By Richard D. Harroch, David A. Lipkin and Richard V. Smith
Selling your company can be difficult and time-consuming. Mergers and acquisitions (“M&A”) require advance preparation, sophisticated advisors, a dedicated management team, and an understanding of the key business and legal issues involved. The following are a number of key lessons learned from M&A transactions involving the sale of private companies, from the perspective of the selling company:
Time is the enemy of all M&A deals for a seller. The price and terms typically only get worse if the process drags on, and there is the risk of the deal falling apart. New issues could arise that result in the price being lowered. The M&A process can take a very long time, and there has to be a driving force on the sell-side and timetable to get the deal to closure. It also helps for there to be a dedicated advocate on the buy-side of the deal to keep the deal moving along.
2. Competitive Process
One of the most important steps in accomplishing a successful M&A exit is to get multiple potential buyers interested. A competitive process helps ensure getting the best price and the best terms, and allows a company to fend off unreasonable requests from one bidder.
3. Due Diligence Preparation
Sellers have to understand that they will be subject to an extensive due diligence investigation, and they must be prepared in advance for all that entails. The buyer will want to see detailed financial statements, copies of all material contracts, information on key intellectual property, employee and benefit arrangements, and much more. Normally, the seller needs to have all of that information in an online data room, which can be quite time-consuming to get correct and complete. Sophisticated bidders will tell the selling company that preparing a comprehensive and well-organized online data room is important. The company will typically respond that it is organized and on top of it—but the selling company often doesn’t understand the enormity of the undertaking involved. (See The Importance of Online Data Rooms in Mergers and Acquisitions.)
4. Non-Disclosure Agreement
It is important for a selling company to have a comprehensive non-disclosure agreement in place with interested buyers. Such agreements should include a prohibition on solicitation of the seller’s employees. (See The Key Elements of Non-Disclosure Agreements.)
5. Investment Banker
A talented investment banker or advisor is important, with the right individual lead person. Key terms for the investment banker engagement letter will include their fee, the “tail” provisions (the circumstances under which the banker is entitled to a fee after termination), indemnification obligations, and conflict of interest provisions. The first draft of a banker engagement letter is always favorable to the banker and needs to be negotiated. (See Negotiating Investment Banker Engagement Letters.)
You have to have judgment as to what is and isn’t important, and the ability to make quick decisions in the negotiations. Receiving advice from experienced financial and legal advisors is essential. Whether you win a point or not is all about leverage or perceived leverage. You also need to understand where and when your leverage is best exercised, and how to effectively trade unimportant points to win the points that matter most.
Buyers want to obtain exclusivity in negotiations as early as they can in the process to avoid competitors or an auction-type scenario. From the seller’s perspective, this buyer request can give the seller leverage to improve high-level deal terms at the outset of a deal. As the seller, you want to delay granting exclusivity as long as you can in order to optimize the deal terms and continue discussions with other interested bidders, and only reluctantly agree to exclusivity if you have no choice or if you have at least gotten to a detailed letter of intent. Sellers want to have a very short exclusivity period (15 to 21 days) and buyers typically want a longer one (45 to 60 days). From the seller’s perspective, it will want the exclusivity period to terminate early if the buyer proposes a lower price or any other worse terms than detailed in the letter of intent. The seller also wants to make sure that any extension of the exclusivity period requires that the buyer affirm its price and terms and that they have completed their due diligence.
8. Letter of Intent
It is often in the seller’s best interest that a detailed letter of intent with seller-favorable terms is agreed to early on, because once exclusivity is granted to a potential buyer, most of the negotiating leverage shifts to the buyer. Therefore, it becomes important to negotiate in the letter of intent all the key terms: price, terms of payment, representation and warranties insurance terms, escrow/holdback, indemnification obligations by the shareholders, key employee issues, pre-closing obligations, post-closing obligations, closing conditions, dispute resolution (such as mandatory confidential arbitration), and much more. (See Negotiating an Acquisition Letter of Intent.)
9. Price and Type of Consideration
The price and type of consideration are issues that will need to be addressed early in the process, and these go beyond agreeing on the “headline” price. Here are some of these issues:
Whether the purchase price will be paid entirely in cash payable in full at the closing.
If the stock of the buyer is to represent part or all of the consideration, the terms of the stock (common or preferred), liquidation preferences, dividend rights, redemption rights, voting and Board rights, restrictions on transferability (if any), and registration rights.
If a promissory note is to be part of the consideration, what the interest and principal payments will be, whether the note will be secured or unsecured, whether the note will be guaranteed by a third party, what the key events of default will be, and the extent to which the seller has the right to accelerate payment of the note upon a breach by the buyer.
Whether the price will be calculated on a “debt-free and cash-free” basis at the closing of the deal (enterprise value) or whether the buyer will assume or take subject to the seller’s indebtedness and be entitled to the seller’s cash (equity value).
Whether there will be a working capital-based adjustment to the purchase price, and, if so, how working capital will be calculated. This is ultimately just an adjustment up or down to the purchase price. The buyer may argue that it should get the business with a “normalized” level of working capital. The seller will argue that if there is a working capital adjustment clause, the target working capital should be low or zero. This working capital adjustment mechanism, if not properly drafted or if the target amounts are improperly calculated, could result in a significant adjustment in the final purchase price to the detriment and surprise of the adversely affected party.
If part of the consideration is comprised of a contingent earnout arrangement, how the earnout will work, the milestones to be met (such as revenues or EBITDA and over what period of time), what payments are to be made if milestones are met, what protections will be offered to the seller to enhance the likelihood of the earnout being paid (such as acceleration of payment of the earnout if the business is sold again by the buyer), information and inspection rights, and more. Earnouts are complex to negotiate and tend to be the source of frequent post-closing disputes and sometimes litigation. Precision in drafting these provisions and agreement on suitable dispute resolution processes are essential.
The selling company’s regular outside counsel will often be inadequate for an M&A event, but there may be great pressure to keep him/her notwithstanding (based on the good work such counsel has performed outside the M&A context). That is a mistake. The company needs a competent, full-time M&A lawyer. If the existing counsel is otherwise well regarded, they should continue to assist the M&A counsel. Your lawyer has to be dedicated and know the urgency of getting things done, but he or she can’t be difficult for the other side to deal with.
11. Strategic Partners
Strategic partners can be the best acquirers. But you have to understand and convince the strategic partner why the acquisition fits in with the buyer’s existing and future business plans. Some strategic investors are granted rights of first refusal or first negotiation as part of early-stage financings or commercial arrangements. This grant is understandable at the time of the financing or commercial arrangement. However, they should be resisted (if possible) and need to be navigated carefully in order to ensure the best possible deal for stockholders. Also, due diligence can be a riskier proposition if the potential acquirer is a direct competitor of the seller.
12. Disclosure Schedule
You absolutely have to start preparing the disclosure schedule (the schedule attached to an acquisition agreement that lists contracts, capitalization, intellectual property, litigation, etc., and exceptions to representations and warranties that would otherwise not be accurate) as early in the process as possible. It’s time-consuming, requires many drafts and can hold up a deal. A great disclosure schedule is the best insurance against post-closing indemnification claims by a buyer. (See The Importance of Disclosure Schedule in Mergers and Acquisitions.)
13. Fiduciary Duty
The Board of Directors of the seller needs to understand its fiduciary duties and engage in a deliberative, thoughtful process to limit liability issues for the company and the Board. Early on, the Board needs to identify and be sensitive to actual and potential conflicts of interest.
Shareholder issues need to be dealt with early on. What shareholder approvals will be necessary? How quickly can they be obtained? Will there be dissenters’ or appraisal rights issues? Will the deal require the approval of any shareholder or group of shareholders who are unhappy about the way the company has been run or the return on their investment?
15. M&A Committee
An M&A Committee of the Board is often established, and it’s essential that such a committee can act quickly and nimbly. The benefit of such a committee is to help expedite the negotiating process and limit the burden on the entire Board.
16. Employee Issues
Employee retention/incentive issues can have significant cost and closing condition implications. The seller will want to make sure that its management team and employees will be treated fairly and incentivized by the buyer moving forward, but if the buyer tries to impose the cost of such treatment on the seller, significant issues can arise. The buyer will want to spend a great deal of time with management and employees, as it will want to ensure that the employees will come on board, be motivated, and will be a good fit with the buyer’s culture. In addition, key management who receive certain accelerated or other deal-related payments should be concerned that they won’t suffer adverse tax consequences as a result of Internal Revenue Code Section 280G.
17. Financial Projections
The buyer will spend a great deal of time studying the seller’s financial projections, getting comfortable with the assumptions and the key metrics. The selling company’s CEO and CFO absolutely have to be comfortable and knowledgeable about every component of the projections and be prepared to justify their reasonableness to the buyer.
18. Intellectual Property
The intellectual property due diligence during the M&A process may be incredibly intensive. The seller must be on top of all of its patent filings, trademarks, copyrights, domain names, open source software, etc. The seller also needs to be prepared to deal with the extensive intellectual property representations and warranties that will be proposed by the buyer, and the possibility that the buyer will try to characterize these representations and warranties as “fundamental” (resulting in lengthier survival periods and greater liability exposure). Buyers are also increasingly concerned about data privacy and cybersecurity issues. (See 13 Key Intellectual Property Issues in Mergers & Acquisitions.)
19. Incomplete Records
Sellers almost always have problems with incomplete Board and stockholder minutes, option agreements, contracts with all amendments, etc. An early internal review of these matters (and correction or completion of such materials as needed) is important, as these problems can hold up a deal.
The seller has to review and understand what consents it will need from other parties to its contracts in connection with the acquisition. Sellers should attempt to limit or eliminate any consent requirements that could slow up or kill a deal, or permit landlords, licensors, or other third parties to demand increased payments in exchange for such consent.
There is a careful balancing act between wanting to disclose to the potential buyer everything about the business early in the process (to avoid misunderstandings later) and limiting disclosure of the really important secrets or other confidential information until a deal is near certain. Sellers need to be concerned about a potential buyer going away armed with important knowledge they could use to compete with the seller’s business, particularly if the potential buyer is a competitor.
22. Definitive M&A Agreement
The definitive acquisition agreement is hugely important to both the seller and the buyer. There are many issues that need to be negotiated, and sophisticated M&A counsel is essential for the seller. Some of the more important issues include: (a) will there be an escrow or holdback of the purchase price or will the buyer solely rely on representations and warranties insurance, and if there is an escrow, will the escrow serve as the sole remedy for a breach of the acquisition agreement; (b) what are the scope of the seller’s representations and warranties and how many can be qualified by “knowledge” and “materiality” caveats; (c) what are the covenants of the seller and any shareholders prior to closing and after the closing; (d) what are the key conditions to closing the deal; (e) how are various risks allocated, such as litigation, intellectual property issues, unknown liabilities, etc.; (f) how are employees to be treated; (g) what are the indemnification obligations of the parties; (h) how can the M&A agreement be terminated before a closing and what are the financial consequences; (h) what regulatory requirements (such as antitrust approvals) must be satisfied before closing and what issues will these raise; and (i) how are disputes to be resolved (e.g., by arbitration). (See 18 Key Issues for Negotiation Merger and Acquisition Agreements for Technology Companies.)
23. The CEO’s Role
The CEO’s role in an M&A process is hugely important. The CEO has to sell the vision for the business and clearly articulate why the company is such an attractive and growing business with sophisticated and differentiated technology, products, or services. The CEO must have an understanding of the fundamental legal and business issues that will arise and be able to make many judgment calls on those issues. The CEO also needs to keep the Board, the M&A Committee, and key investors informed at each stage of the process. The CEO is often put in a difficult position—to negotiate tough on key terms of the deal, knowing that he or she is negotiating with a future employer and not wanting to be perceived as difficult; this problem is exacerbated if the buyer is a private equity investor offering the CEO and other members of management a piece of the post-closing equity. That is why it may be better for a financial advisor or the M&A Committee of the Board to take the lead in negotiating the deal terms/acquisition agreement, which then permits the CEO to act as a facilitator to get the deal done.
24. Shareholder Representative
It’s important to engage a good third-party shareholder representative service to deal with post-closing issues. These include administration of the indemnity escrow provisions, dealing with the working capital and other price adjustment provisions, and enforcing any earnout provisions. It’s not a good idea to have these critical tasks handled by an unpaid volunteer from among the investor ranks.
25. Deviations from Projections During the M&A Process
Since an acquisition process can take a significant period of time to complete, one issue that can come up is the variability of the financial performance of the business while the M&A deal is pending. If the seller misses its projected financial numbers during the process, a buyer can see this as a red flag and require a reduced purchase price or may even terminate the negotiations. Therefore, it is imperative that the management team keeps its eye on the ball in running the business (even though they will be distracted by the M&A process), and that the projections presented to the buyer for the anticipated diligence and negotiating period be easily obtainable.
A Comprehensive Guide to Due Diligence Issues in Mergers and Acquisitions
Data Privacy and Cybersecurity Issues in Mergers and Acquisitions: A Due Diligence Checklist to Assess Risk
What You Need to Know About Mergers & Acquisitions: 12 Key Considerations When Selling Your Company
Mergers, Acquisitions and Investments Involving U.S. Companies with Chinese & Other Foreign Parties
Copyright © Richard D. Harroch. All Rights Reserved.
About the Authors
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on internet, digital media, and software companies, and he was the founder of several internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He is the co-author of the recently published 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He was also a corporate and M&A partner at the law firm of Orrick, Herrington & Sutcliffe, with experience in startups, mergers and acquisitions, and venture capital. He has been involved in over 200 M&A transactions and 250 startup financings. He can be reached through LinkedIn.
David A. Lipkin is an M&A partner in the Silicon Valley and San Francisco offices of the law firm of McDermott Will and Emery LLP. He represents public and private acquirers, target companies, and company founders in large, complex, and sophisticated M&A transactions, as well as working with startups and other emerging growth companies. David has been a leading M&A practitioner in the Bay Area for 20 years, prior to that having served as Associate General Counsel (and Chief Information Officer) of a subsidiary of Xerox and practiced general corporate law in San Francisco. He has been recognized for his M&A work in the publication The Best Lawyers in America for several years, and is the co-author of the recently published 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He is a member of the Board of Directors of the Giffords Law Center to Prevent Gun Violence, and has served on additional educational and charitable boards. He has been involved in over 200 M&A transactions. He can be reached through LinkedIn.
Richard V. Smith is a partner in the Silicon Valley and San Francisco offices of Orrick, Herrington & Sutcliffe LLP, and a member of its Global Mergers & Acquisitions and Private Equity Group. He specializes in the areas of mergers and acquisitions, corporate governance and activist defense. Richard has advised on more than 500 M&A transactions and has represented clients in all aspects of mergers and acquisitions transactions involving public and private companies, corporate governance, and activist defense. He is the co-author of the recently published 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He can be reached through LinkedIn.
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