Strategies for parenting start-ups, post-acquisition

In recent years, we have seen more acquisitions of start-ups by big corporations in the tech industry, healthcare, retail, fashion, beauty, food, and transportation. The benefits of M&A transactions in these sectors has been more widely recognized. For instance, for a start-up, partnering with a large corporation provides broader market access, deeper industry knowledge and accelerated brand development opportunities. From the perspective of the corporation, it means access to growing markets, new technologies, and tapping into niche skills, talents and entrepreneurial and agile culture.

Despite the surging interest in enhancing collaborations between start-ups and bigger companies from both sides, Accenture research estimated half of such attempts are to fail, and Imaginatik and MassChallenge’s survey found that 50% of the start-ups rated their experience in interacting with big corporations as “mediocre or worse.” An important factor affecting the start-ups’ ability to adapt to the new relationship is the hierarchical nature and the well-established but rigid governance of most large corporations, which tend to suffocate the creativity and agility of the target. Consequently, the target becomes frustrated and the innovation that initially sparked the partnership is stunted.

So how can we improve the situation? In an interview by Mergermarket of three experts in the start-up M&A filed (the Interview), the answer is fairly straightforward: much like parenting in the real world, when a corporation acquires a start-up, it has to be a good parent and foster the growth of the newly acquired company.

Although all of the interviewees agree that there is no one-size-fits-all integration model, a successful model should bring everyone in the merging entities on board and be in informed by the strategy of the parent. Once the partnership is underway, experts such as Jamie Leigh have suggested that the parent ensure that open communication channels are being developed to empower entrepreneurship, and allow for experimentation, while at the same time providing financial and operative oversight and support.

Further, corporations need to be flexible and open to changes in order to avoid post-acquisition apathy. A report by hello tomorrow and the Boston Consulting Group echoed this point and suggested that the parent should avoid imposing its existing governance model on the target, or going too far in the other direction and adopt a laissez-faire model. A tailored governance plan should be in place that strikes the right balance between swift decision making and appropriate risk management. Finally, in the Interview, the experts emphasize the importance of recognizing the mentality of the employees in the process. Corporate employees should be informed about the upcoming alliance to enhance acceptance. As with any addition to a household, employees tend to feel threatened by a newcomer, and they often require reassurance and coaching to facilitate the integration process.

At the same time, while being parented, a start-up also needs to be active in the formation of the new relationship with the parent. As Dawn Belt of Fenwick & West pointed out in the Interview, as early as the negotiation phase, a start-up should be aware if the vision and values of the two companies are in alignment, and if a cultural marriage is attainable. While it is easy to get excited about the dollar amount of the M&A, start-ups need to be thoughtful and deliberate about finding a good home. Arnaud Leroi, a partner at Bain & Company, commented that large companies have become more open to accommodate the needs from start-ups. As such, start-ups are encouraged to initiate discussions about the level of post-acquisition autonomy, control over operations as well as the future roles of its key members with the parent. Much like the change management required for large corporations, start-ups need to ensure that they have a strategy that is deliberately planned and implemented.

Generally, it is important for both the parent and the start-up to acknowledge that not everything can be planned out up front and that both sides need to be prepared for some hiccups along the way. As such, it is important for both parties involved in the acquisition to have a strategic plan in place, and approach the transition with a flexible mindset.

The author would like to thank Maha Mansour, articling student, for her assistance in preparing this legal update.

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eSports: making it into the big leagues means learning the new rules

As mentioned in our first blog post on eSports, the eSports industry has experienced, and is projected to experience substantial growth. As the eSports industry continues to develop at a rapid pace, we are starting to see risks that are specific to the industry. In assessing whether a target is worth its price tag and whether its projections are attainable, the following are a few unique characteristics that pertain to the eSports industry that you should know about prior to entering into this space.

Know the game

Firstly, knowing the game and the third parties involved is crucial in the eSports industry. Despite several eSports teams exceeding the $100 million valuation, their value is often heavily reliant on tournaments and competitions held by the game developers because these widely broadcasted events in turn attract sponsors and advertisers. However, the goals of the game developers may not always align with the owners of eSports teams. For instance, Blizzard Entertainment, Inc. (“Blizzard”) recently announced that it will drastically cut their support for one of its most popular eSports games, Heroes Of The Storm. This included an announcement that Blizzard will cancel, among other things, the Heroes Global Championship, the premier tournament that boasted a $1 million prize pool and drew over 3.2 million hours of viewership in just 10 days back in 2018. Unexpected announcements (such as a game developer deciding to focus its resources elsewhere) have the potential to cripple the future revenue of a company that generates a portion of its revenue through prize money, sponsorships and streaming for that particular game. While many would call this instance an anomaly, the damage this announcement had on team owners and professional players that invested their resources into the game was material.

Furthermore, game developers often have unrestricted control over the structure and format of how the eSport ecosystem is run for their specific game. For instance, Riot Games, creator of League of Legends, switched their eSports operations to a franchise model (similar to traditional sports) for the beginning of their 2018 season. Aside from the ‘buy-in’ fee of USD$10 million (or USD$13 million if the team was not part of the previous 2017 season), this switch resulted in Riot Games having full control over which 10 teams (of a rumoured over 100 applicants) would be allowed entry into the franchise. Some teams, such as Dignitas, one of the original League of Legends professional teams in North America, who participated in tournaments since 2011, had their application denied. Unexpected changes such as this have the potential to greatly diminish, or even eliminate the value of an investment in an eSports team.

Know the trend

Like other industries, the eSports industry is equally subject to the trends of what’s cool and popular at the time. Given the growth of the industry, it is no surprise that new games are hitting the market at record speeds. Newcomers such as Blizzard’s Overwatch and Epic Games’ Fortnite have taken the industry by storm. For instance, Epic Games announced that it will provide $100 million for Fortnite eSports tournament prizes for its first year of competitively play (2018-2019 season). This number is nearly four times larger than any other prize pool announced for any other eSports game. Furthermore, Epic Games boasts about their 78.3 million players for the month of August 2018, which is just one year after they launched in late July 2017. This immense popularity directly takes away from play time, viewership and advertising exposure of the previously established games. Therefore, in eSports acquisitions, it’s more important than ever to focus on gaming trends and product life cycles. As an eSports team owner, you wouldn’t want to miss the boat on a game you didn’t expect to take off.

Know your rights

An important consideration for every team is choosing their name and associated brand. It’s crucial to know your branding rights and the parties that can affect those rights before you pour resources into building your brand. For instance, a recent article highlights how the Toronto Esports Club was forced to remove the word “Toronto” from its team name “Toronto Uprising”, despite having built a brand with that name over the previous Overwatch season and being in the minor league of Overwatch. Toronto Defiant, a new team that received the Overwatch league franchise for 2019, purchased the exclusive naming rights for “Toronto” and Blizzard responded by forcing Toronto Esports Club to rebrand their team within 6 weeks. These issues are often not resolved by exercising ones’ intellectual property rights to the brand name nor is it about whether a company has the right to exclusively buy the use of a word that is already in use by another party, in this case, “Toronto” – it is based on the terms and conditions these teams first agreed to in order to join the league or play the game in the first place – and these terms and conditions often give, in this case, Blizzard, the authority to enforce decisions in its sole discretion.

The substantial growth of the eSports industry makes companies in the space a desirable target for acquisition. However, given the unique characteristics of this emerging industry, it is important to pay attention to the risks and perform the proper due diligence before expanding into the world of online gaming.

The author would like to thank Travis Bertrand, articling student, for his assistance in preparing this legal update.

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Looking back at M&A activity in 2018

Looking back at global M&A activity during 2018, a report on global M&A by Mergermarket shows that while global M&A deal value rose over the last year, the number of deals fell for the first time since 2010. The value of deals rose to $3.53 trillion US dollars, an increase of 11.5% since 2018, making last year the third-largest year on record for deal value since 2001. This rise in value was partly due to 36 deals with value of over $10 billion as well as the pressure felt by companies globally to consolidate, driving firms to compete for targets and increasing target valuations. Despite the rise in deal value, overall volume fell for the first time in a decade. Increasing trade tensions, political instability, the effect of Brexit and increased regulatory oversight are some of the factors believed to have taken a toll on M&A activity in 2018.

One particularly notable trend was the decrease in Chinese acquisitions of US firms, which fell by a staggering 94% in the past year to $3 billion from a record setting year of $55 billion in 2017. Many experts point to a deteriorating political and trade relationship with China as the cause of such a sharp decrease. In contrast, Chinese acquisitions of European businesses rose by over 81% sin the last year, totaling $60.4 billion US dollars in value. In June 2018, Lin Feng, founder and CEO of Chinese investment and advisory firm DealGlobe stated “We are now focusing on Europe-bound deals and having U.S. deals on hold. The trade war between China and U.S., if not short-term, will be a mid-term thing and will take some time to conclude.” With no sign of political tensions easing between the two countries, it will be interesting to see if this trend of Chinese M&A activity will continue in 2019.

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Tax competition is coming – review of the Federal Fall Economic Update

On November 20, 2018, the federal Government of Canada released their Fall Economic Update – a review of the country’s finances and economic health that addresses trends and changes taking place in Canada and the world since the federal Budget in the spring.

Of particular note in 2018 was the anticipated response to the U.S. tax reform enacted by the Trump administration. In addition to slashing corporate tax rates from approximately 35% to approximately 27% (including state taxes) – an amount that puts pressure on Canada’s corporate tax rates, which vary between 26.5% and 31% – the U.S. tax reform introduced a temporary Bonus Depreciation measure, allowing businesses to depreciate certain capital property at a much faster rate, thereby reducing taxes when they purchase capital property.

In the Fall Economic Update, the Government of Canada acknowledges that U.S. tax reform has hurt or eliminated the Canadian tax advantage, but chose not counter it with any changes to Canadian corporate tax rates. Instead, they are introducing three new tax measures that substantially increase the first-year tax depreciation available to businesses that invest in depreciable property in Canada. These tax measures are effective immediately as November 20, 2018, and continue to have full effect until the end of 2023, at which point they will slowly be reduced until their elimination by the end of 2027.

By way of brief background, owners of depreciable property, such as machinery, intellectual property and technology, may deduct a portion of the cost of such property from their taxable income each year. The portion is determined by the “Class” of the depreciable property as found in the Income Tax Regulations (Canada). However, most Classes are subject to the “half-year rule”, meaning that the tax deduction is reduced by 50% in the year that the property is purchased. With these new changes, the Government of Canada has effectively eliminated the “half-year rule”, giving owners a boost to the tax deduction they get in the year that the property is purchased.

Manufacturers & Processors: Prior to the Fall Economic Update, Class 53 depreciable property, which includes most manufacturing and processing equipment, had a tax depreciation rate of 50% per year, and was subject to the half-year rule in the year that the property was purchased. Starting on November 20, 2018, taxpayers are now permitted to deduct 100% of the cost of purchasing Class 53 depreciable property in the year that they acquire the property.

Clean Energy Investments: Prior to the Fall Economic Update, 43.1 and Class 43.2 depreciable property, which includes clean energy technology, had a tax depreciation rate of 25% and 50% per year, respectively, and was subject to the half-year rule in the year that the property was purchased. Starting on November 20, 2018, taxpayers are now permitted to deduct 100% of the cost of purchasing Class 43.1 and Class 43.2 depreciable property in the year that they acquire the property.

Accelerated Investment Incentive: For all other depreciable property, the Accelerated Investment Incentive applies, permitting taxpayers to claim and deduct from their taxable income one-and-a-half times the normal tax depreciation rate for all property.

What does this mean for taxpayers contemplating an investment? Purchasing depreciable property – especially manufacturing and processing equipment and clean energy technology – is now accompanied by an boosted tax deduction in the year in which the property is purchased, allowing taxpayers to lower their tax bill while they invest in their business.

A few restrictions do apply. All three of these tax incentives are pro-rated over a short taxation year, and will not be available again, so a portion of that boosted tax deduction is lost if the taxation year in which the property is purchased is less than twelve months.

Further, these tax incentives are also not available if the property was previously owned by the taxpayer or a non-arm’s length person or if the property was transferred to the taxpayer on a tax-deferred rollover basis.

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U.S. M&A: full speed ahead for 2019

Optimism is the name of the game for the U.S. M&A market. A recent report by Deloitte cites positive tax reform, a relaxed regulatory climate and growing cash reserves as the primary reasons for expecting 2019 to be a big year for M&A. 79% of the 1,000 U.S. corporate executives and private equity firms surveyed said their organizations will close more deals in 2019 than 2018. 70% of the respondents also expect the aggregate value of deals closed to exceed 2018, with over half of deals expected to be between $500 million and $10 billion.

Interestingly, divestitures are expected to make up a critical component of overall M&A activity for 2019. 81% of respondents said they will sell units or portfolio companies in 2019, up from 70% last year. Corporations cited financing needs, change in strategy, and unneeded technology as the main reasons for future divestment. On the other hand, private equity firms primarily expect their divestments to be strategic sales.

The results show a significant shift in the factors expected to drive the corporate respondents M&A strategy. The previous number one strategic driver, acquiring technology assets, dropped to number three as companies appear to be focusing more on their customers, products and services. The most important driver of corporate M&A strategy was expanding the customer base in existing geographic markets, with expanding and diversifying products and services coming in closely behind at number two.

Looking abroad, one third of participants stated foreign targets will account for at least half of their M&A activity. Canada remains the most likely target for U.S. cross-border M&A. 44% of corporate respondents and 38% of private equity respondents expect to pursue a target in Canada. China ranked number two with 28% of total respondents expecting to target China for their M&A deals. Conversely, Brexit continues to tank the UK’s marketability as 24% of respondents (down from 31% last year) expect to make a deal in the UK.

Despite citing economic forces, tariffs, and other local and international legislation as possible curbs to deal activity and success, nearly 90% of all respondents anticipate the current level of M&A activity to continue or grow. Overall, respondents are looking favourably upon the new year for their M&A investment activities.

The author would like to thank Travis Bertrand, articling student, for his assistance in preparing this legal update.

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Brewery M&A in Canada

The brewing industry is one of Canada’s oldest, and has undergone substantive transformations in recent decades. After a period of consolidation that culminated in the mid-1980s, only ten Canadian breweries remained, of which three controlled more than 95% of the market. As a result of further worldwide M&A activity, the industry is now dominated by three major multinational players. These control 90% of all Canadian retail sales, and account for more than 70% of industry revenue in 2018.

Although the industry has enjoyed steady growth in recent years and continues to have a positive outlook, much of this growth can be ascribed to the increasing popularity of craft beer. According to a recent industry report, this shift in consumer tastes from mainstream light and premium brands towards craft beer is not only a Canadian phenomenon, but has also taken hold in Europe and the United States. While there is no universal definition of craft beer, it is typically associated with small, independent, traditional brewers producing less than 400,000 hectolitres a year. This shift in consumer taste is reflected in the number of new breweries that have entered the industry in recent years. In 2012, less than 250 establishments were operating in Canada. Today, despite substantial regulatory barriers to entry, there are 766 Canadian breweries, of which the vast majority are craft brewers.

The surging popularity of craft beer has created a challenge for the established players in the brewing industry, which is further exacerbated by the slow decline of Canadian beer consumption. Although Canadians’ spending on beer has increased, this is mainly because of the higher average price of craft beer compared to traditional brands. Currently, craft beer still only accounts for a fraction of the Canadian beer market, but is expected to make further inroads thanks to government incentives and increasing consumer demand for locally produced goods.

In their efforts to capitalize on this shift in consumer demand, the dominant companies may consider acquiring craft brewers. This strategy, however, has only seen mixed success in Canada and the United States, as the brand appeal of a previously independently owned brewery may be diluted. Further, craft breweries may have limited growth potential outside of their local market. As noted by others covering the industry, the ability of individual brewers to grow from small into medium-sized enterprises is limited, particularly because of tax reasons and regulations that make it difficult for microbreweries to sell outside of certain locations. This means that there are relatively few attractive acquisition targets. While M&A can help the established players in building out their brand portfolios, they will also need to invest greater resources in in-house innovation. Ultimately, no matter the approach taken, consumers will benefit from ever better selection in the coming years.

The author would like to thank Felix Moser-Boehm, articling student, for his assistance in preparing this legal update.

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Technology and creativity: keys to unlocking real estate?

With increasing globalization, shifting demographics and advancing technologies, just to name a few, society is changing rapidly. These changes, as reflected by evolving tastes, preferences and needs, influence both how and where people live and work. As part of their joint publication, Emerging Trends in Real Estate 2019 (the Report), PwC and the Urban Land Institute forecast that in response to mounting pressure on the Canadian real estate industry (the Industry) to confront these changes, we may begin to see Industry players increasingly embrace both technology and creativity.

Smart technologies may help the Industry adapt to a changing market

One trend that the Report identifies for 2019 is the “intersection of technology and real estate”. Virtual and augmented reality and drones, for example, will allow builders and developers to provide clients with greater insight into pre-construction projects and to show on-site progress once construction is underway, respectively.

Technology may play an even more significant role behind the scenes. In particular, we may see enhanced reliance on data analytics whereby Industry players use these technologies to help analyze consumer patterns and inform their decisions of which categories of property to target and/or avoid and how best to revamp their current portfolios so as to stay relevant in an ever-evolving market.

Higher price tags and risk aversion may encourage the Industry to get creative

With the rising costs of real estate and fewer “good deals”, the Report also forecasts Industry players getting creative in their approaches to navigating this riskier environment. One such approach may involve fewer purchases and instead, greater redevelopment of existing properties. Take retail, for example. With the acceleration of e-commerce (and certain other factors), retail properties have been experiencing pronounced difficulties such that the traditional “urban mall” is an increasingly less sustainable business model.

However, these retail properties are prime targets for redevelopment. In fact, the Report cites a trend of landlords planning to convert their malls into mixed-use spaces that offer a combination of retail, residential and other amenities.

Another approach may involve strategic partnerships and joint ventures. Specifically, some developers and investors intent on diversifying their portfolios by purchasing properties in unfamiliar markets are partnering with others who have expertise in those markets so as to minimize the risks associated with such acquisitions. Further, some developers and investors may shift their focus altogether to Canadian cities and/or other countries where real estate is less expensive.

With the new year just around the corner, it will be interesting to see how Industry players employ technologies and what creative approaches they adopt in order to effectively respond to the changes confronting the Industry and any further changes that may arise.

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Canadian M&A market still thought to be strong despite recent cut backs

Despite some cut backs in M&A activity expected over the next 12 months, the results reported in Ernst & Young’s (E&Y) 19th edition of the Global Capital Confidence Barometer (the “Report”) make clear that Canadian executives remain optimistic about Canadian and global M&A markets. Canadian executives are traditionally thought to be very bullish on the Canadian and global economy, and it is suspected that the decline in deals since the last Report is a temporary and strategic step back for companies to “digest recent acquisitions and assess the changing global geopolitical landscape.” The current state of geopolitical uncertainty in Canada stems primarily from the consequences of the newly negotiated USMCA and the next phase of Brexit, and it is expected that local M&A activity may pick back up once key players have a better idea of how these developments unfold.

The Report highlights a number of encouraging findings related to the Canadian and global M&A markets. These include that:

Despite these statistics, 34% fewer Canadian executives (from 80% on E&Y’s last survey to 46% this year) reported having the intention to actively pursue M&A deals in the coming year. Instead, Canadian respondents will aim to prioritize improving their working capital and further investing in existing operations. There is also a current push in Canada to invest in workforces, and specifically to motivate, retain, and reskill workers.

All in all, Canada is regarded as one of the world’s top investment destinations (ranking third in the world, the highest in its history). As such, despite the projected regression in M&A activity over the next twelve months, there are reasons for Canadians and Canadian executives to remain positive.

The author would like to thank Brandon Burke, articling student, for his assistance in preparing this legal update.

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The role of environmental, social and governance (ESG) factors in M&A

In private equity, environmental, social and governance (ESG) factors are often overlooked and undervalued. Due diligence is usually more focused on the financial and quantitative aspects of the target. However, in recent years, ESG has proven to be a powerful underlying factor for business successes and failures. As evidence by the #MeToo movement, and the various human resource scandals that have made headlines in recent months, an unhealthy corporate culture can have serious consequences for even the biggest of enterprises. A study that looked at 231 mergers and acquisitions between 2001 and 2016 found that ESG compatible deals performed better than those with disparate positions on ESG, by an average of 21%.

This figure should be considered alongside the fact that in 2016, more than 15,000 deals were terminated or withdrawn. The face value of these terminated deals totals USD three trillion. One can appreciate the time, effort, and costs incurred in relation to these proposed transactions, which is why investors need to look beyond the bottom line, and see how a target is achieving its results early on in the evaluation process.

The first challenge is in recognizing how ESG translates into financial success. Perhaps the most prominent link comes from employee management. Employees working within a healthy ESG environment are more focused on teamwork and productivity. There are also cost benefits to be realized from having a stable workforce and better employee retention. Studies have shown that companies with the best corporate culture generate three times the total returns to shareholders.

Another major link is sales. Consumers are paying more attention to environmentally friendly and ethically sourced products. In this highly connected global market, reputation is emerging as a key consideration. Consumers do not shy away from endorsing their favorite products or quite literally burning them on social media for millions to see. There is also a rational connection between ESG and a company’s overall maturity. A company that has sustainability measures and solid governance policies is likely to have optimized its operations to reduce costs. It will likely also have better community, and governmental relations to bolster its reputation. Therefore, identifying a target’s ESG becomes a valuable tool and a risk management strategy for an acquirer.

This can be a challenge because ESG is not readily apparent or quantifiable, and it’s often beyond the scope of the standard legal due diligence process. Recognizing the importance of these factors in the context of risk management, companies have harnessed the power of big data, to provide non-financial insights to businesses looking to make an acquisition. Such tools can not only provide a historical report card, but can also forecast risks and opportunities. While still at the early stages, higher demand will inevitably lead to better reporting and analysis. Investors looking to protect their capital should carve out ESG as a standard component of every deal, and the data will follow.

The author would like to thank Maha Mansour, articling student, for her assistance in preparing this legal update.

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Record year predicted for the cybersecurity industry

With a growing reliance on technology, it does not come as much of a surprise that the importance of cybersecurity is increasing as well. In its Mid-year Market Review, Momentum Cyber reported that $2.3 billion had already been lost as a result of cryptocurrency breaches. This staggering loss may be one of the many reasons why there is a greater focus on cybersecurity and why the number of mergers and acquisitions (“M&A”) in the cybersecurity sector has been rising. It was even predicted in August 2018 that this would be a record year for the industry.

This prediction is evidenced by Blackberry’s recent announcement that it intends to purchase Cylance for $1.4 billion in cash. Cylance creates software that is aimed to prevent cyberattacks from occurring on internet-connected devices, such as cell phones and tablets. This acquisition is not the first cybersecurity acquisition for the company. In 2015, Blackberry also purchased Good Technology, a company that specializes in enterprise mobile security products.

Blackberry is not the only company contributing to the recent spike in cybersecurity M&A activity. In August 2018, Cisco announced that it would be acquiring Duo Security for $2.35 billion and only earlier this month, Thoma Brava announced that it would purchase the software security firm Veracode, for $950 million. In the first half of 2018, 101 cybersecurity M&A deals had been reported, resulting in an 11% increase year-over-year.

Reasons for the growing interest in cybersecurity include:

  • An increase in investment opportunities;
  • Further innovation, revealing the need for greater cybersecurity; and
  • The heightened need for confidentiality and anonymity on the internet.

As the end of the year approaches, we will soon learn whether 2018 is in fact a record year for cybersecurity M&A. Moreover, given the importance of cybersecurity and recent acquisitions within the industry, it is likely that the upward trend of cybersecurity M&A activity will persist in 2019.

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