Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions

Transcription

1 NEW 2017 Editio of Structurig Veture Capital, Private Equity, ad Etrepreeurial Trasactios W e are proud to eclose the 2017 Editio of Structurig Veture Capital, Private Equity, ad Etrepreeurial Trasactios by co-authors Jack S. Levi ad Doald E. Rocap, seior parters i the iteratioal law firm of Kirklad & Ellis LLP, i cojuctio with special editors Russell S. Light of Kirklad & Ellis LLP ad the late Marti D. Gisburg of Georgetow Uiversity Law Ceter. Here is a summary, writte by the authors, of major developmets reflected i the ew editio. Highlights of the New Editio l Chages i federal securities law. SEC substatially broadeed Reg. D s exemptio from 1933 Act registratio for issuace of ew securities. Effective i early 2017, SEC substatially rearraged Reg. D s several exemptive provisios, which allow a compay (whether a corporatio, partership, or LLC) to issue its securities to PE/VC ad other ivestors without 1933 Act registratio. Because 1933 Act registratio for a compay s securities is a legthy, expesive, ad public process, the compay frequetly prefers to issue its securities i a uregistered private placemet. I the past, Rule 504 (which imposed the fewest hurdles to a uregistered securities issuace) covered a securities issuace up to $1 millio, Rule 505 (which imposed more hurdles tha did Rule 504) covered a securities issuace up to $5 millio, ad Rule 506 (which imposed the most hurdles) covered a ulimited securities issuace. SEC s recet Reg. D amedmets (1) icreased the amout permitted i a Rule 504 issuace from $1 millio to $5 millio, (2) completely elimiated Rule 505, ad (3) made o chage to Rule 506, all as more fully described below. 5 SEC expads Rule 504 exemptio. A compay (so log as either a 1934 Act reportig compay or a ivestmet compay) ca (after SEC s recet Copyright 2017 CCH Icorporated. All Rights Reserved. 1 MORE

2 amedmets) issue up to $5 millio of uregistered securities uder Rule 504 to a ulimited umber of accredited ivestors ad a ulimited umber of o-accredited ivestors (who eed ot meet ay sophisticatio requiremet), with o private offerig memoradum or other specific disclosure requiremet. The compay caot, however, employ geeral solicitatio or advertisig for potetial purchasers uder Rule 504 (except for the 3 specific circumstaces described below), meaig that the compay caot offer its securities through: a publicatio (icludig a ewspaper or magazie advertisemet or article), broadcast, or other use of mass media metioig the offerig, a semiar or meetig with oe or more potetial purchasers ivited by geeral solicitatio or advertisig, a statemet o a public website, a face-to-face discussio, phoe call, letter, or other oral or writte commuicatio about the offerig to ayoe with whom the compay or its sposor or fiacial adviser/placemet aget (or their employees or agets) does ot have a pre-existig substative relatioship i.e., a relatioship that allows the compay to reasoably coclude that each perso beig solicited is a accredited ivestor. Accredited ivestor geerally meas: a huma beig with at least $1 millio et worth (or joit et worth with spouse), excludig primary residece ad mortgage debt thereo, or more tha $200,000 icome (or $300,000 joit icome with spouse) or a director or executive officer of the compay, or a etity (ot formed for the purpose of acquirig the securities) with total assets exceedig $5 millio. The compay (issuig securities without SEC registratio pursuat to Rule 504) must, however, comply with ay applicable state securities rules applicable to each state i which the compay is issuig such securities. Securities the compay issues uder Rule 504 (except for the 3 specific circumstaces described below) costitute restricted securities for SEC purposes ad hece caot be publicly resold without SEC registratio or a exemptio (e.g., SEC Rule 144). 5 Rule 504(b)(1) sales of securities do qualify for geeral solicitatio or advertisig ad, after issuace, costitute urestricted securities for SEC purposes. I 3 specific circumstaces (ivolvig compliace with state 2

3 securities laws) SEC Rule 504(b)(1) permits a compay to use geeral solicitatio or advertisig i issuig its securities without 1933 Act registratio, i which case such securities do ot, after issuace, costitute SEC-restricted securities ad hece ca be publicly resold without SEC registratio or a exemptio therefrom (e.g., SEC Rule 144). The first such circumstace covers sales of securities i oe or more states which provide for state registratio of the securities, alog with delivery of a substative disclosure documet to each purchaser. 1 The secod circumstace covers sales of securities i oe or more states that do ot provide for state registratio of the securities, but where the compay registers ad offers its securities i at least oe state that does allow for such registratio (alog with delivery of a substative disclosure documet) ad delivers the registratio state s disclosure documet to each purchaser i the o-registratio states. 2 The third circumstace covers sales i oe or more states that allow geeral solicitatio ad advertisig for sales of securities to accredited ivestors. 3 Securities issued by a compay uder ay of these 3 circumstaces (so that geeral solicitatio ad advertisig is allowed) do ot costitute restricted securities ad hece ca be publicly resold without SEC registratio. 5 Rule 505 repealed. SEC completely repealed Rule Rule 506(b) uchaged. SEC did ot chage Rule 506(b) ad hece a compay ca still issue (uder Rule 506(b)) a ulimited amout of securities without SEC registratio to a ulimited umber of accredited ivestors plus up to 35 o-accredited ivestors who are sophisticated (aloe or i cojuctio with a sophisticated purchaser represetative), with a private offerig memoradum delivered to each o-accredited ivestor, but with o geeral solicitatio or advertisig allowed. Uder federal preemptio rules, a Rule 506(b) issuace is geerally exempt from state regulatio other tha form filig ad a fee. Securities issued uder Rule 506(b) costitute restricted securities ad hece caot be publicly resold without SEC registratio or a exemptio therefrom (e.g., SEC Rule 144). 1 Most states have such a provisio. 2 A few states have o provisio for registratio ad hece this (ii) procedure ca be used i such states. 3 May states have such a exemptio. 3 MORE

4 5 Rule 506(c) uchaged. SEC did ot chage Rule 506(c) ad hece a compay ca still elect to issue (uder Rule 506(c)) a ulimited amout of securities without SEC registratio to a ulimited umber of accredited ivestors with o private offerig memoradum or other specific disclosure, usig geeral solicitatio ad advertisig, so log as there are o sales of such securities to ay o-accredited ivestor ad the compay egages i ehaced verificatio of each ivestor s accredited ivestor status (rather tha less ivasive self-certificatio). Uder federal preemptio rules, a Rule 506(c) issuace is geerally exempt from state regulatio other tha form filig ad a fee. Securities issued uder Rule 506(c) costitute restricted securities ad hece caot be publicly resold without SEC registratio or a exemptio therefrom (e.g., SEC Rule 144). SEC Rule 701, allowig a compay to sell uregistered (but restricted) securities to its service providers, did ot chage. See discussio at 207.3, 207.7, ad 208. l Delaware court decisios severely limit board s fiduciary duty owed to preferred stockholders. Two Delaware court decisios. Where preferred stock terms require a corporatio to redeem its outstadig preferred stock (e.g., at face plus accrued but upaid cumulative divideds) at a specified date (or dates), but the corporatio s directors coclude that, while such redemptio would be i the preferred stockholders best iterests, such redemptio would ot be i the commo stockholders best iterests, how should the directors resolve such coflict? The Delaware Chacery Court cocluded i a 2017 case that while the board owes full fiduciary duties to commo stockholders, preferred stockholders are owed fiduciary duties oly whe they do ot ivoke their special cotractual rights ad rely o a right shared equally with the commo stock, i.e., that preferred stockholders rights are merely cotractual i ature, so the board does ot owe fiduciary duties to preferred stockholders whe cosiderig whether or ot to take corporate actio that might trigger or circumvet the preferred stockholders cotractual rights. Rather the board has a duty to prefer the commo s iterests, as pure equity holders, by maximiz[ig] the value of the corporatio over the log-term for the beefit of presumptively permaet equity capital (i.e., commo stock). Accordigly the court refused to dismiss commo stockholders claim that the board breached its fiduciary duty to the commo stockholders whe the board sold part of the corporatio s busiess i order to fud a madatory preferred stock 4

5 redemptio obligatio, because sellig part of the corporatio s busiess impaired the corporatio s ability to geerate log-term value for the commo stockholders. The court stated that the board had a fiduciary duty to determie whether it was i the commo stockholders best iterest to breach the preferred stock redemptio obligatio (eve if the corporatio would the be subject to a cotractual damage claim from the preferred holders), rather tha to sell assets ad thereby dimiish the corporatio s log-term busiess potetial. Similarly, i a 2013 Delaware Chacery Court decisio, where the board sold the etire busiess which was treadig water for a price that left o proceeds for the commo stock after paymet of the preferred obligatios, the court cocluded that the board should have determied whether the sale was i the commo stockholders best iterest eve if rejectig the sale ad cotiuig the struggle to improve the corporatio s busiess would have made it less likely the preferred would ultimately be paid off. Possible solutio: automatic self-effectuatig pealties. Because of these cases deyig preferred fiduciary duty, the preferred holders (at least for a Delaware corporatio) may wat the preferred stock terms to iclude specific ad automatic self-effectuatig ecoomic pealties to the commo stock (ad i favor of the preferred stock) upo o-paymet of ay preferred redemptio or preferred divided obligatio, e.g.: 5 a icrease i the preferred s (accruig) divided rate, 5 a reductio i the preferred s coversio price (if the preferred is covertible ito commo stock) or a sprigig coversio right (if the preferred is ot otherwise covertible), perhaps with subsequet periodic coversio price reductios so log as o-paymet cotiues, ad 5 periodic issuace to the preferred holders of pealty warrats to buy commo stock at a low price. The existece i the preferred terms of such ecoomic pealties o the commo stock icreases the likelihood that the board would comply with the preferred terms (i order to avoid such ecoomic pealties to the commo) or, if the board did ot comply with the preferred s terms, such pealties o the commo would at least icrease the ecoomics for the preferred holders. Similarly, a cotractual drag-alog provisio i the articles of icorporatio ad/or i cotractual agreemets betwee the commo ad preferred holders allowig the preferred holders to sell all of the corporatio s stock to the best bidder uder specified circumstaces (e.g., failure to redeem the preferred o a specified schedule), with sale proceeds shared i accordace with the preferred ad commo stock s liquidatio 5 MORE

6 priorities ad with all of the commo stockholders obligated to cooperate ad sig appropriate documetatio would put additioal pressure o the commo stockholders to cooperate with the preferred stockholders i sellig the corporatio. See discussio at l Executive compesatio. Calculatio of service provider s OI o receipt of equity iterest i corporatio versus partership/llc. Where a compay s service provider ( SP ) receives a equity iterest i the compay i coectio with the SP s performace of services for the compay, SP s icome tax ramificatios vary sigificatly depedig o whether the compay (1) is formed as a corporatio (so that Code 83 applies without modificatio) or (2) is formed (ad taxed) as a partership or LLC (so that Rev. Proc s more-service-provider-favorable tax rules apply). Where Rev. Proc applies (i.e., the compay is formed as a partership or LLC), SP s OI is govered by Rev. Proc s liquidatio value ( LV ) approach (which frequetly produces a zero LV at the time of issuace), with a deemed 83(b) electio, rather tha (where the compay is formed as a corporatio) by Code 83 s fair value ( FV ) approach, with o deemed 83(b) electio. SP geerally should be able to obtai the same Rev. Proc tax advatages (LV approach with deemed 83(b) electio) eve though the compay is formed as a corporatio where the compay s equity owers (icludig SP) ow the compay s stock through a partership or LLC. See discussio at ad (icludig Example 3). Revised GAAP accoutig rules for executive stock-based or optio-based compesatio ca icrease employer s GAAP et icome. Uder revised 3/16 GAAP rules, i the case of a stock sale or award to a executive, the compay s GAAP compesatio expese (which reduces the compay s GAAP et icome) is equal to: (1) the stock FV at the time of the sale or award, (2) less the price (if ay) paid by the executive, while the compay s GAAP tax expese (which also reduces the compay s GAAP et icome) is reduced (thus icreasig the compay s GAAP et icome) by the compay s tax savig (calculated over the life of the award) resultig from its tax deductio o accout of the stock sale or award. Uder the 3/16 revised GAAP rules, i the case of a stock optio grat to a executive, the compay s GAAP compesatio expese (which reduces the compay s GAAP et icome) is equal to: 6

7 5 the optio s FV at grat date, takig ito accout both (a) the spread (if ay) at grat plus (b) the FV of the optio privilege, i.e., the value to the executive from deferrig the stock purchase decisio ad paymet of the optio price (geerally approximately 30% of the optio price for a optio grated at the moey), while the compay s GAAP tax expese (which also reduces the compay s GAAP et icome) is reduced (thus icreasig the compay s GAAP et icome) by the compay s tax savig (calculated over the life of the award) resultig from its tax deductio o accout of the stock optio grat ad exercise. For both a stock sale or award ad a stock optio, the revised GAAP rules measure GAAP compesatio expese at grat date, but (through post-grat adjustmets) measure tax cosequeces at tax recogitio date based o the compay s actual ultimate tax results. Thus, if stock FV rises betwee grat date ad tax recogitio date (which for a stock grat or sale is geerally immediately upo grat or sale if there is o SRF or there is a SRF plus a 83(b) electio, or at vestig where there is a SRF with o 83(b) electio, ad for a optio is geerally at exercise if there is o post-exercise SRF or if there is a 83(b) electio at exercise), the compay would recogize a icrease i tax beefits ad hece i its GAAP icome. Thus, uder the 3/16 revised GAAP rules a substatial icrease i the compay s stock price betwee grat date ad tax recogitio date geerally results i a substatial decrease i the compay s taxes ad hece a substatial icrease i the compay s GAAP et icome. Ideed, after adoptio of the 3/16 GAAP rules, several high-tech compaies reported large icreases to their GAAP et icome attributable to tax beefits flowig from the exercise of employee stock optios. These same GAAP rules apply whether the compay is a corporatio or a partership/llc. See discussio at (which cotais umerical examples based o several alterative grat ad vestig/exercise scearios). l PE/VC fud formatio ew U.S. Departmet of Labor rules may prohibit a PE/VC fud from acceptig a commitmet from a smaller pesio pla or IRA. Hotly debated DOL rules (issued durig the Obama admiistratio) became effective 6/9/17 (although the Trump DOL aouced it cotiues to aalyze the rules) apparetly prohibitig a PE/VC fud sposor from commuicatig with a U.S. o-govermetal beefit pla ivestor (e.g., a U.S. pesio pla or IRA) i a maer viewed as a recommedatio that the beefit pla ivest i the fud uless the beefit pla ivestor utilizes a large idepedet istitutioal ivestmet adviser i decidig whether to make such ivestmet i the fud. If a fud sposor markets a LP iterest to a beefit pla which does ot have such a large idepedet fiduciary (geerally a smaller pesio pla or IRA), the fud sposor could be 7 MORE

8 viewed as a fiduciary makig a recommedatio to the beefit pla ad thus as violatig the DOL coflict of iterest rules, although it ca be argued that a fud sposor which simply provides a private offerig memoradum to a beefit pla ivestor without ay further commuicatio from the fud to the beefit pla has ot become a fiduciary makig a prohibited recommedatio. Shortly before the rules 6/9/17 effective date the Trump DOL somewhat ambiguously aouced that it will ot pursue claims agaist fiduciaries who are workig diligetly ad i good faith to comply... or treat those fiduciaries as beig i violatio.... See discussio at l Exit scearios reduced tax rates for shareholder s gai o sale of Code 1202 qualified small busiess stock. Code 1202 grats a reduced LTCG tax rate ad a reduced Medicare tax rate for a idividual s gai from sale of a C corp s stock which the idividual has held more tha 5 years ad which meets a umber of other statutory requiremets. The extet of the tax rate reductio (from the ormal 20% LTCG ad 3.8% Medicare tax rates) turs o whe the idividual acquired the stock: Date stock acquired Reduced LTCG tax rate Portio of LTCG subject to 3.8% Medicare tax 9/28/10 ad thereafter 0% 0% 2/18/09 through 9/27/10 7% 25% 8/11/93 through 2/17/09 14% 50% Stock-sale gai is eligible for Code 1202 s reduced tax rates oly if the trasactio meets a umber of (overly complex ad i some places overly vague) requiremets, icludig: 5 The corporate issuer must be a U.S. C corp. 5 The gai must be taxable to a idividual (directly or through a flow-through etity). 5 The idividual (or flow-through etity) must have acquired the stock from the corporatio at origial issuace, ot from a third party, with exceptios for gifts ad bequests. 5 The stock must have bee held loger tha 5 years, with tackig for gifts, bequests, ad certai 351 (icorporatio) ad 368 (reorgaizatio) evets. 5 The stock must have bee acquired for cash, property (other tha stock), services, or (uder certai circumstaces) i a Code 351 icorporatio or 368 reorgaizatio i exchage for 1202 stock of a predecessor corporatio. 8

9 5 The corporatio must have had o more tha $50 millio of aggregate gross assets (geerally measured by tax basis) immediately after the shareholder acquired the stock. 5 The corporatio must have used at least 80% of its assets (by value) i coductig a active busiess (or busiesses) durig substatially all of the shareholder s holdig period for the stock. 5 The corporatio must ot have made certai types of stock redemptios. 5 The shareholder must ot have egaged i certai types of short sales with respect to the corporatio s stock. 5 The maximum amout of a idividual s LTCG from sale of a sigle corporatio s stock eligible for the reduced rate i ay tax year is the greater of: (1) a aggregate limitatio of $10 millio (takig ito accout the idividual s gai durig such year ad all prior years) or (2) a aual limitatio of 10 times the idividual s aggregate basis i such stock sold by the idividual durig such year. See discussio at as applied to Portfolio Compay stock owed by PE/VC fud partership. Where PE/VC fud buys, holds for more tha 5 years, ad the sells Portfolio Compay stock which meets 1202 s requiremets, the fud s LTCG should qualify for 1202 treatmet to the extet allocable to a idividual LP or a idividual GP. This should iclude GP s 20% carried iterest i fud s Portfolio Compay stock gai, so log as GP s percetage iterest i such gai has ot icreased from the date o which fud purchased the Portfolio Compay stock to the sale date. It is ot relevat for 1202 qualificatio that GP s share of fud s profit o Portfolio Compay s stock exceeds GP s share of fud s capital ivested i Portfolio Compay, i.e., that GP supplied (e.g.) 1% of fud s capital ivested i Portfolio Compay stock but is etitled (by virtue of GP s carried iterest) to a larger share of fud s profit o Portfolio Compay stock, so log as GP s percetage share of fud profit from Portfolio Compay stock did ot icrease betwee fud s purchase of the Portfolio Compay stock ad fud s sale of such stock. See discussio at 907.1(1) (Example 1). Additioal issues. The authors have also added discussio of a umber of other Code 1202 subrules, icludig: 5 I applyig the $50 millio asset test whe a shareholder purchases Portfolio Compay stock, whe are Portfolio Compay s assets measured by tax basis ad whe by FV? Where tax basis is the correct measure ad Portfolio Compay ows equity i a subsidiary, is the test applied to the equity iterest s tax basis or the uderlyig assets tax basis, ad does the aswer vary depedig o whether the subsidiary is a corporatio or a partership/llc? 9 MORE

10 5 Where corp #1 (the stock of which qualified for 1202 before the acquisitio) is acquired by corp #2 i a tax-free 368 reorgaizatio i exchage for corp #2 stock, are corp #1 s assets added to corp #2 s assets i determiig whether corp #2 meets the ot-more-tha-$50 millio asset test at the time of the acquisitio, so that future appreciatio i corp #2 s stock held by corp #1 s old shareholders qualifies for 1202, ad, if so, does corp #2 cout corp #1 s assets at their old basis i corp #1 s hads or at FV? 5 Does the step-trasactio doctrie apply i determiig if Portfolio Compay has exceeded the $50 millio asset test, e.g., where Portfolio Compay issues ew stock to A while plaig to issue additioal ew stock to B, is the cosideratio to be paid by B i the ear future viewed (i applyig the $50 millio assets test to A s stock purchase) as if already received by Portfolio Compay? 5 I applyig the active busiess test (i.e., i determiig if 80% of Portfolio Compay assets by FV have bee used i coductig a active busiess) durig substatially all of a shareholder s stock holdig period, (i) uder what circumstaces does Portfolio Compay s workig capital cout as a active busiess asset ad (ii) do Portfolio Compay s R&D activities costitute active busiess? See discussio at l Exit scearios miority shareholder protective devices whe TargetCorp is beig sold. Whe TargetCorp is beig sold (to BuyerCo) ad some of TargetCorp s shareholders object to the terms of such sale, state corporatio law ofte grats TargetCorp s shareholders oe or more protective devices, which ca iclude: (a) (b) (c) disseters rights of appraisal, shareholder vote, ad miority shareholder class actio suit assertig that TargetCorp s board of directors i sellig TargetCorp did ot satisfy the busiess judgmet rule, as supplemeted (at least for a Delaware corporatio) by (i) the Revlo ehaced scrutiy stadard requirig the board to obtai the highest price reasoably attaiable for TargetCorp s shares i a sale of TargetCorp s cotrol where cash is all or a substatial portio of the cosideratio or (ii) the etire fairess stadard for a cotrollig shareholder coflicted trasactio, all as further described below. Disseters rights of appraisal. 5 Sale of TargetCorp assets. If BuyerCo is acquirig substatially all of TargetCorp s assets, the laws of may jurisdictios permit a dissetig TargetCorp shareholder to receive from Buyer i cash the appraised FV of 10

11 his or her TargetCorp stock as determied by a court. Delaware ad some other states, however, dey appraisal rights to a TargetCorp shareholder whe TargetCorp sells all or substatially all its assets uless TargetCorp s charter otherwise provides. 5 Sale of TargetCorp by merger. If BuyerCo is acquirig TargetCorp by merger, the laws of most jurisdictios allow a dissetig TargetCorp shareholder to receive from BuyerCo i cash the appraised FV of his or her shares, as determied by a court, although various state laws cotai exceptios. Delaware, for example, deies appraisal rights to a TargetCorp shareholder whether BuyerCo s acquisitio of TargetCorp is accomplished by (1) two-party forward merger (TargetCorp ito BuyerCo) or (2) three-party forward merger (TargetCorp ito BuyerCo s subsidiary) or (3) three-party reverse subsidiary merger (BuyerCo s subsidiary ito TargetCorp) if 100% of the cosideratio to TargetCorp s shareholders (other tha cash for fractioal TargetCorp shares) is comprised of BuyerCo stock listed o a atioal securities exchage or held by more tha 2,000 holders. Nevertheless, eve where the above rules would grat appraisal rights to a TargetCorp shareholder, a 2016 Delaware statutory amedmet deies such appraisal rights if the TargetCorp shares seekig appraisal are listed o a atioal securities exchage ad either: (a) (b) the total umber of TargetCorp shares seekig appraisal does ot exceed 1% of TargetCorp s outstadig shares of such class eligible for appraisal rights or the FV of the cosideratio (provided i the merger agreemet) for all the Target shares seekig appraisal does ot exceed $1 millio, but oetheless does allow appraisal rights (otwithstadig (a) ad (b) above) if the merger is a short-form merger, i.e., a merger ot requirig TargetCorp shareholder approval because BuyerCo already ows at least 90% of TargetCorp s shares at the time of the Target-ito-Buyer merger. See discussio at Shareholder vote. 5 Sale of TargetCorp assets. If BuyerCo acquires all or substatially all of TargetCorp s assets, state law geerally requires TargetCorp shareholder approval, with the ecessary percetage for approval varyig accordig to the law of TargetCorp s jurisdictio of icorporatio ad the specific provisios of TargetCorp s charter (which may require a higher percetage tha applicable state law). 11 MORE

12 I Delaware, for example, a sale of all or substatially all of TargetCorp s assets requires approval of a majority of TargetCorp s outstadig votig stock, uless TargetCorp s charter calls for a higher percetage. May other states require more tha a majority (frequetly two-thirds) for approval. States differ i their iterpretatio of substatially all of a corporatio s assets, with some judicial opiios idicatig that over 50% may be substatially all, or i some cases eve less tha 50%. 5 Sale of TargetCorp by merger. A merger geerally requires approval from TargetCorp s shareholders with the required percetage varyig from state to state, subject to icrease by a corporatio s charter. I Delaware, for example, a merger requires approval from a majority of TargetCorp s outstadig votig stock, uless TargetCorp s charter calls for a higher percetage. May other states require more tha a majority (frequetly two-thirds) for approval. However, where BuyerCo has first purchased a portio of TargetCorp s stock i a teder offer ad/or oe or more egotiated purchases ad BuyerCo the desires to squeeze out TargetCorp s remaiig (miority) shareholders by merger, a vote of TargetCorp s shareholders ca be avoided i two circumstaces: First, most state laws cotai a exemptio allowig a short-form merger without ay TargetCorp shareholder vote betwee BuyerCo ad oe of its subsidiaries (here TargetCorp) with TargetCorp s miority shareholders receivig BuyerCo stock, cash, or other cosideratio as specified i the short-form merger agreemet. The percetage owership that BuyerCo must already have i TargetCorp i order to utilize this short-form merger procedure (without a TargetCorp shareholder vote) varies from state to state (90% beig the ecessary percetage i Delaware). Where the acquisitio is friedly ad TargetCorp has adequate authorized but uissued stock, TargetCorp might grat BuyerCo a top-up optio to purchase from TargetCorp (typically for a BuyerCo ote) such umber of previously uissued TargetCorp shares as are ecessary (after BuyerCo s teder offer or ope-market purchases) to meet the state law threshold for a short-form merger. Secod, a 2013 additio to Delaware law (as further ameded i 2016) allows a vote of TargetCorp s shareholders o a merger betwee TargetCorp ad BuyerCo to be avoided where: 12

13 (a) (b) (c) (d) (e) TargetCorp has more tha 2,000 shareholders or is listed o a atioal securities exchage immediately prior to executig the merger agreemet, ad BuyerCo or its subsidiary ( AcquirigCorp ) makes a first-step offer for ay ad all TargetCorp stock, ad immediately followig cosummatio of the offer, the TargetCorp stock purchased by AcquirigCorp pursuat to such offer, together with the TargetCorp stock otherwise owed by AcquirigCorp ad ay rollover stock (as defied below), is sufficiet to approve the secod-step squeezeout merger (uder Delaware law ad TargetCorp s charter), geerally more tha 50%, ad all o-tedered TargetCorp stock (other tha rollover stock) is exchaged i the secod-step squeeze-out merger for the same amout ad kid of cosideratio per share as was received by the tederig TargetCorp shareholders i the teder offer (i.e., cash i the same amout per share as i the teder offer where the teder offer cosideratio was cash), ad TargetCorp is icorporated i Delaware. Rollover stock meas TargetCorp shares covered by a writte agreemet requirig the shareholder to trasfer such shares to AcquirigCorp i exchage for AcquirigCorp stock, so log as such TargetCorp shares are actually trasferred to AcquirigCorp o later tha immediately prior to the time the merger becomes effective. Before the 2016 Delaware statutory amedmet, all o-tederig TargetCorp shareholders were required to receive (i the squeeze-out merger) the same type ad amout of cosideratio per share for their TargetCorp stock as the tederig TargetCorp shareholders (i.e., requiremet (d) above but without the parethetical exceptio for rollover stock, which was added by the 2016 amedmet). However, after the 2016 amedmet, AcquirigCorp ca ow acquire TargetCorp shares owed by oe or more TargetCorp shareholders (icludig TargetCorp executives) i exchage for AcquirigCorp stock, eve though all of TargetCorp s other shareholders receive cash for their TargetCorp shares (both i the teder offer ad i the squeeze-out merger). While the 2016 statutory amedmet allows TargetCorp stock owed by ay TargetCorp shareholder (ot merely by a TargetCorp executive) to be treated as rollover stock, i.e., acquired by AcquirigCorp i exchage for AcquirigCorp stock, the provisio is likely to be used most ofte i practice to roll oe or more key TargetCorp executives TargetCorp stock ito AcquirigCorp stock. 13 MORE

14 Especially where BuyerCo is a ew etity (formed by a PE fud to acquire Target i a LBO), BuyerCo may (after the 2016 amedmet) offer TargetCorp executives (who will become post-merger BuyerCo key executives) a opportuity to exchage their TargetCorp shares for BuyerCo shares tax-free (as part of BuyerCo s Code 351 formatio ad buyout of TargetCorp), thus allowig such TargetCorp executives to exchage their low tax basis TargetCorp stock without CG recogitio for higher FV BuyerCo stock (which takes a post-merger low carryover tax basis from their old TargetCorp stock). See discussio at l Exit scearios Target board s fiduciary duty. (1) Busiess judgmet rule. Uder state corporatio law, busiess judgmets reached by TargetCorp s directors are geerally respected ad accorded deferece if the board acted o a iformed basis, i good faith, ad i the hoest belief that the actio was take i the best iterests of the corporatio ad its shareholders. I order for the board to claim the beefit of this judicial busiess judgmet rule, the board must be able to demostrate that it acted with due care after thorough study ad coscietious deliberatio. 4 (2) Revlo ehaced scrutiy. However, uder Delaware law, whe TargetCorp s board is cosiderig a trasactio i which TargetCorp s shareholders give up TargetCorp s cotrol i.e., (i) a sale of TargetCorp where cash is all or a substatial portio of the cosideratio (e.g., PE fud sposors Newco s LBO acquisitio of TargetCorp or BuyerCo acquires TargetCorp with cash comprisig all or a substatial portio of the cosideratio) or (ii) a combiatio of TargetCorp ad BuyerCo with TargetCorp s shareholders receivig BuyerCo stock but with the combied BuyerCo-TargetCorp eterprise thereafter cotrolled by oe BuyerCo shareholder (or by a group of BuyerCo shareholders actig i cocert) TargetCorp s directors have a duty more rigorous tha required by the busiess judgmet rule to protect the iterests of TargetCorp s shareholders ad obtai the highest price for their shares reasoably attaiable (the so-called Revlo duty), so courts typically subject the directors coduct to ehaced scrutiy to esure that they have acted reasoably to achieve these goals. Ehaced scrutiy ivolves a judicial determiatio as to (i) the adequacy of the decisio-makig process employed by TargetCorp s directors, icludig the iformatio o which they based their decisio to pursue the trasactio, (ii) the reasoableess of TargetCorp directors actios i light of the circumstaces the existig, ad (iii) the ability of TargetCorp s board to accept higher offers eve after a defiitive agreemet for the trasactio has bee siged. There is o oe path to satisfyig TargetCorp directors Revlo duty ad, depedig o circumstaces, courts have bee satisfied with: 4 While Delaware law is clear o the board s fiduciary duty issues discussed i text ad some other states laws are less clear, most states are likely to agree o the priciples herei euciated, subject to the other-costituecy statutes eacted by some states, as discussed i (5) below. 14

15 (a) (b) (c) (d) a full market check where TargetCorp or its fiacial advisers solicit iterest from a wide array of potetial bidders for TargetCorp before sigig a merger agreemet with BuyerCo (that icludes a Target o-shop provisio), or a limited market check where TargetCorp or its fiacial advisers (cofidet that they ca idetify virtually all likely bidders) solicit iterest from a small umber of likely competig bidders (agai, before sigig a merger agreemet with a o-shop provisio), or either some or perhaps eve o pre-sigig market check by TargetCorp, so log as the siged BuyerCo-TargetCorp acquisitio agreemet allows competig bidders for TargetCorp to submit usolicited alterative offers (eve after the BuyerCo-TargetCorp acquisitio agreemet has bee siged but before the TargetCorp shareholder approval) ad also allows TargetCorp directors to termiate the BuyerCo-TargetCorp acquisitio after payig BuyerCo a reasoable termiatio fee if TargetCorp s directors believe a usolicited alterative offer is superior to the terms offered by BuyerCo, or o pre-sigig market check by TargetCorp, so log as the siged BuyerCo- TargetCorp acquisitio agreemet allows TargetCorp ad its fiacial advisers to actively solicit offers from select alterative bidders for a short post-sigig period (a go-shop ) ad allows TargetCorp directors to termiate the BuyerCo-TargetCorp acquisitio agreemet, after payig BuyerCo a reasoable termiatio fee (typically smaller tha the fee described i (c)) if TargetCorp s directors believe such a alterative offer is superior. Whe some board members have a iterest i the trasactio differet from the iterest of TargetCorp s shareholders geerally e.g., i a LBO where Newco or its PE fud sposor offers TargetCorp s maagemet the opportuity to cotiue as post-acquisitio Newco/Target executives, perhaps with icreased compesatio, ad/or to ivest i Newco by buyig, or receivig optios to buy, Newco commo stock it is advisable to form a committee of TargetCorp idepedet directors (who have o iterest i the acquirer) to foster a arm s legth egotiatio betwee the acquirer ad TargetCorp, ad ofte to egage i a auctio process or limited market check with the assistace of a idepedet ivestmet baker. Where the ehaced scrutiy stadard is ot met ad a Delaware court cocludes that TargetCorp s disiterested directors did ot thoroughly review the proposed sale of TargetCorp (ad alterative opportuities) ad take reasoable steps ecessary to maximize TargetCorp shareholders sale proceeds, Delaware courts have ejoied BuyerCo s acquisitio of TargetCorp, or if the acquisitio has already bee cosummated, have held TargetCorp directors persoally liable for breachig their fiduciary duty by sellig TargetCorp for too low a price. 15 MORE

16 (3) Exceptio to ehaced scrutiy, allowig busiess judgmet rule to apply. Delaware courts have, however, held that the ehaced scrutiy stadard does ot apply to a trasactio otherwise fallig withi the parameters for ehaced scrutiy (as described i (2) above) where: (i) (ii) (iii) the trasactio has bee approved by a fully iformed, ucoerced majority vote of disiterested TargetCorp shareholders (or by such a majority of TargetCorp s fully iformed, ucoerced, disiterested shareholders tederig their TargetCorp stock to BuyerCo, which is viewed as the equivalet of a majority shareholder vote), ad the BuyerCo-TargetCorp trasactio has already bee cosummated so the issue before the court is damages (ot a ijuctio), ad the trasactio is ot covered by the more rigorous etire fairess stadard applicable where TargetCorp is egagig i a coflicted trasactio with its cotrollig shareholder (as discussed i (4) below). (4) Cotrollig shareholder coflicted trasactio. Where TargetCorp has a cotrollig shareholder (the TargetCorp cotroller ) ad BuyerCo s acquisitio of TargetCorp is a coflicted trasactio, Delaware courts have adopted a etire fairess stadard of review (which is eve more rigorous tha the ehaced scrutiy stadard described i (2) above). Oe type of coflicted trasactio is where the TargetCorp cotroller seeks to acquire the remaiig TargetCorp shares ot previously held by the TargetCorp cotroller. I such case Delaware courts apply a etire fairess stadard, requirig proof that both price ad process have bee fair (almost always requirig a full trial if a miority shareholder sues), uless the followig six-part test is satisfied: (a) (b) (c) (d) (e) (f) from the outset the TargetCorp cotroller coditioed the trasactio o o-waivable approval by both (i) a TargetCorp board idepedet committee ad (ii) a majority-of-the-miority shareholders, the idepedet committee is idepedet of the TargetCorp cotroller, the idepedet committee is empowered to freely select its ow legal ad fiacial advisers ad to defiitively reject the TargetCorp cotroller s offer, the idepedet committee meets its duty of care i egotiatig a fair price for the miority shareholders, the miority shareholders are fully iformed, ad the miority shareholder approval is ucoerced. 16

17 This Delaware six-part test is also employed i a secod type of coflicted trasactio where the TargetCorp cotroller is sellig TargetCorp to a idepedet third party (BuyerCo), but the TargetCorp cotroller receives some beefit that the TargetCorp miority shareholders do ot receive (a differetial trasactio ), which could iclude: (A) (B) (C) a higher price per TargetCorp share tha the TargetCorp miority shareholders are receivig, or BuyerCo shares i exchage for part or all of the TargetCorp cotroller s shares while the TargetCorp miority shares are receivig oly cash, or satisfactio of a extreme liquidity eed o the part of the TargetCorp cotroller (ot shared by the TargetCorp miority shareholders). I such a differetial trasactio, the TargetCorp cotroller is permitted to receive such a beefit without requirig etire fairess, i.e., that both price ad process have bee fair, so log as the six-part test discussed above is satisfied. Etire fairess is ot implicated solely because TargetCorp has a cotrollig shareholder, but oly where TargetCorp has a cotrollig shareholder ad BuyerCo s acquisitio of TargetCorp is a coflicted trasactio (as described above). Thus, where the TargetCorp cotroller sells its etire stake i TargetCorp, receivig idetical cosideratio per share to the miority shareholders, the busiess judgmet rule (ot the etire fairess stadard) applies (supplemeted by ehaced scrutiy i a sale of TargetCorp s cotrol where cash is all or a substatial portio of the cosideratio or the combied BuyerCo-TargetCorp eterprise is cotrolled by oe BuyerCo shareholder or a group of BuyerCo shareholders actig i cocert), uless the cotroller forced a iappropriate TargetCorp fire sale i order to solve the cotroller s persoal liquidity crisis. (5) Other costituecy statutes. Approximately 30 states (but ot Delaware) have eacted various versios of other-costituecy statutes, permittig (or i a few cases requirig) TargetCorp s board of directors, i actig o BuyerCo s proposed acquisitio of TargetCorp, to cosider iterests other tha those of TargetCorp s shareholders. Various of these statutes permit or require the board to cosider the iterests of: TargetCorp s employees, TargetCorp s customers, TargetCorp s creditors, TargetCorp s suppliers, commuities served by TargetCorp, TargetCorp s log-term iterests, 17 MORE

18 the local ad atioal ecoomy, BuyerCo s reputatio, ability, ad potetial coduct, other factors TargetCorp s board deems pertiet, ad the possibility that TargetCorp s cotiued idepedece may best serve TargetCorp s log-term iterests. Some of these other-costituecy state statutes apply to ay acquisitio of TargetCorp, while some apply oly to certai forms of acquisitio, e.g., a sale of all or substatially all TargetCorp s assets. There is little precedet o the extet to which a court may hold that such a permissive or madatory other-costituecy statute exoerates TargetCorp s board from liability (or ijuctio) where TargetCorp s board has ot egaged i the activities which would have bee required to satisfy the board s fiduciary duty had a other-costituecy statute ot bee i effect, i.e., because TargetCorp s board accepted a acquisitio proposal that did ot provide TargetCorp s shareholders with the highest price reasoably attaiable for TargetCorp s shares. See discussio at to l Delaware fiduciary duty rules for a partership or LLC s GP/maagig member. Fiduciary duty. Delaware partership ad LLC law grats a partership or LLC substatial leeway to cotract or expad (by clear provisios i the etity s basic agreemet) the extet of a GP s or maagig member s fiduciary duty. A 2013 Delaware Supreme Court decisio (dealig with a LP s claim that the publicly traded partership s GP had breached its fiduciary duty whe the GP approved a coflicted trasactio betwee the partership ad the GP) held that the GP is presumed to have acted i good faith so log as the GP followed the procedures set forth i the partership agreemet, eve if, by all appearaces, the trasactio was ufair to the LPs. However, four years later a 2017 Delaware Supreme Court decisio reversed course ad required the GP to comply with each of the coflict procedures set forth i the partership agreemet, as described below. Both of these decisios ivolved the same publicly traded limited partership (the Partership ), ad i both cases, the same LP alleged that the same GP had breached the partership agreemet by ufairly favorig the GP to the detrimet of the LPs. I the 2013 decisio, the Partership (composed of the GP ad a large umber of LPs whose iterests were publicly traded) etered ito a joit veture with the GP o terms proposed by the GP, with the GP receivig 75% of the joit veture profits ad the Partership receivig oly 25%. The GP appoited a special committee comprised of idepedet directors, which approved the trasactio. The court foud that (i) with 18

19 oe exceptio either the special committee or the fiacial adviser sought better terms from the GP, (ii) the fiacial adviser did ot use commo valuatio metrics, ad (iii) the fiacial adviser s opiio regardig the trasactio suggested that the GP s proposal was based o a EBITDA multiple for the LPs substatially below the multiple reported o the fiacial adviser s website for other similar trasactios. The court evertheless cocluded that the complait did ot plead facts sufficiet to show that the GP s decisio to approve the related party trasactio was so far beyod the bouds of reasoable judgmet that it seems essetially iexplicable o ay groud other tha bad faith, basig its decisio o a iterpretatio of four provisios i the partership agreemet: (1) Ay stadard of care ad duty... uder the Delaware Act... shall be... waived... to permit the [GP] to act... so log as such actio is reasoably believed by the [GP]... to be i the best iterests of the Partership (the Fiduciary-Duty- Waiver-ad-Partership-Best-Iterests clause). (2) The GP is allowed to buy property from ad sell property to the Partership i a fair ad reasoable trasactio o less favorable to the Partership tha those geerally... available from urelated third parties (the Related-Party- Trasactio clause). (3) The GP will ot be liable for moetary damages so log as the GP acted i good faith (the GP-Exculpatio clause). (4) Ay actio take or omitted by the GP i reliace upo the opiio [of a ivestmet baker or other cosultat or adviser]... shall be coclusively presumed to have bee doe or omitted i good faith (the Coclusive-Presumptio clause). Iterpretig these 4 clauses together (rather tha requirig the coflicted trasactio to satisfy each clause separately), the court cocluded that (i) the GP would be liable for damages oly if the GP acted i bad faith, (ii) the GP s actios, based upo the special committee s determiatio, which were i tur based o the fiacial adviser s advice, are coclusively presumed to be i good faith, ad (iii) this is true eve if the terms of the [joit veture]... were ot as favorable as a third party trasactio or otherwise fair. I the 2017 decisio (ivolvig the GP s repurchase from the same publicly traded Partership of the 75% iterest i the same joit veture), the GP formed a special committee of idepedet directors which, after receivig a report from its fiacial adviser, cocluded that the purchase price the GP proposed to pay to the partership was fair. The Delaware Supreme Court rejected the approach it had take i the 2013 decisio ad held that the partership agreemet required the trasactio to comply with the 19 MORE

20 stadards i the Related-Party-Trasactio clause (fair, reasoable, ad o less favorable tha available from urelated third party), regardless of whether the GP reasoably believed the trasactio to be i the Partership s best iterests (as required by the Fiduciary-Duty-Waiver-ad-Partership-Best-Iterests clause), lookig to specific provisios over more geeral oes. Turig to the questio of good faith ad whether the GP-Exculpatio clause isulated the GP from moetary damages, the court lowered the pleadig stadard aouced i the 2013 case ad required the plaitiff oly to plead facts supportig a iferece that [the GP] did ot reasoably believe the... trasactio was i the best iterest of the Partership. The court also rejected the GP s argumet that, uder the Coclusive-Presumptio clause, the GP was etitled to a presumptio of good faith because it relied o the fiacial adviser s opiio whe approvig the trasactio, reachig this result i part due to alleged flaws i the fiacial adviser s aalysis ad i part because the fiacial terms of the trasactio were fully baked by the time the adviser appeared o the scee to reder a fairess opiio. See discussio at (7). No-waivable coveat of good faith ad fair dealig. Delaware partership/llc law prohibits a partership or LLC agreemet from limitig or elimiatig the statutory implied cotractual coveat of good faith ad fair dealig. I a series of cases, icludig a 2017 decisio, the Delaware Supreme Court held that GP s reliace o a coclusive-presumptio-of-good-faith clause i a partership agreemet i.e., a provisio statig that GP s reliace o a idepedet adviser s opiio or a idepedet committee s decisio or some other specified act coclusively demostrates good faith does ot prevet GP s actio from breachig Delaware s statutory o-waivable implied duty of good faith ad fair dealig. I the 2017 decisio a publicly traded partership (Target) was acquired by a affiliate of Target s GP ( Purchaser ), with the amout of stock ad cash cosideratio paid by Purchaser to Target s LPs havig bee approved by: (i) (ii) a allegedly idepedet coflicts advisory committee ad a majority vote of Target s idepedet LPs (i.e., LPs who were ot affiliated with Target s GP), both of which approval methods Target s partership agreemet stated were sufficiet to immuize the related-party purchase from LP challege. However, proxy material prepared by Target s GP i coectio with Target s LP vote failed to disclose that (a) a member of Target s idepedet coflicts advisory committee held a positio with a affiliate of Purchaser util four days after his 20

21 appoitmet to Target s idepedet committee ad (b) was the reappoited to such positio with the Purchaser affiliate immediately after closig of Purchaser s acquisitio of Target. The court cocluded that, although Target s partership agreemet both disclaimed fiduciary duties ad extiguished disclosure duties, oce [GP] wet beyod the miimal disclosure requiremets of the LP Agreemet, ad issued a 165-page proxy statemet to iduce the [LPs to cast the]... safe harbor [majority-lp vote], implied i the laguage of the LP Agreemet s coflict resolutio provisio was a obligatio ot to mislead [the LPs], i.e., a requiremet that the [GP]... ot act to udermie the protectios afforded [LPs]... i the safe-harbor process, otwithstadig that the express terms of the LP Agreemet did ot address, oe way or aother, whether the [GP]... could use false or misleadig statemets to eable it to reach the safe harbors. Such terms [i.e., a GP obligatio ot to mislead the LPs ad hece udermie the LP vote protectios] are easily implied because the parties must have iteded them ad have oly failed to express them because they are too obvious to eed expressio.... Also [i]mplicit i the express terms is that the Special Committee membership be geuiely comprised of qualified members ad that deceptive coduct ot be used to create [a]... false appearace. See discussio at (6). l Federal icome tax rates for 2017 ad thereafter. C corp icome tax rates. The top federal C corp icome tax rate for 2017 ad thereafter (o both OI ad LTCG) cotiues at 35% (subject to a approximately 3 percetage poit reductio o qualified U.S. productio busiess et icome). See discussio at 107(5) ad (6). Idividual icome tax rates. The top federal idividual icome tax rates for 2017 ad thereafter (which also apply to partership, LLC, or S corp-level icome flowig through to a idividual equity ower) are: 5 For OI ad STCG, the top rate cotiues at 39.6% (subject to a approximately 3 percetage poit reductio o qualified U.S. productio busiess et icome). 5 For ormal LTCG, the top rate cotiues at 20%. 5 For QDI (qualified divided icome), the top rate cotiues at 20% (i.e., the same as LTCG). 5 For Code 1202 LTCG (from qualified small busiess stock held more tha 5 years), the top rate cotiues at: l 0% for such stock acquired o or after 9/28/10, l 7% for stock acquired betwee 2/18/09 ad 9/27/10, ad 21 MORE