How to Prepare for an M&A Transaction · – Retirement/Succession Issues – Shareholder Priorities • Why are you doing this deal (Buy-Side)? ... – Who is running the business?

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How to Prepare for an M&A Transaction

Jason Werner and Eric Rauch

November 6, 2019

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• Business Priorities

• Corporate Housekeeping

• Internal Personnel Management

• Managing Outside Advisors

• Negotiation Strategy

• Nuts & Bolts – Deal Structure

• Nuts & Bolts – Excluded Liabilities

• Nuts & Bolts – Purchase Price Adjustments

• Nuts & Bolts – RWI Policies

• Questions

Overview

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• Why are you doing this deal (Sell-Side)? – Liquidity

– Survival and Growth

– Retirement/Succession Issues

– Shareholder Priorities

• Why are you doing this deal (Buy-Side)? – Financial Performance

– Competition

– Talent

– Assets

– Synergies

Business Priorities

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• Sell-Side – Preparing for Due Diligence

– Reverse Due Diligence

– Corporate Clean-Up

– Transaction Bonuses

– Employee Retention

• Buy-Side – Market Analysis

– Understanding Key Risk Factors

– Clear Mandate

Corporate Housekeeping

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• Sell-Side – Who is in the “Circle of Trust”?

– Who is running the deal?

• Letter of Intent

• Due Diligence

• Day-to-Day

– Who is running the business?

• Buy-Side – Points of Contact

– Deal Team vs. Operational Team

– Decision Makers

Internal Personnel Management

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• Investment Bankers – Sell-Side

• Mandate

• Fees

– Buy-Side

• Mandate

• Fees

– Negotiating Engagement Letters (You Should)

• Transaction Value

• Key Man

• Payments on Escrow and Earnouts

• Tail Period

– Managing Investment Bankers

External Advisors

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• Outside Counsel – Clear Delineation of Responsibility

– Points of Contact

• Deal Team to Deal Team

• Specialists to Specialists

– Clear Expectations

• Communication

• Fees

• Priorities

– Empower Your Advisors to Talk to Each Other

External Advisors

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• Type of Counter-Party – Sophistication

– Strategic vs. Financial

• Style of Negotiation – Tone

– Client-to-Client

– Legal-to-Legal

– All-Hands

• Leverage – Who has it

– When to use it

• Drafting Approach

Negotiations

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• Talk to your Tax Advisors Early and Often

• Securities Transaction

• Sale of Holding Company versus Operating Companies


• Asset Transaction

• Merger Transaction


Nuts & Bolts – Deal Structure

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• Benefits of Securities Transaction – Simplicity

– Limited Impact on Material Contracts

– Does Not Require the Transfer of Underlying Assets & Liabilities

– Structuring Options

– Seller’s Preference

• Disadvantages – Difficult with Large Cap Table

– May Required Use of Drag or Similar Provisions

– Buyer Inherits Liabilities

• Sale of Holding Company versus Operating Companies


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• Benefits of Asset Purchase – Protections against rest of the world (successor liability can create

exceptions) • Excluded Liabilities are distinct from other forms of buyer protections,

such as indemnification, as they operate not just between Buyer and Seller, but also limit Buyer’s exposure to suits by third parties

• Note that it is possible for in some instances for successor liability to attach to Buyer, which may expose the Buyer to third party liability, although in such case the Seller would still be required to indemnify for any losses

– Clear division of liability and assets between Buyer and Seller

– Fresh start with employees

• Inconvenience of Asset Purchase – Consent more often required to transfer contracts and permits

– Transfer of IP and Real Property


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• Straight Merger vs. Triangular Mergers

• Benefits of a Merger Transaction – Flexible from a tax perspective

– Does not (typically) require 100% of equityholder approval

– Can streamline cap table management

• Disadvantages of a Merger Transaction – Complexity

– Appraisal Rights, and generally increased risk of litigation by non-signing equityholders

– May trigger anti-assignment provisions

– May be used as a pretext to further limit indemnification


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• Overview of Excluded Liabilities (aka Retained Liabilities)

– Excluded Liabilities are a defined set of liabilities of the target company that will not be transferred to the Buyer in the transaction

– Seller will be fully-responsible for satisfying any such liabilities, and the parties can agree on timelines or mechanics to ensure satisfaction/payment (including Buyer paying them on Seller’s behalf, with appropriate set-off/recovery)

– Excluded Liabilities often cover all liabilities that are not covered in the list of expressly assumed “Assumed Liabilities”

– To protect the Buyer, the definition of Excluded Liabilities should also include an enumerated list of categories that will be the responsibility of Seller, with a clarification that when a liability could be argued to be both an Assumed Liability or an Excluded Liability, it will only be considered an Excluded Liability

Nuts & Bolts – Excluded Liabilities

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• Overview of Excluded Liabilities - Example – “Excluded Liabilities include all Liabilities either: (A) arising from or relating to any

Occurrence first arising on or prior to the Closing (except to the extent explicitly constituting Assumed Liabilities), or (B) arising from or relating to the following: (a) any Excluded Asset including any Employee Plan, (b) the employment or engagement by Seller or termination of employment or engagement by Seller any employee, consultant, independent contractor or other service provider, (c) Transaction Expenses, (d) any Liabilities to indemnify, reimburse or advance amounts to any present or former officer, director, employee or agent of Seller (including with respect to any breach of fiduciary obligations by same), (e) any Liabilities under any Excluded Contracts or any Acquired Contracts which are not validly and effectively assigned to Buyer pursuant to this Agreement, (f) any Liabilities associated with Indebtedness of Seller, (g) any Liabilities arising out of, in respect of or in connection with the failure by Seller to comply with any Law on or prior to the Closing Date, or (h) Taxes (1) relating to the Assets or the Assumed Liabilities with respect to a Tax period (or portion thereof) ending on or prior to the Closing Date (2) that arise out of the consummation of the transactions contemplated hereby or (3) of Seller, including Taxes that become a Liability of Buyer under any common law doctrine of de facto merger or transferee or successor liability or otherwise by operation of contract or Law.”


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• Interaction with Representations and Warranties – To the extent the definition of Excluded Liabilities is

comprehensive, it will effectively make most representations and warranties irrelevant (other than affirmative reps), as liabilities arising from breaches will likely also be covered as Excluded Liabilities

– For affirmative reps, such as representations that the assets are sufficient to operate the business, or as to top of the line financials, indemnification for rep breaches will still be the only recourse


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• Indemnification of Excluded Liabilities – In addition to standard indemnification coverage for breaches of

representations, warranties and covenants, the purchase agreement should include a specific indemnification coverage for liabilities arising out of or relating to the Excluded Liabilities

– Claims for indemnification based on Excluded Liabilities should survive indefinitely


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• Indemnification of Excluded Liabilities – A Buyer’s protection from Excluded Liabilities is typically

uncapped, with no basket or deductible that must be met

– Coverage for Excluded Liabilities is often flat, without limited survival periods, knowledge qualifiers, limited lookbacks, or materiality determinations

– To the extent a liability is an Excluded Liability, the Seller retains full responsibility and the Buyer should not assume liability


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• What, When & Why

• Working Capital

• Cash

• Indebtedness

• Other Adjustments

• Mechanics

• Dispute Resolution

• Payment of Adjustments

• Indemnification

Nuts and Bolts – Purchase Price Adjustments

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• What are Purchase Price Adjustments? – Contractual mechanism to adjust the base purchase price

– Working Capital, Debt, Cash, Transaction Expenses, Change of Control Payments and/or other key components

– Formula based - Intersection of legal concepts with accounting concepts and economic reality

• When are Purchase Price Adjustments Used? – Private M&A Transactions

– Volatile inputs


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• Why are Purchase Price Adjustments Utilized?

• Reduces post-Closing legal disputes by providing a contractual mechanism to address (perceived or otherwise) changes in the underlying value of a company

• Addresses gap in time between LOI (or signing) when an offer is based off of the most recent financial statements and Closing

• Tries to provide a mechanism to resolve the inherent information imbalance at Closing - the inputs to the final purchase price typically cannot be known until sometime after Closing, when Sellers no longer own the Company

• Minimizes incentives to sellers act irrationally and/or operate their company outside of the ordinary course

• Moderates need of buyers to invest additional capital at or immediately following closing to operate the business


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• Working Capital Adjustments Work Off of a “Target” – The goal is to establish a target number that represents “normal” working capital number that

reflects the amount of working capital needed to run the business

– Once established, the working capital adjustment works by determining the difference between working capital as of the closing and the target

• The Target is highly negotiated – Simple average of a proscribed period

– Seasonality

– Growth rate

– Non-recurring adjustments to EBITDA

– Specific timing issues related to the time of Closing

– Idiosyncratic factors can lead to a negative target

• Prevent post-closing disputes around target by setting a firm number

• Start conversations about the target early

• Targets can also be used for cash, inventory and other adjustments


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• One-Way (Down) or Two-Way (Up and Down) – A “one-way” adjustment only permits downward purchase price

adjustments

• Favors buyers

• Increases pressure on sellers to be conservative (and accurate) in their estimate of working capital

• Can result in money left on the table for sellers and motivate sellers to take abnormal actions with respect to the operation of the business prior to Closing

– A “two-way” adjustment permits purchase price adjustments in favor of either party

• More equitable and lessens pressure on Sellers

• Buyers may argue that they only have approval to fund X dollars at closing so they cannot allow for upward purchase price adjustments


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• One Step or Two Step – A “one-step” adjustment occurs post-closing, comparing the

finally agreed upon numbers against the target(s) • Prevents potential overpayment/underpayment of funds

• Delays payment of purchase price

• Simpler mechanic reduces complexity around closing

– A “two-step” adjustment includes two adjustments, first at closing based on Sellers’ best pre-closing estimate against the target(s), and second, comparing the finally agreed upon numbers against the estimate

• Potential to reduce the amount of the post-Closing adjustment

• Can reduce post-Closing disputes

• Can lower the amount of related escrows or holdbacks

• If buyer balks at sellers’ estimate, can delay closing (Buyer can negotiate for approval right, or even right to modify)


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• Sources of Recovery

– Escrow/Holdback/Offset (may include top-up requirement)

– Direct Recovery

– Indemnification

• Working Capital Pitfalls

– Indebtedness or transaction expenses get lumped into WC and reduce target

– WC is agreed to be calculated in accordance with non-GAAP measure and can’t be cleaned up by Buyer as a post-Closing matter

– Dispute Resolution Matters

– Procedural obstacles to recovery

• Collars or other limitations on recovery amount or source

• Unclear resolution procedures


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• Generally, a policy that insures the buyer for its losses based upon or arising out of breach of seller/target reps

• Insurance for “unknown unknowns” that can arise after an acquisition - Seller fraud

• Can supplement, reduce or replace seller indemnity - Can facilitate “clean walk” for sellers; bid enhancement - Credit enhancement

• Integrated with, but separate from, purchase agreement

• RWI-related issues need to be considered at numerous stages of negotiation between parties

• Can be some of the final issues to be resolved pre-signing (e.g., scope of specific indemnities)

Nuts & Bolts – Rep & Warranty Insurance

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• RWI Policies are not: – An “all risk” solution

– Valuation arbitrage for known risks

– A way to lessen the diligence burden

– A way to shorten the diligence process

– A Panacea


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• Market remains competitive

• Typical purchased limits are 10-15% of EV

• Premiums and related costs typically 3-4.5% of purchased limits - Surplus lines taxes, UW fees

- Supplemental broker comp

• “Sweet Spot” in the $100MM - $1B range

• Economic compression begins to set in below $50MM EV/$5MM - Premium and broker compensation floors

- Diligence expectations/low materiality as to retention

- Additional professional expenses

• Can still be special cases where RWI makes sense for a small deal


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• Policies do not cover everything that a seller indemnity may, insurance companies may also be harder to recover against than Sellers

• Retention & Limits

• Exclusions - Known breaches (built in NCD anti-sandbag) - Other “Standard” Exclusions - Deal-specific Exclusions

• Carve-outs from “Loss” - Fines and penalties - Prior consent requirements

• Redlining the Reps for Purposes of Coverage

• Rollover

• Where does RWI fit in the overall recovery waterfall? Who is taking coverage risk? (denial of coverage; claims administration purgatory)

• Proper signaling or reservation in the LOI is important


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Questions?

Documents

How to Prepare for an M&A Transaction · – Retirement/Succession Issues – Shareholder Priorities • Why are you doing this deal (Buy-Side)? ... – Who is running the business?