By Gordon E. Forth, Esq.
© 2011 Woods Oviatt Gilman LLP
During 2011, Rochester M&A activity continued to increase in line with national trends. Experts largely attribute this to the emerging economic recovery, improved capital availability, continuing low interest rates and buyer’s building cash levels. Lower middle market transactions in particular (i.e. companies with $250 million or less in annual revenues), which are very prevalent in the Rochester area, are occurring at an especially brisk pace that is projected to continue. More succinctly, buyers exist for business owners looking to exit.
What risks do sellers face when pursuing an M&A exit? The main risks can be separated into three categories: damage to the seller’s business; deferred purchase price non-payment; and post-closing liability to the buyer. When considering a sale, a potential seller should weigh these concerns, but also be aware of available tools and techniques that mitigate risks.
Business sale rumors can devastate customer, supplier and employee relationships and provide ammunition to competitors. This risk needs to be assessed when designing a sale process. A broad auction is possible if multiple potential buyers exist. An extensive process, however, increases the likelihood that word will leak out that the business is for sale. Alternatively, a negotiated sale with a single buyer can leave sellers vulnerable if closing fails. In my experience, a small, controlled bidding process involving several hand-picked potential buyers provides a reasonable compromise. It can also generate very good results.
Maintaining highly valued confidential business information during due diligence is challenging. Although non-disclosure agreements provide contractual comfort, they cannot adequately address potential buyers who are competitors. In these situations, special procedures can safeguard information. For example, releasing business critical information (such as customer lists and pricing) at benchmarks as the transaction progresses can be effective. Similarly, sellers may initially limit disclosure of key technology to results, and release technology itself (e.g., source code) later in the deal process. Employee and customer non-contact and non-solicit covenants are additional possibilities, although I find buyers strongly resist them.
As part of the M&A process, sellers need to investigate the buyer to avoid a bad marriage. Does the buyer have a reputation for completing acquisitions, renegotiating terms or engaging in litigation? What is its ability to pay or finance the transaction? If seller financing or buyer stock is involved, what are the buyer’s finances and prospects? If the buyer is publicly traded, what do analysts say? If seller’s principals will continue on as part of the management team post-closing, what is buyer’s management style and how has it treated management teams of other targets? The importance of this type of buyer due diligence cannot be overstated.
Most buyers insist on an exclusive negotiating period, which is generally included in a letter of intent (although this may differ in the auction context). I view a letter of intent as a necessity. It confirms a meeting of the minds on the principal terms before taking the business off the market. The seller should avoid being tied up for too long, however, as this will reduce the odds of ultimately selling the business if negotiations fail. A useful technique is to make continued exclusivity dependent on transaction milestones.
It goes without saying that price is the term of most interest. A fixed price has certainty and low risk to sellers, but often is not possible. Usually, a post-closing adjustment is required. For example, if buyers use balance sheet items as part of the price, then changes between the pricing date and closing need to be determined. Earn-outs are another common technique used to bridge pricing gaps. Both types of provisions have resulted in significant M&A litigation. With this in mind, a seller needs to work closely with its professionals to clearly lay out the price change basis, calculation mechanics and dispute resolution procedures.
When seller financing is involved, non-payment risk is introduced. Sellers are often surprised to learn that the buyer’s financing commitment requires seller financing to be subordinated behind the buyer’s credit facility. This can result in the seller not getting paid if financial troubles befell the buyer. Sellers need to evaluate the buyer’s creditworthiness, including its capital structure. Equally as important are the subordination terms (which can vary widely) that restrict the seller’s leverage to force payment. Sellers may seek alternative ways of getting paid such as pledge of separate collateral and guarantees.
Buyers will seek seller representations and warranties to confirm information relied on in making its offer. Buyers suggest comprehensive assurances while sellers attempt to narrow their scope and include limiting qualifiers. This negotiation represents an allocation of risk. For a seller, the risk translates into liability to the buyer for losses from misrepresentations and breached warranties which are recoverable under indemnification provisions. These provisions may also include losses from breached covenants and agreed upon risks or liabilities (i.e., pending litigation or environmental issues). In my opinion, indemnification provisions are second in importance only to price and payment terms.
An indemnification cap, which limits a seller’s entire monetary liability in the absence of fraud, can manage most of a seller’s post-closing exposure. In the past two years I have negotiated caps ranging from a flat dollar amount to between 10% and 100% of the purchase price proceeds. Limiting the time period during which indemnification claims can be can also reduce a seller’s exposure. Buyers generally will accept survival periods of between one and three years on all but a few fundamental issues. Additionally, including anti-sandbagging provisions can eliminate buyer claims based on matters it had knowledge of pre-closing. These techniques will provide a seller with peace of mind that a significant portion and, possibly all, of its sale proceeds will not be subject to return.
Finally, buyers seek to secure a seller’s indemnity with holdbacks or escrows from sale proceeds. Holdbacks are not funded at closing while escrows are paid to an escrow agent. I encourage sellers to seek escrows because it is generally easier to access these funds and it eliminates buyer credit risk for these funds. A technique to consider is a staged release of the escrow funds as time elapses and the buyer’s risk declines.
Working through risks in the M&A sale process can be daunting and emotional to a business owner who has never encountered these issues. Effectively managing the risks with available tools and techniques, however, can reduce this angst and allow him to get to the goal line with appropriate comfort so that he may enjoy the fruits of his labor.
Gordon E. Forth, Esq. is a partner at Woods Oviatt Gilman and Chair of the Firm’s Business & Finance Department. He concentrates his practice in the area of corporate finance, with primary emphasis on public and private offerings of securities, mergers, acquisitions and venture capital transactions. He can be reached at (585) 987-2801.