Maintaining Impact Through M&A

As the COVID-19 crisis continues to make capital markets, including venture capital, an uncertain source of financing, founders and boards of impact businesses may increasingly look to M&A and other strategic alternatives to assure their survival. Mergers, business and asset sales, large-scale technology licensing, as well as other strategies should all be on the table. However, founders and boards of impact organizations will be rightly concerned with the ability to maintain their organizations’ missions, following such fundamental transactions. Not only is the ability to stay “on mission” important to the organization for its own sake, but it also adds real value (both pre- and post-transaction) that should be taken into consideration during planning and negotiations in connection with such transactions. In this article, we discuss a number of items that impact organizations should consider at different stages (at the preparatory stage, during negotiations with potential transaction partners, and following the closing of the transaction). It is important to understand at the outset that the relative negotiating leverage of the parties (including access to alternative transactions) can significantly influence the ability to implement the measures described below.

Considerations at Preparatory Stages

Proactively Change Corporate Form Even Before Sales Process Begins (Sweet Pill)

In the context of a sale of the company, Delaware law requires the board of directors to conduct a process designed to maximize stockholder value.[1] In order to maintain mission lock post-closing, it may be helpful to convert into an entity that allows the board to consider issues other than maximizing stockholder value in connection with, and in anticipation of, the sale of a company.

Recently, more public companies have considered changing into social purpose corporations (SPCs), public benefit corporations (PBCs), benefit corporations, or similar forms. Such new corporate forms require a dual profit/mission mandate. Although these are for-profit entities that share many traits with regular corporations, their governance documents (and relevant state law) require adherence to a specific and/or general public purpose. For these corporate forms, in determining what is in the best interests of the corporation and its stockholders, the board of directors may consider things other than maximizing stockholder value. These dual profit/mission mandates may allow an acquirer’s offer to be rejected unless it addresses the specific or general public purpose that is aligned with the target’s purpose. For instance, a board of directors of a PBC may not be required to submit a takeover offer to stockholders for approval if the board does not believe that the buyer will prioritize the public purpose of PBC. However, such entities are not available in all states, and their legal rights and obligations vary from state to state.

Conversion into an alternative entity is not without its own risks, all of which need to be considered in such a transformation. For example, stockholders of a traditional corporation are entitled to dissenter’s rights in connection with a conversion into a PBC. In addition, certain states require benefit corporations to have a “benefit director.” A “benefit director” is entitled to bring a “benefit enforcement proceeding” to enforce the general specific public-benefit purpose. Nonetheless, a “benefit director” may have a conflict between their traditional fiduciary duties and their duty to preserve a public purpose. Similarly, some states grant shareholders and, potentially, third parties the right to bring “benefit enforcement proceedings.” This expanded base of potential plaintiffs may increase a company’s exposure to litigation.

Diligence/Reverse Diligence:  Confirming That Acquirer Will Be a Good Partner

Preserving mission following closing is desirable in many instances, but it may be particularly important where the transaction will be structured as a merger of equals and the company has mission-driven investors, or in instances where the value of the company is, in large part, based on its mission. In a merger of equals, two businesses are combined, and the former stockholders of each company will hold stock in the combined company. Similarly, a business where the mission is important to attracting and retaining customers will want to ensure mission continuity in order to preserve value following the transaction. Otherwise, following the merger, the activities of the combined company may not align with a mission-driven investor’s investment philosophy, or the combined company may lose customers who were attracted to the mission.

To determine whether there is mission alignment and ensure mission continuity, a company considering a business combination should consider reverse due diligence on the counterparty/acquirer. Sending a due-diligence request list to the potential acquirer, which includes questions related to environmental, social, and governance (ESG) issues, is critical in order to determine whether there is mission alignment. The thoughtfulness and completeness of a party’s responses to such inquiries signals commitment to mission. While many of the responses may be qualitative, it is important to emphasize benchmarking when data is available in order to determine how the counterparty/acquirer compares with others in the industry and other potential counterparties/acquirers in a competitive process. Furthermore, when analyzing supply chains of the counterparty/acquirer, it is important to consider what is being monitored and reported and whether any third-party verifications are available. Where one party does not monitor or report customary metrics or there are no third-party verifications available, companies where mission is important should consider whether there is actually mission alignment between the parties.

Considerations During Negotiations

Entity/Transaction Structure:  To Ensure Mission Success Post-Closing

If a target company has not yet converted into an alternative entity, the target (or the selling stockholders or members) should consider converting the target company as part of the transaction. Note that benefit corporations, SPCs, and PBCs each require periodic impact reporting, which will enable monitoring of post-closing mission lock. Both the benefit corporation and SPC require that such reporting be made public. While public reporting creates a public-relations incentive and increases the credibility of the commitment to maintain mission lock, private reporting is sufficient for monitoring and enforcing post-closing mission lock. A buyer’s willingness to convert the post-closing company into an alternative entity in connection with the transaction signals their intent to maintain mission.

Whether or not the target company is converted, protective provisions can be included in the target company’s charter, or in a stockholders’ agreement, to block the ability to change the target company’s mission. Rollover equity (held by founders or other key sellers) can be given the right to enforce such protective provisions. It should be noted that, at least in traditional corporate forms, in any direct conflict between mission-protective provisions and traditional fiduciary duties, fiduciary duties are likely to prevail. Limited liability companies, with their more contract-based governance structure, could provide additional latitude to preserve mission through governance. One further post-closing governance mechanism to be considered would be the requirement to form an impact committee that is empowered to exercise oversight over mission-related activities. The degree to which such a committee may affect change (particularly when there are trade-offs between bottom line and impact focus) should be considered in light of the conflict in fiduciary duties discussed above. If an impact committee is not formed, parties should consider having one board member with “sustainability” expertise.

To the extent that the value of the target company is derived from intellectual property, such intellectual property could be held separately from the acquirer corporate structure, with the continued right to the inbound license at least partially based on mission focus, including ongoing reporting and benchmark achievement requirements.

Considerations for Post-Closing Matters

Enforcing Mission Continuity Post-Closing

One way to enforce mission post-closing is to provide for the acceleration of payment of contingent consideration, in the case of an earn-out, or a release of escrowed proceeds, if there is a material deviation from the agreed upon mission following closing. This will align an acquirer’s financial interest with the mission, or the acquirer will face an immediate cost. In order to ensure that acceleration is not improperly demanded, acceleration should be tied to measurable metrics and, if available, third-party verifications and certifications (or loss thereof).

A requirement for third-party evaluation and/or certification can provide some level of comfort that the acquired entity will continue to pursue its social purpose. Parties should consider whether “B Corp.” certification is appropriate, though such certification will require conversion to a benefit corporation or similar entity. Note that a B Corp. is not a type of legal entity but is a certification promulgated by the non-profit B Lab.

Potential Challenges and Risks

Sellers may meet resistance to any deal terms that limit an acquirer’s governance powers post-closing, especially in a challenging market. A seller may have difficulty in convincing an acquirer that the seller’s mission has value that needs to be protected or, even if the seller can make that case, that such value needs to be protected by post-closing rights granted to selling equity holders. An acquirer may view post-closing, mission-imposed limitations as impeding their ability to operate the business as they see fit and limiting value, so care must be taken to frame these limitations as accretive to value.

Although, as discussed above, an acquirer’s offer may be rejected by a board if it does not address the specific or general public purpose that is aligned with the target’s purpose, where there are multiple potential acquirers and one potential acquirer offers substantially more value but is not mission aligned, a board of a PBC may be required to recommend that the company convert into a traditional corporation.  Such conversion would add potential complexity because stockholders in a PBC have dissenter’s rights in connection with a conversion to a traditional corporation.

Selecting a new corporate form and implementing a transition can be a complex process, and many of the new corporate forms described above have not been well-tested in state courts. There are dozens of different forms, with significant differences between forms. Even within a particular state’s regime, the laws providing for the new corporate forms can seem to be inconsistent with each other.

To the extent sellers are relying on impact-related reporting, either for diligence or post-closing compliance matters, such reporting itself will present its own challenges. Most companies who do report on impact matters are years behind in their reporting. Different corporate forms and certifying authorities require different reporting standards. For public companies, impact reporting needs to be harmonized with public filings.

Conclusion

Market forces following the outbreak of COVID-19 will present challenges to many companies. In these uncertain times, some companies may need, or decide, to pursue strategic alternatives. Mission-driven businesses should consider whether and how to preserve mission in connection with such potential transactions. Companies will need to consider the various stakeholders to craft the right strategic approach to preserve mission. Changes to corporate form, whether before or in connection with a transaction, may assist in preserving mission, but such changes are not without their challenges. The benefits and burdens of increased reporting and complex fiduciary duties must be considered. With the proper structuring and balancing, a company may be able to continue to address the needs of stakeholders, preserve mission, and increase value.


[1] See Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).