I did a brief video a few years back addressing the five biggest mistakes entrepreneurs make doing deals generally (see above), which covered the following topics:
- not diligencing the guys on the other side of the table (at 0:26)
- not building a strong transaction team (at 1:11)
- not running negotiations through the lawyers (at 2:10)
- not checking your emotions at the door (at 2:49) and
- blinking first (at 3:28)
A number of clients and friends have asked me to come-up with another list relating solely to selling a business and specifically to legal mistakes. Here it is:
THE 5 BIGGEST LEGAL MISTAKES ENTREPRENEURS MAKE SELLING THEIR COMPANY
Mistake #1: Not Negotiating/Executing a Confidentiality Agreement
From the seller’s perspective, the first step in connection with the sale of a business is the negotiation and execution of a confidentiality agreement (sometimes referred to as a “non-disclosure agreement” or an “NDA”) with the potential buyer. This is one of the few transaction documents that the seller’s attorney typically drafts, and its main purpose is to protect the target company’s proprietary and/or confidential information if the deal does not go forward by expressly prohibiting the potential buyer from disclosing such information, other than to its representatives (such as senior executives, attorneys, etc.) on a need-to-know basis. A well-drafted confidentiality agreement will also prohibit the potential buyer from soliciting and/or hiring the company’s employees. (I discuss the key issues regarding confidentiality agreements in detail in my post here.)
Most importantly, the negotiation of a confidentiality agreement will allow the seller to determine if the potential buyer is someone he can do business with. Indeed, this is the first of many transaction documents that will need to be negotiated, with the letter of intent and the acquisition agreement to follow. Accordingly, if, for example, it takes two weeks to negotiate a simple confidentiality agreement, with lots of revisions and nitpicking by the buyer’s attorney, this is obviously not a good sign and does not bode well going forward; on the other hand, if the buyer signs the agreement in a day or two, with few changes, this will set a positive tone and should give the seller confidence to move forward with the transaction.
Mistake #2: Not Negotiating the Material Terms of the Sale in the Letter of Intent
In my 18+ years of doing M&A transactions, the most common (and sometimes critical) mistake that I have seen from the sell-side is the failure to negotiate the material terms of the deal in the letter of intent (“LOI”). I cannot emphasize enough that the seller’s strongest negotiation leverage is prior to the execution of the LOI. This is the time-frame when the seller (or his investment banker) should be creating a competitive environment, and potential buyers/bidders should be played off of each other.
Once the LOI is executed, all of the seller’s leverage is gone because he generally won’t be able to shop his company around to other potential buyers for a period of 60-90 days due to a “no-shop” provision. Accordingly, during the period prior to the execution of the LOI is when there should be a competitive bidding environment (or the perception of one), with prospective buyers competing on price and terms. While working at two major law firms in New York City, I saw first-hand how investment banks like Goldman Sachs and Morgan Stanley play this game quite effectively.
One potential buyer, for example, may offer a higher purchase price, but may require that a substantial portion of the purchase price be put into escrow and require a “cap” on liability (discussed below) equal to the purchase price; another buyer may offer a lower purchase price, but not require an escrow and accept a 10% cap on liability. Accordingly, prior to choosing a buyer, the seller should negotiate and weigh all of the material terms of the offer, and the LOI should reflect those terms.
Mistake #3: Not Requiring a Reverse Termination Fee
Big companies and private equity firms will sometimes execute an LOI with the seller in order to create, in effect, an “option” to buy. They lock-up the seller with a no-shop provision, get a free look at the seller’s books and other confidential information, and then play games (such as lowering the purchase price) or just walk away with valuable information under their belt. This is a nightmare scenario for the seller, who has few options other than suing the potential buyer for failing to negotiate in good faith – which will likely be difficult to prove and costly.
In order to protect the seller from such a scenario, the potential buyer should be required to pay a fee (referred to as a “reverse termination” fee or “reverse break-up” fee) if the negotiations or acquisition agreement is terminated through no fault of the seller. Indeed, this is customary in public deals and large private deals if the buyer is unable to obtain financing and can be as high as 10% of the purchase price. At a minimum, the seller should push for reimbursement of its attorneys’ fees and other transaction expenses if the potential buyer walks for no good reason.
Mistake #4: Not Capping the Seller’s Potential Liability
After he sells his company, an entrepreneur obviously wants to sleep well and enjoy the fruits of his years of labor. Accordingly, it is critical that certain key provisions be inserted into the acquisition agreement to protect the seller post-closing. One such provision is a cap on liability, which (as noted above) should ideally be negotiated in the LOI. A cap on liability basically means that if something goes wrong post-closing and it turns out, for example, that the seller has breached a representation and warranty in the acquisition agreement, the buyer can only recover up to a certain amount.
Sellers should strive for a cap of 10-20% of the purchase price and should also try to minimize any buyer carve-outs. Alternatively, if part of the purchase price will be put in escrow to cover any post-closing indemnification claims by the buyer, the seller should push hard to make the escrow the exclusive remedy. The message to the buyer is simple: inherent in any business are certain ongoing risks — thus, once the business is sold, the buyer should only be able to recover a limited amount of the sale proceeds (absent fraud).
Mistake #5: Not Including a “Basket” and Other Protections in the Agreement
The buyer should not be permitted to “nickel and dime” the seller for immaterial breaches of the representations and warranties. Accordingly, the seller should insert a basket (i.e., a deductible) into the indemnification section of the acquisition agreement (e.g., 1-2% of the purchase price). The buyer thus would only be permitted to recover its aggregate amount of damages in excess of the amount of the basket (though buyers sometimes insist that if its damages exceed the basket, the seller should be responsible for the first dollar). Sellers should also push to include a mini-basket for individual claims — e.g., unless the buyer’s damages exceed $10,000 with respect to a particular claim, it does not get counted toward the basket.
Another important seller protection is a so-called “non-reliance” provision, which requires the buyer, in effect, to acknowledge that it is buying the business based solely on the seller’s representations and warranties in the acquisition agreement. Such a provision is intended to prevent the buyer from suing the seller based on any oral statements, writings, projections, etc. outside the four corners of the agreement.
Based on the foregoing, it should be clear that if you’re selling your company you need a solid corporate lawyer to protect you and watch your back. Obviously this is a bit self-serving, but a well-drafted acquisition agreement is like a good insurance policy in the event of a dispute or litigation. Indeed, we live in a litigious society, and it is prudent to retain a solid corporate lawyer to make sure you don’t get blindsided and to help you think through key legal issues, like the ones above. Cheers, Scott