Maybe
you thought selling the deal was the hard part. For sure the critics
pounced last fall when eBay Inc. CEO Meg Whitman said her company was
buying Skype Technologies SA. Why should the online auction giant be
willing to pay as much as $3.9 billion for a fledgling company that
enables free long-distance calling via the Internet? If all eBay wanted
was to provide an online phone service to its users, couldn't it
accomplish that a lot more cheaply with a licensing agreement?
Whitman had her reasons: Skype's huge growth potential, strong
technology leadership and geographic reach, with registered users in
more than 225 countries. But almost as important -- given what it would
take to actually get the deal done -- she had her lawyer. "This was one
of the more complex deals I've worked on," says Keith Flaum, a partner
with Cooley Godward LLP in California who served as eBay's lead
counsel. "Even though I knew what all the issues were, negotiating and
drafting the actual contract language was very complicated."
The deal closed in September, and while it's too early to tell if
Whitman's gamble will pay off, eBay's first-quarter 2006 revenue was up
35%, to $1.4 billion, over the same period in 2005, with Skype
contributing $35.2 million in sales, up 42% from its performance a year
earlier.
So why was eBay-Skype such a bear? Two reasons, says Flaum: EBay
wanted to include earnout payments to keep Skype's founders and
management team on board and motivated; and multiple buyout plans had
to be developed for Skype investors, who were scattered across North
America, Europe and Asia. Flaum won't say how many weeks or months went
into the contracts that addressed these issues, and he's naturally
circumspect about delving too deeply into his client's affairs. But he
will say this: "Each and every word was heavily negotiated."
As good as many in-house counsels are at dealmaking, they still have
many reasons for calling on outside counsel for help. Specialized
knowledge; project-management help, especially when a transaction
involves coordinating lawyers and professionals around the world; extra
people to throw at various tasks -- the list is long. And as important
as it is to connect the legal issues with the specific business goals
in a deal, there's also much to be said for know-how about the kinds of
issues that just don't come up every day -- with eBay-Skype offering a
case in point.
Start with earnouts. According to Flaum, three often-interrelated
factors tend to bring earnouts into play: a buyer's desire to retain
key talent, a buyer making an acquisition based largely on a target's
future performance, or a price gap between the buyer and the seller.
While people often assume that bridging a price gap is the driver
behind most earnouts, retaining talent and incentivizing behavior are
much more common, says Flaum. In the eBay-Skype deal, it was a
combination of those factors.
Skype was founded by the dynamic duo of Niklas Zennström, 39, and
Janus Friis, 29, who together have launched four technology companies,
including Skype in August 2003. They've also developed a number of
successful technologies, including the popular file-sharing software
that powers Kazaa, a company they founded and later sold. It was
clearly important to eBay that Zennström and Friis continue leading
and growing Skype.
While Zennström and Friis had a proven track record, Skype's
voice-over-Internet-protocol technology did not. Sure, VoIP was popular
-- Skype surpassed the 100 million member mark in April, up from about
1 million when it launched -- but it was far from achieving mainstream
appeal. And with billions on the table, Whitman and her team wanted to
be sure that Skype fulfilled its promise.
EBay and Skype agreed on an earnout payment structure that broke the
price of the deal into $2.5 billion up front, and up to $1.4 billion
based on Skype hitting certain targets in the future. According to
eBay's Securities and Exchange Commission filings, the targets are
based on Skype's revenue, gross profits and number of active users. If
the targets are hit during any four-quarter period between Jan. 1,
2006, and June 30, 2009, the payout will be about $1.05 billion.
Additionally, if Skype exceeds the targets during 2008, a further $350
million in bonus payments will be made. All of Skype's management team
elected to receive reduced up-front payments and are eligible for the
earnout.
This may seem fairly straightforward, but it's a lot easier to sum
up after the fact than it is to structure in the first place. Earnouts
often entail dozens of decisions. The provision in the eBay-Skype deal
covered 15 pages and included "one-and-a-half alphabets of
definitions," says Flaum. Plus trying to get all parties to agree on
the details can lead to some hard-fought battles.
"You want to make sure that what's on the paper and what gets signed
reflects everybody's understanding of how the earnout is going to
work," says Michael Littenberg, a partner with Schulte Roth & Zabel
LLP in New York whose clients include Reuters and Thorn EMI and who has
structured earnouts on both the buy side and sell side in domestic and
cross-border deals. "You sit down and determine what you're trying to
accomplish and what the appropriate metrics are for measuring that."
Thus, while eBay and Skype settled on revenue, gross profit and
number of active users, other transactions might warrant other metrics:
Ebitda, for example, or divisional profitability, subscribers or
technology development. As pharma and biotech companies know, that last
category can be especially tricky.
Once both parties agree on metrics, a new series of negotiations
begins to flesh out the details around questions such as: What is the
duration of the earnout? How do you handle revenue or profitability
from a future acquisition? Will the earnout be measured in accordance
with GAAP, or is it going to be a non-GAAP measure? Who will handle the
accounting? If the target management is staying on, how much
operational control will they have?
"It's in everyone's best interest to lay these issues out clearly.
It puts some meat to the formula," says Littenberg. "If you get it
wrong or you just don't think of the details, it can create problems on
the back end."
One of the stickiest points in an earnout negotiation is the degree
of operational control granted the target. When the target's management
team is sticking around, it makes sense that they'd want the freedom to
operate the business as they see fit. But that's not always how the
acquirer sees it.
When Flaum represented Siebel Systems Inc. in its
acquisition of CRM application services provider UpShot for $70 million
in 2003, an earnout provision was included to retain talent and drive
behavior. But Siebel didn't grant operational freedom to UpShot's
management team.
"Siebel wouldn't agree to any covenant that it would use its best
efforts to optimize revenues," Flaum says, "or to achieve the earnout
because those are too unclear and can lead to disputes."
Occasionally, target companies do score such legal protection. Flaum
says he was shocked to win such points for two small target companies
he represented recently. "The buyers didn't check with good outside
counsel, and my clients, I'm sure, are going to be pleased if they're
not earning the earnout, but can claim that the buyer breached those
covenants."
To help buyers contemplate an earnout structure, Flaum uses issue
lists that help clients think through the multiple scenarios and
negotiation points -- "Very few clients want to read through a 70-page
acquisition agreement," he says. While he sees a fair number of
earnouts move forward, it's not unusual for clients to decide against
the earnout when they see the time, energy and money that will be
required to work through the details. "Oftentimes," says Flaum, "they
decide they'd rather pay more up front and avoid the headaches later."
OK, enough about earnouts. On to the equally challenging task of
structuring dozens of individual buyout transactions, as had to be done
for Skype's far-flung owners. While eBay-Skype was done under British
law, privately owned Skype was based in Luxembourg, with offices in
London and Estonia. In addition, its owners -- including VC investors
Index Ventures, Draper Fisher Jurvetson, Bessemer Venture Partners and
Mangrove Capital Partners -- were scattered across at least 10
countries in North America, Europe and Asia.
EBay ultimately decided to offer Skype shareholders a choice of cash
or stock, which resulted in multiple transactions, each of which had to
comply with the relevant laws and regulations -- in terms of ownership,
securities and taxes -- in their respective jurisdictions.
Consider ownership. Many countries don't have merger statutes, and
you have to think ahead of time about deal structure so you end up
owning 100% of the company, says Flaum. If you structure a deal in the
U.S. as a merger and 51% of shareholders approve, in most jurisdictions
you end up owning 100% of the company. But in Norway, for example, if
you acquire 90% of the outstanding shares, you still don't wholly own
the company. However, that 90% threshold triggers a procedure that
allows a buyer to squeeze out the remaining 10%.
Compliance in the eBay-Skype deal was further complicated by eBay
issuing stock as part of the consideration. In the U.S., says Flaum,
you can issue stock to accredited investors without registering it with
the SEC, while in other countries you may have to comply with
registration requirements that (like in the U.S.) can be time-consuming
and expensive. If an exemption is not available, a buyer may decide to
offer cash in one country and stock elsewhere.
But in the case of a cross-border deal such as eBay-Skype, involving
shareholders in multiple countries, you have to be careful because one
wrong transaction can collapse the entire deal. "If you blow it and
don't comply, in most cases that gives recision rights not just to the
person you blew it with, but to every shareholder," Flaum says.
Tax issues also become more challenging when the acquisition
consideration includes stock. Under certain deal structures in certain
jurisdictions, in order for the stock portion of the deal to receive
tax-deferred treatment, no part of the consideration can be paid in
cash, says Flaum. In other structures up to 20% of the consideration
can be cash and in others up to 60% can be cash. "In light of the
multijurisdictional aspects of the Skype deal," says Flaum, "all of
these factors had to be taken into account."
A miscalculation on taxes when determining structure can have
disastrous results, adds Littenberg. "There are certain tax structures
that just plain old won't work because they're wildly inefficient. And
what's efficient from the U.S. side may not be efficient from the
foreign side."
Keeping the compliance issues straight in cross-border deals usually
introduces the need for advisers in the countries in question. As the
web of lawyers, accountants and consultants widens, the effort to
coordinate the players and move the deal forward becomes magnified. So
too, says Littenberg, does the need for oversight, particularly when
working with firms in developing countries.
"You won't necessarily have the breadth of counsel choices, and
sometimes the logical choice is conflicted out," Littenberg says.
"Culturally, it can also be a challenge, for example, when you're
trying to sign a deal quickly. The whole world doesn't necessarily
believe in working 24/7 to get the deal done."
Complex deal structures mean considerable strategic thinking on the
part of in-house and outside teams. But having a sense of what deal
structures to pursue and which to abandon early on can save time up
front and headaches down the line. - Suzanne Stevens
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