Exclusive Q&A on Cross-border Mergers and Acquisitions with Ariella Dreyfuss

Can you outline the regulatory framework for cross-border M&A in your jurisdiction?
 
Israel is open to and seeks to attract foreign investment. Accordingly, there are generally no limitations on foreign ownership of Israeli companies and assets, with the exception of those foreign entities with connections to certain hostile nations, or for target corporations that hold certain Control Permits issued by the State. There are also no currency control regulations. Foreign investors will of course have to comply with local laws, the pertinent ones in an M&A deal being the restrictive trade practices law, employment laws and tax laws. Certain fields will also have their nuances, for example security and encryption, communications, environment, banking and life sciences – the applicable laws of which would become more relevant in an asset purchase deal rather than a merger or share purchase.
 
Have there been any recent regulatory changes or interesting developments?
 
Recently the Israel Tax Authority (ITA) published a draft circular on the applicable tax to be paid on holdback/deferred consideration in an M&A transaction. While not binding it reflects the ITA’s position and brings more clarity as to how the ITA can be expected to act.

Until the draft circular was published, it was questionable whether consideration due to a founder/key employee held back upon an exit to be paid at a later date (typically upon the completion of a predefined employment period), would be treated as income and subject to tax at a rate of up to 50%, or a capital gain and subject to a lower tax rate of 25% – 32%.

The ITA has now indicated that such payment should be treated at the lower capital gains rate provided that the following conditions are met:
 

1. The shares are ordinary shares, with identical rights to the other ordinary shares in the company.
2. But for the hold back mechanism the gain from the sale of such shares would be considered a capital gain.
3. The entrepreneurs/key employees held such shares for at least six months.
4. The holdback payment does not include any additional consideration, and equals the consideration that would have been due to the entrepreneurs/key employees at the closing of the sale – i.e. the same price per share paid to all ordinary shareholders. (If the price per share is higher, only the difference will be taxable as income.)
5. The entrepreneurs’/key employees’ salary is not reduced going forward.
6. The purchaser accounts for the holdback payment as consideration for the purchase of shares in the transaction and not salary.
7. The entrepreneurs/key employees report and fully pay their taxes for the sale of their shares – including in connection with the unpaid holdback payment. (If in the end an entrepreneur/key employee does not receive the total consideration, s/he will be entitled to a tax refund.)

This is good news for investors and buyers, as founders and senior management can no longer resist hold back mechanisms on the grounds that they would be prejudicially taxed.
 
Are you noticing any trends with regards to specific markets, industries or deal volume?
 
In 2013 the Law for the Promotion of Competition and Reduction of Concentration was enacted in Israel to address the concentration of a significant proportion of the economy’s financial and non-financial assets in the hands of a small number of industrialists. The law seeks to divest such control, and force some of Israel’s leading players to dispose of certain assets. As a result there has been an increase in the number of M&A deals with corporations seeking to divest early at a reasonable value, rather than having a fire sale closer to the compliance date in December 2019.
 
In the high tech space, the current hot technologies for investors are cyber security, robotics, augmented reality and Fintech.
 
What are some of the key issues that need to be considered by a foreign investor when planning an investment in your jurisdiction?
 
One of the key issues for a foreign investor to consider when making and investment in an Israeli company, is whether the target received financing from the Israel Innovation Authority (formerly the Office of the Chief Scientist of the Ministry of Economy). This authority offers favourable financing to Israeli companies as the grants are repayable by way of royalties upon the commercialization of the sponsored product. In other words if the project is not successful, there is no repayment obligation. However, these grants impose certain restrictions, particularly limitations on the transfer of the funded intellectual property and know how, and the manufacturing of the funded product - outside of Israel. A foreign investor who intends to use the funded IP or transfer manufacturing, should be aware that such transfers have a price. The allocation of responsibility for obtaining the requisite approvals from the Authority, and paying the relevant “fines”, should be addressed in the transaction documents. Even if there is no intention to transfer the IP or manufacturing outside of Israel, if the investment would constitute a change in control in the target company, the foreign investor would be required to undertake to the Authority to comply with the terms of the grant and applicable laws.
 
Another key issue for an investor, particularly an investor who is buying out a founder or senior management, is Israel’s statutory restrictions on non-compete provisions.  According to Israel’s Restrictive Trade Practices Law, when a shareholder sells his shares, any exclusivity undertaking according to which such shareholder agrees not to compete with the target company may not exceed four years as of the closing of the transaction. If however the shareholder continues to be employed by the company following such exit, the non-compete period may continue for a longer period, provided that it does not exceed two years as of the date of termination of such shareholder’s employment.
 
What are the most common disputes in cross-border M&A transactions?

Prior to the closing of an M&A, disputes can arise pertaining to a breach of a no-shop (exclusivity) obligation, a party’s withdrawal from negotiations, or the intentional non-fulfilment of a conditions precedent to frustrate the closing and derail the deal.

Post-closing, disputes can arise in connection with the target’s breach of its representations and warranties, as the target has painted an inaccurate picture and is worth less than the purchaser paid.
Disputes regarding purchase price adjustments are also common.  When the purchase price is based on a formula or an assumption (for example, that the current assets minus the current liabilities equals X), there is usually a post closing mechanism to confirm the actual purchase price.  The final purchase price is frequently a point of contention, as each party attempts to interpret and calculate the numbers in their favour.

Disputes also arise from a seller infringing his non solicitation, confidentiality or non-compete undertakings, the breach of which can significantly devalue the target.

Finally disputes can arise in earn out mechanisms, particularly where these mechanisms include performance milestones.
 
What is the preferred means of resolving disputes?
 
While arbitration is popular in Israel as it ensures confidentiality and is considered more efficient, for M&A deals parties still tend to favour the court system. This inclination is fuelled by the fact that after an exit the parties have little common interest. Even in cases where arbitration is chosen, parties reserve their rights to turn to local courts to seek immediate interim relief, i.e. an injunction to prevent a seller breaching his non solicitation, confidentiality or non-compete undertakings. Disputes arising from price adjustment mechanisms are the exception to this trend. Here the parties usually agree to have an expert auditor appointed to determine the accurate purchase price, in lieu of a judge.
 
What buyer protections exist for buyers entering into unfamiliar territory?
 
The best protection for a buyer entering into a transaction in an unfamiliar territory is thorough due diligence, in order to identify all the risks, whether legal or financial in the proposed deal. Once this process has been completed these risks can be evaluated and responsibility allocated in the transaction documents, including any necessary adjustment to the original purchase price.

The most common protection for buyers in an M&A deal is an escrow arrangement, where part of the consideration is held back as security against any breaches of the representations and warranties by the sellers, or certain risks identified in the due diligence process. For example tax exposure or threatened or ongoing litigation.

The value of a company largely depends on the talent of its employees and management. Although a buyer cannot force continued employment, it can align interests by insisting on earn out provisions or offering other financial incentives to senior employees. This will ensure that management stay on with the target and continue to guide the company through territory that the buyer is unfamiliar with, and cannot navigate itself.
Non-compete provisions, although limited in their enforceability, are also an important tool to protect the value of the target and the buyer’s interest.

Finally, a new market is emerging in Israel with respect to warranty & indemnity (W&I) insurance. Insurance companies are beginning to offer buyer’s insurance against a seller’s breach of its representations and warranties, and this may be an interesting option for buyers entering into unfamiliar territory.

It should be noted, that while in other jurisdictions indemnity provisions are used to protect buyers, they are not required under Israeli law, as a breach of a representation or warranty would simply be treated as a breach of contract. On the contrary, indemnity clauses are typically employed by sellers in Israeli deals, to limit the scope of their liability.

Ariella Dreyfuss, originally from England, has lived in Israel since 2005. She advises international and Israeli entrepreneurs and companies engaged in a wide range of high tech activities, including, communications, life sciences, medical devices, internet, financial services, art and cyber-security.
 
From incorporation through to an exit, Ariella guides companies through multi-layered corporate and commercial agreements, establishing strategic partnerships, raising capital, consummating complex mergers and acquisitions - while considering each companies unique commercial concerns.

Ariella can be contacted on + 972 3 6400 600 or by email at adreyfuss@barlaw.co.il