As I have previously noted, I was a corporate attorney for nearly eight years at two major law firms in New York City; and the majority of my work there was spent negotiating and documenting large mergers and acquisitions for multinational corporations, financial institutions and private equity firms. When I moved out here to California in 2005 and started focusing on representing entrepreneurs (which meant predominately middle-market M&A transactions), I was surprised to see how unsophisticated a lot of the players are here; in short, it’s a different environment than New York. Nevertheless, I love living in California, and I am trying to provide to entrepreneurs (via these blog posts) some legal tips and lessons I learned at the big firms in New York City. Below are ten tips for entrepreneurs who are contemplating acquiring a private company.
1. Execute an Exclusivity Agreement. The entrepreneur’s first step in connection with an acquisition should be to execute a tightly-drafted exclusivity (or “no-shop”) agreement, granting it the exclusive right for a period of time (e.g., 90 days) to negotiate with the seller/target and to complete its due-diligence investigation. Such an agreement is often part of the letter of intent (the “LOI”); however, from the buyer’s perspective, it may be preferable, as discussed below, to execute a separate letter agreement and skip the LOI. Indeed, if the buyer executes an exclusivity agreement with the target early on, it can avoid (i) getting into a bidding war with other prospective buyers and (ii) spending significant time, money and resources on due diligence without any assurance that the seller will not strike a deal with another party.
2. Avoid Negotiating the Material Terms in an LOI. Other than with respect to a no-shop provision (discussed above) and a Hart-Scott-Rodino filing (discussed below), there are generally no significant benefits to the buyer in executing an LOI. Indeed, the seller’s negotiating leverage is strongest prior to the execution of an LOI — particularly if the target is represented by an investment banker who has effectively created a competitive selling environment (or the perception of same) — and thus it is in the seller’s interest (not the buyer’s) to negotiate the material terms of the deal in the LOI. The buyer can avoid this trap in one of two ways: (i) by executing an exclusivity letter agreement and skipping the negotiation of an LOI — i.e., proceeding directly to the negotiation and execution of a definitive acquisition agreement; or (ii) by executing an LOI that includes a binding no-shop provision, but is otherwise non-binding (except perhaps with respect to expense reimbursement and/or other “special” provisions) and is as non-specific/general as possible (e.g., “this letter summarizes a proposal pursuant to which the Buyer would acquire the Target”). Either approach gives the buyer not only strong negotiating leverage, but also the time and flexibility to complete its due-diligence investigation prior to agreeing to any material terms. Moreover, it will minimize the risk that the LOI will be construed as a binding agreement between the parties — the major reason why a buyer should be circumspect with respect to the execution of an LOI — leading to potential damages if the transaction is not consummated. (Note: an LOI does serve a useful purpose in deals greater than approximately $65 million — i.e., it enables the parties to make any required filing under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.)
3. Do Your Diligence. A comprehensive due-diligence investigation is critical to the success of any acquisition. The fundamental purpose of due diligence is to validate assumptions with respect to valuation and to identify risks. Accordingly, there are typically three separate investigations: operational/strategic, financial and legal. Clearly, the scope of the investigations must be tailored to the particular transaction; however, it cannot be emphasized enough that most deals fail due to inadequate diligence — resulting in the buyer (i) overpaying for the target, (ii) assuming significant unknown liabilities and/or (iii) experiencing major integration problems. As I witnessed first-hand, the more-sophisticated acquirors (e.g., successful private equity firms) spend an extraordinary amount of time in the field (not in the data room) interviewing customers, suppliers, competitors, creditors and, of course, management in order to obtain a deep understanding of the target’s value drivers and business risks. They also demonstrate extraordinary discipline and will walk away from a deal (regardless of the time and money spent) if they determine that they are overpaying and/or certain significant risks cannot be contained (see “Mistake #4” here). In short, adequate diligence (coupled with rigorous analysis) is key.
4. Buy Assets, Not Stock (Equity). It is generally advantageous for an acquiror of a private company to purchase assets, not equity, of the target for two principal reasons: (i) it will get a stepped-up tax basis in the acquired assets; and (ii) it will minimize the assumption of any unwanted liabilities. Indeed, in a stock transaction or merger, the buyer assumes all of the target’s liabilities by operation of law; in an asset transaction, however, the buyer only assumes those liabilities that are expressly agreed to in the acquisition agreement. There are nevertheless certain liabilities that, regardless of the asset-purchase structure, will be assumed by the buyer under the doctrine of “successor liability” as a matter of public policy, the most significant of which include (i) products liability, (ii) environmental liability, (iii) liability under “bulk sales” laws and (iv) certain employee benefits and labor issues. Accordingly, the buyer must protect itself in the acquisition agreement against such liabilities with carefully-drafted indemnification provisions. The buyer must also protect itself in an asset deal against a fraudulent conveyance claim by the target’s creditors by requiring that (i) the sale proceeds stay with (or be used for the benefit of) the target and not be distributed to the target’s stockholders and/or (ii) adequate arrangements are made to pay-off the target’s creditors. Needless to say, every deal is different and must be structured and negotiated with the assistance of competent counsel, including tax counsel; however, the buyer entrepreneur should always be thinking about cherry-picking assets (with the caveats discussed above).
5. Tailor the Acquisition Agreement to the Particular Transaction. The buyer’s initial draft of the acquisition agreement must be tailored to the particular transaction. Indeed, this is not the time for the buyer’s counsel to use some off-the-shelf form (or “the agreement we used on that other deal”), with new names inserted. Instead, the initial draft should reflect ongoing substantive discussions among members of the buyer’s transaction team regarding risk allocation, purchase price considerations, the diligence findings and the overall negotiating strategy. The buyer’s counsel must, for example, specifically discuss with his client how aggressive the initial draft should be. Perhaps from the buyer’s standpoint, the purchase price is so good and any significant risks deemed to be remote (or containable) that the buyer wants a “seller-friendly” (or “middle-of-the road”) draft to avoid losing the deal. On the other hand, perhaps the target has so many potential problems, and the buyer perceives it is paying a full purchase price, that the agreement must be aggressively drafted, with broad representations and warranties and indemnification obligations of the seller to protect the buyer. Needless to say, the role the buyer’s counsel plays is critical: he must understand the target’s business and the significant deal risks in order to protect the buyer and to ensure that the buyer is making an informed judgment with respect to price and terms. Deals often take on a life of their own — with emotions and egos involved — and there is nothing more important on the buy-side than a lawyer who is watching his client’s back.
6. Escrow a Portion of the Purchase Price. One step the buyer can take to protect itself is to escrow a portion of the purchase price (e.g., 15-20%) for a period of time post-closing (e.g., 18-24 months). Indeed, escrows are relatively common (particularly where there are multiple sellers) because of the inherent unfairness of requiring the buyer to sue the seller(s) to try to get some of its money back for a problem or liability it never agreed to take on. Alternatively, the buyer can push for a hold-back (i.e., a right to hold part of the purchase price) and/or a right of set-off in deals where part of the purchase price has been deferred (e.g., where the buyer has issued a promissory note to the seller as part of the purchase price); however, escrows are obviously more amenable to sellers (i.e., less controversial) because the money is held by an independent third party and the buyer does not have the unilateral right to withhold payment. A few important points worth noting in connection with escrows: (1) the buyer should avoid limiting its recourse solely to the escrow without any carve-outs unless it is completely comfortable with the size of the escrow and has otherwise made an informed judgment with respect to the significant deal risks and terms; (2) the old pooling-accounting requirements of limiting escrows to 10% of the purchase price and one year in duration are no longer applicable; and (3) where there are multiple sellers, the buyer should require the sellers to appoint a representative who is authorized to make all decisions relative to the escrow (as well as other substantive issues). This recent M&A Holdback Escrow Report from J.P. Morgan underscores the importance of an acquiror utilizing an escrow to protect itself in the event of any indemnification claims against the seller (“[o]f the deals analyzed, 40% had claims filed against the escrow”).
7. Use Earn-Outs Only As a Last Resort. Earn-outs (i.e., post-closing contingency payments) are often touted by unsophisticated investment bankers and counsel as an effective way to bridge the gap between what the buyer is willing to pay for a business and the seller’s asking price. The reality, however, is that earn-outs often lead to major disputes and business problems post-closing and should, accordingly, be avoided if at all possible. On the legal side, a number of critical issues must be negotiated, including the following: (i) the metric (e.g., revenue, EBITDA, profit, etc.) and milestones, (ii) measurement/accounting issues, (iii) exclusions/carve-outs (e.g., allocation of administrative or general overhead expenses, intercompany transactions and charges, etc.), (iv) the duration of the earn-out period, (v) the effect of acquisitions or dispositions relating to the acquired business and (vi) most significantly, post-closing operational control issues. The amount of time and energy that is required to address adequately the foregoing issues can be extraordinary (often leading to pages and pages of provisions), and there will still be gaps because it is virtually impossible to anticipate every post-closing contingency. On the business side, earnouts usually create significant impediments to the integration process and conflicting interests between the buyer and the target post-closing — e.g., if the metric is revenue growth, the target may sign-up a number of new customer contracts that may not be profitable or in the best long-term interest of the business; if the metric is profit or EBITDA, the target may cut back on capital expenditures or other expenses (such as marketing or advertising) — particularly as the end of the earn-out period approaches. Moreover, target management may lose its motivation if it is unable to achieve its goals and thus is never entitled to an earn-out payment. The bottom line is that earn-outs are very tricky from both a legal and business perspective and should only be used as a last resort.
8. Include a Carefully-Drafted “MAC”. From the buy-side, one of the most important representation and warranty of the seller (and closing condition if there is a signing and a subsequent closing) is that the business has not suffered a material adverse change (“MAC”). Lawyers have a field day wordsmithing the definition of MAC — arguing over such issues as (i) the applicable period, (ii) whether “prospects” should be included, (iii) whether the target and its subsidiaries should be “taken as a whole” and (iv) of course, the exceptions. The bottom line, however, is that most MAC definitions are extremely ambiguous, and there is little case law to provide any guidance as to what constitutes a MAC. Moreover, the leading Delaware case, IBP, Inc. v. Tyson Foods, Inc., suggests that the standard as to what constitutes a MAC is quite high — “measured in years, rather than months.” Accordingly, the buyer must be careful about relying on a MAC to terminate an acquisition agreement (or otherwise to sue the seller for breach of the MAC rep) unless the definition includes specific objective criteria — e.g., a specific dollar decrease in EBITDA or sales, etc. (Note: as a downsize protective measure, an expense reimbursement provision should be coupled with the MAC and other closing conditions.)
9. Don’t Give Away the “Basket”. One of the provisions sellers generally insist on in the acquisition agreement is a “basket” to prevent the buyer from “nickel and diming” the seller for any claims post-closing. The size of the basket varies from deal to deal, but based on a recent study of the Committee on Negotiated Acquisitions of the American Bar Association (of which I am a member), the norm is approximately .5% of the purchase price. If the buyer agrees to a basket, there are a number of significant issues that it must address, including the following: (i) it should push for a “first-dollar” basket (sometimes referred to as a “threshold”) as opposed to a “deductible” so that if the seller’s damages exceed the basket, it would be responsible for all of the damages (i.e., beginning with the first dollar); (ii) the basket should only relate to breaches of representation and warranties and not to breaches of covenants or specific indemnity provisions (this is a common mistake); (iii) any materiality qualifiers in the representations and warranties should be disregarded for purposes of the basket — otherwise there would be a so-called “double-materiality” problem (another common mistake); and (iv) there should be appropriate carve-outs to the basket, the most common of which include capitalization, due organization, due authority and ownership of shares.
10. Watch Out for Caps. One of the most important and hotly-negotiated issues in any private-company acquisition is the cap (or ceiling) on the seller’s damages. Like other material terms in the acquisition agreement, there is no right or wrong answer (or “customary” or “market” amount): it all depends on the context of the transaction — i.e., the bargaining power of the parties, the risk profile of the target, the purchase price, etc. For example, in an auction context with ten bidders expressing interest in a target, the cap may end-up being 10% or less of the purchase price due to the competition; on the other hand, if the target has a host of significant problems (and/or is financially troubled) and there is only one prospective buyer on the horizon, the cap may end-up being equal to the purchase price (or there may be no cap). The lesson here (and the key takeaway of this post) is that the buyer must fully understand the target business and the significant deal risks in order to make an informed judgment with respect to price and terms, including the cap. Indeed, as discussed in paragraph #6 above with respect to the escrow being the sole remedy, if the cap is less than 100% of the purchase price, the buyer should push hard to include certain carve-outs, including the seller’s breach of (i) any covenants, (ii) specific indemnity provisions (e.g., environmental, taxes, ongoing litigation, etc.) and/or (iii) certain representations and warranties (akin to the carve-outs to the basket).
Tags: acquisition agreement, basket, cap, ceiling, corporate attorney, due diligence, earn-out, entrepreneurs, escrow, Hart Scott, letter of intent, LOI, M&A, MAC, material adverse change, no shop, successor liability