Selling a company is often difficult and time consuming. The mergers and acquisitions (M&A) process is one that requires careful planning, competent professionals assisting the target company, and an understanding of the deal dynamics involved in the negotiations. CEOs and companies that have not been engaged in many M&A transactions frequently make mistakes that can result in a less favorable price or terms that would have otherwise been obtainable —or even kill the deal altogether.
The following is a list of common mistakes made by private companies attempting to sell themselves:
1. Not being prepared for the extensive effort and time the deal will take. Successful exits through M&A are not easy. They are time consuming, involve significant due diligence by the buyer, and require both a great deal of advance preparation as well as a substantial resource commitment by the seller. Acquisitions can often take 6 to 12 months or more to complete.
2. Failing to create a competitive sales process. The best deals for sellers usually occur when there are multiple potential bidders and leverage of the competitive situation can be used to obtain a higher price, better deal terms, or both. Negotiating with only one bidder (particularly where the bidder knows it’s the only potential buyer) frequently puts the selling company at a significant disadvantage. Sellers must try to set up an auction or competitive bidding process to avoid being boxed in by a demand for exclusivity by a bidder. By having multiple bidders, each bidder can be played off against the other bidders to arrive at a favorable deal. Even the perception that there are multiple interested parties can help in the negotiations.
3. Not having an appropriate NDA. A well-drafted nondisclosure agreement (NDA) is essential to protect the company’s secrets and proprietary information, particularly when the bidders are strategic competitors. While it is not necessary when first contacting a buyer with basic information about the selling company, it will be a mistake to engage in extensive disclosure during an M&A process without an NDA in place, one that includes special M&A-related protections for the seller. The NDA will require the potential buyer to not disclose or use confidential information of the seller and restrict the buyer’s ability to contact employees, customers, and suppliers. The NDA also should prohibit the buyer from soliciting or hiring any employees of the seller if a deal is not consummated, for a designated period of time.
4. Not having a complete online data room. An online data room contains all of the key information and documents that a bidder will want to review. This will include key contracts, patents, financial statements, employee information, and much more. An online data room is extremely time consuming to put together, but is essential to successful completion of a deal. A properly populated data room established early in the M&A process will not only allow buyers to complete their due diligence more quickly, but also will enable the seller and its advisors to expeditiously prepare the disclosure schedule, a critical document in the M&A process. But almost every seller underestimates how important this is, and how time consuming it is to get complete and correct.
5. Hiring the wrong legal counsel. You shouldn’t have a general practitioner or general corporate lawyer guide the seller through the M&A process or negotiate and draft the acquisition documents. You must have a lawyer who primarily or exclusively handles mergers and acquisitions. There are many difficult and complicated issues in structuring M&A deals, putting together acquisition agreements, and executing the transaction. You want a lawyer who understands the issues thoroughly, understands customary market terms, understands the M&A legal landscape, is responsive with a sense of urgency, and who has done numerous acquisitions.
6. Not hiring a great financial advisor or investment banker. In many situations, a financial advisor or an investment banker experienced in M&A can bring value to the table by doing the following:
- Assisting the seller and its legal counsel in developing an optimal sale process
- Helping to prepare an executive summary and confidential information memorandum for potential buyers
- Surfacing up and contacting prospective buyers
- Coordinating meetings with potential buyers
- Coordinating signing of NDAs
- Assisting the seller in properly populating the online data room
- Coordinating the seller’s responses to buyer due diligence requests
- Prepping the management team for presentations to the potential buyers
- Assisting in the negotiations on deal terms and price
- Advising on market comparable valuations
One tip prior to hiring a financial advisor or an investment banker: have them give you a list of likely buyers, with annotations listing their relationships with senior executives of those buyers. You want an advisor that has strong relationships with the likely buyers and can get their attention.
7. Not negotiating the terms of the financial advisor or investment banker engagement letter. The first draft of an engagement letter is generally one-sided in favor of the financial advisor or investment banker. Companies that just sign or minimally negotiate such letters are making a huge mistake. These letters are negotiable, and savvy legal counsel/deal professionals typically negotiate on the following issues, among others:
- The compensation payable to the advisor is typically a success fee, based as a percentage of the ultimate sales price. What is often negotiated is the percentage (for example, the bankers will want 2% or more, the company will want a fee closer to 1% but possibly increasing if certain sales price thresholds are met). The calculation of the fee owed should also exclude various items, such as any portion of the purchase price attributable to the cash that the company has on its balance sheet at the closing, or contingent purchase price payments that may never be made.
- Whether there is a minimum fee payable on a sale regardless of the purchase price (companies want to avoid this, but bankers want to make sure they are getting adequately compensated for their efforts).
- How long and under what situations a “tail” applies (when a fee will be due after the engagement letter is terminated but the company subsequently is sold). Companies try to limit this tail to 6 to 9 months and only for potential buyers that signed an NDA with the company during the terms of the engagement letter.
- The amount of any upfront retainer payable to the banker (it is common that the retainer is waived and the advisor or banker is paid nothing unless a transaction is successfully completed).
- The amount of any expenses reimbursable to the investment banker (usually a cap is negotiated with a requirement that any amounts expended must be “reasonable”).
- The circumstances where the engagement letter can be terminated without any liability and without a tail applying (for example, if the key banker departs from the banking firm or the banker breaches the engagement letter).
- Whether the banker will deliver a fairness opinion and the fee for such opinion.
- The scope of indemnification protection to the banker.
- An outside termination date when the engagement letter will automatically expire.
- A restriction/representation and warranty regarding any conflicts of interest by the banker.
8. Having an inadequate understanding of competitors and market comparables. A well-informed seller will have a deep understanding of the competitive landscape, as the buyer will be asking many questions about how the seller is differentiated in the marketplace. To avoid having unrealistic selling price expectations, the seller needs to understand how other comparable companies are being valued in the marketplace. If your competitors have sold for multiples of 5 times revenues or 10 times EBITDA, you will need a compelling rationale why you should be valued much higher (for example, you have greater growth, better technology, etc.)
9. Having incomplete books, records, and contracts. Due diligence investigations by buyers frequently find problems in the seller’s historical documentation process, including some or all of the following problems:
- Contracts not signed by both parties
- Contracts that have been amended but without the amendment terms signed
- Missing or unsigned Board minutes or resolutions
- Missing or unsigned stockholder minutes or resolutions
- Board or stockholder minutes/resolutions missing referenced exhibits
- Incomplete/unsigned employee-related documents, such as stock option agreements or invention assignment agreements
Deficiencies of this kind may be so important to a buyer that the buyer will require certain matters to be remedied as a condition to closing. That can sometimes be problematic, such as instances where a buyer insists that ex-employees be located and required to sign invention assignment agreements.
10. Not having a complete disclosure schedule far in advance. A disclosure schedule is the document attached to the acquisition agreement setting forth a great deal of required disclosures relating to outstanding key contracts, intellectual property, related party transactions, employee information, pending litigation, insurance, and much more. A well-prepared disclosure schedule is critical to ensuring that the seller will not breach its representations and warranties in the acquisition agreement.
Accordingly, this is an extremely important document to have ready quickly, and it is very time consuming to get correct. But virtually every company gets this wrong, requiring multiple drafts that potentially delay a deal. And disclosure schedules prepared at the last minute are more likely to be poorly prepared, creating unnecessary risks for the seller and its stockholders.
11. Not negotiating the key terms of the deal in a letter of intent. This is one of the biggest mistakes made by sellers. A selling company’s bargaining power is greatest prior to signing a letter of intent. As Richard Vernon Smith, an M&A partner at Orrick, Herrington & Sutcliffe in San Francisco, has said: “The letter of intent in an M&A deal is extremely important for ensuring the likelihood of a favorable deal for a seller. Once the letter of intent is signed, the leverage typically swings to the buyer.” This is because the buyer will typically require a “no shop” clause or exclusivity provision prohibiting the seller from talking to any other bidders for a period of time. The key terms to negotiate in the letter of intent include the following:
- The price, and whether it will be paid all cash up front, all stock (including the type of stock), or part promissory notes.
- Any adjustments to the price and how these adjustments will be calculated (such as for working capital adjustments at the closing or for a “cash free/debt free” deal).
- The scope and length of any exclusivity/ no shop provision (which is always in the best interests of the seller to keep this as short as possible, such as 14 to 21 days).
- The non-binding nature of the terms (excluding with respect to confidentiality and exclusivity).
- The amount of any escrow and a provision stating that the escrow will be the exclusive remedy for breaches of the agreement (and any exceptions from this exclusive remedy, such as for breaches of “fundamental representations”).
- The length of any escrow.
- Other key terms to be included in the acquisition agreement (discussed in the next section below).
12. Failing to negotiate and agree upon a favorable acquisition agreement. One key to a successful sale of a company is having a well-drafted acquisition agreement protecting the seller as much as possible. To the extent feasible and depending on the leverage the seller has, you want your counsel to prepare the first draft of the acquisition agreement. Here are some of the key provisions included in the acquisition agreement:
- Amount of the escrow holdback for indemnification claims by the buyer and the period of the escrow/holdback (the typical ideal scenario for a seller is 5 to 10 percent of the purchase price for 9 to 12 months). In some deals it may be possible to negotiate for no post-closing indemnification by the buyer and no escrow/holdback.
- The exclusive nature of the escrow/holdback for breaches of the acquisition agreement (except perhaps for breaches of certain fundamental representations, such as capitalization and organization of the company).
- The conditions to closing (a seller will ideally want to limit these to ensure that it can actually close the transaction quickly).
- The adjustments to the price (a seller ideally wants to avoid downward adjustment mechanisms based on working capital adjustments, employee issues, etc.).
- The triggers for earnouts or contingent purchase price payments.
- Where stock is to be issued to the selling stockholders, the extent of rights and restrictions on that stock (such as registration rights, co-sale rights, rights of first refusal, Board of Director representation, etc.).
- The nature of the representations and warranties (a seller wants these qualified to the greatest extent possible with materiality and knowledge qualifiers). Intellectual property, financial and liability representations and warranties merit particular focus.
- The nature of the covenants applicable between signing and closing (a seller wants these to be limited and reasonable, with the ability of the company to get consents if changes are needed, with the consent not to be unreasonably withheld, delayed, or conditioned).
- The scope of and exclusions to the indemnity (baskets, caps, carve outs from the indemnity all being important issues).
- The treatment of employee options
- The terms of any employee hiring by the acquirer
- Provisions for termination of the acquisition agreement
- The treatment of any litigation against the seller
- The cost for obtaining any consents and governmental approvals
- The allocation of risk, especially concerning unknown liabilities
As David Lipkin, an M&A partner at the law firm of Morrison & Foerster in San Francisco, has said, “A well-drafted M&A agreement will reduce the risks of not closing the deal, mitigate the potential post-closing risks, and ensure that the expectations of the target company and its stockholders are met. One of the worst mistakes a seller can make is to assume that a ‘middle of the road’ approach to each issue will offer it appropriate protection.”
13. Not appreciating that time is the enemy of all deals. The longer an M&A process drags on, the higher the likelihood that the deal will not happen or the terms will get worse. The seller and the seller’s lawyer must have a sense of urgency in getting things done, responding to due diligence requests, turning around markups of documents, and the like. It is also essential that one seller representative is delegated authority to make quick decisions on negotiating issues so that the deal momentum can be maintained.
14. Not having an experienced M&A negotiator lead the negotiations. It’s critical to have an experienced M&A negotiator leading the negotiations. That can be the CEO if he or she has relevant M&A experience. But you need someone who is a match for the buyer’s sophisticated lawyers or corporate development team. Often though, the smart CEO will want to avoid being seen as difficult in the negotiation when the buyer will be expecting the CEO to stay on after the acquisition. And the savvy CEO will be aware of the conflicts of interest that will arise. The selling company wants to avoid acrimonious negotiations, as this could eventually kill a deal if the buyer determines that there won’t be a cultural fit. The CEO or the Board may then determine that it will be more appropriate for the lead negotiator to be a representative from the Board, an M&A Committee of the Board, or a representative from a major shareholder in collaboration with experienced M&A counsel.
15. Negotiating the deal without regard to tax considerations. The tax structuring implications of a deal can have a significant impact on the net economic return to the stockholders. Buyers often prefer to do asset purchase deals as those can provide a “step up” in tax basis (and may mitigate the potential of taking on unknown liabilities of the seller). But sellers will usually prefer a stock sale or engaging in a reverse triangular merger, as this eliminates the risk of “double taxation” present in many asset deals, and enables the seller to avoid the burden and expense of winding up the company’s remaining assets and liabilities.
16. Neglecting the day-to-day operation of the business during the M&A process. The process of selling a company will be hugely distracting and time consuming. Nevertheless, management must keep its eye on the ball and ensure that the business continues to grow and operate efficiently in line with projections given to the buyer. One of the worst things that can happen in an M&A process is for the selling company’s financial situation to deteriorate during the process. This may kill the deal or result in the buyer renegotiating price and terms.
17. Failing to communicate the vision and strategic fit. The selling company’s CEO must be able to effectively communicate to bidders the company’s vision and significant growth prospects. Regardless of the company’s current performance, unless the buyer is excited that the company will continue to scale and be significantly more valuable to the buyer in the future, a deal at an attractive price will not happen. If the buyer is a strategic buyer, you have to be able to articulate the synergies and strategic fit of combining with the acquirer.
18. Absence of credible financial projections. The buyer will expend a great deal of time doing diligence on the company’s current financials and future projections. Having unreasonable projections or unrealistic assumptions will adversely affect the credibility of the management team. If the management team does not know the company’s key metrics cold and lacks the ability to convincingly demonstrate the reasonableness of the projections, this will give the buyer pause.
19. Not considering change of control provisions in key contracts. If the selling company has key contracts, licenses, or leases that require consents from third parties in connection with a change in control of the company, it is critical that these consent requirements be identified early on in the process. The same holds true with respect to important governmental permits. Counsel will need to be deeply involved in identifying and evaluating these requirements. Then a plan should be adopted to obtain those consents in a timely manner. A buyer may insist that those consents be obtained prior to a closing of the sale.
20. Not adequately taking into account employee-related issues. Transactions will typically include a number of employee issues. The questions that frequently arise in M&A transactions are the following:
- What is the acquirer’s plan for retention and motivation of the company’s employees?
- How will the company’s stock options be dealt with? (From the seller’s perspective, it is desirable to have the acquirer assume all the options but count only the vested options toward the purchase price.)
- Do any options accelerate by their terms as a result of the deal? Some options may be a “single trigger” (accelerate by reason of the deal closing) and others may be “double trigger” (accelerate following the closing only if employment is terminated within a defined period of time). The option plan and related option grant agreements must be carefully reviewed to anticipate any problems.
- Does the company need to establish a “carve out” to pay employees at the closing, or a change in control bonus payment to motivate management to sell the company?
- How do the investors make sure that the buyer’s incentive arrangements to the management team do not adversely affect the price payable to the shareholders?
- Will payouts to employees related to the deal trigger the excise tax provisions of Internal Revenue Code Section 280G (the so-called “golden parachute” tax)? If so, the seller needs to obtain a special stockholder vote to avoid application of this tax liability.
21. Not understanding the negotiation dynamics. All M&A negotiations require a number of compromises. It is critical to understand which party has the leverage in the negotiations. Who wants the deal more—the buyer or the seller? Are there multiple bidders that can be played against each other? Can you negotiate key non-financial terms in exchange for a concession on price? Is the deal price sufficiently attractive that the seller is willing to live with indemnification obligations that are less than optimal? It’s important to establish a rapport with the lead negotiator on the other side and it’s never good to let negotiations get heated or antagonistic. All negotiations should be conducted with courtesy and professionalism.
22. Not carefully negotiating earn-out provisions. An earn-out arrangement provides a selling company or its stockholders the potential to recover an additional payment following the closing, dependent on the financial performance of the business or achievement of designated milestones. The inclusion of an earn-out provision in an acquisition agreement can be useful in bridging the valuation gap between a seller and a buyer. But earn-out provisions frequently lead to disputes and even litigation unless carefully and thoughtfully drafted. Here are the key points to negotiate:
- What are the realistic financial milestones to be achieved before the earn-out is payable? Buyers tend to prefer profit or EBITDA metrics, whereas sellers prefer metrics that have less chance to be manipulated, such as gross revenues. Usually, metrics which are easy to measure and verify are beneficial to the seller.
- What overhead and extraordinary liabilities will be excluded from the calculation if the milestones are based on profit or EBITDA?
- What is the timetable for the earn-out? Over one year or several years?
- What payments are required as milestones are achieved?
- Is the earn-out payable in a lump sum or sliding scale?
- Is there a cap on the earn-out payments?
- What protections does the seller get to ensure that the buyer will take reasonable best efforts to operate the business in a way that won’t artificially decrease the earn-out? (for example, will the buyer promise to adequately fund the business post-closing?)
- What happens if the buyer itself is subsequently sold? Does that buyer then assume the earn-out obligation or are the earn-out payments then accelerated?
- How will disputes be resolved? (Arbitration is typically more desirable for a seller.)
- Can the buyer offset indemnification claims against the earn-out?
- What information, auditing, and inspection rights will the seller get?
It’s important to understand that earn-out provisions are fully negotiable and the likelihood of getting paid is significantly dependent on how well the provision is drafted.
Copyright © Richard D. Harroch. All Rights Reserved.