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Attack of the acqui-hires

August 10, 2012: 10:28 AM ET

Why tech companies buy the cow, even though they can get the milk for free.

FORTUNE -- I'm a sucker for VC exits. Even when I don't know the purchase and sale prices, there is something instinctively positive about a portfolio company being acquired by Google or Facebook or LinkedIn. "We funded this startup, and it became so important that Larry and Sergey just had to have it."

The reality, however, is that many of these deals are more about HR than IP. They're the acqui-hires: Transactions in which the primary assets changing hands are engineers.

You've almost certainly heard of acqui-hires, and now UNC law professors John Coyle and Gregg Polsky have written what seems to be the first academic paper on the subject.

Their goal wasn't to quantify the rise of acqui-hires, but rather to define them and then understand why they're happening in the first place. Particularly why they are happening so much in California, where the laws – including the non-enforceability of non-competes -- don't typically prevent a large tech company from more traditional hiring practices. After all, law firms poach groups of attorneys all the time without technically "buying" them from their old firms.

What they found was that the vast majority of acqui-hires are for VC-backed companies that would be unable to raise another round of financing (i.e., in lieu of eventual liquidation). In other words, it's a face-saving move for the sellers (both entrepreneurs and VCs):

As one investor put it: "[I]t's a lot cooler to say you 'sold' your company even if everyone lost money than to say your company was an utter failure and you put it into liquidation proceedings and grabbed a nice offer from Google." Or as another interviewee explained, "The talent wants the mystique of having been 'bought out.'"

Coyle and Polsky also discovered that engineers prefer acqui-hires to "straight hires" because of the possible tax benefits. Namely, they can treat their "signing bonuses" as capital gains rather than as ordinary income. There even can be greater tax benefits if the acqui-hire is structured as a tax-free reorg, which is rare but not unheard of.

What's worth noting, however, is that the tax benefits may be a short-term characteristic of the acqui-hire, so long as the IRS begins paying attention. The basic justification for both buyer and seller is a façade – buying the right not to be sued and/or acquiring company stock/assets – and the idea of a few engineers meeting "workplace in-force" requirements is questionable.

"I think the IRS has a strong argument here that most of these would be ordinary income," Polsky tells me. "This is very different from buying a Ford assembly line with ten thousand workers, which would cost a lot to reassemble."

For the sellers, the researchers discovered that the acqui-hire rationale is twofold: (1) Big tech companies would prefer not to be on the bad side of venture capitalists, who someday might have something more valuable to sell them. So let the VCs save face (and recoup at least some of their investment) via an acqui-hire, rather than just hire the engineers outright. (2) Acqui-hires allow buyers to pay incoming engineers more than existing engineers, without upsetting pay-scales. "His salary is in line with yours, but we had to also buy his equity…"

All of this sounds win-win, but it also is true that certain acqui-hires put VCs in a very bad position. Namely, the acqui-hires for companies that could, indeed, raise further funding. These are the deals Michael Arrington referenced back in April, suggesting that angels and VCs may alter initial deal terms so that investors aren't forced to take cents on what should be dollars.

Polsky said that he didn't see any evidence that such changes (such as increasing liquidation preferences) actually are occurring. Even if VCs do add such provisions, they would be loath to actually enforce them. Not only because suing an entrepreneur can cause major reputational damage, but also because the entrepreneur still has the right (in California) to just up and leave.

In fact, they're only practical recourse is to prevent the entrepreneur from getting funded the next time around. Said one interviewee: "VCs don't sue their founders. They keep a list. And they tell their friends."

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About This Author
Dan Primack
Dan Primack
Senior Editor, Fortune

Dan Primack joined Fortune.com in September 2010 to cover deals and dealmakers, from Wall Street to Sand Hill Road. Previously, Dan was an editor-at-large with Thomson Reuters, where he launched both peHUB.com and the peHUB Wire email service. In a past journalistic life, Dan ran a community paper in Roxbury, Massachusetts. He currently lives just outside of Boston.

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