As an unfortunate consequence of the deterioration of the US-China relationship, more and more Chinese companies are divesting and exiting their US-based operations. This can be a difficult type of transaction to pursue. This article offers some guidance for companies on what they need to bear in mind as they head down that path:
In order to execute a smooth exit from US operations, Chinese companies should retain a good US financial adviser. Careful consideration should also be given to how the asset is packaged, preparing stand-alone audited financial statements, and optimizing the business for post-closing operations. Chinese companies should be prepared to use US law and engage in longer negotiations as a result. CFIUS-related requirements and risks should be understood during the early stages of the deal.
This article was first published in China Law & Practice.
Retain a US-based Financial Advisor. The US has a deep market of M&A buyers and spending the time to properly market the US business can maximize value. An experienced investment bank will assist with proper marketing, including creating marketing materials and preparing the management team for their presentations. Most importantly, a reputable, experienced investment bank will have a substantial network of potential strategic and private equity buyers and will also have a good sense of which buyers will be more interested in any given industry or business. Once buyers have been identified, an investment bank can assist with conducting the auction process, including day-to-day interaction with buyers and responding to their questions. Having the banking team handle such buyer communications assists with bridging cultural and time-zone divides, particularly where the seller’s team is based in China.
Properly “Package” the Asset. Sellers should seek to clearly define the perimeter of the target business. Some businesses have been operated on a stand-alone basis from the Chinese parent organization; others are integrated with the parent organization and depend on the parent for key aspects, such as intellectual property, contracts, IT systems, and personnel. In any divestiture transaction, US buyers will heavily scrutinize what assets the business needs to operate, and whether any will not be included within the transaction perimeter. Similarly, on the liability side, US buyers will seek to have the seller retain historical liabilities and/or provide substantial protection via seller indemnity. And in any auction process to sell the business, it is always to the seller’s advantage to be able to move quickly, to avoid losing buyer interest, lock in a price and mitigate business degradation. Therefore, it is to the seller’s advantage to properly and precisely identify the business’s assets and liabilities and to “package” it up as much as possible in a stand-alone entity structure or bundle of assets.
In the China-US context, however, performing such reorganizations can be substantially more difficult, due to the tax costs of restructuring, capital controls associated with moving financial assets, national security and export law restrictions in moving intellectual property, and data privacy issues with moving consumer information. Doing this “packaging” exercise will require additional time and careful legal and tax planning, to avoid creating further costs and liabilities.
Further, the Chinese seller will frequently be dependent on the US business’s employees for much of this information but may not want to inform such employees regarding the transaction, either for confidentiality or retention reasons. Doing this “packaging” exercise in advance of a deal can be more easily characterized as a normal internal restructuring.
Financial Statements. Related to the “packaging” exercise, most US buyers will require stand-alone audited financials for the acquired business. Such financials serve many functions: First, they give the buyer confidence in the business’s financial condition and will help support the purchase price and reduce due diligence time. Without them, some US buyers will insist on doing a lengthy “quality-of-earnings” analysis as part of due diligence. Second, publicly traded US buyers will need historical audited financials for the target business to disclose to the US Securities and Exchange Commission (SEC), if the target meets certain size thresholds. Third, if the buyer is using any debt financing or obtaining representations and warranties insurance, giving audited financials to the financing sources or insurer is almost unavoidable.
In the US-China context, it is advisable to budget additional time to conduct the audit. The Chinese seller teams may be unfamiliar with US audit standards and also may be dependent on the US target’s finance team to provide auditors with the necessary information. In any situation, the audit will need to separate out finances of the US and non-US sides of the business. All of this should be done in advance, where possible.
Optimize for Post-closing Relationships. In any business separation, it is important to ensure that both sides of the business are able to continue to operate their businesses post-closing. Issues such as sharing intellectual property, splitting customer contracts and coordinating post-closing collaboration (particularly if the business is being split on a regional basis) should be carefully considered.
In the US-China context, this exercise is becoming more difficult because of the legal restrictions imposed by both countries’ national security and other laws. As one example, in most cases, it will be very challenging for the Chinese side of the business to obtain consumer data on US consumers. As a result, close data sharing is impossible, and even more ordinary business activities may need to be restricted or run through a third party. As another example, due to export controls restrictions on transferring technology, sharing R&D resources through joint development agreements also becomes much more challenging.
Be Prepared to Use US Law. Most US buyers will be significantly more comfortable with using US-style acquisition agreements governed by US law and enforced by US courts. On one hand, this should not concern most Chinese buyers: the US courts, particularly in Delaware and New York, are extremely sophisticated in complex commercial transactions and typically do not have any bias towards the US party. On the other hand, Chinese sellers should be aware that US-style acquisition agreements tend to be relatively buyer-friendly and will take longer to negotiate. For instance, US agreements tend to contain lengthy representations and warranties regarding the target business, which go into significant detail and require careful review. Further, while in many jurisdictions, anything provided in diligence in the data room is deemed to be “known” to the buyer, in the US, it is market for the seller to prepare “disclosure schedules” that contain disclosures regarding legal and other aspects of the business. Such disclosure schedules can be hundreds of pages long and will take significant time and effort to prepare. Correspondingly, the due diligence process in the US is relatively comprehensive: US buyers will generally retain legal, accounting and operation advisors, who will each expect substantial amounts of information to be provided. So generally additional time should be budgeted to execute US-style agreements.
Unwinding CFIUS Restrictions. If the US business operates under a mitigation agreement with the Committee on Foreign Investment in the United States (CFIUS), it is important for the seller to determine any CFIUS-related requirements and risks in the early stages of the deal. If selling to a non-US buyer, ongoing mitigation conditions imposed by CFIUS may be a showstopper from the perspective of certain buyers. The mitigation agreement likely provides for CFIUS approval of any proposed sale of the business. There may be a pre-closing notice period required for CFIUS’ evaluation of the transaction. Approval of the sale would be a separate decision from CFIUS agreeing to modify or terminate the mitigation agreement following closing. If CFIUS is satisfied that the buyer is a US person, CFIUS can terminate the mitigation agreement promptly upon receipt of evidence of closing. If the buyer is a non-U.S. person, however, CFIUS might request a notice filing in order to perform a full risk assessment to determine if the sale presents potential national security risks CFIUS might want to (continue to) mitigate.