SCL Event Report: Foundations of IT Law Programme – IT Law in Corporate Transactions

January 27, 2015

The eighth module in the Foundations of IT Law Programme was ‘IT law in corporate transactions; including trade sales, private equity, joint ventures and venture capital’, a seminar, hosted by Macfarlanes LLP, and chaired by Chris James of Telefonica.

The intent of the seminar was to ‘absorb knowledge from the experts’, including (i) Rupert Casey, partner at Macfarlanes LLP; (ii) Matt Wilson, Head of Legal, Digital Ventures at Telefonica; and (iii) Nick Pantlin, who is a partner at Herbert Smith Freehills LLP.

The first presentation was given by Rupert Casey of Macfarlanes LLP. It covered various aspects of IT law in trade sales and private equity transactions.  Rupert asked ‘why is IT that important?’  As is commonly known in the modern world, albeit not necessarily immediately linked to the world of corporate law, IT is becoming a large part of everyone’s life. Rupert explained that, as lawyers, this shift into technology creates important considerations such as those arising in relation to associated rights, liabilities and privacy.  This may not be, as Rupert states, ‘the sexy side of IT’, but until the various rights and liabilities have been reviewed in a due diligence process, with such risks allocated through warranties and indemnities, the move from ‘coffee shop idea to the reality of a payday cheque’ will not be realised for the technology entrepreneur.

Rupert explored the pros and cons of both a trade sale and a private equity deal.  In a trade sale, the buyer is ‘already in that space’ which, given its understanding of the industry, will tend to equate to a higher price.  This may be because the purchaser will see strategic benefit and not simply a need to make a return on its investment. The risk, however, is that potential bidders use the process as a ‘fishing expedition‘ and garner confidential information on their potential competitor.  Conversely, a private equity buyer will generally be more focussed on return on their investment, and hence this objective may result in a lower price.  Equally, they are more likely to be adverse to risk, creating an increased requirement for appropriate contractual protection.  A private equity buyer will, however, be keen to grow the business, and is therefore likely to provide resources for support.

Rupert placed a key emphasis on understanding the drivers and motivations for the deal, both from a buyer’s and seller’s perspective, noting that ‘it is important not to rush in’.  He emphasised that the output of the due diligence report will relate directly to the understanding of the deal, the level of care in relation to the information received, and the questions asked. Rupert’s main theme, that subsequently flowed through all presentations, was the need to ‘think about the deal from a reader’s perspective’, and ensuring that the due diligence covers the fundamental questions of the buyer. The concept of a ‘red flag’ report is becoming more and more favoured in the industry, and the days of producing volumes of due diligence material, which would more often than not be left unread, has all but passed.

Rupert then provided further detail on the particular warranties which are core in relation to IT and its associated IP.  These warranties will focus on the legal and beneficial ownership of the rights and licences to use the IP, and any infringement or any reason why continued use of the IP would infringe third-party rights.  These warranties are, as Rupert describes, ‘the core building blocks of what do I have, and can I use it without being sued?‘ Rupert then considered specific IT-related topics, such as cyber threat and cyber security, cloud technology, source codes and escrow accounts and maintenance deals.  There can be no ‘one size fits all’ solution; hence value will be gained by, again, understanding the particular concerns, and allocating the risk in the contract accordingly.

The final part of Rupert’s presentation focused on what he described as ‘a source of constant irritation‘ – the request for an indemnity.  Rupert states that indemnities would usually (and validly) be used in scenarios where a party creates a risk that the other party would have to bear.  Rupert used the example where a buyer uses software which the seller had copied from a third party, thus infringing a third-party’s rights.  Indemnities, for example, for breaches of the other party’s contractual obligations alone, would appear ‘superfluous‘ and a ‘statement of the obvious‘ and thus not necessary, meaning that they should be excluded or requests for inclusion resisted.

Matt Wilson‘s presentation dealt with the various considerations from a venture capital and joint venture point of view.  To echo Rupert’s comments, Matt emphasised the need to ask ‘why?‘, because ‘everything will flow out from this initial question‘. 

Venture capitalists are keen to get involved and reap the rewards, through rapid growth and expansion of the business, by investment into ‘a novel technology or business model in, usually, high technology industries‘.  Venture capitalists are ‘in it for the money’, and in answer to the ‘why?’ question, large players such as Horizon Ventures and Sequoia Capital would always state, ‘financial returns’.  Corporate venture capitalists, such as Google, are increasingly becoming involved in information technology; Matt explained how Google has grown its fund for potential ventures from $100 million to $1.5 billion in a short time-frame.  With a large, successful organisation such as Google, Matt questioned why one would put money into another company, such as Uber?  In addition to the stock answer of good returns, Matt explained several other potential drivers behind the deal, including the use of complementary products and rights to accelerate an investor’s own business, gain competitive advantage in the industry, improve commercial terms with common suppliers and also as a means to gain market intelligence through access to information attained through the rights associated with the equity stake in the new company.

Matt explained that various technology considerations may be unearthed in a venture capital transaction.  He highlighted that some of the concerns would be a function of the industrial norm of starting these technology companies ‘in someone’s garage‘. Questions which may arise as a result are: ‘who owns the intellectual property?’ or ‘Is there even a company formed at all?’ He then expressed a word of warning in regard to including an ‘exclusivity’ clause in relation to the products the company provides. Exclusivity, perceived as a nice to have for the venture capitalist, may in fact act to narrow the market in which the products may be sold, and therefore have an impact on the very reason why the company is successful ‘by creating a deal that is so onerous that the investee changes behaviour, and hence are less valuable’.

Joint venture deals are often more complex, and the trend is increasingly toward negotiating bespoke deals in relation to the form, type and equity split of a joint venture. Using the example of Tesco Mobile, a joint venture between O2 and Tesco, Matt explained the various drivers parties may perceive in entering into a technology joint venture, such as entering into new territories, the benefits of economies of scale, knowledge pooling and the increased speed to market.  There are potential pitfalls however, including the misalignment of the partners’ interests, conflicts between cultures and nationalities, and ‘control freakery’, where partners seek certainty around control and ownership.

Matt wrapped up his presentation with a few key take-aways.  He reiterated the importance of having a clear picture of the objectives before you commence.  He emphasised the importance of not damaging relationships and goodwill by stressing non-important items in the contract:  some common legal protections may impact the behaviour of the parties, and hence lower the inherent value in the investment in the process.

The final presentation was given by Nick Pantlin, who gave an insight into transitional services agreements (‘TSA’) in the separation, extraction and cross-licensing of a deal.  In common with both Rupert and Matt’s prior presentations, Nick emphasised the need to ‘understand the deal’ and, in particular in relation to TSAs, it is important to understand the TSA in relation to the deal as a whole. 

Nick cautioned against viewing the TSA as a supplemental, potentially less important, aspect of the corporate transaction, as the timeline of the potential deal will often be heavily subject to the transitional services being in place prior to completion.  The TSA’s challenge is to provide a mechanism to deal with the buyer’s desire to maintain business continuity through using the seller’s expertise and experience, whilst at the same time providing the seller with sufficient deal certainty and a clean break.  

Nick then proceeded to explain some of the key issues in relation to managing the risk and liabilities of the parties to the TSA.  As both Rupert and Matt had previously covered, there are both custom and deal specific sets of issues, and the better your understanding of the deal at large, the better your ability to draft the TSA so as to allocate the risk accordingly.  Some of the key issues encountered in a TSA would be, for example, third-party licences required to deal with the IP in the transitional services, the physical movement of data from one system to the other, the agreement in relation to the service levels of the services, and any testing and acceptance criteria of any software.  Some of the more commonly encountered risks which would be covered off under a warranty or indemnity would include any TUPE-related issues for the transitional staff, data protection and intellectual property rights. As Nick continued to reiterate, these issues could potentially become the most important factors of the deal at large.

Nick’s final section concentrated on the case study of the demerger of TSB and Lloyds.  Nick’s experience in this deal highlighted the potential importance and complexity of the TSA.  A 2.5 year TSA was put in place (with a long term service arrangement for a further 7.5 years) to allow TSB to continue to utilise its business critical services, such as IT, for a period following the demerger.  This resulted in a shared IT platform between Lloyds and TSB which sets a key ‘precedent‘ in the banking market.  Nick explained some of the particular challenges, such as ensuring that Lloyds’ business services treated TSB no less favourably than Lloyds’ own brands, and the ever-looming exit deadline, by which time TSB is to be in a position to use its own independent business critical functions, including IT.  Nick described the TSA process in this transaction as the ‘making and breaking of the deal‘.

Gruffudd Jones is a Trainee Solicitor working in the commercial team at Macfarlanes LLP.