Key Regulatory Considerations for M&A in the Current Market

Key Considerations for M&A in 2023

It's a great question and a timely topic to discuss, especially in this market. I'll talk about two aspects in particular, but I'll focus on the latter. 

In my meetings with executives, corporate development teams, and various M&A professionals, everyone is really focused on the macroeconomic economy. They are considering factors such as inflation, debt markets, and the impact of interest rates on financing. This has certainly put a damper on a significant amount of M&A activity over the past year. 

Many discussions revolve around how to address these issues in documentation and the risk profile of a particular company in this market. However, the reality is that this market has halted a lot of traditional M&A acquisition analysis. Many things may be on the back burner, but there is little execution happening. 

Another area of focus is educating our executive team, corporate development team, and discussing with different lawyers and regulators more generally about addressing the heightened regulatory and, in particular, antitrust scrutiny we're seeing globally.

I'll specifically focus on three regulators: the FTC and the DOJ in the US, the European Commission in the EU, and the Competition and Markets Authority (CMA) in the UK. All three regulators have been targeting big tech, such as Microsoft and LinkedIn, attempting to slow down or outright stop some of their acquisition and investment activities.

The premise is that some of these types of acquisitions are presumptively anti-competitive. We, of course, disagree with that, believing there's a lot of benefit to M&A for both small and large companies. However, that's the environment we're working through, and there are many things we need to consider to find solutions and continue our acquisition activity.

Regulatory Challenges

I've definitely seen a market shift towards more aggressive behavior, though others might call it more proactive behavior, depending on where you sit on that spectrum, particularly in the US.

Since the appointment of Lina Khan to head up the FTC and Jonathan Kanter to lead the DOJ antitrust division, we've seen increased enforcement activity and more aggressive rhetoric around big tech M&A, under the auspices of protecting consumers and competition more generally.

The practical impact of this is twofold. First, it puts a dampening effect on traditional M&A activity that many companies engage in, because they need to be more concerned about how regulators might act. Secondly, from a legal perspective, it changes the dynamic of both the negotiation and the deal documentation. I'll give you a couple of examples.

You mentioned the UK CMA and the European Commission. There has also been an increase in activity and the types of deals that these regulators are examining. Whereas it used to be possible to focus primarily on the US and hope that the EU and UK would follow suit, that's no longer the case. I consider the FTC/DOJ, the UK CMA, and the European Commission to be the big three in terms of antitrust regulators that people need to keep in mind, and they're all taking much more aggressive stances against certain types of M&A.

As for other jurisdictions we're worried about, China is a significant player in the semiconductor and hardware markets, presenting a different dynamic that needs to be navigated not only through antitrust regulation but also significant geopolitical issues.

What's front-page news on the Wall Street Journal these days are those three regulators. So, what am I counseling my clients and team members in terms of addressing these regulatory hurdles? One of the main things I'm focused on is ensuring deal teams know that getting approval will take much longer than it has historically.

If your deal is reportable and needs to go through an antitrust or regulatory filing, there used to be a regular cadence in terms of filing, discussing with regulators, and obtaining approval. That's no longer the case, particularly given the new US administration and the heads of the FTC and DOJ. We've been counseling teams to expect anywhere from 12 to 18 months between signing and closing for reportable transactions.

This long period raises questions for both the buyer and the seller. If you're the buyer, does the thesis and valuation still make sense if you have to wait a year? If you're the seller, how can you run your business if you have to wait 12 to 18 months before closing, and how does that impact your employees and the risk of the deal not closing?

I've also considered with different teams whether, if there is significant regulatory scrutiny on a deal, we should litigate to get the deal through, knowing that it takes time, costs a lot of money, and is a huge distraction. This is something I wouldn't have counseled just two years ago because the cost-benefit analysis wouldn't have panned out. 

In this market, however, if you really want to get a deal done and have conviction that it makes sense, you need to consider how far you're willing to go, including litigation. Every company and deal team must seriously consider whether that's a viable option.

Effect of Regulatory on negotiations

I'll be careful because I don't want to come off as saying that the regulators are anti-deal necessarily. While they are focusing a lot on big tech M&A, I don't think there's a general aversion to acquisitions or deals generally, whether it be investments or carve-outs that are pro-competitive or have a consumer impact. Let me start off with that disclaimer.

At the same time, this current set of regulators I've mentioned before are less predictable and seem less reliant on historical precedent when it comes to evaluating transactions. That makes it very hard for deal teams, including myself, to counsel on the likelihood of a deal being approved. 

You may have seen a number of articles recently about novel theories of harm that different regulators are considering. The best example would be the recent challenge by the FTC of the acquisition by Meta of a company within the VR space. Meta did go to the mat for that deal to get it pushed through, believing their deal was not anti-competitive, and ultimately prevailed.

However, the FTC may still consider that deal a win because their novel theory of harm suggested that Meta moving into the VR space, even though it is not yet fully established, had the potential to dominate that market way down the line. This was enough for them to sue to try to block the deal. So, this makes it difficult for attorneys and advisors of antitrust and regulation to figure out what these regulators are most worried about.

I will say there's probably a political and sometimes geopolitical angle that all these regulators are playing, which we can't control. In the past, as attorneys, we could tell people based on the past 10 or 20 years of precedent what to expect from the FTC and DOJ. However, we live in a different world now. It's much more difficult to gauge how the FTC, DOJ, or any regulator will evaluate a transaction, particularly if you're in big tech or a hot market like AI.

There are different pieces of advice that I've given and received from various advisors, but there's no definitive answer. This is new ground for all of us. Practically speaking, what we're seeing in the market is the movement of antitrust and regulatory provisions, typically negotiated way down the line, into the purchase agreement or similar documentation, as early as the indication of interest or the letter of intent.

Traditionally, a letter of intent is a brief document stating that financing is available for the deal, the board of directors supports it, and the intended purchase price. Now, we're seeing letters of intent that also include details like break fees if regulatory clearance isn't obtained, or the covenants to be negotiated for the interim period. This is because 12 to 18 months, the new expected duration between signing and closing, is a long time.

Buyers typically want some level of control over the business during this period, but it's a reasonable ask for a seller not to have their operations dictated for such a long period. If it's a fast-growing business, for example, that can double in size in 12 to 18 months, why would they agree to that?

This situation has front-loaded many conversations that would typically occur later in the process. It's no longer just about the purchase price or how executives will be treated. It's about in-depth contingencies, how much the buyer will pay the seller if things go awry, and this is being addressed much earlier in the process. 

The issue with this is it's time-consuming and fraught with asymmetry of information. Sellers often can't assess the risk of regulatory rejection because they don't have a full understanding of the buyer's profile. This has resulted in many deals dying earlier in the process. 

One piece of advice I give to our executives and others we work with is this: if you truly believe a deal makes sense, if you have conviction about the synergies and the contribution the acquired team could make to your bottom line, you should pursue the deal. 

This situation emphasizes the importance of the story you'll have to tell. If you're the buyer, you have to convey to the seller why the deal makes sense and how you'll treat them well. That same story needs to be told to regulators and antitrust authorities to explain why the deal is beneficial not only for the buyer and seller but also for the market and consumers. These narratives need to be formed much earlier in the process now.

Managing value 

I'm hesitating because my answer would have been different just two years ago. In the M&A market of 2021, the approach was much more laissez-faire. However, we've noticed a slight increase in the use of certain collars or triggers that can impact the purchase price upward or downward if a certain amount of time passes.

For example, if you expect a 6 to 12 month regulatory period for review and approval, the seller may argue that if their revenue doubles after 6 months, an offer of 100 million no longer makes sense. They might want a price adjustment, and that could be negotiated into the deal.

That said, speaking as a lawyer and not a corporate development professional or business person, these arrangements are usually terrible ideas. They inevitably lead to litigation, claims, or some form of conflict. This is mainly because the deal hasn't closed, and the buyer wants to ensure the seller isn't taking unnatural measures to achieve an increase in purchase price. They might be working towards a particular metric instead of focusing on the business as a whole.

Moreover, if the buyer agrees to increase the price, they'll often want to scrutinize how and why your revenue doubled, to ensure they're not inheriting something problematic. While we're seeing a slight increase in these arrangements to compensate for the increased regulatory period, for the most part, I wouldn't advise such a strategy. It could potentially create a problem for yourself.

Other considerations regarding regulatory risks

One of the major considerations for both the buyer and seller is understanding how the market will react to a particular transaction. This isn't just a legal issue. It's also about how your competitors, customers, and consumers may perceive your deal. 

For transactions that are reportable, regulators often consult the broader market to get their opinion on whether a transaction is sensible or why it might not be. Thankfully, regulators usually discount the opinion of your competitors when assessing antitrust concerns. 

That said, they still listen. Many competitors will proactively reach out to regulators and government officials to voice concerns. On the other hand, there are times when suppliers or customers reach out to express their support for these types of transactions. Therefore, it's a bit of both, although there are probably more instances of competitors raising a red flag.

These days, especially for larger, more transformative, game-changing transactions, my counsel is to get ahead of it and be well-prepared. If, for example, the deal leaks before it's signed, a competitor gets wind of it, and takes their concerns to the regulators, you could find yourself in a difficult situation without prepared answers.

Being proactive and aligning the right internal teams is crucial. Interestingly, I was part of a panel recently where we discussed what it means to be proactive. For some, it means bringing in more experts, such as a communications team. 

However, as you probably know, for significant M&A transactions, you want to limit the number of people who know about the transaction to maintain confidentiality, regardless of how helpful having more people involved might be later on. 

So, while it's important to bring in more people than perhaps you have historically to prepare for situations like these, it's equally essential to keep a tight control on who knows and why they need to know.

Suing the regulatory bodies

There are different options depending on the jurisdiction you're focused on. In the US, you're allowed to litigate if the FTC or the DOJ rejects your deal. You can counter the narrative, submit evidence, and go to court, although this process can take several months or longer.

However, there are certain jurisdictions where you can't litigate or make a claim against a finding that a deal is anti-competitive. The best example is the UK's Competition and Markets Authority. They act as judge, jury, and executioner of all anti-competitive deals. I won't comment on whether this approach makes sense. There are reasons they chose to structure their competition authority in this way, particularly post-Brexit, to give them more power.

You can appeal the UK CMA's decision on procedural grounds, meaning if the process was not followed correctly, but that's not the same as having full litigation where you can discuss everything and present a comprehensive opinion on why you think a deal should go through.

Most big deals have some nexus to the UK, meaning they either have customers or revenue, or something that will trigger a filing or the jurisdiction directly of the UK CMA. So, it's challenging to avoid the UK altogether.

You can also litigate in other jurisdictions in the EU. The main issue extends beyond conviction and time. It's really a question of whether you need a deal so much that you're willing to pay a premium, including a premium to the stock price if it's a public deal, litigation fees, and the time it takes to get regulatory approval, litigation through, and then whatever else needs to happen in the end to get a deal done. There are deals that make sense even on extended timelines, but for most executive teams, there are very few that would be beneficial for their company.

In the US, the FTC and DOJ have litigated a few deals in the past couple of years. Although I don't have the exact numbers, it's less than 10, and they've lost most of those deals, only winning one or two. However, the fear of going to litigation can be enough to deter many deals from the outset. If you were to ask most people whether a deal makes sense if it required spending a hundred billion dollars on litigation fees and waiting a year and a half, most dealmakers would likely say no.

The FTC and DOJ are composed of very intelligent professionals who are well-versed in their fields. Part of what they're trying to do, as I mentioned earlier, is establish novel theories of harm. So even if they ultimately lose the case, they're introducing these novel theories of harm to the public, which they'll likely use for future litigation and claims.

If it's not obvious, one of the objectives many of these regulators are trying to achieve is preventing the next Facebook-Instagram acquisition. Most regulators, whether in the US or globally, reference that as a deal they believe should have been blocked. I won't comment on whether it should have been blocked, but it's always cited as a transaction that should not have happened, including both the Facebook-Instagram and Facebook-WhatsApp deals.

However, Let me try to explain the regulators' viewpoint. If anyone from Lina Khan’s staff heard this, they might dismiss my opinion, but I observe two main concerns they focus on. One of them, which we were very aware of when I was at Intel, is the so-called killer acquisition theory.

Meta, formerly known as Facebook, is often cited as a prime example of this. The theory is that a larger tech company, anticipating that a small startup or smaller company might develop technology, a product line, or a business that could compete with its core business, acquires that company. They then "kill" it, either internally, bury it, or integrate it into their existing offerings, eliminating any future competition. I believe there's some merit to this theory.

However, it's also important to note that many of these smaller companies often don't aspire to become the next Meta or Google. Their goal is, in fact, to be acquired by another company or a fund, such as private equity or venture capital. It's their stated goal, and understandably so, not everyone can become the next Microsoft. It seems like an obvious statement.

These companies often seek liquidity opportunities through acquisition, and I think it's vital to maintain that funnel because that's how innovation happens. If entrepreneurs thought they would have to spend 20-plus years at their company, I doubt we would see as much innovation as we do.

So, while I understand the killer acquisition theory, I also recognize the need for this funnel, whether you call it liquidity or other opportunities, for these startups. It incentivizes people to start companies and to make money quicker than in 20 plus years.

Regulatory effects on consumers

I concur that a lack of choice is inherently detrimental. If you only have one, two, or three choices for a service, that's not ideal. There's the risk of collusion, and it also makes it challenging for other competitors and startups to enter that space once these fortresses have been established by larger companies with their products.

I also recognize that consumers don't always prefer dealing with larger companies. The assumption is that you're paying for the back-office operations and substantial overhead of these corporations, as opposed to dealing with a smaller, local business.

However, I continue to believe that the FTC's intent to protect individual consumers and smaller businesses affected by big M&A is correct. My personal opinion is that there are more effective ways to achieve this than what sometimes appears to me as a blanket prohibition against big tech.

I don't believe that's the correct tool to use. There are a multitude of different tools, policies, laws, and regulations they could implement to foster innovation, if that's their aim, and to protect consumers without necessarily cutting off the M&A funnel.

The FTC, DOJ, and other regulators often make headlines by halting significant deals, claiming they're preserving competition. While I understand the need for such actions, I believe that if the core objective is, for instance, to expand innovation, there are numerous other strategies they could be employing. These could include tax incentives and grants, among other things, to boost innovation rather than solely trying to prevent certain types of M&A.

Drawing from my buy-side experience, I can say that a lot of my transactions have led to the acquired company being able to offer their product to a larger audience. Often, we were able to lower the cost of goods sold, thereby increasing margins. The reason being that larger companies usually have better supply chains, superior vendor agreements, and so on, which can reduce costs for smaller companies lacking those same synergies.

For the most part, we were successful in better proliferating the product of the acquired company. However, as you know, not all M&A works out. There were deals where the company and the business we acquired didn't perform as well as they had hoped. I would argue that this isn't due to any particular anti-competitive issue, but rather the more mundane story of a small company being suffocated by the larger one.

Problems could arise from an integration process that wasn't as smooth as it could have been, or from executive teams that transitioned and were unhappy working for a larger company. And as you know, not all M&A works out. The success rate is just around 60% of deals actually hitting their valuation thesis.

Regulatory effects on Employees

Absolutely, we often discuss the 12 to 18 month regulatory waiting period and its impact on the business. How do you run a business with this cloud hanging over the heads of both executives and rank-and-file employees until the deal closes? 

The deal documentation contains covenants that restrict and permit certain activities of the seller, making it challenging for them to run their business as they were used to before signing. It's tough.

The solution lies in transparency with the selling company and its employees about the situation. The selling company's executive team should explain that while we might be in this for the long haul, we believe it's the right opportunity for us and here's why. In the end, you'll be compensated appropriately.

However, I'm aware of a couple of deals in the market right now where the buyer expressed concerns that the selling team, composed of serial entrepreneurs, wouldn't wait for this deal to close. These entrepreneurs love to build and create new businesses. If we have to wait 12 to 18 months for this deal to close, we risk losing the key talent we want.

The practical impact, in the end, is that many deals that historically would have at least reached the signing stage haven't even gotten close.

Other Deal killers in M&A

In more traditional M&A transactions, particularly sub-billion or sub-half billion deals where you're buying an established startup in series B or series C stages, one recurring issue I'm seeing is related to the intellectual property of the target company. Often, these companies are so focused on generating revenue and growing their business, they overlook vital aspects such as ownership, registration of IP, trademarks, patents, copyrights, and algorithms.

When conducting my legal due diligence, intellectual property is usually the first thing I examine. It's not always straightforward, and often there are complexities to unravel. I'll share some orange flags, not necessarily red flags, that you should be wary of both in the U.S. and abroad.

Many times, young entrepreneurs receive funding from their university in the U.S. While that's commendable, they often overlook the fact that because they accepted funding from a public research institution, the institution or university may have ownership or claim to the intellectual property developed using their funds.

A more extreme example is Israel's Innovation Authority, previously known as the Office of Chief Scientist. They frequently issue grants and funds to university graduates or startups. Due to this funding, the Israeli Innovation Authority may lay claim to certain IPs and ownership of the developed technology.

These are orange flags because more often than you might expect, founders and executives from selling teams aren't aware that their IP is encumbered by these government ownership claims. While they are relatively easy to clear up, usually requiring a negotiated payment, they can cause delays.

For technology companies, especially those founded right after or during college, this issue arises more often than you might think. It's surprising that some buy-side clients overlook these potential complications.

Practically speaking, during due diligence, don't take the founders', executives', or CTO's word that they own all their IP and developed everything in-house. Even if they've done all the necessary groundwork, if they received any grants or funds from a public institution, that's something buyers should diligently investigate and clean up as necessary.

Trademarks killing deals

Trademarks will probably not kill deals, though it does depend on the value of your trademark. For instance, if you're buying a company with a globally recognized trademark, like Coke, it might raise more of an orange or red flag, but it's not necessarily a deal breaker.

The issue becomes more pronounced in the pure technology space, especially with code development or patents. In these situations, determining who contributed to that IP isn't always straightforward, and it can't always be easily divided.

Market situation with IPs

One example that's both exciting and challenging, particularly for an attorney, involves the changing focus on patents. Years ago, everyone was intensely focused on protecting their patents, ensuring no one could touch anything resembling their invention. 

However, we're now seeing a slight shift away from the importance of patents to a company, largely because many standards in the patent world have become more open. They've been proliferated across different technologies and as a result, are not as proprietary or valuable.

This leads me to question if the same transition is happening in software and code. It appears to be the case. If so, does our current approach to protecting our code and algorithms become less important? 

Interestingly, many technologists suggest that it makes it more important. As the lines get blurred, it's critical to clearly define what's yours. However, it's never as simple as putting a container around your material. It's interwoven in many other things.

The next four or five years will be interesting to observe, especially as the advancements in AI truly start to take off.

Deal breaks due to IP

Yes, I have several examples, unfortunately. One that comes to mind relates to the patent example I shared earlier. The selling company didn't realize they didn't have adequate protection over their technology. 

Picture a pizza with eight slices. They thought all eight slices were theirs, but to run the product, they needed the entire pizza. It turned out that half of that pizza was actually owned by somebody else. There was third-party IP that was incorporated and utilized in the end product more than they were aware of.

This company wasn't as diligent as they should have been. Over time, as they started to commercialize their product, we discovered that most of their technology, particularly the key technology providing value to their customers, was actually a third-party technology licensed into their product.

Upon realizing this, we noted that instead of buying their company and continuing to pay licensing fees to these other entities while paying a premium for their product, we could achieve the same outcome by simply licensing the product ourselves. This situation occurred at least half a dozen times in various transactions I've worked on.

Advice for Deal teams

From a lawyer's perspective, one crucial piece of advice for executive teams, deal teams, or any team working on a potential acquisition is to pay attention to document integrity. When you have a deal that's reportable to the regulators, you're required to submit a comprehensive filing, which includes a host of internal documents detailing your analysis of the deal.

What can easily kill a deal are items that should never be included in your internal documentation. This extends to non-privileged emails, casual communications with colleagues, or anything that could be perceived as anti-competitive or disparaging of the other side or the regulators.

A few examples of comments that have raised red flags include statements like, "We want to buy them because they'll be our biggest competitor in the next 5 years," or "We want to buy the technology because it's better than ours and we don't want them to compete with us," or even, "We should buy this company despite their misogynistic, sexist founders." Obviously, you probably shouldn't be pursuing such a company in the first place.

However, it's essential to ensure your documentation, which will eventually be reviewed by regulators, is as clean as possible. This is particularly crucial given the current regulatory environment.

A legal team will delve into your internal systems and extract all pertinent information. This could be from a Slack channel, a Team's channel, emails, or any other platform. They'll examine your computer for anything that could be relevant to the acquisition and the specific acquisition narrative. Lawyers typically undertake this process.

There's a process of document review and retention, usually coordinated with outside counsel who are experts in this field. A submission, which includes all of these materials, is then made. It's a substantial collection of documents.