mandag 22. mars 2010

Ask the attorney: M&A waters can be dangerous – especially for the buyer

(Editor’s note: “Ask the Attorney” is a weekly VentureBeat feature allowing start-up owners to get answers to their legal questions. Submit yours in the comments below and look for answers in the coming weeks. Author Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs.)
Question:  My co-founder and I are friggin crushing it.  We launched our company about two years ago, and we now have an opportunity to buy a couple of struggling companies in our space.  We have lawyers we work with, but I was wondering if you could just give me a heads-up on some of the legal issues we should be thinking about.  Thanks!
Answer: As I mentioned last Monday, this is an area that can be filled with legal landmines. We’ve looked at the importance of executing an exclusivity agreement, avoiding negotiating the material terms in an letter of intent, doing your diligence, buying assets (not equity) and protecting against a fraudulent conveyance claim.  Here are four more issues that should be on your radar.
Escrow a Portion of the Purchase Price.  An important step you can take to protect yourself is to escrow a portion of the purchase price (say, for example, 15 percent) for a period of time post-closing (maybe 18 months).
Escrows are relatively common (particularly where there are multiple sellers) because of the inherent unfairness of requiring the buyer to sue the seller(s) to try to get some of its money back for a problem or liability it never agreed to take on.  Alternatively, the buyer can push for a hold-back (a right to hold part of the purchase price) and/or a right of set-off in deals where part of the purchase price has been deferred (for example where the buyer has issued a promissory note to the seller as part of the purchase price).
Escrows, however, are more amenable to sellers because the money is held by an independent third party and the buyer does not have the unilateral right to withhold payment.
Use Earn-Outs Only As a Last Resort.  Earn-outs – post-closing contingency payments – are often touted by unsophisticated investment bankers and counsel as an effective way to bridge the gap between what the buyer is willing to pay for a business and the seller’s asking price.  In reality, earn-outs often lead to major disputes and business problems post-closing and are best to avoid if possible.
On the legal side, a number of critical issues must be negotiated, including

the metric (such as revenue, EBITDA or profit) and milestones
measurement or accounting issues
exclusions/carve-outs, like allocation of administrative or general overhead expenses, intercompany transactions and charges and the like
the duration of the earn-out period
the effect of acquisitions or dispositions relating to the acquired business
post-closing operational control issues

The amount of time and energy that is required to adequately address these can be extraordinary (often leading to pages and pages of provisions), and there will still be gaps because it is virtually impossible to anticipate every post-closing contingency.
Don’t Give Away the “Basket”.  One of the provisions sellers generally insist on in the acquisition agreement is a “basket” to prevent the buyer from “nickel and diming” them for any claims post-closing.  The size of the basket varies from deal to deal, but the norm is about 0.5 percent of the purchase price.
If you agree to a basket, push for a “first-dollar” basket (sometimes referred to as a “threshold”) as opposed to a “deductible”. That way, if the seller’s damages exceed the basket, it would be responsible for all of the damages.  You should also make sure that the basket only relates to breaches of representation and warranties and not to breaches of covenants or specific indemnity provisions. This is a common mistake.
Watch Out for “Caps”.  One of the most important and hotly negotiated issues in any private company acquisition is the cap (or ceiling) on the seller’s damages.  Like other material terms in the acquisition agreement, there is no right or wrong answer (or “customary” or “market” amount): it all depends on the context of the transaction – that is, the bargaining power of the parties, the risk profile of the target, the purchase price, etc.
For example, in an auction context with numerous bidders expressing interest in a target, the cap may end-up being 10 percent or less of the purchase price due to the competition. On the other hand, if the target has a host of significant problems (and/or is financially troubled) and there is only one prospective buyer on the horizon, the cap may end-up being equal to the purchase price (or there may be no cap).
The lesson here – and the key takeaway of this answer – is that you, as the buyer, must fully understand the businesses that you are buying and the significant deal risks in order to make an informed judgment with respect to price and terms, including the cap.  If the cap is less than 100 percent of the purchase price, you should generally push hard to include certain carve-outs.
Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.
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