Mergers & Acquisitions

Not every buyer can afford to pay the purchase price in cash. In addition to determining the length of the loan and interest rate, the parties need to determine the extent to which the assets or stock of the business will serve as collateral if the buyer defaults. Lenders typically wish to record liens against the assets of the business via UCC financing statements. Such liens put other parties on notice that if such parties lend money to the business, they will be subordinate (meaning second or even third or fourth in line) to collect the cash and other assets of the business in the event of a default. This can make it difficult for the business to obtain additional loans, which may be needed down the road to make capital improvements or expand. 

Some lenders may also seek a personal guaranty from the borrower and their spouse, which means that if the business defaults, the lender can pursue personal collateral, like the equity in the borrower’s home and personal accounts. 

From the seller’s perspective, if they are providing seller-financing (i.e., accepting the purchase price in installments), they may want to ask not only for collateral (and perhaps a personal guaranty), but for a pledge agreement as well. A pledge agreement establishes that if the buyer defaults on the loan, then all, or a portion, of the buyer’s ownership interest in the business will transfer to the seller.

Sometimes the seller will be offered a chance to retain equity in the business, i.e., hold back a percentage of their ownership interests. The parties should decide in advance if this entitles the seller to actively make decisions about the business post-closing, or alternatively, if the retained equity is meant to provide a passive interest only. If passive, the seller can expect to share in profits but not to have decision-making power. However, many states mandate that equity ownership of any kind entitles the holder to certain minimum voting rights. For example, the consent of passive owners may be required to dissolve the business. Both buyers and sellers need to think through the ramifications of retained equity prior to close and ensure they understand the minimum rights afforded equity holders under their particular state’s laws.

The purchase price is not always paid entirely in cash. Sometimes, buyers will offer stock/equity in affiliate or subsidiary companies as consideration. Sellers should carefully review their rights as a post-closing investor in such companies, as there are often restrictions on their right to sell and limited voting rights. In addition, if there is more than one class of stock (i.e., Class A Stock and Class B Stock), distributions may not be made equally among all stockholders. For example, Class B Stock may not be entitled to any distributions until the Class A stockholders have been repaid their principal in full, plus a certain return on their investment. 

Additionally, the company may have significant debts that must be repaid before distributions can ever be made to stockholders. Both buyers and sellers should pay attention to these nuances. Sellers run the risk of being sued for misrepresentation if they fail to disclose relevant details and downsides. On the other hand, buyers who gloss over the details may be left with buyer’s remorse and little recourse if they fail to read the documents provided. At Penwell Law, we seek to avoid these negative outcomes by providing a thorough review and meaningful explanations to our clients.

If the seller is staying on post-closing to assist in running the business, there may be contingent consideration in the form of “earn-out.” Under this scenario, the buyer sets revenue or other performance-based goals for the business for a year or more following the transaction. This is mean to keep the seller engaged and motivated. If the goals are met, the seller receives additional compensation, sometimes in the form of cash and sometimes in the form of stock/equity. What appears at first glance to be a simple concept can become thorny for both the buyer and the seller if concepts like gross versus net revenue aren’t negotiated in advance. We have also seen instances where sellers are surprised to find that revenue from subsequent acquisitions are excluded from the earn-out revenue calculations. Like many issues in M&A, this falls under the you-don’t-know what you-don’t know category. Often sellers reading through earn-out agreements on their own will miss these potential issues because they’re simply not address in what they’re reading. At Penwell Law, we look both for existing problems in the document, as well as problems created by what is missing.

One of the main reasons entrepreneurs want to buy an existing business is that they can hit the ground running with operations, employees, customers and revenue in place. Part of that strategy includes having enough money on hand at closing to pay for the typical expenses of the business for at least the first month or two, i.e., the “working capital”. Buyers want to know how much Seller typically spends on rent, vendors, employee salaries, supplies, insurance, software and any other products or services necessary to operate the business. Working capital is calculated by subtracting current assets from current liabilities on the company’s balance sheet. However, averaging the working capital over twelve months may not be wise, as certain months may be more cost-heavy than others. If for example, certain pricey license registrations come due every May and the closing is on May 1st, the buyer should make sure they have adequate funds to meet such expenses, in addition to the more normal monthly costs. Similarly, buyers should scrutinize monthly revenue trends in case there are months that are typically lower or higher in revenue throughout the year. You can imagine a perfect storm for a buyer wherein they set the working capital based on a twelve-month average and then close in an atypically low-revenue, high-cost month. Once the working capital target is set, buyer and seller should work together to determine what cash, accounts receivable and other liquid assets will remain in the business at closing to meet the target. If the buyer is concerned that there may be a shortfall, they should push to set up a purchase-price escrow account to fund the difference.

Buyers use the due diligence process to learn more about the business they are buying. They want to know about profits and losses, whether there are debts, the customer base, employees, operating expenses, the office or retail space and whether it is rented or owned, what contracts are in place, and they want to get an idea of the relative stability of the company. For example, are the customers satisfied or has there been growing discontent? Have employees recently threatened to leave? Have there been lawsuits against the company? If production is involved, how old is the equipment? If real estate will transfer with the business, how old is the building and what kind of shape is it in? These and other questions drive purchase price negotiations and help the buyer to make a well-informed decision. Some buyers may thrive on the challenge of turning around a business in distress. Others may want to avoid risks at all costs and buy a business in turn-key condition. The critical element is disclosure. Seller should not hide business flaws and risks, both ethically and because they may be liable after closing for making misrepresentations. 

In order to ensure that the information provided in due diligence is correct and not misleading, the seller will make a series of representations and warranties in the purchase agreement. Below are typical examples:

• The business is in good standing in the state where it was formed and has the full power and authority to run as currently conducted.
• The governing documents provided in due diligence are up to date and accurate.
• The seller(s)/owner(s) have the authority to sell the equity or assets of the business, including clean title.
• The company and its assets are not encumbered by debt and/or liens (or such debts and liens will be paid off in full at closing.)
• The sale of the business will not cause a breach of the governing documents or a contract with a third party or governmental agency.
• The sale of the business will not cause the revocation of permits.
• The contracts to be assumed by the buyer are legally binding, in full force and effect, and can be effectively transferred to buyer. (If prior written consent is required, that should be flagged during due diligence.)
• The financial statements provided in due diligence are accurate and not misleading. They do not omit pertinent information.
• There haven’t been any recent events negatively affecting the business, such as customers threatening to take their business elsewhere, employees threatening to leave, vendors substantially increasing their prices, or other material changes.
• There is not any ongoing litigation and there hasn’t been any litigation in recent years.
• The business has paid all of its taxes.
• If the business owns real property, seller should disclose the condition of that property.
• If property is rented, the terms of the lease should be disclosed.
• The list of employees is true and accurate, including all of their salary info, length of employment and classification as exempt or non-exempt.
• All benefit plans provided are up to date and accurate.
• The business is insured and the policies provided in due diligence are up to date and accurate.
• All necessary permits are in good standing and can be effectively transferred.
  All material contracts were provided in due diligence and copies of such contracts are true and correct.

*Note that while the buyer will also make representations and warranties, they will be more limited. For example, the buyer will typically represent that they are either an adult with the capacity to enter into the transaction or that the entity buying the business is in good standing and authorized to enter into the transaction. The buyer must also represent that their execution of the transaction will not result in a violation or breach of their governmental documents or any material contract. Buyer may also represent that they have reviewed the disclosure schedules and the information provided in due diligence and made their purchase decision based upon their own investigation of those materials.

Most sellers in reviewing the representations and warranties listed above may be able to think of exceptions and disclosure issues right away. If all of those exceptions were listed directly in the purchase agreement, it would be difficult to read. (Imagine trying to jump from one section to another with 100 pages of financial statements in between.) Instead, most representations will include a reference to a separate disclosure schedule. For example, Section 5 of the purchase agreement may state, “Except as set forth on Schedule 5, there has been no litigation during the five (5) year period prior to the closing date.” Other schedules may simply provide a spot to attach particularly relevant documents from due diligence. For example, “Financial statements for the three (3) year period prior to the closing date are provided at Schedule 6.”

The concept that one party must defend another against claims and reimburse them for such costs is called indemnification. Typically, in an M&A transaction, the buyer wants to be indemnified by the seller for losses and damages caused by the seller’s pre-closing actions or misrepresentations regarding the state of the business. While in some transactions, indemnification obligations are unlimited, in others the parties negotiate for a “basket” and a “cap.” The basket is the threshold amount of losses and damages that a buyer must incur before the seller is obligated to indemnify them. The “basket” prevents the seller from being nickel and dimed by the buyer for de minimis problems post-closing, like a copier machine unexpectedly breaking down. A “tipping basket” establishes that once the damages reach a certain amount, for example $10,000, they are entitled to full recovery from the first dollar (i.e., if the damages come to $10,001, they are entitled to $10,001, not just the $1 over the threshold amount.) You can think of each dollar accumulating in a basket until it tips over and becomes the seller’s problem in its entirety. A “true deductible basket” is essentially the opposite and means that if the damages are $10,001, the buyer is only entitled to the excess $1 once the threshold is reached.) 

The “cap” is the upper limit of the seller’s responsibility to indemnify the buyer for losses and damages. It is important to note that in both the case of baskets and caps, these limitations will not apply in cases of fraud or intentional misrepresentations. In addition, the buyer may push for “fundamental representations” to be exempt as well. Fundamental representations are those representations that the buyer and seller agree are most critical to the deal. One way to think about “fundamental representations” is if the buyer knew at the outset that these particular representations were not true, they would not be willing to buy the business. Often, there is overlap between the breach of “fundamental representations” and fraud. For example, it is fundamental to the deal that the seller actually own the business and have the authority to sell it. If it turns out this representation is not true, the seller has committed fraud, in addition to breaching a fundamental representation.

Sellers often worry that the buyer will not retain adequate cash from closing to pay for an indemnification claim if one arises. One way to address this is by setting an up an indemnification escrow account. Typically, the escrow account is funded at closing with part of the cash purchase price. The parties negotiate as to the amount and length of time that the cash should be escrowed. Sellers may push for an indemnification escrow amount to match the indemnification cap. However, buyers typically want the amount to be lower because the escrow account ties up their cash proceeds, often in a non-interest bearing account. In terms of duration, sellers push for the longest term possible, while buyers push for the shortest.

In addition to indemnification escrow accounts, the parties may also set up purchase-price adjustment escrow accounts. In transactions where there is a working-capital target, buyers often request that all or a portion of that target be held in escrow to address any shortfall. For example, if the seller represents that the business will have $100,000 in working capital at closing, but there is in fact only $90,000 in working capital at closing, the remaining $10,000 would be withdrawn from the purchase price escrow account and transferred to the buyer. As with the indemnification escrow account, the buyer’s fear is that seller may not retain sufficient funds post-closing to make up the difference.

No buyer wants to purchase a company only to have the seller open an identical business next door. Restrictive covenants typically protect the buyer in three ways: (1) Non-competition provisions, which establish that the seller will not set up a competing business within a certain geographic range of the business, for a certain period of time; (2) Non solicitation provisions, which prevent the seller from poaching customers and employees, and (3) Confidentiality provisions, which prevent the seller from disclosing private company information to third parties. The scope and duration of restrictive covenants are subject to negotiation, and state law varies as to their enforceability. In this regard, it is important to note that courts treat restrictive covenants associated with the sale of a business differently from those imposed in the context of an employment agreement. Even states that are generally hostile toward restrictive covenants tend to honor them more liberally in the context of a business sale.