform company will determine what form of consideration create a new subsidiary for each acqui- the platform company will use for Third, sponsors need to develop a sition or whether some or all of the add-on acquisitions: cash, stock of the strategy for presenting the platform company equityholder arrangements target companies will be acquired

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 12 directly by the platform company. The with stock and stockholders agree- the performance of the overall company, creation of separate subsidiaries allows ments. A corporate form is also not individual subsidiaries or business the platform company to isolate liabili- necessary to make an initial public units. Also, former CEOs of small ties of an individual target company offering. On the other hand, the LLC closely-held target companies may not from the rest of the group and facilitates structure offers greater flexibility in be accustomed to reporting to a board selective sales or spin-offs of particular providing varying profits interests to of directors. As a result, it is very useful businesses. Moreover, by merging each equity participants and employees to develop a policy for acquired com- target into a newly-organized Delaware and potentially offering favorable panies that stipulates the issues that subsidiary, you can standardize the capital gains treatments with respect need to be taken to the parent domicile, charters and by-laws of each to management equity incentives. company board. subsidiary. (One disadvantage of this When forming a platform company, Accounting Matters. Many consolida- “forward merger” is that it may lead to the sponsor and management team tors have been the victim of unknown a greater number of third party consents must also decide whether the consol- accounting irregularities in their target and governmental re-permitting appli- idation strategy involves attempting companies which have ultimately cations.) If acquisitions are being to build brand recognition for the plat- required write-downs or impacted their structured as “tax-free” reorganizations, form company name. In some cases, exit strategy. We therefore urge sponsors the target companies must be held the individual target companies will to carefully assess accounting issues directly by the company which issues have strong name recognition and in connection with build-up strategies. the stock consideration; that is, the building a global brand will not be These general considerations platform company cannot create an desired, but if the platform company present only some of the many intermediate holding company. name is expected to be branded, selec- important decisions for the financial Acquisition Strategy in Light of a Public tion of the name becomes important. sponsor contemplating using a plat- Offering. If a public offering is feasible, Among the issues to consider are: form company consolidation strategy. consulting with counsel regarding whether the name can be trademarked, Although not all decisions need to SEC regulations and no-action letters the availability of associated domain be made before the process starts, it concerning integration of private place- names and the availability of the name is advisable to discuss these and ments (i.e., the issuance of stock to with the respective secretaries of state other considerations with experienced target company stockholders) and in the jurisdictions where the company counsel, accountants and other advi- subsequent public offerings should be will conduct business. sors in order to maintain flexibility part of the planning process. In addition, Integration. One of the most chal- during the “build-up” process. when and how pending acquisitions lenging issues with any acquisition — Margaret A. Davenport and would need to be disclosed in the regis- strategy is successfully integrating the Felicia A. Henderson tration statement should be a high acquired businesses. This involves, priority item. Subsequent to the public among other issues, the assimilation offering, an acquisition shelf registration of new personnel, the integration of may be filed, subject to compliance with the acquired business’ equipment, SEC regulations and no-action letters, technology, financial and information to facilitate further acquisitions. systems, the coordination of sales Organization of Platform Company. and marketing efforts, the centraliza- If the platform company is a Newco, tion of certain functions to achieve it can be structured as a corporation cost savings and to promote coopera- or a limited liability company. A cor- tion and sharing of resources and poration is still the more customary generally the maintenance of common vehicle, and investors and manage- standards, controls, policies and proce- ment employees are usually familiar dures. To further integration efforts, it is useful to issue options based on

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 13 alert Alert: Good News from the IRS on Section 83(b) Elections and Carried Interest

General partners of private investment interest was subject to vesting. The in cases where the carried interest funds may no longer need to file 83(b) uncertainty stemmed from the fact is subject to vesting, whether or not elections. In order to determine that, under general tax principles, a section 83(b) election is made. whether an election is still appropriate if property is transferred subject to Therefore, we believe that section in a particular situation, some history vesting and a “section 83(b) election” 83(b) elections are no longer generally and analysis is necessary. is not made, the recipient is essentially required in cases where shares of It is well accepted that the mem- taxed as if he or she received the prop- the carried interest are granted to the bers of the general partner of a private erty at the time the property becomes members of the general partner of investment fund are generally not vested. Because a share of the carried a private investment fund. currently taxed upon the receipt of interest would typically no longer It is important to recognize, a share of the carried interest. This constitute a mere “profits interest” however, that both announcements was not always the case. During the at that time – assuming the fund’s are subject to a number of important 1970s and 1980s, the IRS occasionally assets have appreciated in value – exceptions and do not apply in all asserted that the receipt of a carried the announcement arguably did not situations. For example, they only interest resulted in ordinary income to protect the recipient from ordinary apply if the carried interest is received the recipient. Then, in 1993, the IRS income treatment at the time the in exchange for the provision of issued a public announcement stating interest vested. By contrast, if a section services to or for the benefit of the that, in most situations, the IRS would 83(b) election was made at the time partnership in which the interest is not seek to tax the receipt of a carried the carried interest was received, we received and only if the carried interest. This favorable IRS treatment believed it was relatively clear that the interest is retained for at least two was conditioned upon the transferred announcement did protect the recip- years. As a result, we recommend interest representing a mere “profits ient from ordinary income treatment. that participants in leveraged interest”– i.e., an interest in future This is because a recipient who makes employee co-investment plans still profits only, that would result in no a section 83(b) election is treated as generally make section 83(b) elec- distributions to the recipient if the receiving the property on the actual tions, because in this context the fund assets were liquidated at fair transfer date, rather than the vesting recipient typically does not provide market value (measured immediately date. Given the relative ease of making services to or for the benefit of the after receipt of the interest). a section 83(b) election and the employee securities company. In addi- Uncertainty remained, however, dramatically different potential tax tion, members of the general partner as to how the 1993 announcement* consequences, we recommended that of a private investment fund may applied in cases where the carried section 83(b) elections be made. wish to continue to make section 83(b) Last August, the IRS issued a elections as a protective measure in *Both announcements were issued in the form of IRS second public announcement that case one of the exceptions were found revenue procedures. An IRS revenue procedure is a “statement of procedure” that affects the rights of “clarifies” the 1993 announcement. to apply. taxpayers under the Internal Revenue Code. Although According to the IRS, the favorable — Andrew N. Berg, Adele M. Karig and IRS revenue procedures do not constitute substantive tax law, tax practitioners generally agree that the IRS treatment afforded by the 1993 David H. Schnabel would be hard-pressed to take a contrary position. announcement generally will apply

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 14 Covering Your Assets (continued) conduct. Second, what are the facts verdicts against the target, a detailed 2. The Liability Case: concerning the target’s corporate description of the way in which the Is the Target’s Conduct Defensible? conduct? And third, does the target target has managed the litigation, and A potential buyer will also want to possess insurance coverage, can it get the various other issues referred to in understand precisely what the target insurance going forward and/or is it the sidebar. is alleged to have done (the “liability indemnified by a third party so that it By analyzing the responses to these case”), and to gain an understanding is protected, at least partially, against questions alone, experienced products of how the alleged conduct can reason- present and future liabilities? Absent counsel may well be able to (i) predict ably be defended. With regard to the reliable answers to these questions, the most likely trajectory of the litigation, target’s liability, there are a series of buyers can find themselves in serious (ii) identify areas in which the target issues that should be the focus of due trouble: in October, Federal-Mogul can save money on defense and/or diligence. At the outset, the acquiror Corporation filed for bankruptcy to indemnity costs, and (iii) propose should have a complete understanding escape asbestos liabilities stemming strategies by which the target’s litiga- of the product that is the subject of largely from its 1998 purchase of the tion liability can be structured to actual or potential litigation, and of the British company T&N (formerly Turner provide higher levels of certainty and context in which the product was & Newell), which was revealed to have predictability over the probable life of designed, manufactured and distributed. much larger asbestos liabilities than the investment. continued on page 16 was believed at the time of the acquisi- tion; and, in July of this year, Berkshire What is the Target’s Litigation Experience and Profile? Hathaway appears to have been blind- • How many cases are pending against the target? sided when USG Corp., the country’s • How many potential additional plaintiffs are there (that is, what is the population largest wallboard manufacturer, filed for of people who used or were otherwise exposed to the product at issue, and when bankruptcy protection from its asbestos did the use or exposure occur)? liabilities only nine months after • How strong is the liability/corporate conduct case against the target? Berkshire Hathaway had invested over $100 million dollars in the company. • How does the safety of the product at issue compare to the safety of similar products manufactured by other companies? 1. Litigation History: Past As Prologue. • What sorts of injuries do plaintiffs typically allege? As to the target’s litigation history, • What are the legal theories on which plaintiffs typically rely? while the target may want to believe • Has the target settled cases or taken cases to verdict, and, if so, how many and (and, more importantly, want the how much did the target pay? potential acquiror to believe) that the • Has the target been held liable for punitive damages? litigation risk is behind it, or that it has adequately reserved for any future risks, • Who are the plaintiffs’ firms bringing cases against the target? things in the products liability world • In what jurisdictions have cases been filed? often get worse before they get better. • What are the target’s legal defenses and how often have they been successful, In order to evaluate the risk, the acquiror either in the form of dispositive motions or at trial? must first obtain an accurate profile of • Who are the codefendants, if any, in the litigation? How has the target organized the target’s litigation experience. This and managed the litigation? aspect of the process should focus on • How good is the law firm defending the target? ascertaining facts such as the number • What is the ratio of the target’s defense costs to its indemnity costs? and quality of the cases pending against • How has the target managed other products litigation, and how experienced is it the target, the number of potential in managing litigation matters generally? future cases, the strength of the liability • Does the target have employees who can provide in-house expertise concerning case against the target, the number the issues in the litigation and who can testify if needed? and average value of settlements and

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 15 Covering Your Assets (continued)

What was the product’s function? Was packaging contain warnings? If so, were any) combined with a knowledge of the the product in fact dangerous? Did it they timely, complete and accurate? target’s actual conduct (the liability case) cause injury when used as intended, or Was the product removed from the are the keys to a successful due diligence only when misused? Over what period marketplace? If so, was the removal assessment. Another important ingre- did the target manufacture and/or voluntary or was it required by a state dient is the legal theories that have been distribute the product? Was the product or federal agency? Are there renegade alleged by plaintiffs – or would be avail- distributed to retailers or directly to end- former employees who give damaging able to future plaintiffs – in cases users, or both? Was the product used testimony against the target? Do target brought against the target. The theories in industrial or residential settings, or employees have a plausible story to tell, available to plaintiffs will define the both? How many units of the product are they willing to tell it, and, if so, are standards by which a judge or jury will were distributed and over what period they effective witnesses? evaluate the target’s conduct and of time were they sold? Does the target The buyer will also want to under- the likelihood of a successful defense. continue to manufacture the same or stand what medical science has to say Products liability cases are generally a similar product? What other compa- about the product, whether in the context based on theories of negligence, breach nies manufactured the same or similar of or outside of the litigation. Are there of warranty, strict liability, or some products, and have they been sued in medical/ epidemiological studies of the combination of all three. To prevail on connection with such products? product’s impact on users? Is medical a negligence claim, a plaintiff generally The buyer will also want to know, causation generally accepted in the scien- must show that the defendant (the to the extent possible, what the target tific community? Is there, as is the case manufacturer, distributor or retailer) understood about any dangers associ- with the inhalation of asbestos fibers, for failed to exercise reasonable care in the ated with its product, when it developed example, a latency period between the design, manufacture or marketing of that understanding, and what it said time of exposure to or use of the product its product. To prevail on a warranty internally and did once any such dangers and injury? If so, what is the typical claim, a plaintiff generally must show were understood. Are there internal latency period? Does the amount of that the defendant breached an express company documents that describe the exposure to the product affect the likeli- or implied contract pursuant to which danger? Were the dangers disclosed to hood and severity of injury? What have it had agreed to sell a product that customers or others? Did the target medical experts testified to in any cases was free of defects and was fit for its seek to downplay or hide the dangers? brought against the target? Can the intended purpose. By contrast, to prevail During the production period, was types of injury typically caused by the on a strict liability claim, the plaintiff the target sued by anyone injured by product be treated successfully? must prove that the product was defec- the product, or did the target receive This is not an exhaustive list, but tive in design or in the manner in which any workers’ compensation claims it should provide a sense of the many it was manufactured – i.e., that some relating to the product? Did the target questions about the product and the aspect of the product rendered it more communicate about the problem with target’s conduct in relation to the dangerous than the finder of fact deter- government authorities, other producers product that should be asked and mines it should have been – and that of similar products, trade associations answered as part of any products the defect caused the plaintiff’s injury. and the like? Did the product’s design, liability due diligence exercise. While In some circumstances, strict liability including any safety features, represent the questions are straightforward, can also attach for failure to provide the state of the art at the time it was lawyers with products liability experi- adequate warnings. In a strict liability produced-in other words, was the ence can use the answers to such case, the focus typically is on the danger- product as safe as science could make questions to advise an interested buyer ousness of the product or the absence it at the time? What kind of internal as to the risks presented by the liability or presence of warnings. If the person safety research or human factors case against the target company. conducting products liability due dili- research did the target undertake? 3. The Legal Underpinnings of the gence understands the product at issue and knows what theories have been What benefits, if any, did the product Litigation. The answers to these ques- used or would likely be used by plaintiffs, provide to the target’s customers or to tions are essential because a knowledge he or she can ask the right questions society as a whole? Did the product’s of the target’s litigation experience (if and properly evaluate the risk.

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 16 In a courtroom, the quality The acquiror will also want to payment streams and to determine evaluate all legal defenses that are its ability to weather a storm if unanti- of the defense must always reasonably available to the target (partic- cipated costs are incurred. Most be balanced against the ularly those that have already been tried targets involved in the manufacture in the litigation, but also those that and distribution of a product giving severity of the harm caused. might not have been used), keeping in rise to litigation liabilities will have mind that, in a courtroom, the quality of insurance of some kind. For a highly In other words, even the the defense must always be balanced leveraged transaction designed on a against the severity of the harm caused. financial model, the scope of insurance best, most credible legal In other words, even the best, most coverage and the timing of its avail- defense may not prevail credible legal defense may not prevail ability are crucial data. While complex where the plaintiff is highly sympathetic insurance issues are beyond the scope where the plaintiff is highly and the defendant has a deep pocket. of this discussion, there is no question That having been said, the person that an analysis of available insurance sympathetic and the defen- conducting the due diligence will want to coverage is an essential part of any know the answers to questions such as: products liability due diligence review. dant has a deep pocket. are the injuries alleged by plaintiffs typi- Any such review should include an cally the result of unforeseen misuses of analysis of whether the target has the product? Do plaintiffs who are injured insurance, how much insurance it has, with a contractual indemnification in typically engage in post-sale modifica- how and when the layers of coverage place, the target can and probably will tions of the product? Was the person who are accessed, whether there are per- be sued directly by an injured party. used the product a sophisticated user occurrence limits, whether the target But, depending on the terms of the and/or did the person who was injured is self-insured up to certain levels and indemnification in place, the target rely on an intermediary to provide whether defense costs are counted may be in a position to demand that adequate warnings and instructions as against or are in addition to the policy the indemnifying party take responsi- to proper use? Did the users of the limits. A financial buyer might also bility not only for any liabilities, but product assume the risk? Is a govern- want to know whether the policy for the defense of any cases as well. ment contractor defense available? coverage could be bought out in a Unfortunately, as with insurance This type of information will further lump sum transaction and whether the coverage, contractual indemnification assist a buyer in evaluating the litigation target could obtain, at a reasonable is only as good as the indemnitor risks and, in particular, in evaluating price, additional insurance to cover providing it. Accordingly, a comprehen- whether legal mechanisms can be used future liabilities (sometimes referred to sive due diligence process will include to limit such risks. as tail-end liabilities) above certain an evaluation of the solvency and B. Does the Target Have Collateral trigger points. Additionally, the buyer financial wherewithal of the indemni- will want the due diligence effort to fying party. Financial Protection? Of the many include a review of the solvency of the issues that must be addressed during Conclusion Products liability exposure insurance carrier and the carrier’s products liability due diligence, one has never been greater. But that does not payment practices and history, if any, of the most important is the extent to mean that any target with such exposure with respect to other companies that which the target’s litigation-related liabil- should automatically be removed from a have similar coverage and are involved ities will be covered by insurance or by private equity firm’s target list. Firms can in similar litigation. a third-party indemnitor. and should look at targets with products Finally, a buyer will want the due Because of the highly leveraged liability exposure as representing both diligence to focus on any potential structure of most transactions, a unique risks and unique opportunities. contractual indemnification to which buyout firm will need to understand By focusing on minimizing downside the target is entitled. Manufacturers are not only the amount of confirmed exposure and maximizing strong sometimes indemnified by purchasers and unconfirmed insurance coverage litigation management and financial for liabilities that arise after a product available, but also how that coverage is predictability, buyers can transform liti- has left the manufacturer’s control, accessed and the schedule on which it gation risk into such opportunities. or by suppliers of certain component is likely to be paid. This will enable the — Mark P. Goodman and parts of a product. Of course, even prospective buyer to project insurance Steven D. Greenblatt

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 17 What the End of Good Will Means for Finance Agreement Covenant (continued)

Perhaps the most common yardstick in Potentially Increased Burdens and the borrower’s GAAP balance sheets. A financing agreements today is EBITDA Potentially Affected Obligations borrower that neglects to keep a set of (and not EBIT). EBITDA adds amortiza- Even though a borrower’s ability to comply frozen GAAP books could be unaware tion back to earnings. Therefore, EBITDA with many obligations should remain of a breach in its financial covenants. – by definition – already excludes the unaffected, the change from amortiza- The change could trigger re-negotiation effect of amortization of goodwill. In tion to periodic testing could make clauses in some credit agreements. addition, EBITDA often adds other non- administering some existing agreements cash charges back to earnings. Under more burdensome and may impact Credit agreements sometimes provide those circumstances, EBITDA will some common financing covenants. that parties will renegotiate covenants exclude the effect of an impairment to Here are some specific examples. affected by changes to GAAP. To elimi- goodwill and, as a result, the change from nate future uncertainty and unforeseen The change could require more effort to amortization to periodic testing of good- consequences, borrowers and lenders maintain a set of frozen GAAP books. will should not impact the calculation alike may wish to begin that process of EBITDA. (If the specific agreement’s Frozen GAAP does protect borrowers promptly. from unforeseen changes to GAAP. definition of EBITDA does not add back The change could affect covenants with But the borrower will have the addi- other non-cash charges, however, the earnings-based and balance-sheet tests. change could substantially affect the tional burden of reconciling its financial calculation of EBITDA after an impair- covenant calculations to the old GAAP For agreements that do not freeze GAAP, ment.) The change generally should not standard. Because covenant compliance the change from amortization to periodic affect borrowers’ obligations under the under a credit agreement is generally testing may affect covenants relating to following EBITDA- based covenants: required to be calculated on a quarterly net income, net assets or stockholders’ equity. Without amortization of goodwill, (assuming non-cash charges are added back) all three will remain higher until there is Covenant Variations Where typically found an impairment. But the effect of an Leverage Ratios Total Debt to EBITDA Credit agreement maintenance tests impairment, depending on its size, could Senior Debt to EBITDA Some indentures be dramatic and result in unwelcome Funded Debt to EBITDA surprises to borrowers and lenders alike. Coverage Ratios EBITDA to Interest Expense Indenture incurrence tests EBITDA to Fixed Charges Credit agreements Balance Sheet Tests. Without amorti- EBITDA Maintenance Credit agreement maintenance tests zation of goodwill total assets and stockholders’ equity will not decrease automatically, making easier the ordi- 3. Compliance with many covenants does basis, the burden of reconciliation on nary-course compliance with balance not depend on earnings or asset values. a regular basis may become relatively sheet tests found in credit agreements, Many covenants in financing agree- routine. Since most indenture covenants such as maintenance of net worth ments address matters not related to are incurrence rather than maintenance and maintenance of debt-equity ratios. financial performance. For example, covenants, borrowers with frozen GAAP However, an impairment of goodwill negative covenants relating to limits on in their indentures will generally only will decrease total assets and share- business changes and restrictions on have to create the frozen GAAP calcu- holders’ equity, which would make a affiliate transactions are typical in many lations when incurring debt, paying borrower’s maintenance of net worth private equity transactions. Obligations a dividend or taking some other poten- and maintenance of debt-equity ratios under non-financial covenants should tially prohibited action (unless, of more difficult. A sudden impairment remain the same after the change. The course, their credit agreement already could come as an unwelcome surprise change in GAAP, however, could never- requires making the calculation on a with far-reaching consequences under theless impact such covenants indirectly quarterly basis). a credit agreement. From a lender’s because exceptions to non-financial Borrowers should remember that perspective, the higher asset values covenants are often expressed as a under a frozen GAAP agreement, total created by the disappearance of amorti- percentage of earnings or net worth. earnings, assets and stockholder’s zation might mask credit issues that equity may be lower than indicated on

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 18 original covenants were sized to some agreements do, companies should amortization to periodic testing for uncover. In addition, the change could consider how the change resulting from impairment will not likely affect also affect restrictions on mergers and SFAS 142 will fit the exclusion in the EBITDA-based covenants, check all a variety of balance-sheet based excep- context of the specific agreement and covenants, especially those relating tions to covenants, particularly where the particular borrower’s financial state- to earnings, assets and equity. dollar amounts are expressed as a ments.) Earnings-based tests may also • The change may advantage or disad- percentage of net worth. appear in a variety of exceptions to other vantage a borrower or lender to an Earnings-Based Tests. High yield inden- covenants, particularly when dollar agreement, depending on the opera- tures typically impose limits on restricted amounts are expressed as a percentage tion of the particular covenant. of earnings. payments (i.e., limits on investments and – For existing credit agreements, on payments on equity or subordinated Some Action Items As the practice which are generally not as hard to debt). Under certain circumstances, of amortizing goodwill ends and SFAS amend as indentures, consider these covenants do permit a borrower 142 becomes effective, a borrower renegotiating affected provisions. to make a restricted payment from a should consult both its accountants – For agreements currently under percentage of cumulative earnings. (The and financing lawyers about the negotiation, bear in mind potential calculation typically adds 50% of earn- effect the change will have on specific effects of SFAS 142, and consider ings and 100% of loss.) Increasing financing agreements and consider freezing GAAP (with the application cumulative earnings (by reducing amor- the following courses of actions: of SFAS 142 specifically included), tization) would increase the size of the • For agreements with “frozen” GAAP, to reduce uncertainty and alleviate restricted payments basket, permitting always calculate covenants by refer- the burden of keeping a set of higher than anticipated dividends and ence to GAAP in effect at the time “special” frozen pre-SFAS 142 the like. (If the agreement’s definition of specified by the agreement. adoption GAAP books. earnings excludes the cumulative effect • For agreements without frozen of a change in accounting principles, as — Paul D. Brusiloff GAAP, although the change from

Tax Benefits for “Qualified Small Business Stock” (continued)

If rollover treatment is elected, gain Some venture capital funds are concerned about the effects on the fund if an investor is recognized only to the extent that the makes a rollover election with respect to QSBS held by the fund. For example, if an amount realized on the sale exceeds the investor sells QSBS it held directly and elects to treat as replacement QSBS its pro rata cost of the replacement QSBS. The cost share of stock purchased by the fund (assuming such an election can be made), is the basis in the replacement QSBS is reduced fund’s tax basis in the replacement QSBS adjusted? These and other concerns (such as recordkeeping requirements) have caused some venture capital funds to address in by the amount of the rolled-over gain. their partnership agreements the right of their partners regarding rollover elections with Realized gain in excess of the amount respect to stock held by the fund. permitted to be rolled over must be recognized, but may be eligible for the should consider whether it makes sense information necessary to make a QSBS reduced capital gains rate under Section for them to examine their stock holdings determination and to comply with the 1202 discussed above. Investors may (and stock recently sold) and request reporting requirements (if any are ever defer gain indefinitely by making elections information from their portfolio compa- issued). Funds in the formation stage upon subsequent sales and repurchases nies to determine whether any of their might consider addressing the rights of QSBS. Proposed legislation (included stock might qualify as QSBS – and if so, of their partners with respect to Section in the bills regarding Section 1202 to alert their investors to enable them 1045 elections. These rules are com- discussed above) would increase the to take advantage of these tax benefits. plicated, there are many pitfalls and rollover period from 60 to 180 days. Funds contemplating an investment in written guidance is sorely lacking – Venture capital funds, particularly a company that may be a qualified small consult your tax advisers! those with a substantial number of business may want to ask the company — Adele M. Karig and individual investors (direct or indirect), to agree to maintain and furnish the Amanda Buck Goehring

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 19 Don’t Forget Your MAC (continued)

Knife the MAC? In IBP v. Tyson, the of the target in a durationally-significant performance under an acquisition Delaware chancery court rejected manner.” In the context of the IBP deal agreement. As a result, they are trying Tyson’s argument that IBP had suffered – a long-term strategic transaction – to negotiate MAC clauses which can a MAC entitling Tyson to back out of and given IBP’s volatile earnings history, be easily distinguished from the one in its merger agreement. During due dili- the court was not persuaded that a the IBP/Tyson agreement. In addition, gence, Tyson learned of accounting MAC had occurred. The court, rejecting when acquisition agreements provide problems at an IBP subsidiary, but Tyson’s other claims, took the extraordi- for a bringdown of the representations agreed to a $3.2 billion merger anyway. nary step of ordering Tyson to complete and warranties – i.e., a closing condi- The merger agreement contained a the merger. tion that the reps and warranties made MAC clause, but IBP’s representation The MAC clause in the Tyson-IBP at signing are also true at closing – we as to the absence of undisclosed liabili- merger agreement was broadly drafted, have noticed a reluctance on the part ties had a carve-out for the accounting without any carve-outs for general of buyers to allow the condition to be problem – a problem that eventually economic conditions. The court felt limited to breaches of reps and required IBP to take a $60.4 million that construing the broad language of warranties that would cause a MAC. write-down. Tyson claimed that this the MAC clause as addressing only Hey, MAC! A buyer should not assume write-down, coupled with IBP’s poor “fundamental events that would mate- it has a walkaway right just because performance in 2000 and the first rially affect the value of a target to a something bad has happened to the quarter of 2001, constituted a MAC. reasonable acquiror” would eliminate target company – even if the buyer has The court, based on the specific facts the need for negotiating detailed MAC negotiated a favorable MAC formula- of the case and applying New York law, clauses with numerous carve-outs and tion. Deciding whether a MAC has disagreed, finding that the MAC clause qualifiers. We have not yet detected occurred takes careful consideration – should be interpreted in light of disclo- widespread agreement with this senti- not only of what a reasonable buyer sures in the merger agreement itself ment on the part of practitioners. In would think is material, but also of and in IBP’s financial statements. fact, quite the opposite has occurred. what the buyer actually knew about the According to the court, the MAC clause We have noticed that buyers of busi- business when agreeing to the deal. “is best read as a backstop protecting nesses are even more cautious than — Franci J. Blassberg and the acquiror from the occurrence of they might previously have been about William D. Regner unknown events that substantially the likelihood of their success in relying threaten the overall earnings potential on a MAC clause to excuse their

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January 18 Andrew N. Berg Tax Issues for Private Investment Funds New Orleans, LA

The Debevoise & Plimpton Private Equity Report l Fall 2001 l page 20