On Monday, Yahoo announced that it was buying the mobile news reader app Summly for about $30 million. Summly has a staff of five and no revenue. It was also reported Monday that Apple was buying the indoor-GPS company WifiSLAM for $20 million. That start-up, only two years old, has a handful of employees.
This kind of acquisition, known as acqui-hiring, may seem strange to those not involved with the deal. Why buy the company If the founders or engineers are fantastic, why not just poach them from the start-up Why buy the whole company instead of just stripping out its most valuable parts It’s like buying a house because you like the furniture.
Think about the issues this way: If the real value of the start-up is in the assembled team of human capital, and not its technology or assets, why should the start-up’s angel investors and venture capitalists get any payout at all California law makes noncompete agreements difficult to enforce, so there is rarely a legal reason that would prohibit poaching valuable employees.
Acqui-hiring has increased in intensity in Silicon Valley in recent years as Apple, Google, Yahoo, LinkedIn, Twitter, Facebook and other technology companies have snapped up start-ups. Often, the start-up’s product gets shut down, and the engineers start working on new projects for the company that bought them.
John Coyle and Gregg Polsky, law professors at the University of North Carolina, explain the acqui-hiring phenomenon as driven by Silicon Valley social norms. Engineers don’t want to appear disloyal to the start-up or its investors. And the acquisition allows the founders, employees and investors to claim a successful exit, even if the product gets shut down.
The deals are often structured with cash or stock delivered to the target’s founders and investors. In addition, some cash or stock also goes into a compensation pool offered to the engineering team hired by the acquirer. The deal consideration in the compensation pool vests over time, and the engineers become subject to a covenant not to compete, enforceable even in California because it is connected to the sale of a business.
There is a tax angle as well. Suppose Max, a software engineer and founder of a social media start-up, has a choice between leaving his start-up to work for TechGiant and receiving a signing bonus of $1 million or selling his start-up to TechGiant and receiving $1 million, half of which will be attributed to the value of his founders’ stock in the start-up.
The portion of consideration attributed to the sale of his founders’ stock will generate low-taxed capital gains, not ordinary income. Max would save about $100,000 in taxes in this example, depending on his marginal tax rate.
TechGiant might lose out a bit on the other side of that transaction, as it would be trading an immediate ordinary deduction for compensation for an acquisition expense that would likely be amortized over 15 years. As Professors Coyle and Polsky point out, however, in the typical situation, the target stock could be declared worthless in a year or two, generating a full deduction at that point.
Moreover, many Silicon Valley technology companies are mostly tax-indifferent when it comes to employee compensation. Many companies have low effective and marginal tax rates thanks to accumulated net operating losses or creative tax planning strategies related to intangible assets located overseas.
To be clear, tax appears to be a second-order consideration in the acqui-hiring context. The main factor appears to be that Max wants to be able to tell his friends that he successfully sold his start-up to TechGiant. And the venture capitalists, who often have the power to block a sale, at least want their money back so they can claim victory as well.
For further reading, see John Coyle & Gregg Polsky, Acqui-hiring, which will also be published in a forthcoming issue of The Duke Law Journal.
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. Twitter: @vicfleischer
