Part IV in a seven-part series on the anatomy of an M&A deal from the seller’s perspective. To read Part I, which covers the basics of pre-transaction planning, click here. If a mergers and acquisitions (M&A) transaction is analogized to a baseball game, negotiations are the seventh-inning stretch. For seller and buyer alike, this process is a potentially thorny and grueling one, as both sides are often pursuing opposite agendas: You want to sell your business at the highest price along with the best terms possible, while your buyer aims to bring purchase your business for the fewest dollars possible and achieve their ideal purchasing terms. At the same time, both you and your buyer share at least one objective: to close the deal as quickly as possible. During negotiations, momentum is your greatest asset. The faster you are able to arrive at the agreed upon definitive documents, the more likely your deal will close. Of course, you still need to get to and through closing, but by this juncture, there should be fewer obstacles in the way. Know when to give, and when to take—the push/pull concept. It is crucial to determine what you really must have in the deal, and what you can live without. Some would argue that the fairest transactions are ones in which both parties reach an agreement unhappy (meaning both parties had to compromise). But as a seller, beware. The further you plunge into it, the more the transaction will drain both your time and your finances. You will become vested in the transaction, and you may experience transaction fatigue. Buyers know this—after all, most have completed multiple transactions and so have experience playing their cards. For most sellers, on the other hand, the sale transaction is their first and only experience. Do not allow a buyer to leverage you because it believes (rightfully or wrongly) that you are tired of the transaction, that you are fearful of the costs of not closing, etc. It is at this juncture that a buyer may seek an advantage, believing that you will accept anything just to get the deal done. Don’t play into the buyer’s expectations. Beyond the finalized purchase price, there are many provisions and potential adjustments that can greatly impact your bottom line. Experienced legal counsel, along with input from your accountant and M&A consultant, will help you navigate the terms of the contract, so that you can achieve the best overall buyout while providing value to your buyer—thus creating a win-win situation. Every M&A negotiation is different. However, most contracts share several important issues that shape the broad nature of the deal.
Reps and Warranties
Representations (reps) and warranties are the results of a due diligence investigation. During a negotiation, you and your buyer will need to agree on exactly what is being sold (represented): the company’s assets, liabilities, intellectual property, and so on. Detailed reps and warranties are generally less favorable to the seller than to the buyer. The more you promise, the more opportunities your buyer has to claim a breach of the purchase agreement. The reps and warranties are the bulk of the agreement. You can always judge the importance of certain provisions by their length and the amount of details surrounding them. There are usually many, many reps and warranties for a seller to make. Be ready—you will be asked to personally guarantee these as the owner of the business. It will not be enough for your business to simply make the reps and warranties. You and every other material owner will likely need to stand behind the statements being made by your business. And keep in mind that reps and warranties are statements of absolute truth unless qualified and/or caveated in the Disclosure Schedules (see below).
Indemnities and Escrow
Definitive purchase agreements typically contain indemnities that are general in nature as well as indemnities that tie to specific activities (usually “issues” spotted during diligence) of your business. Your counsel will work with you to limit the indemnities as much as possible—in time effective, dollar amount exposure, and so on. Indemnity obligations may be secured by monies that are held back by the buyer or set aside and held by a third party in escrow. A buyer will use these monies to set off any unforeseen contingencies that arise post closing. Purchase agreements will delineate the amount held in escrow, along with the holdback period. It is critical to understand these terms in regards to your liability. Know which warranties and reps are excluded from claims against escrow. For example, escrow may not be enough to reimburse the buyer in the event of fraud or unpaid taxes. Make sure you know the indemnity limits, so that you can protect yourself against any unreasonable responsibilities post closing. Along with your reps and warranties, indemnifications and held back monies should be areas that you review and negotiate carefully.
Earnouts are tricky and should be approached cautiously. Buyers like to insert contingent purchase price payments upon the occurrence of certain events because it limits their exposure upfront. But as a seller, earnouts can be a nightmare. In a nutshell, an earnout is a portion of the purchase price you may receive after a business reaches certain financial conditions in the buyer’s hands. When you and your buyer disagree about the value of your business, an earnout provides a compromise: your buyer pays less up front, while you have the opportunity to obtain your desired amount down the road. Be very careful about agreeing to an earnout. While many times an earnout is unavoidable, make sure to have your attorney carefully construct its terms. Think about it: You are being measured on the future success of the business, but are not longer in control of the business; the buyer has control. Thus, in the worst-case scenario, you are obligated to the success of a business you have no ability to impact. Make sure your earnout speaks to resources and commitments the buyer will make to you so you can reach your goals. Also, know that earnouts are the one area in which you may find disagreement with the buyer post-closing, and thus earnouts are the most litigated portion of any M&A transaction.
Wherever you can, limit the adjustments your buyer can make to the purchase price. As negotiations come to a close, changes in your working capital, revenue, and assets may prompt your buyer to make adjustments on their closing balance sheet to adjust the purchase price in their favor. Suffice it to say, adjustments should be considered carefully, but if the alternative is an amended deal structure or the termination of the deal, an adjustment may be your best recourse.
As noted in the reps and warranties section above, Disclosure schedules are an integral part of the purchase agreement. Disclosure Schedules are detailed and tedious, and you will undoubtedly not find it a valuable exercise. However, the Disclosure Schedules are extremely important for two reasons: First, the Disclosure Schedules are where you add in the caveats and exceptions to your reps and warranties. Bear in mind that your reps and warranties are absolute statements of truth—unless qualified or excepted. Second, the Disclosure Schedules are the written embodiment of your due diligence exchange. In a sense you are going through the disclosure process again, only this time in a legal format. While time-consuming and monotonous, developing full and complete Disclosure Schedules is vitally important to you as the seller. In the end, when the transaction closes, the only documentation that will survive and memorialize the transaction is the definitive agreements, including the Disclosure Schedules (which are appended to the purchase agreement). You will not be able to tell the buyer that you sent them a copy of a certain customer inquiry via the diligence process if that document is not included in the Disclosure Schedules. Make certain to work with your counsel to establish full and complete Disclosure Schedules.
Once contract negotiations wind down, it is time to set a closing date. If you have made it through this far with the deal intact, congratulate yourself, but know that your work is far from over. Time is still of the essence. And remember: You have not sold your business until you have sold your business. Be sure to close the transaction with cash in your hand. My next article will provide pointers for closing swiftly and effectively. If you have any questions about top considerations for M&A negotiations or selling your business please contact Michael Mercurio at: firstname.lastname@example.org | 301.575.0332 | Linkedin Michael Mercurio is business law and transactions attorney. He serves as outside general counsel to clients on matters related to corporate and business law, commercial transactions, government contracting and real estate. As a strategic partner to firm clients, Mr. Mercurio regularly counsels entrepreneurial individuals and assorted entities on all aspects of business and commerce including formation and structure; ownership, management and control; financing and capital; expansion and acquisition; sale and transfer; and contraction and dissolution. You can also connect with Offit Kurman via Facebook, Twitter, Google+, YouTube, and LinkedIn.