There is an old saying that the man who uses himself for his attorney has a fool for counsel. Likewise, a selling owner acting as his or her financial advisor in negotiating an acquisition has a fool for an acquisition consultant/investment banker. There is no way a typical selling owner/entrepreneur could have an accurate knowledge of the company's value or a remote grasp of how the representations, warranties and indemnifications must be creatively structured to minimize their risk.
The pricing of middle-market acquisitions is rarely announced. The few that are made public are only announced in detailed SEC filings, which are usually reviewed only by sophisticated acquisition consultants/investment bankers. The seller's accountant or law firm doesn't have expertise with the overall pricing and pricing trends of middle-market deals by industry. In addition, almost all attorneys accept the prevailing norms that sellers should be responsible for events occurring prior to the closing date. Therefore the selling owner, who is not advised by an acquisition consultant with an aggressive philosophy predicated on equitable treatment of the little guy, is forced to rely on the validity of the following types of comments for guidance in deal pricing:
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“That is the normal way transactions are done,” acquirers often state to defend their proposals.
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The boasts of prior sellers about the transaction price their company commanded.
Obviously, individuals who sell their companies have strong emotional self-interests in exaggerating selling prices. In addition, strategic acquirers can have any number of motivating, and possibly conflicting, self-interests that cause them to distort their actual purchase prices for prior deals and their overall pricing philosophies. Prudent people recognize that the conflicts in these situations make it unlikely they will be a source for actual deal pricing.
The Impact of Timing on Deal Prices
There is an incredible consolidation taking place in many industries. The quantity and pace of the acquisition frenzy is unlike any in the past 20 years. Many deals in the “consolidation type” industries are happening fast and apparently painlessly for selling owners. Unfortunately, this is usually a sure sign that a company is being sold at a discount price with the seller often having significant post-closing exposure in nonfinancial areas.
In 1996, my firm represented a heating and air conditioning equipment distributor on the Pacific Coast. An aggressive but realistic price of $11 million was established for the seller. A major strategic acquirer in this industry made an offer of $9.5 million. As I discussed their offer and justified the validity of our price, I said they could make a very attractive return on investment at my transaction price. The acquirer's CFO stated that they could buy many companies at a much lesser price. He further said they had consummated eight deals during the past year and that none had been consummated at my multiple of earnings level. When I inquired as to how these sellers were advised, the CFO said that five were not advised by a financial advisor and three had used their local CPA firm in that capacity.
Subsequently, in late 1996, this distributor was sold at its target price of $11 million in an all-cash deal. The point is that sellers who are not properly advised almost always sell at a vastly discounted price.
Usually, fully priced, adequately secured deals do not move quickly unless the seller has substantial leverage. These deals usually move at a moderate pace with considerable negotiating obstacles. This reflects the fact that acquirers typically do not initially make their best offer. An actual sale illustrates this point.
In 1994, a plumbing distributor was approached by a major public company. The potential seller retained my firm; a target price of $13.5 million was established. The acquirer adamantly maintained that their best price was $11 million. We terminated discussions.
In 1996, the same plumbing distributor decided to actively pursue the sale of their company. At that time, their earnings were less than in 1994. In spite of this, the public company that had approached them originally now raised their offer to $12.25 million. I indicated that was not adequate. Two weeks later they raised their offer to $14.25 million. That offer was also rejected. Two months later, a sale was consummated with another public company for $14.5 million, which was at the upper end of our price range.
The point is clear. The initial acquirer was attempting to steal the company. Selling owners must be patient to get the price they deserve. It's necessary to have expert negotiating skill on their side if they want the leverage necessary to produce a realistic premium price.
Letter of Intent Discussion Points
The pricing of the deal is only one facet of the transaction. Before the likely potential acquirer is selected, a general discussion of all issues should occur at the letter-of-intent stage. The representations, warranties and indemnifications are every bit as important and should also be generally discussed at this preliminary stage. If not done properly by a sophisticated and expert negotiator, it could blow the deal.
The advantage of a preliminary discussion is that you obtain an understanding of the acquirer's position on all key issues at an early stage of negotiations. If the acquirer is unreasonable in nonfinancial areas, a prudent selling owner must break the deal to assure future security. However, if the acquirer's position in these areas appears to be reasonable, it is likely that the deal will be successfully consummated. This reduces the risk of an uncompleted deal, before an acquirer begins the comprehensive due diligence process. This is important because that process often disrupts the seller's company.
Critical Financial Impact of Nonfinancial Issues
When a middle-market company (transaction price up to $100 million) is bought, a smaller company is typically being sold to a much larger acquirer. The acquirer usually has done numerous deals and has sophisticated professionals on staff that know how to structure deals that work to the acquirer's utmost advantage.
If selling owners stop to reflect, they'd realize that in any transaction where one party is much larger and more familiar with a process than the other, it is usually that party who obtains the better deal. This is never more true than in acquisitions.
This unfortunate situation has become the norm. Correspondingly, most attorneys are used to structuring deals with representations, warranties and indemnifications that conform to the “norm.” Acquisition consulting firms seriously concerned about clients' financial interests find these norm terms offensive.
Norm terms put selling owners in extreme jeopardy after the deal is done. In a best-case scenario, they open the door for selling owners to have their price chopped by 5 percent to 10 percent due to post-closing issues. In a worst-case scenario, if the representations, warranties and indemnifications are not properly structured and limited in scope and duration, the impact on a seller can be catastrophic.
The seller can lose an amount up to or exceeding the total deal price due to post-closing events that the seller knew nothing about when the deal was closed. In middle-market acquisitions, that is the “norm.” This violates the overriding principle of capitalism, which is “those who take the risks get the rewards.” The principle is not supposed to be “those who get the rewards don't accept any risks.”
In most mid-sized acquisitions, the latter statement is how an acquirer wants it to be, and it's what they are used to getting. It's up to your financial advisor to stop them. If there are unforeseen rewards that an acquirer realizes from the deal, they probably were developing before the sale.
In these situations, the acquirer theoretically bought the company at a discount price. Acquirers never share unanticipated gains with sellers. Correspondingly, why should they demand that the unsuspecting seller absorb the full burden of negative surprises?
Regardless of the amount the acquirer collects from the seller under the indemnification provisions, the selling owner's covenant not to compete will still be in effect. Correspondingly, selling owners could lose up to or in excess of their total deal proceeds due to the post-closing discovery of unknown liabilities, and they would be unable to work in their industry to earn a living due to the restrictions in their covenant not to compete. Sellers willing to accept the “norm” representations, warranties and indemnifications have placed themselves in this precarious position, whether they know it or not. That is not a risk a seller should have to bear. Here are some of the issues that can trigger a seller's post-closing exposure.
Unknown liabilities
These include product liability, contract and employee claims. Many are issues that an innocent seller acting in good faith will not have any knowledge of at closing. In spite of this, if the normal representations, warranties and indemnifications are agreed to, the seller could have post-closing exposure up to or exceeding the deal price.
If sellers cannot shift the liability for these issues to acquirers or significantly limit their exposure, they retain full responsibility for these issues potentially for many years after the acquisition is completed. The seller is not only responsible to the claimant but also to the acquirer as an indemnified party.
In many situations, latent employee dissatisfaction can be triggered by an acquirer's conduct after a closing. Although the events creating the claim might have occurred before the closing, they would not have become an issue except for the acquirer's actions. Consequently, a liability that did not exist at the time of closing becomes a post-closing liability for the seller.
Similar issues exist in the product liability area. Often, claims due to damage caused by equipment sold years before the acquisition do not arise until after a sale. The seller's exposure for these claims depends on the negotiated representations, warranties and indemnifications, along with other protections that the seller should put in place.
I believe the only liabilities that sellers should be responsible for are those they are aware of. Other liabilities should be the responsibility of the acquirer. The financial implications in this area are enormous to a selling owner.
Environmental claims
Environmental problems found on a seller's property might have been caused by others, whether a previous occupant or by disposal or drainage from another company. If the acquirer receives a clean report from either a Phase I or a more detailed Phase II environmental audit, the seller should use this as justification to restrict any post-closing liability that they have to an acquirer. A satisfactory environmental audit should be all the security an acquirer needs to adequately assure the property(s) are clean.
Accounts receivable
Often, and especially in “consolidation type” industries, an acquirer believes the collection of prior receivables should be the responsibility of the seller, either directly or indirectly. Hogwash!
A sophisticated acquirer can determine exposure for bad accounts receivable during the due diligence process before closing. If they have any significant collection exposure, it should be negotiated as a deal price reduction before closing. In no case should a sophisticated seller accept any liability for the acquirer's subsequent collection of receivables. This removes any pressure from acquirers to use reasonable efforts to collect receivables.
Inventory
Acquirers often expect the seller to be directly or indirectly responsible for inventory not sold within a normal period. It seems inherent in this assumption that the acquirer has only good inventory. Obviously this isn't the case, so why should the seller be held to this standard?
During due diligence, the acquirer should evaluate the seller's inventory, inventory controls and inventory levels. If an excessive amount of damaged, slow-moving or obsolete merchandise exists, this should be addressed prior to the closing in the form of a reduced transaction price. Once a deal is closed, the inventory should be solely the acquirer's responsibility. To do otherwise is to give the acquirer a blank check. Many acquirers will gladly take advantage of this loophole.
As a seller evaluates the importance of the representation, warranty and indemnification issues, they should remember that negative developments from poorly-structured deals can place them in jeopardy for an amount in excess of the transaction price.
After the deal is consummated, except to the extent the acquirer might benefit from the seller's personal goodwill, the seller is of limited utility to an acquirer. Any money that can be claimed against the seller will reduce the transaction price for the company and increase the acquirer's return on investment.
If that sounds cynical, you're not familiar with the reality of corporate acquisitions. This is one area in which a seller doesn't want to get educated the hard way. The consequences are too grave.
In what is probably the largest financial battle of your career, make sure you are advised by a knowledgeable professional capable of forcefully negotiating with a larger acquirer to structure a deal that eliminates or severely limits your exposure to post-closing liability.
George Spilka is president of George Spilka and Associates, Allison Park, Pa. The consulting firm specializes in mergers and acquisitions. The author can be reached at (412) 486-8189 or by e-mail at [email protected].