Introduction

In recent years, M&A has faced a whirlwind of challenges and opportunities. Over the last five years alone, the market has responded to historically low interest rates, a pandemic, rising interest rates, and dynamic new technologies. This article will cover trends in tech M&A, life sciences M&A, and private equity, with a special look at generative AI in life sciences. It concludes by providing a short overview of California-specific M&A considerations.

Recent Trends in Tech M&A

Technology M&A in California has followed an interesting – almost counter-cyclical – course in the years leading into the pandemic and afterwards. The pre-pandemic years of 2018 and 2019 were record years in the then-long standing bull market recovery that started in the aftermath of the 2008–2009 Great Financial Crisis. In 2019, both US deal volumes – at 15,458 – and deal values – at USD2.1 trillion – represented highs, driven by a decade of historically low interest rates.

The Zoom boom

As the pandemic hit in the 2020 and 2021 years, the tech M&A market and the wider economy began to diverge. As the wider economy grappled with pandemic-induced slowdowns, the shift to working from home created a boom for tech. Though the most visible beneficiaries were companies like Zoom that specifically facilitated work from home, the overall rising tide of pandemic-induced digital transformation (and government stimulus) propelled old economy companies to increase tech spending, which in turn buoyed both tech company valuations and overall deal activity. In those years, US deal volume and values both rose to historical highs of 22,115 and USD3.3 trillion, respectively.

Interest rate bust

Continuing in counter-cyclical fashion, as the broader economy recovered through the 2022 and 2023 years, tech M&A started a downward slide. The Federal Reserve’s fiscal tightening increased interest rates, depressing valuation multiples that investors were willing to pay for future growth. Investors began to reward companies for profitability rather than growth-at-all-costs, which triggered widespread cost-savings driven lay-offs across a large portion of the tech sector. Tech M&A became a casualty of this trend, as companies both became sensitive to the change in investor focus, as well as the ongoing operating expense of bringing on large teams (particularly if the business was not yet profitable).

AI buds

Since ChatGPT entered the popular consciousness in 2022, AI-driven tech investment and M&A have both gained increasing prominence. Year-over-year, 2023 saw a 23% increase in the global value of AI M&A transactions. 

Regulatory uncertainty

With its rise, tech M&A has increasingly come under scrutiny by regulators. On the antitrust front, uncertainty is the norm, as the Biden administration has demonstrated a willingness to pursue novel theories of competitive harm to challenge transactions. On the foreign direct investment front, many other jurisdictions have adopted local versions of US Committee on Foreign Investment in the United States, which has introduced significant friction into cross-border transactions. Finally, AI has joined data privacy as an area of emerging regulation, as the EU follows up on the GDPR with a new slate of regulations on AI – with others sure to follow.

Transaction structures

As California tech companies are mostly incorporated in Delaware, the prevalent forms of M&A tend to follow nationwide trends – reverse triangular mergers for larger deals, and either stock or asset acquisitions for smaller transactions or special situations. The below section will describe some legal structures that tech counterparties use more.

SPACs

One phenomenon that started in 2019 was the rise of SPACs, or Special Purpose Acquisition Vehicles: blank-check public companies that served as vehicles for private companies to go public via a reverse merger. SPACs were formed by sponsors, who raised cash in trust, identified an acquisition target, and through a combination of the cash in trust and newly issued shares, consummated business combination transactions with privately held companies that resulted in those target businesses becoming public. Though the structure itself had been around for decades, the low interest rate environment, combined with a surplus of privately held companies – particularly in the tech sector – that wished to access the public markets but were not yet mature enough to do so via a traditional IPO, created an upsurge of SPAC activity that started to pick up steam in 2018 and continued in 2019, into the eve of the pandemic. Recent years have seen SPACs dramatically fall in volume, as the trading performance of de-SPAC-ed companies languished and rising interest rates diminished the attractiveness of parking capital in SPAC trust accounts.

Acqui-hires

A consequence of the reluctance to pursue blockbuster acquisitions has been a corresponding rise in so-called “acqui-hire” transactions. “Acqui-hire” is short-hand for smaller transactions where the focus is on bringing on an existing team – usually engineers – rather than purchasing a product or customers. Acqui-hires can be done either as stripped-down asset sales, or as so-called “sign and releases”, where the acquiror pays consideration in exchange for a release of claims by the seller entity, which allows the acquiror to hire the whole team without the threat of legal claims. Given the recent drying up of start-up financing and the dearth of traditional acquisitions, acqui-hires have ticked up as an alternative to shutting down the company.

Re-vesting of management proceeds

Human capital is often baked into the M&A valuation. As a result, parties often contract to create an incentive plan for key employees and managers to remain employed post-closing. One of the major ways parties accomplish this is by holding back a portion of the purchase price otherwise due to management, to be paid out over certain intervals, contingent on the employees' continued service. Such payments often require careful structuring to navigate the tax risk of a potential recharacterisation of such payments as compensation.

Representations and Warranties Insurance (RWI)

RWI’s growing popularity in M&A nationwide has spread to Silicon Valley.

RWI works by covering a party if a representation (“rep”) or warranty turns out to be false. The insurer, not the party that made the representation, is liable for losses sustained due to that breach up to a certain amount. The use of RWI does have challenges in tech M&A. First, obtaining “specific indemnities” for risks identified in due diligence is a common practice with certain acquirors, and so RWI’s exclusion for known risks often means the need for a separate special escrow (or purchase price adjustment mechanism). Second, most tech acquirors treat key operational reps – such as IP and privacy – on a quasi-fundamental basis, where there is recourse above the escrow amount but not to the full purchase price. Because RWI pricing is usually just a percentage of coverage value, it is often prohibitively expensive to obtain the extra coverage for those quasi-fundamental reps, which in turn means either that the acquiror has to give up significant coverage, or the sellers cannot have a nil seller indemnity “walk away” transaction. Third, RWI providers have become increasingly skittish about underwriting privacy and cyber-security risk, and typically insist on piggybacking on the target’s existing commercial cyber policy, making it more difficult to insure one of the key reps in tech transactions. Fourth, many early-stage (or even mid-stage) start-ups do not have audited financials, so either the buyer has to do extra quality of earnings diligence in order to get coverage for the financial statements-related reps, or risk an exclusion on those reps.

Recent Trends in Life Sciences M&A

Compared to tech M&A, M&A in life sciences remained relatively strong from 2022 through 2023, generally consistent with pre-pandemic activity. The outlook for 2024 is optimistic. Many major biopharmaceutical patents are set to lose exclusivity in the next decade, and with high levels of available capital for M&A, companies in this space are looking to stock their innovative treatments pipeline. Moreover, heightened scrutiny over drug prices under the Inflation Reduction Act has encouraged companies to diversify and re-evaluate their drug portfolio as well as look to other means of providing better patient outcomes, such as through medical device improvements.

As in other sectors, US regulators continue to target larger, high-profile life sciences deals. While two blockbuster transactions, Amgen’s acquisition of Horizon Therapeutics and Pfizer’s acquisition of Seagen both closed in 2023 after clearing challenges by regulators, the willingness of regulators to pursue challenges could discourage blockbuster transactions in favour of more modest additions.

In terms of deal structuring, since 2021, medical device manufacturers and diagnostic and research companies saw a noticeable decrease in the use of earn-outs in favour of up-front payments. Where earn-outs were used, they tended towards milestones with earlier achievement timelines. To contrast, deals involving biotech and pharmaceutical companies continued to see the use of earn-outs with a large portion of the total consideration subject to the achievement of such earn-outs.

The earn-out consideration for these deals tends to be linked to more burdensome milestone requirements, which has led to a decrease in achievement of earn-out milestones, in particular for biotech and pharmaceutical companies. Uncertainty with respect to later-stage trials and regulatory approvals, plus shifts in buyer focus are behind this trend. As such, target companies in this space considering exits via M&A should focus on up-front payments and early milestones. 

Recent Trends in Private Equity-Backed M&A

PE-backed M&A in 2013 unfortunately tracked the same trends as described above for the tech sector. Elevated inflation, high interest rates, and persistent valuation gaps between capital allocators and sellers were all significant factors behind a 28.9% decrease, year-over-year, in PE deal volume, and a 45.2% decrease, year-over-year, in PE deal value. In stark contrast to 2021, during which PE-backed M&A soared, and 2022, during which activity slowed but remained strong, the latest industry metrics have led analysts to determine that 2023 was a worse year for PE M&A than 20201, the year the COVID-19 pandemic started.

With the tepid performance of 2023 in the rear-view, the outlook for 2024 is cautiously optimistic: inflation is thought to be easing and further interest rate cuts are projected to be on the horizon (although the timing and extent of further rate cuts is now less certain after prices and hiring increased for a third straight month ending in March 2024), PE allocators are sitting on a record amount of dry powder due to steady fundraising efforts with a desire and need to deploy capital, and the holding period for PE of their portfolio companies has been extended in comparison with recent periods, which is  creating pressure to realise investment returns.

In 2024, expect to see more of the following recent trends.

Secondary/“continuation” funds

In 2023, in part driven by the aforementioned uptick in fund maturities, PE fund general partners (GPs) increasingly turned to GP-led secondaries (also known as “continuation” funds) to secure liquidity for limited partners (LPs). Such transactions:

• enable GPs and LPs to sell or restructure fund holdings to create an exit opportunity for existing investors who want liquidity;
• allow PE funds to continue their investments in companies they believe still have upside;
• enable existing investors who do not need liquidity to stay invested in promising assets; and
• allow new investors to enter funds with a potentially shorter investment horizon to liquidity.

Following a trend of year-over-year increases in secondary deal volumes for each year from 2017 to 2023, analysts are projecting a further sharp increase into 2024. 

While secondary transactions become a more regular occurrence, they are not without controversy – approximately one third of these processes failed in 2023, higher than the historical norm, and their pursuit therefore comes with the risk of becoming expensive distractions for the GP and LPs alike.

Corporate carve-outs and increasing international considerations

Following a trend that started in Q4 of 2021, PE capital allocators are increasingly pursuing corporate carve-outs and divestitures from larger organisations. These transactions enable selling organisations to shed non-core or non-strategic divisions, thereby improving their financial picture for investors, while simultaneously providing PE with a store of targets that can serve as platform companies or add-ons, and which are often easier to secure financing for due to publicly available financial and other information.

Some of the reasons behind this trend include activist pressure in the market for larger entities to focus on their core business and unlock value by disposing of non-core assets, as well as boards of directors independently determining that focusing on core assets is a stronger path to value creation.

Analysts project the growth of corporate carve-out transactions to continue in 2024. Although identified here as a trend in the United States, the ever-increasing international footprint of large multinational organisations correlates with an increase in the frequency of carve-out transactions involving international considerations (whether involving talent, IP or material assets from outside the USA).

Deployment of capital on a global basis

A final trend that is worth keeping an eye on is the interest of capital allocators in deploying capital on a global basis. While there may be an emphasis on growing and expanding capital allocation in North America, there is a focus on expansion and scaling efforts in Asia, the Middle East, and markets that offer new opportunities in the UK and Western Europe. 

Spotlight on Generative AI in the Life Sciences

Over the past three years, more than USD41 billion in collaborations between generative AI and life sciences companies have resulted in the incorporation of AI by large pharma and biotechnology companies to assist with drug discovery and design, drug target identification, disease diagnosis and prognosis, patient identification and outcome prediction for clinical trials, as well as other research, development, and discovery efforts. However, the use of AI is generating its own set of legal issues, as explored below.

Collaboration agreements

The agreements governing the use of AI in biotech collaborations are evolving to contain detailed provisions relating to data ownership and use, exclusivity, and hosting. In the negotiation stage, a term sheet should expressly identify the parameters and allocate data and intellectual property ownership and the risks of such collaboration. A term sheet may also describe:

• the overall scope of the project;
• any deliverables, including the timing and specific topics to be addressed in any reports;
• the milestones and research budget, including the identity of the payors and how expenses should be allocated;
• the duration of the project, including how any extensions should be governed;
• how “project data” should be handled, including how it should be defined, kept confidential and licensed;
• ownership of project data and terms of licences to the project data;
• ownership of project results and the licence terms to such project results;
• any rights of first negotiation;
• how publications should be handled;
• allocation of responsibility for compliance matters;
• data privacy protections; and
• confidentiality provisions.

AI due diligence

Conducting diligence on AI companies can also present unique challenges in assessing intellectual property, data privacy, and regulatory issues. Data sets used to train AI algorithms need to be evaluated for quality and use of any copyrighted or open-source materials, sensitive biometric information, confidential data or trade secrets. As a result, it is crucial to conduct a thorough evaluation of an AI vendor’s cybersecurity practices and receive clarity on the specific measures that these companies take to protect sensitive information. A collaboration agreement may address these risks by requiring indemnification from the AI vendor for losses resulting from cyber-attacks, and by requiring the AI vendor to assist with risk and security assessments, with mitigation efforts in the event of a cyber-attack, and with any regulatory investigations.

Evolving regulation

The regulatory landscape surrounding AI is rapidly – and continuously – shifting. Practitioners will need to stay afoot of developments in data privacy regulations, as well as the applications and boundaries of copyright laws as applied to AI technologies. The EU recently passed the world’s first comprehensive law to regulate the use of artificial intelligence and other jurisdictions will likely follow. To address risk of non-compliance, a collaboration agreement may (i) allocate to the AI vendor the responsibility of keeping abreast of regulatory developments, and (ii) require indemnification for non-compliance.

California-Law Nuances in M&A

Long arm statute

Typically, a corporation’s state of incorporation has jurisdiction over that corporation and its relationship with shareholders. However, California exercises limited control over “quasi-California corporations”, or foreign corporations with a significant connection to California. A company is considered a quasi-California corporation if:

• more than 50% of the outstanding voting securities are held by individuals with a California address recorded in the corporate books; and
• more than 50% of an average of the property, sales, and revenue factors is attributable to California.

Once a corporation is deemed a quasi-California corporation, several California corporate laws apply “to the exclusion of the law of the jurisdiction in which it is incorporated”. This includes California's requirement that each class of shares of a merging company approve the merger, which can cause significant issues for companies if the holder(s) of one class (eg, the common) are underwater. Moreover, dissenters to a merger are entitled to California appraisal rights in addition to those of the incorporating jurisdiction.

Non-competes

California has long had strong, pro-employee restrictions on non-compete agreements, making nearly all employee non-compete (and non-solicitation) agreements unenforceable as an “illegal restraint of trade”. Note that California does permit non-competes in the sale-of-business context, making it important to clearly delineate the nature and scope of restrictions. Two recent updates, which became effective in early 2024, have strengthened those protections in California. First, Senate Bill 699 amended the code to extend to all non-competes that parties try to enforce in California, regardless of where the agreement was signed (such that an employee with a non-compete who relocates to California would now be covered by the pro-employee restriction). Second, Assembly Bill 1076 requires that employers who entered into non-compete (or customer non-solicitation) agreements with employees (current or former) who were employed in California after 1 January 2022 notify such employees that the non-competes are void under California law.

Fairness hearings

Generally, using stock as consideration requires either SEC registration or an exemption such as Reg D. A less commonly known exemption is where certain governmental authorities, including state governments, conduct a fairness hearing.

California, through its Department of Financial Protection and Innovation, is among the few states that utilises this exemption. Upon request, the Department holds fairness hearings that are open to the public and focus on the substantive and procedural fairness of the transaction. This can be an effective way to avoid registration in situations where more popular exemptions such as Reg D are not available.

No one-way loser pays

Under a concept known as the “American rule”, each party typically covers their own litigation costs, regardless of the outcome. Due to potential uncertainty and risk, contracting parties often waive or modify this rule, sometimes placing all risk on one party. However, in California, such “one-way loser-pays” provisions can pose significant challenges. If a contract assigns “loser pays” costs solely to one party, the provision will be interpreted to apply to all parties. Thus, contract drafters who are unaware can unintentionally become subject to a “loser-pays” provision as a result of attempting to shift the burden to the other party.

Release agreement

At the end of an agreement, parties will often enter into a release agreement in order to pre-emptively settle disputes or resolve outstanding issues. California permits such release agreements, with certain nuances. Most notably, under California law, releases only apply to claims that were not known or suspected at the time of the execution of the release. However, parties can waive that protection if they do so explicitly. Thus, when entering into a release agreement under California law, parties must carefully consider if they intend to waive unknown claims, and if so, take steps to make such waiver clear.

Spousal consent (community property)

Corporations doing business in California must consider California marriage law. California is a community property state where nearly all property acquired during a marriage, including equity, is considered community property. Each spouse generally has management and control of the entire community property. However, neither spouse may dispose of community property for less than the fair and reasonable value, without the written consent of the other spouse. Thus, when a corporation enters into an agreement that transfers ownership of an interest of a married person in California, the corporation should generally request that both spouses agree to such transfer (either in the main agreement, or in a separate spousal consent form) to pre-emptively prevent community property concerns.