Exit Planning Exchange

By Laura Kevghas and Donald Richards

Top Five Buyer Blunders and How to Avoid Them

Many of the past Viewpoints we’ve published have advised sellers on how to secure a great deal in the M&A market. In this issue, we take a seat on the other side of the conferencetable to highlight five common and sometimes critical buyer mistakes that can be fatal to a transaction.

Some of these mistakes or misunderstandings can cause a seller to mistrust a prospective buyer. Others lead a buyer to present an offer that doesn’t meet the seller’s needs or interests.  In any case, they can result in a deal that’s in serious jeopardy.

Why This Matters:

Most buyer mistakes are avoidable. Being aware of how things can go wrong will help you improve your chances of sealing the deal.

1. KNOW the Real Decision-Maker(s)

Things can get off track right from the start if you don’t take the time up front to clarify key and hidden Decision-Makers in the seller’s world. John Kenny, Executive Vice President of Corporate Development for Iron Mountain, states that one of the most important factors that needs to be uncovered early on is whether the people that you’re dealing with on the seller side are the people who can actually approve a transaction. “I’ve seen a lot of cycles wasted and deals just never get done,” he said, “because you’re talking to someone who isn’t authorized to make a decision, or the board isn’t aligned with the sale.”

Although unfortunate, it is not unheard of for someone on the seller side to overstate how much authority they have to get a deal done. Mirus once had a principal of a seller represent himself as the sole decision-maker, only to have the partner committee turn down the letter of intent the principal had negotiated because his partners did not want to sell the company at any price!

Exaggeration of authority may be difficult to ascertain, and supports the idea of asking probing questions up front . Confirming as many deal-related details as possible early in the relationship helps streamline the deal process and keep it from derailing.

2. DON’T Focus on Price Alone

Some buyers assume getting the best price possible is the only thing that matters to a seller. In reality, many sellers have other goals that are important to them. Not taking time to uncover these objectives can be a big mistake.  John Kenny also advises learning as much as possible about the complete dynamics of a seller’s situation in advance. “One of the first questions to ask is why the asset is for sale,” he adds,“…and also understand whether it’s a distress situation and whether it’s been shopped for a while. Are they shooting for the whole market, or targeting you specifically?”

Mirus represented a client recently who wanted to ensure that his staff, many of whom had helped him grow the business for more than twenty years, had bright futures with the company post-acquisition. One finalist in the auction process,who didn’t believe this was a real objective of the seller, was dropped from the process despite a high proposed purchase price, when they indicated that they planned to cut employees and close facilities after the close of the sale.

Similarly, many entrepreneurs want to know that the company brand and culture they’ve spent years building–and which they believe support their company’s success–are going tobe maintained. Factors like these are often especially important when a family owned business goes on the market.

“Seller motivations are important, because if the seller cares about their brand, or their people, or their staff’s ongoing employment; and these factors don’t match up with integration into the new company, then you might as well stop–because you won’t be the preferred buyer,” adds Kenny.

3. Romance the Seller

Sellers want to believe a prospective buyer is really pursuing them and truly cares about the business the seller has built.  This is especially true if the seller is planning to stay involved with the business, but it can also be true even if the seller is planning to exit.

“You need to distinguish the different situations,” said attorney Les Fagen, a partner in the Venture Capital practice group at Cooley Godward Kronish’s Boston office. “If it’s a family-owned or founder-owned business, not spending time ‘romancing’ the seller can definitely be a problem.”

Taking time to get to know the seller, and letting the seller get to know you, are essential to building the type of personal bond that will help move a deal forward. Making sure that there are enough face-to-face meetings, spending time getting to know sellers and their key players, listening closely and asking good questions, and helping the seller learn about you are examples of the types of things a buyer can do to help a seller feel “wooed” and special.  At the end of the day, relationships buy companies.

4. BUILDING A Win-Win DEAL

Some buyers focus on winning during every negotiation with the seller, whether it’s related to the purchase and sale agreement, employment agreements or post-closing integration. Every purchase and sale agreement has numerous points that involve a give and take between buyers and sellers. Sellers can get fed up and walk away, simply due to the perception that a buyer is trying to shift all possible risks to the seller’s side.

“Being too aggressive in negotiating the indemnities in the purchase agreement is one of the more common problems,” Les Fagen elaborate(s) . “The seller wants certain limitations on liability, and the buyer wants all these protections in the document. Not wanting to intelligently assume risk on a buyer’s part is probably one of the most common reasons that deals fall apart.”

5. Organization

A seller can quickly lose confidence when a buyer doesn’t appear competent or knowledgeable in terms of how they approach the sales process. “One of the key success factors for an acquisition is earning the seller’s trust, that you will indeed be able to close the transaction,” pointed out Fagen. “The seller wants to know that the buyer has the ability, the wherewithal, and the determination to close and close promptly. I’ve seen a number of deals fall apart because the buyer took too long and didn’t keep the process moving forward.”

The due diligence process is seen by many sellers as a proxy for how they will work with the buyer post-closing.  A smooth due diligence process comforts the seller and his/her management team that the buyer’s company is also well run, and that integration and post-closing activities will be smooth and well-managed.

Planning for Success

Buying and selling a business can be challenging for those on both sides of the table. If you’re on the buyer’s side, understanding as much as you can about your seller in advance will help you anticipate and avoid the common mistakes discussed here. Through good planning, excellent listening and communication skills, understanding your seller’s motivations, and knowing your seller’s key influencers; you can become a successful buyer, and complete profitable transactions.

Laura Kevghas is a principal and Donald Richards is a partner at Mirus Capital Advisors, Inc., with a collective history of more than 150 buy-side transactions. Mirus is a middle-market investment bank that specializes in advising companies on strategic mergers and acquisitions. By combining a proven process, industry and  transactional expertise, creative thought, and personalized service, Mirus has completed hundreds of transactions for both public and private companies. Mirus is a registered broker-dealer and FINRA/SIPC Member. For more information, visit www.merger.com.

Investment Banking Services Since 1987 - 200 Wheeler Road, 4th Floor, Burlington MA 01803 • Tel: 781-418-5900 • Fax: 781-418-5999 • www.merger.com

By Sarah C. Richmond

The day you dreamed of has arrived: SuperCo has just offered big bucks to purchase your company. Before buying the Porsche, keep in mind that the purchase price is only one factor that determines how much money you will get out of the deal. The founder who is aware of the pitfalls will best be able to maximize her value in the sale.

I. Be Careful Along the Way.

A company that has reached the point of sale after one or more venture rounds will have negotiated preferred stock terms with its venture capitalists along the way. A founder who does not pay careful attention to the VC’s liquidation preference may be in for a rude awakening when the VC walks away from the sale with a lot more than the founder expected.

The liquidation preference is the amount the VC gets upon a liquidation, merger or sale of the company before any payments are made to common stockholders. The most typical liquidation preference (and most appealing to founders) is one where the VC receives his original investment back if it is more than he would get by sharing in the sale proceeds on a percentage basis. This way the VC gets his money out first if the company is sold in a fire sale.

A more aggressive VC may try to impose what’s called a “participating preferred” liquidation preference, which is much worse for the founders. With this stock, the VC gets his original investment back in a sale of the company (or even a multiple of his original investment), and then also shares in the remaining sale proceeds on a percentage basis. If you hit a home run, the participating preferred benefit will be lost in the rounding error. If you only hit a single or a double, it can dramatically shift the benefits of the sale from the founders to the investors. Since you can never be sure about where you will end up, try to avoid giving a participating preferred liquidation preference if you can.

II. Talk to a Tax Lawyer.

A common mistake founders make when selling their business is talking to “the tax guy” too late. There are lots of ways to structure a deal (asset sale, stock sale, merger), multiple company structures (S Corp., C corp., LLC), and various combinations of stock and cash that can be given as payment. Each structure has its own tax consequences for both the buyer and seller, and there are ways to minimize and defer the taxes if you get the structure right from the start. It’s not too early to think about these concerns when you first set up your company.

Will officers be subject to ongoing employment, consulting or non-compete agreements with the buyer? If so, it might save tax dollars to allocate some of the purchase price to these agreements. A good tax attorney can help you work through this, so talk to one before signing a letter of intent.

III. What are you Getting?

You can be paid in stock, cash or a note (which is less common). Cash is always taxable, and stock may be taxable, depending on the deal. If you are getting stock, don’t assume that you can go out and sell the stock the day after the deal closes just because it is public company stock. Why not? In order to be able to sell the stock, the stock must either be registered as of the closing, come with registration rights, or become eligible for sale under securities laws within a short period of time.

IV. When are you Getting it?

Timing of the purchase price is also key, and buyers can tinker with the timing by using an “earn-out.” This is where the seller receives part (or even all) of the purchase price after the closing, depending on the performance of the seller’s business. An earn-out is useful when the expected profitability of the acquired company is hard to assess at the time of closing. From a seller’s perspective, an earn-out has several problems: it is difficult to come up with an exact formula to measure performance, the seller is dependent on the buyer to provide the necessary resources to make the earn-out happen, and many acquisitions fail, resulting in little or no earn-out payment.

What should you do in an earn-out situation to maximize your eventual payout? Accept an earn-out only when one or more of the selling shareholders will stay on with the buyer and exercise control over development and marketing of the acquired assets. Make sure the earn-out formula directly tracks the performance of the assets acquired in the sale, rather than the seller’s overall business. Evaluate the timing of the earn-out, as well as the milestones and the likelihood of achieving them. Make sure the buyer commits to a large enough marketing and hiring budget for the entire earn-out period. Maintain as much control as possible over whether the earn-out is reached: paying attention to these details before the sale is finalized is the best way to do that.

IV. Beware of “Hidden” Liabilities.

A buyer can put mechanisms in place which can lower the value of the sale after the closing. In an asset sale context, the buyer can exclude specified liabilities of the seller, and those liabilities can reduce the purchase price post-closing when the seller is stuck with the bill. Also, many purchase agreements are drafted with such strong representations, warranties and indemnities that the selling shareholders remain exposed long after the deal is done. Review the deal documents carefully: watching your purchase price disappear after the closing can be a very painful experience.

V. Be Smart.

Evaluate your buyer. Most deals these days are paid for with at least some stock, and the selling shareholders will thus become partial owners of the acquiring company for at least some period of time. Also, many (if not all) of the seller’s employees will typically continue on with the acquiring company. Do your homework and carefully evaluate the strength of your buyer. Make sure you are joining forces with a company you believe in.

Bring a knowledgeable lawyer into the process early on. The farther along in the process you get, the less room there is for the lawyer to help.

Last but not least, don’t forget to run your business while negotiating the sale. Deals crash for all sorts of reasons, and you don’t want to be left holding less than what you started with.

Sarah C. Richmond is a partner at Gesmer Updegrove LLP, a Boston law firm focused on entrepreneurial companies and their investors.  She can be reached at sarah.richmond@ gesmer.com

By William S. Andronico and Craig Eaton

As the U.S. emerges from the recession that has plagued the economy during the past 18 months, private equity firms that have been entrenched in their investments are beginning to evaluate exit options in the hopes of earning what is now a long overdue return on their investments. However, there is still a lot of uncertainty on the horizon and as a result, transactions are being subjected to deeper scrutiny as buyers seek out companies with a compelling growth story that can withstand today’s prolonged due diligence process.

In this market, there is no guarantee that any exit will be as timely or profitable as fund investors would hope or require, but market ready businesses can still be sold quickly and at a solid multiple. The key to success? Strategically preparing for an exit. Not only will exit readiness enable the efficient execution of a sale, but it will also maximize its value.

How Important Is Exit Readiness?

As credit markets have tightened, it has become even more critical that companies looking to sell anticipate risks and issues that might arise and potentially disrupt, or lower the value of a deal. Buyers will undoubtedly uncover any hidden problems during the buy-side due diligence process; therefore, it’s important that the seller is aware of any “hidden gems” and has that knowledge available when negotiating sale price.

In addition, there is an ever-present “need for speed” during any transaction, particularly given the drain on management’s time and energy associated with preparing for and executing a sale. In order to quickly and effectively execute a transaction, it’s critical that the seller is fully prepared to exit when the business is taken to market. If not, the seller risks exposing the company to the buyer, prolonging the deal and ultimately lowering the sale price.

Sell-side Due Diligence: Readying For An Exit

Sell-side due diligence is a valuable component of any exit strategy, particularly in today’s uncertain economic environment. Sophisticated bidders have advisors on hand to find any problems within the business and therefore, it’s important that the seller has taken an in-depth look at the company in advance to prevent any unwanted surprises. Sell-side due diligence allows the seller to proactively address any risk areas of the deal and can even expedite the transaction process. Well executed sell-side due diligence includes a thorough assessment of the financial health of the company, as well as an evaluation of all operational, technological and human resource issues. A thorough sell-side due diligence partner assists with five critical phases of the deal:

1. Pre-sale planning. The seller and its due diligence partner must identify any potential issues in order to avoid broken deals or decreased valuations. Pre-sale planning includes performing due diligence and preparing an analysis of the business positioning, providing support and insight for the information memorandum and assessing the baseline valuations range, among other activities.
2. Data room and management presentations. It’s critical to develop financial data and schedules on a basis of accounting consistent with the information memorandum.
3. Negotiation and execution. Sell-side due diligence enables the seller to anticipate the purchaser’s challenges to valuation, support negotiations from a fact-based position of strength and avoid any delays to the transaction process.
4. Operational separation. The seller and its due diligence partner must proactively identify any stand-alone issues including commercial and customer risks, and analyze the cost of those issues.
5. Post-closing issues. Once the deal is closed, the information garnered via thorough sell-side due diligence can help with purchase price adjustments and other post-closing issues that might arise.

Sell-side due diligence allows sellers to counter transactional risks by taking a proactive approach to mitigate potential deal breaking issues. Before moving forward with a potential deal, sellers should:

• Evaluate the financial health of the company by assessing the quality of earnings and identifying any non-recurring charges or credits to maximize the company’s value;
• Develop realistic budgets and forecasts;
• Assess trends in revenues and EBITDA to identify key business drivers;
• Appraise the quality of assets to be sold and liabilities that would be assumed;
• Evaluate trends in required working capital and develop a target working capital level in advance of the purchase agreement;
• Appraise the impacts of fixed versus variable costs, capital expenditure requirements and the importance of certain administrative activities;
• Identify internal management and operational weaknesses, as well as any potential transitional issues;
• Identify tax risks including federal, state and sales tax obligations;
• Determine the optimal tax structure of the seller before the deal and for the deal, and evaluate the impact on potential buyers;
• Consider related party activities and the related transfer pricing or intercompany activities;
• Define key terms and expectations in purchase agreements;
• Mind the GAAP (Generally Accepted Accounting Principles)

Tax Pitfalls and Opportunities

Whether the exit involves an IPO, a strategic/financial acquisition, or another exit option, tax matters can and do drive valuation, specifically when valuable tax assets such as net operating losses and tax credits exist. Two primary areas that require attention are the deal structure and the optimization of the underlying tax assets residing within the target.

From the seller’s perspective, it is essential to:

• Negotiate whether the sale will be an asset sale or a sale of stock. From a tax standpoint, a stock sale will generally benefit the seller and therefore, if it is an asset sale, it’s important to get a premium on the asset sale to put the seller in the same after-tax cash position.
• Consider state tax exposures prior to sale and to mitigate any concerns that might arise. For example, the seller should look at how to structure the sale from a state income tax perspective, evaluating ways to allocate income to low-tax states.
• Look at items such as tax accounting methods that might trigger income on an asset or stock sale, and evaluate how to mitigate the impact on the sale.
• Look for the possibility of tax-free reorganizations, particularly if dealing with a public strategic buyer.

An agreement between the parties related to taxes on a pre- and post- transaction basis should be drafted. Issues related to taxes such as documentation related to basis, net operating losses and credits come up several years after transactions are completed and it is important to identify the responsibilities of both the seller and buyer. This includes taxes triggered through change-of-control payments.

The choice of entity and whether the sale is structured as the sale of stock, a straight asset sale or a deemed asset sale can have many variables that should be considered prior to sale.

Looking Ahead…

As markets and exit multiples continue to stabilize and investor demand for liquidity continues, private equity firms are seizing the opportunity for potential exit strategies – looking to maximize the return on their investments. However, planning how to exit an investment is just as important as completing the transaction. Companies should be sure they’ve considered all options and invest proactively in presale diligence to expedite the sale process, maintain control and credibility, and enhance exit value.

By Andrew Crain

The purchase agreement documents the legal sale of the company’s assets or the shareholders’ company stock to the buyer, and the terms of the purchase agreement are just as important as the purchase price in determining the seller’s economic benefit from a transaction.  To help you better understand the purpose and contents of the purchase agreement, this paper describes the major provisions including (1) what is being sold, (2) payment amount and payment terms, (3) assurances from the seller regarding the stock or assets being sold and assurances from the buyer regarding the purchase, (4) remedies of each party if the other breaches the agreement, (5) if the agreement is to be signed in advance of the actual sale (rather than simultaneously) a list of conditions that must be met in order for the sale to occur, and, (6) if appropriate, a provision that the seller will consult for the buyer, and/or a promise that the seller will not compete with the buyer, for a period of time after the sale.

(1)        The list of what is being sold will specifically identify the shares of stock or the assets (and liabilities) to be included in the transaction.  In an asset sale, this list typically includes customer lists, business records, bills of material or formulas, goodwill, equipment, intellectual property, and working capital.  Working capital includes inventory, accounts receivable and accounts payable.  The amount of working capital is negotiated, but typically is set as the 12-month average of inventory plus receivables, minus payables.  For seasonal businesses, the seller may be required to include enough working capital for the buyer to operate the business at its seasonal peak.

(2)        The payment amount and terms will list the purchase price to be paid at the closing of the transaction, the method of payment, and the details of any seller financing and any royalty or earn-out provisions.

(3)        The assurances made by the seller in the purchase agreement are called representations and warranties.  These typically include statements that: The company exists and is in good standing in the states where it does business

• The transaction has been authorized by and will be legally binding on the seller
• The transaction will not breach any law or any other agreement
• The seller owns the stock or assets free and clear of any creditors’ liens (or will pay off its debts and clear those liens at the closing of the transaction)
• The company’s financial statements fairly present its financial condition
• The seller has filed all tax returns and paid all taxes owed on the stock or assets
• There is no litigation, either pending or threatened, regarding the stock or assets
• The company has all permits, licenses and approvals needed to operate its business
• There has been no recent material adverse change in the company’s business
• If the company owns trademarks, copyrights or patents, a variety of representations and warranties regarding this intellectual property
• If the sale includes real estate, a variety of representations and warranties concerning the description of the property, proper title to the property, and compliance with environmental laws

Most of these representations cover facts and circumstances that the seller knows to be true.  Often, however, the seller is also required to give representations and warranties regarding problems that already exist but are unknown at the time of the transaction and become known later, only after the transaction has occurred.  Sellers sometimes ask, how can I represent and warrant a fact that is not yet known to me?  The answer is that representations and warranties are a method of allocating risk between the buyer and seller:  if existing but unknown circumstances come to light after the closing and reduce the value of the company, buyers typically require that the sellers bear those costs.  In order to limit exposure, the seller can often limit certain representations and warranties “to the best of seller’s knowledge” or to a “material” level.

As the representations and warranties are negotiated and discussed, the seller should alert its investment banker and attorney to any facts or circumstances that are inconsistent or contrary to a requested representation.  Those facts and circumstances are then listed in exhibits to the purchase agreement as exceptions to the representations and warranties, and because the buyer is thus made aware of those exceptions, the seller has no liability to the buyer for those facts and circumstances.

(4)        The buyer bases its purchase decision in part on its due diligence review of the company, and in part on the seller’s representations and warranties.  If a representation turns out to be untrue, the buyer has not received what it bargained for, and will want a remedy from the seller.  The purchase agreement typically provides that the seller will indemnify the buyer for any losses resulting from a misrepresentation, breach of warranty or fraud.

The seller, of course, wants to limit its exposure and to know that the proceeds of the sale are safe.  To balance the interests of the buyer and the seller, most purchase agreements provide for both a time limit (the “survival period”) and a dollar limit (the “cap”) on the seller’s indemnification obligations.

The survival provision typically provides that most representations and warranties will expire after 12 or 18 months following the closing; beyond that date, the buyer cannot seek indemnification for the representations and warranties.  Certain fundamental representations and warranties (such as organization, authority, title, taxes and environmental matters) typically do not expire.

The cap provision typically provides that the seller’s maximum liability to the buyer is limited to a percentage of the purchase price.  Depending on the circumstances of the transaction, that percentage may be as little as 10% or as much as 100% of the purchase price.  Fundamental representations and warranties and fraud by the seller may be subject to a higher cap or may even be uncapped.

In some transactions, the purchase agreement provides that a portion of the purchase price – often equal to the indemnification cap – will be paid by the buyer into an escrow account rather than directly to the seller.  The escrowed money is held by an escrow agent for an agreed-upon period during which the money is available to the buyer to cover any indemnified losses, and then at the end of the escrow period the balance is released to the seller.  Escrows are typically used when the buyer cannot easily enforce the indemnification provision – for example, when an entire company is sold and the proceeds are immediately distributed to multiple stockholders.

In other transactions where a portion of the purchase price is to be paid over time as a contingent “earnout” measured as a percentage of future sales, gross profits or net income, the purchase agreement sometimes provides that, in lieu of an escrow, the buyer may set off future earnout payments to cover any indemnified losses

(5)        If the purchase agreement is signed in advance of the closing, the agreement will contain a list of closing conditions that must be met in order for the closing to occur.  These conditions will be specific to each transaction.  Sellers should seek to limit this list, as any unmet condition will provide the buyer with the opportunity to terminate the planned transaction.

(6)        In some transactions the seller’s industry expertise will be valuable to the buyer and may also be valuable to competitors.  In these cases, the buyer may request that the seller enter into a consulting agreement so that the buyer will benefit from this expertise.  Conversely, the buyer may insist that the seller enter into a non-competition agreement so that competitors may not benefit from this expertise with resulting harm to the buyer.  In deals that include a consulting agreement or a non-competition agreement, and depending on the corporate organization of the company, in order to minimize tax obligations the seller may prefer to allocate a greater portion of the total transaction price to the consulting fee and/or the non-competition payment and to reduce the purchase price of the stock or assets accordingly.

The terms of the purchase agreement are just as important as the purchase price in determining the seller’s economic benefit from a transaction.  The form and timing of payment, the scope of the seller’s representations and warranties (and thus the allocation of risk between buyer and seller), the indemnification provisions, and the tax implications of the transaction structure all affect the transaction value for the seller.  For example, consider Deal 1, an all-cash transaction with limited representations and warranties and minimal indemnification obligations, versus Deal 2, a transaction involving cash plus seller financing with numerous representations and warranties and indemnification obligations that include a lengthy survival period, a large cap and an escrow.  Because of the terms of the purchase agreement, the seller may choose the beneficial terms and relative certainty of Deal 1 over the less-favorable terms of Deal 2, even if Deal 2 is priced at $100 and Deal 1 is priced at $90, $80 or even $70.  Just as the purchase price is negotiated between the buyer and seller, the terms of the purchase agreement are also negotiated between the parties with the assistance of their investment bankers and attorneys.  We are well-informed regarding current market norms for both price and terms and very experienced at negotiating favorable transactions for our clients, and we look forward to assisting you in successfully negotiating and closing your transaction at advantageous price and terms.

Andrew Crain is a Managing Director at Briggs Capital, LLC, 858 Washington Street, Suite 100,Dedham, MA 02026, tel. 781.493.6581 ext 207 andy@ briggscapital.com; www.BriggsCapital.com