Part VI 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. The day you sign away ownership of your business is a major milestone in the M&A process, but it is not the end of the deal. Both parties—buyer and seller alike—still face obligations to each other, as well as to the business in question. Many consider the closing date “Day One,” as it is usually the first time the buyer assumes control of the business’s operations. This is the first day you no longer own your business. Beyond the shift in leadership, there will be changes in personnel, organizational structure, and strategic management. Whether you remain involved in a management role or not, employees may seek you out for clarification or advice. Your responsibility to your former business may be far from over. The same is true from a legal perspective. Depending on the terms of your purchase agreement, you may be on the hook for indemnification claims and purchase price adjustments contingent not only on the business’s performance, but also relating to any further details not discovered during due diligence that may emerge post-closing It is crucial to stay involved during this period of transition. Dot your i’s and cross your t’s. Unforeseen factors can effectively ruin your payout if your buyer dramatically lowers the purchase price or if an indemnification claim exceeds the amount held in escrow. On top of your reps and warranties, any covenants into which you enter will restrict your conduct post-closing. Understand your responsibilities. Below are several factors most sellers will need to watch out for after signing.
A definitive agreement typically contains covenants that spell out your and your buyer’s obligations post-closing. These generally pertain to both your former business as well as any new business you engage in after the transaction. In a non-solicitation covenant, the seller agrees not to solicit employees or customers of their former business. Non-compete covenants, on the other hand, allow the buyer to restrict seller from opening a similar business within the same industry and/or geographic region. Employee and customer matters are other common factors in covenant negotiations. You or your buyer may be obligated to provide employees with salary and benefits for a certain period of time, during the ownership transition. Your buyer may require you to issue press releases or statements announcing the sale to customers and the public at large.
Indemnification is an important and often very complex clause in M&A transactions. It is the buyer’s best weapon against breaches of reps and warranties laid out in the definitive purchase agreement. You should familiarize yourself with the following indemnification limitations to understand your liability:
- The number of claims your buyer is allowed to make
- Minimum scope of indemnification, i.e. what constitutes a claim
- The duration of indemnification, i.e. how long you’re on the hook
- What amount can be claimed against escrow
Indemnification structure depends on the overall terms of the deal. Purchase agreements typically include an indemnification “cap,” which limits the amount you would have to pay the buyer in the event of a breach of warranties. A “basket” amount protects you against paying losses via funds held back in escrow or out of pocket, by providing a dollar threshold that must be met before a claim can be made. There are several kinds of baskets: deductible (most common), “tipping” (or “first-dollar”), and combination. Standard baskets only require you to pay the amount exceeding the threshold and deductible. Tipping baskets include no deductible, and require you to pay the full amount of the claim—both within and outside of the threshold—once the threshold has been reached. Combination baskets also obligate you to the full amount, but include deductibles. Say, for instance, your buyer raises a claim for $100,000, and your basket’s threshold is $50,000. If you agreed to a standard basket with a $30,000 deductible, you would only need to pay the difference, minus the deductible: $20,000. A combination basket with the same deductible would obligate you to pay $70,000. But if you agreed to a tipping basket, you would have to pay the full $100,000. For more information on indemnification and escrow, read Part IV, “Top Considerations for M&A Negotiations.”
Purchase price adjustments are common, but often relatively minor. Your buyer may choose to adjust the purchase price based on current working capital, EBITDA, or other recent financial statements. If your buyer does not raise any substantial claims, and the adjustment is agreed upon by both parties, the adjustment will usually be made via funds in escrow. You and your buyer may agree on the final working capital and purchase price at closing; This is known as a “one-step” adjustment. The much more common “two-step” adjustment, however, allows your buyer to review financial information over several days and adjust the price a second time. In some cases, adjustments or disagreements over valuations lead to disputes. Consult with your attorney and review your purchase agreement to familiarize yourself with your options. Most disagreements will see the two parties acting in good faith to resolve the dispute within a specified time period (usually thirty days). If the parties are unable to reach an agreement in that time, they will submit the company’s financial information to a third-party accountant, who will verify the purchase price. Be aware that purchase price disputes and other post-closing matters can sometimes lead to arbitration as an alternative resolution method.
After you’ve resolved any disputes, indemnified any claims, and fulfilled any responsibilities under restrictive covenants, you can finally start planning for and enjoying your new status in life. My final article in this series will offer guidance on post-transaction planning, so you can meet your long-term business and financial goals.
ABOUT MICHAEL N. MERCURIO
Business attorney and M&A lawyer Michael N. Mercurio serves as outside general counsel on matters related to business law, M&A, and real estate law As a strategic partner to firm clients, Mr. Mercurio regularly counsels entrepreneurial individuals and assorted entities on all aspects of business and commerce, with a core specialty in mergers and acquisitions—both from the sell side perspective and buy side perspective. You can also connect with Offit Kurman via Facebook, Twitter, Google+, YouTube, and LinkedIn. WASHINGTON | BALTIMORE | FREDERICK | PHILADELPHIA | WILMINGTON | VIRGINIA