While the year 2021 was a record year in the M&A market in Israel with the largest number of transactions closed, approximately 238 transactions with a turnover of 17.1 billion dollars along with a dramatic increase in the amount of public offerings by companies (approximately 167 public offerings in 2021 compared to 115 public offerings in 2020 on the Tel Aviv Stock Exchange), from the beginning of 2022 there was a dramatic drop in the value of securities that are traded on various stock exchanges around the world (as of 30.12.2022, from the beginning of 2022 there was a drop of 33% in the NASDAQ-100 Index and of 27% in the Tel Aviv – Technology Index), and this alongside a significant increase in interest rates in the USA and in Israel (from the beginning of 2022 there was a 4.25% increase in interest rates in the USA and 3.15% in interest rates in Israel). The declines in value of securities in the various stock exchanges along with the fear of a global recession caused among other things, a sharp decrease in the number of mergers and acquisitions in Israel for 2022, which as of the end of November 2022 stands at 142 transactions.
In this article, we will discuss the question of how declines in the value of companies, alongside the increase in interest rates will affect the ability of start-up companies, especially companies in the fields of high-tech and life sciences, to raise the funds required to continue their activity. Startups at the beginning of their journey naturally need substantial funds to support their ongoing activities and for the investment in R&D. In most cases, those companies do not yet have revenue, or their revenues do not cover their expenses, and therefore they rely on substantial fundraising in order to finance their activity. Those startups mainly raise funds in fundraising rounds from investors, and more established companies also raise funds through public offerings or take loans from various lenders.
The question arises as to what the future holds in terms of fundraising for startups. In our opinion, because of various reasons that will be detailed in this article, it can be estimated that in 2023 there will be an increase in the number of mergers and acquisitions as compared to 2022. This increase, we predict, will reflect the choice, or often the necessity, of many startups to choose the path of a merger or acquisition as the main path through which they can continue to exist and finance their activity.
Following this, we will discuss the question of how parties to a merger or acquisition should prepare from a legal perspective, especially as we believe that the deal will have to be done quickly due to the urgent need of these companies for money. In addition, we will explain in the article why we expect the transactions to be mostly investment transactions, that in these transactions money will be invested in the company as well as mergers between companies, and not necessarily transactions of purchasing companies in which the consideration is paid to the shareholders of the company that is being sold.
To the trend of the increase in the number of mergers and acquisitions that we predict, we are already seeing the first buds in developing countries similar to Israel. For example, as shown in a report by the BusinessLine, the M&A activity in India in the first nine months of 2022 reached a record of 148 billion dollars, a figure that is 58.2% higher than the corresponding period in 2021.
Also, in the Middle East and North Africa region, which includes many developing countries like the United Arab Emirates, the number of M&A transactions in the first half of 2022 increased by approximately 12% compared to the corresponding period in 2021, and amounted to approximately 359 transactions with a total value of 42.6 billion dollars. These data could hint at the beginning of a trend that will also apply in Israel, in 2023, of an increase in the number of M&A transactions, as we will detail in this article.
Key factors supporting the trend of an increase in the number of M&A transactions in 2023 as compared to 2022:
1.Difficulty of raising funds from investors: Over the past few years, there has been a significant increase in the expenses of startups, which was mainly due to the accelerated increase in the salary expenses alongside the increase in the prices of rent, transportation, and raw materials (especially for companies in the field of life sciences and companies that are more industrial).
For this purpose, those companies need to raise funds to finance their activity, but at the same time they are encountering difficulties in raising funds, as investors are afraid to invest in them because of the economic uncertainty, the fear of entering a global recession, as well as because of the declines in the various stock exchanges, which keep companies away from IPOs.
In such a situation, companies may reach insolvency and liquidation, unless they are able to raise the funds required to continue financing their activity. The shareholders of startups who are in a situation where the company needs funds in order to continue its activity and has no choice but to raise the necessary funds will prefer to merge with a company in the same field or in a field related to it, which has available funds that can help finance the company’s activity.
Alternatively, a company could issue shares at a lower value to an outside investor, but this would significantly dilute the company’s existing shareholders. Another possibility, in order to avoid accepting investments at a lower value than the previous round (Down Round), is that a company would prefer to merge with another company in a transaction of allocating shares of the acquiring company according to the value of the target company which is not significantly lower than the value determined in the previous round. Thus, the loss to the existing shareholders will not be determined, as a result of the decrease in the value of the shares of the merging company.
An example of this is the merger of ironSource with an American company called Unity (NYSE: U), a deal that was carried out at a value of 4.4 billion dollars for ironSource. The deal reflected a significant premium compared to ironSource’s value on Nasdaq before the announcement of the merger, but was still at a significantly lower value than the one according to which ironSource merged with a SPAC company about a year and a half ago.
So, the fact that the consideration in ironSource’s deal with Unity was in shares, made it possible not to determine a significant loss for ironSource’s shareholders. Another example of such a transaction is the merger transaction between Aerobotics Ltd. and Ondas Holdings Inc. Ondas purchased from the shareholders of Aerobotics their shares in exchange for shares in Ondas. The deal structure, which is in shares and not in cash, makes it possible not to determine a loss for the shareholders of Aerobotics, and will also enable Aerobotics to finance its activity with Ondas’s assistance.
2. The value of the companies decreases and therefore they become more attractive for acquisition: The shares of public high-tech companies have fallen by double-digit percentages since the beginning of 2022, this trend also affects the decline in the value of private high-tech companies. The decline in the value of companies creates an opportunity for investors with deep pockets to purchase shares of companies at a discount.
So, in fact, it is a “win-win” situation – the companies raise money that is required to finance their activity, and the investors gain a foothold in companies with a significantly lower value. In addition, companies (as opposed to a financial investor) who have a large amount of cash are expected to take advantage of the decrease in the market value of their small competitors in order to purchase them at a low value, either in an equity transaction or in an asset deal to acquire a specific business unit. In this way, these companies may use the completion of the transaction as a trigger for their business development and to support the increase in the market value of the purchasing company. Recently, we have noticed a trend of transactions, in which a large company acquires a small company that has developed a product or technology in the field of such company’s activity.
A transaction of this type allows the large company to expand its business with a low investment, compared to a situation where it had to develop the required product or technology on its own. For example, SentinelOne, an Israeli company in the cyber field, recently acquired its competitor, an American company called Attivo, which is also a company in the cyber field, for $616 million in a cash and stock deal.
3.Due to the decrease in value, the resistance of the founders of the companies decreases and the chance of closing deals increases: We assume that in the past there were proposals for mergers and acquisitions that were good from a business perspective for the target company but did not come to fruition because of the ego of the main shareholders in those companies.
Because of the decline in the value of startups and the pressure to raise funds, we estimate that those ego considerations will no longer be an obstacle to making deals that were previously rejected.
4. Pressure from activistic funds and investors: Pressure from funds and activists investors in public companies in light of the decrease in the value of companies may lead to pressure on companies to merge or make purchases/investments in smaller competitors in order to support business development and the creation of value for the company.
In doing so, companies will respond to investors’ expectations for continued growth in revenue and profitability. For example, we have recently seen Merger of Equals transactions where venture capital funds or other shareholders press for a merger between portfolio companies operating in the same field to merge while the shareholders inject funds into the merged company.
5. The difficulty in raising loans in light of the increase in interest rates: High-tech companies (mainly public companies) used to raise funds from investors as well as take loans (including convertible loans) from financial investors. The sharp increase in interest rates along with the deterioration in the financial strength of the high-tech companies caused a significant decrease in the economic viability of taking loans as a source of financing for companies.
At the same time, the increase in interest rates means that there is less money available for companies since investors prefer to invest in deposits and other financial instruments that provide high interest rates over risky investment in startups.
Methods to prepare from a legal perspective to improve the chances of successfully completing the merger or acquisition transaction:
1. Make sure that the company is organized in terms of its documents and legal rights – on the target company’s side, assuming that it will be a transaction in which it needs a quick investment, this will also result quick due diligence by the acquiring company or the investors.
In order for the transaction to be completed successfully and quickly, it is important that the target company as a whole will be organized with respect to its agreements, including the arrangements of its legal rights such as in the field of intellectual property.
2. Due diligence – on the investors’ or the acquiring company’s side, since it will be a deal that will have to be closed relatively quickly, it will be important to properly prepare for the effective performance of legal, business and financial due diligence of the target company while identifying essential issues that will arise in the due diligence and providing protections for this in the transaction documents.
3. Identifying clauses in agreements that require the consent of third parties to the transaction or prohibit the assignment of agreements– on the side of the target company, since it will be a quick transaction as mentioned, it is important that the company will examine which of its agreements contain clauses that require the consent of third parties for a change of control of the company in a share transaction or for the assignment of the agreement in an asset transaction.
If such clauses exist, it is recommended to try and get the consent of the third party to the transaction in advance, in order to shorten the time it will take to complete it.
4. Tightening the supervision of the company’s management – in light of the problematic behavior of management in several companies that have recently failed, we believe that the investors will demand as a condition for their investments the tightening of the supervision mechanisms of the company’s management.
A clear example of problematic conduct by management that led to the collapse of a huge company is the crypto trading platform, FTX Trading Ltd. In the case of FTX, the claim was that the investors failed to supervise the company’s management which was corrupt; they didn’t ask the right questions, and didn’t go deeply enough in the due diligence when they invested in it – which in retrospect caused their extensive losses with its collapse.
Investors can monitor company management through a number of mechanisms such as: (1) determining veto rights on various decisions of the company, including transactions with the controlling shareholder, (2) appointing a director on their behalf, and as a complementary measure, obliging the company’s management to submit certain decisions for the approval of the board of directors, in which they may use their veto right, (3) right of access to the company’s documents and current information, (4) appointment of an accountant on their behalf to the company and closer supervision of the company’s financial reports.
We anticipate that there will be founders or CEOs of companies who may oppose the expansion of the investors’ supervisory powers over the company’s management. However, in our estimation, in light of the need for those companies to raise funds, as well as in light of the transition of power in the market from the companies to the investors, the companies will be forced to accept the investors’ demands for tighter management supervision on the companies.
5. Diagnosis and assessments in advance in cases where regulatory approval is required to complete the transaction – we have recently seen larger involvement of the Competition Authority in Israel and a more careful examination of it in relation to M&A transactions. For example, just recently the Competition Authority did not approve the following mergers: a merger between the Strauss )a large food company) and the Wyler Farm (a tofu supplier), a merger between the Manamim waffle maker and the Gilro waffle and ice cream cone maker, as well as the merger between the companies Carmel Wineries and Arza Wineries. Beyond the approval of the Competition Authority, there are other regulatory authorities in Israel whose approvals may be required for M&A transactions such as: the Registrar of Companies, the Government Companies Authority, the Securities Authority, the Tax Authority, the Innovation Authority and more. Therefore, it is important for companies to identify in advance whether any regulatory approval is required to complete the transaction and if so, it is necessary to assess the chance of obtaining the approval and the course of action from a legal point of view to obtain the approval as soon as possible.
