Question
March 18, 2005
BY ELECTRONIC DELIVERY
Mr. Michael B. Verne
Premerger Notification Office
Federal Trade Commission
600 Pennsylvania Avenue, N.W.
Washington, D.C. 20580
Dear Mike:
Thisletter is to recount and confirm the recent discussions (redacted) and I havehad with you relating to issues of control and valuation concerning theformation of a proposed non-corporate joint venture.
Aswe summarized during our calls, two parties, Party "A" and Party"B," will form a limited liability company ("LLC")."A" and "B" each will make certain cash and non-cashcontributions to LLC upon its formation. The non-cash contributions willinclude office furniture and equipment, and hardware. In addition, each"A" and "B" will grant LLC an exclusive software license,and each will enter into a services agreement with LLC whereby LLC will performcertain services for entities owned separately by "A" and by"B" in exchange for future revenues to LLC. On the day of formation,"A" and "B" expect the value of "A's" capitalcontribution to exceed that of "B," such that "A's" capitalaccount balance will exceed that of "B."
Underthe proposed formation agreement, the distribution of profits from LLC to"A" and "B" will be governed by a formula that will dependon certain future revenue calculations. Therefore, the agreement will notguarantee that either "A" or "B" will receive 50% or more ofthe profits of LLC, although both "A" and "B" anticipatethat "A" will receive more than 50% of any profits of LLC.
Alsounder the proposed formation agreement, the distribution of assets of LLC upondissolution will be governed by the parties' mutual agreement. If "A"and "B" cannot agree, they will appoint a third-party liquidator touse its reasonable best efforts to reduce to cash all assets it deems advisableto sell. Subsequently, after payment of expenses and debts, the liquidator willdistribute the remaining assets pro rata to "A" and "B"based on their respective capital account balances.
Becauseit is unclear when the proposed transaction will be . consummated, we haveconducted this analysis under both the existing Hart-Scott-Rodino ("HSR") rules governing the formation of limited liabilitycompanies (i.e., "Formal Interpretation No. 15"), as well as therecently announced HSR rules concerning the formation ofnon-corporate entities, which will become effective on April 7, 2005.
"Control" of LLC
TheHSR rules define "control" of anon-corporate entity as "having the right to 50% or more of the profits ofthe entity, or having the right in the event of dissolution to 50l0 ormore of the assets of the entity." 16 C.F.R. 801.1(b)(1)(ii). Weunderstand that if the governing agreement of a non-corporate entity does notdesignate a fixed percentage of profits or assets upon dissolution for eachperson who acquires and holds interests of the entity, but rather sets out aformula that depends on variables that will be determined in the future,"control" of the entity would be determined by applying the formulato the total assets of the entity at the time of the acquisition, "as ifthe entity were being dissolved at that time." Premerger Notification;Reporting and Waiting Period Requirements, 70 Fed. Reg. 11,504 (Mar. 8, 2005). Thus, for a non-corporate entity that is to-be-formed,the contributing parties would prepare a pro forma balance sheet listing all ofthe assets (including cash) which any person contributing to the formation has agreedto transfer and any credit or obligations which any person contributing to theformation has agreed to extend or guarantee. 70 Fed. Reg. 11,511 (to becodified at 16 C.F.R. 801.50(c)). If no person would have the right to50% or more of the assets of the entity if the entity was dissolved immediatelyafter its formation, no person would "control" the entity and theformation would not be reportable.
Basedon the above facts, it is our understanding that you advised that "A"wouldbe deemed to "control" LLC if "A's" capital contributionsto LLC would exceed those of "B" because "A" would receivemore than 50% of the assets of LLC if LLC was dissolved at the time of itsformation. It is also our understanding that your analysis would be the same ifLLC was formed under the current HSR rules orthe new rules. Please confirm that our understandings are correct.
Valuation of Assets of LLC
If"A" is deemed to control LLC, "A's" acquisition ofinterests of LLC in exchange for its contributions to LLC at its formationcould be reportable if the value of "A's" acquisition would satisfythe $50 million (as adjusted) size-of-transaction threshold test. We assume forpurposes of this analysis that both "A" and "B" would betheir own ultimate parent entities, that the proposed transaction would satisfythe size-of-person and commerce jurisdictional thresholds tests, and that noexemption would otherwise apply.
Underthe current HSR rules, we understand that the formationof LLC would be treated as an acquisition of assets, where "A" wouldreport as an acquiring person in connection with the assets being contributedby "B." The value of the assets contributed by "B" would bethe greater of the acquisition price, if determined, and fair market value. Ifthe value of the assets contributed by "B" would not exceed the $50million (as adjusted) size-of-transaction threshold, the formation of LLC wouldnot be reportable.
Underthe new HSR rules, we understand that the formationof LLC would be treated as an acquisition of non-corporate interests, where"A" would report as an acquiring person in connection with itsacquisition of interests of LLC. The value of the interests of LLC to beacquired by "A" would be the acquisition price or the value of thecash and assets contributed by "A" to LLC at its formation (i.e.,"A's" consideration for the interests to be acquired). 70 Fed. Reg.11,511 (to be codified at 16 C.F.R. 801.10(d)). If "A" cannotdetermine the acquisition price, the value of the interests to be acquiredwould be the fair market value. Id.
Theboard of directors of "A" (or its delegee) would determine the fairmarket value in good faith and within 60 calendar days prior to the HSR filing or prior to the closing if no HSR filing is required.1 16 C.F.R. 801.10(c)(3)1.We understand that the determination should reflect what a third-party in anarm's length negotiation would pay at present in cash for the interests to beacquired. We also understand that the determination need not be made inaccordance with generally-accepted accounting principles, and generally will beaccepted if its basis is commercially reasonable. ABA SECTION OF ANTITRUST LAW, PREMERGER NOTIFICATION PRACTICE CAL (3d ed. 2003), at Int. 92.
UnderSection 802.4 of the new rules, "A's" acquisition of interests of LLCwould not be reportable if the value of the non-exempt assets contributed (by"A" and "B") to LLC at its formation would not exceed the$50 million (as adjusted) size-of-transaction threshold. 70 Fed. Reg. 11,514(to be codified at 16 C.F.R. 802.4). For "A," the exemptassets of LLC would include the assets contributed by "A," and thecash contributed by "A" and "B." The value of the remainingnonexempt assets contributed by "B" would be the greater of theacquisition price, if determined, or fair market value. 16 C.F.R. 801.10(b).
Inthe present transaction, "B" will contribute certain assets to LLC atthe time of its formation, including office furniture and hardware. Weunderstand that the value of the assets contributed by "B" would bethe greater of the acquisition price, if determined, or the fair market value.We also understand that the transfer of the office furniture, if used only toprovide management and administrative support services, would be exemptpursuant to 16 C.F.R. 802.1(d)(4).
Alsoin the present transaction, "B" will grant LLC a royalty-freeexclusive software license, contribute certain existing service contractsbetween "B" and various third parties, and enter into a servicecontract with LLC providing for a future income stream to LLC in exchange forfuture services. We understand that the grant of an exclusive license would beconsidered the transfer of an asset to LLC, and the value of the exclusivelicense would be the greater of the acquisition price, if determined, or thefair market value. We also understand that the fair market value of theexclusive license would be determined in good faith by the board of directorsof "A" (or its delegee), and that the determination would reflectwhat a third-party licensee would pay at present in cash for the license in anarm's length negotiation. We further understand that because the exclusivelicense being contributed by "B" will be royalty-free, the board ofdirectors of "A" (or its delegee) would not need to account for theface value of any future royalties due under the licensing agreement in itsfair market value determination. See PREMERGER NOTIFICATION PRACTICEMANUAL, at Int. 91.
Withrespect to the service contracts, we understand that "B's"contribution of existing contracts would also be considered the transfer ofassets to LLC, and the value of the existing contracts for HSR reporting purposes would include only the premium(s) paid (ifany) to acquire the contracts, and would not include any future revenuesattributable to those contracts. See PREMERGER NOTIFICATION PRACTICEMANUAL, at Int. 183. We also understand that B's entry into a service contractwith LLC requiring future performance by LLC in exchange for future revenues toLLC generally would not be considered an asset of LLC, unless "A"would pay a premium for LLC to assume the obligations under the contract.
Please confirm that the above valuation analysis is correct.
Weappreciate the time and thought you have given us to analyze this transaction.
Footnote
1 We understand that the FTC's Premerger Notification Office wouldaccept as a de facto delegee "A's" chief financial officer or anyfinancial officer of "A" directly responsible for the proposedtransaction. ABA SECTION OF ANTITRUST LAW, PREMERGERNOTIFICATION PRACTICE MANUAL (3d ed. 2003), at Int. 92.