Silicon Valley Practitioner Discusses Technology M&A

Monday, December 19, 2011 - 15:39

The Editor interviews Craig W. Adas, Managing Partner of Weil, Gotshal & Manges LLP’s Silicon Valley office. Mr. Adas is a member of the firm’s corporate department focusing on mergers and acquisitions, private equity and finance. He has a broad corporate and securities practice, with particular emphasis on leveraged buyouts, private and public acquisitions, joint ventures and securities offerings.

Editor: What are the latest developments in the technology sector and in the deal market overall?

Adas: There is explosive growth in mobile devices, such as iPhones, iPads and tablets, and everybody seems to have a device that they are pushing to market. These mobile devices and their operating systems, like Mac OS, Windows 7 and Android, will drive the development of hardware, such as semiconductor chips and a wide variety of software programs, including mobile applications (“apps”).  Each device is loaded with a suite of hardware and software, which collectively constitute a major component of the technology sector.

Other hot areas include cloud computing and SaaS (software as a service) companies. SaaS companies produce software that can be downloaded over the Internet and then configured to the user’s customized needs. Large technology companies have been purchasing cloud and SaaS companies at a rapid pace; for example, Oracle, SAP and IBM all recently announced major acquisitions of companies in this space. Data management and access is another key area, with companies like Dropbox offering cloud-based data storage and sharing capabilities.

Editor: What are the trends with the development of new apps?

Adas: Apps are a hot commodity. In fact, the Apple iTunes Store offers over 500,000 apps, which reflects that there are an incredible number of developers working, mostly from small studios, to come up with the next big app hit. The first step is to develop a product that sparks public interest – perhaps a gaming, business-related or personal-efficiency app – but what really drives adoption of a given iTunes app is word of mouth and ratings that Apple posts on its website. Once the word is out, these apps tend to perpetuate themselves.

Editor: Are consumers becoming more comfortable with this technology vis-à-vis privacy issues?

Adas: Yes, companies have improved the security aspects of their cloud applications and are enjoying more consumer confidence. As a result, there will be more development in that space. A major driver of demand for these products and services is the fact that consumers generally are becoming more technology savvy. Teenage use of computers and handheld devices has become second nature, and they often never touch a piece of paper, for example, in the process of completing a homework assignment. Gaming apps and websites, such as Zynga, are also very popular and constitute a strong market within their young demographic. In terms of business productivity, more and more people are becoming comfortable with technology as an integral part of the workplace, even if they didn’t grow up with it.

Editor: Does all this demand mean that Silicon Valley is poised to lead the U.S. out of its current economic difficulties?

Adas: Silicon Valley is poised to do its part, and it is doing its part in terms of developing new technologies at a very rapid pace. The capital is there, the innovation most definitely is there; however, U.S. tax policy and government over-regulation will limit Silicon Valley’s ability to lead the recovery.

Many U.S. companies have moved operations overseas, due to labor costs and U.S. corporate tax rates. Certainly, the manufacturing sector has left, but other business functions, such as back-office support and customer service functions, also have migrated outside the U.S. Consequently, there is a lot of capital trapped overseas, which companies might opt to repatriate if they had a tax-efficient option. Repatriated funds might be deployed to create American jobs and/or return capital to stockholders, who, in turn, might invest in new domestic companies and enterprises.

Editor: Please talk about your M&A practice. Do you work with incubator funds or super-angels?

Adas: Our office focuses on private equity buyouts, M&A for public and private companies and venture capital (VC). Much of the VC tends to be growth equity, meaning investments that are in the $10 to $100 million range, and in some cases, incubator funds or super-angels were involved in prior rounds. We work with a number of VC funds, including Sequoia Capital, who in turn has a good relationship with Y Combinator, one of the more successful super-angel funds in the industry.

Typically, we don’t work directly with super-angels because they are involved in small financing rounds and may not require comprehensive documentation (as we do at our level). One of the attractions of super-angels is that they often perform limited due diligence, are nimble and don’t impose many conditions on the financing. Super-angels have forced the more traditional VC funds to either act quickly or move upstream and handle larger growth equity investments at later stages.

Editor: How does super-angel involvement at early financing stages affect your due diligence when a deal comes to you at the higher M&A level?

Adas: Some incubator funds and super-angels do a fair amount of diligence, albeit very quickly, while others do very little. Over time, we have learned who is good at performing due diligence, and we may take some comfort in that. However, when we’re representing a private equity sponsor or a VC firm, for instance, in connection with a growth equity investment, we still do a full slate of due diligence because the stakes are higher. Super-angels are bridging a gap in the traditional seed money process, often by sprinkling their money across dozens of companies in $50,000 to $150,000 increments. Some incubator funds are as small as $300,000 to $400,000, while others are $10 million and above.

Editor: Do you see a lot of preferred stock at the second and third tiers?

Adas: Yes. A preferred stock round is typical and involves negotiating economic issues and governance rights. Super-angels are attractive at this level because their primary goal is to get involved at the low-valuation stage, and their investment amounts are often not sufficient to justify a seat on the board. On the other hand, traditional VC or growth equity investors in the $5 to $10 million range most definitely expect to have a board presence, including voting and veto rights with respect to extraordinary transactions.

Editor: What are the key criteria for financing strategies?

Adas: Technology start-ups often start with two goals. The first is finding a high-demand product or service for enterprises or consumers, and the second is raising enough capital to develop and deploy that product or service before its competitors do. No investor or company wants to waste time, even with the very best technology, if there is no market. A key financing strategy is to determine how much capital is required to bring the product to market and to avoid being in constant fundraising mode. Conversely, raising too much money is dilutive to existing stockholders, so there is a delicate balance here.

Editor: With so many legendary technology start-ups originating from the garages of Silicon Valley, is it valid to say that apps development is not a capital-intensive process?

Adas: It is valid right now, though we expect gradual consolidation in that area. Some apps developers will become larger enterprises, adding in engineers, making acquisitions and merging with other development shops. Capital requirements are triggered at these later stages, when companies want to add talent or product capabilities before their own revenues can support these actions.

Editor: What is the progression of financing for start-ups, and are there special liability considerations for directors and officers along the way?

Adas: The initial round often involves family and friends in a financial relationship based on trust. Banks usually stay away unless there is a guarantee or the loan is a small line of credit. Next, seed investors step in, including super-angels and traditional VC funds.

While their directors have all the standard fiduciary duties to stockholders, start-ups often don’t provide D&O insurance; thus, a director or officer must rely upon contractual rights from the company for indemnification. VC or private equity firms will provide a D&O policy to protect its agents who serve on boards of portfolio companies, and most companies will purchase D&O insurance when they grow out of the family-and-friends financing stage and start taking outside money.

Editor: When advising a start-up client at the early stages, how prominently does the ultimate possibility of going public figure into the planning process?

Adas: Going public is not as important as it used to be. Very few of today’s companies can hit everything just right to gain access to public markets, and most expect their exit strategy will involve a sale to a larger competitor. LinkedIn was among a few successful IPOs in the last 18 months, and there are some prominent IPOs on the horizon, including Zynga and Facebook.

Social media companies face a particular obstacle in being fundamentally dependent on “popularity” with a young, capricious consumer base, and I imagine this issue is front and center at every Facebook board meeting. Consider how quickly the high-flying Myspace website dropped to near obscurity. Facebook is distinguished in being the clear market leader, but questions remain as to how long it can sustain dominance and its potential for future growth. Given its current valuation, very few companies can afford to buy Facebook; therefore, an IPO may be the only viable exit strategy.

Another development that we’ve seen over the past several years is the development of a secondary trading market for private companies. Given the dismal IPO market these last several years, private companies like Zynga, Twitter and Facebook have worked with these secondary trading markets to provide liquidity to their employees and shareholders. These secondary trading markets are generally limited to buyers who are accredited investors.

Editor: What issues in a start-up formation can be proactively managed with effective contract drafting?

Adas: Contract issues break down into two categories: economic issues, such as liquidation preference, redemption and conversion rights and anti-dilution, and governance issues like voting/veto rights and board appointment privileges. Effective documentation is critical to avoiding business interruptions caused by a deadlocked board or a preferred stockholder base with too many veto rights. While everyone has the same goal of getting to a profitable liquidity event, individuals may disagree about timing and methodology.

Editor: Please describe the role of patent trolls in the formation of a start-up technology company. What is the impact of the new patent law?

Adas: The less pejorative term is non-practicing entities (NPEs). They tend to go after bigger companies with deep pockets that are able to purchase blanket licensing rights for all the patents in the NPE’s portfolio. Start-ups often don’t have patents at all; therefore, a critical aspect of our due diligence is to ensure that these clients have proper documentation for product development, and that all of their employees and consultants have signed the right proprietary inventions agreements. We will conduct patent searches for conflicting technology, but at the earlier stages, we usually rely upon the company’s internal documentation.

Our patent litigation practice is among the highest rated in the country and focuses largely on defense. While the true impact of the America Invents Act is yet to be determined, its enactment has not slowed this practice at all.

Please email the interviewee at craig.adas@weil.com with questions about this interview.