In Part II of this article, we will do a little myth busting in the world of Mergers and Acquisitions, review how rep and warranty insurance fits into your deal, and review options for purchase price adjustments.
Q. What are some common myths and misunderstandings about the deal process?
Myths abound when it comes to understanding the intricacies of merger and acquisition transactions. Following are a few of the most commonly misunderstood “facts” about M&A deals, and the rationale behind why these myths are incorrect.
Myth: The size of deal drives its complexity.
Fact: The same issues arise in a small deal as a large one, and often smaller companies have less developed internal systems to rely on for information. Issues relating to customer contracts, third party consents, payoff of banks, transitioning employees and benefit plans and due diligence review are necessary regardless of the company’s enterprise value.
Myth: Acquiring a public company requires more negotiation.
Fact: Private company deals have the same terms as public ones, but also include indemnification provisions, which are typically NOT included in public company deals. So, deals involving private companies can require more, or at least as much, as those involving public companies.
Myth: There’s a standard form of agreement.
Fact: While any good purchase agreement should cover the same key areas – structure, purchase price, representations, indemnification, conditions to closing, closing deliveries, and noncompetition agreements among them – many of these provisions are highly negotiated and tailored to the parties’ unique goals.
Representations and Warranties in your Deal
Besides requiring payment of the purchase price, a key function of the purchase agreement is to allocate risk between buyers and sellers, through representations and warranties (reps and warranties) which the Seller makes about the quality of the business, and indemnification where the Seller agrees to hold the Buyer harmless if there are any breaches of the representations. In essence, returning a portion of the purchase price. So, the language in the reps and warranties is very important and negotiating for limitations in the indemnification is also critical. A seller will want it to be as small a percentage of the purchase price as possible.
The Due Diligence Process
Have realistic expectations about how time consuming the Due Diligence (DD) process is. Responding to DD requests and pulling that information together takes up a significant amount of time – expect weekends and evenings. Don’t plan a vacation. You must do all of this on top of running your business, and it will be critical to hit your budgeted earnings levels.
While the buyer will have done a lot during the LOI stage, legal due diligence typically begins only when the buyer’s counsel starts drafting the purchase agreement. As well, most of the due diligence information and documentation needs to be memorialized in disclosure schedules that are attached to and incorporated into the purchase agreement.
This is generally more than one person can do, so you’ll need to involve key people at your company to help during this process – they’ll need to be familiar with important areas of the business and be discrete. You will want to consider retention bonuses for some employees because you’ll be asking a lot of them and you will want them to stay through closing. Sellers should realize that responding to due diligence requests and preparing disclosure schedules are the single biggest time commitments in the deal process.
Q. What is rep and warranty insurance and how does it work?
Response: Rep and warranty insurance has been around for about 15 years, and we’re seeing it more and more frequently. Reps and warranties are statements made by the seller in the purchase agreement about the quality and nature of the business being sold. After the purchase price, these are some of the most critical parts of the agreement. If the representations made by the seller turn out to be incorrect, the buyer can be indemnified and have some portion of the purchase price returned. While buyers want a broad indemnity package, sellers want a narrow one – rep and warranty insurance can help bridge this gap. It’s used most often in deals of $20M or more, and either the buyer or the seller can obtain coverage, although its more common for the buyer to be insured.
About Rep and Warranty Coverage
Coverage limits frequently range between 10% and 30% of the purchase price. The retention under an R&W insurance policy is the insured’s aggregate deductible under the policy (like an indemnification basket in an acquisition agreement). It generally ranges from 1% to 3% of the purchase price. Premiums generally range between 2% and 4% of the coverage amount. So, if you have a $20M deal, want coverage of 20% or $4M, you could expect to pay between $80K-$160K.
Expect it to add some time to the process – the insurer will need to review the due diligence memos and materials after the due diligence is substantially complete. However, it can help differentiate a buyer, close a deal more quickly, cut down on time spent negotiating the purchase agreement, and help alleviate risk for both the buyer and seller.
Q. How do purchase price adjustments work and what should parties watch out for?
Response: Purchase Price adjustments are ways the purchase price is increased or decreased at closing, typically based on the company’s balance sheet. Buyers often use purchase price adjustments to ensure there is sufficient working capital. This is the most common type. Most businesses need a certain amount of working capital to operate, and if it isn’t there, the buyer needs to infuse cash, effectively increasing the purchase price. However, this can penalize the seller for making capital expenditures. In this case, a shareholder equity target may be more appropriate.
Preparation of Financial Statements – The parties must decide who will prepare the financial statements. The buyer is usually in a better position to prepare them. So, it’s critical to provide the seller with rights to review the financial statements, along with any underlying documentation.
Inventory – A buyer will want to conduct an inventory, and also understand the seller’s policy on reserves for accounts receivable.
Accounting Principles to Use – The parties must decide on what accounting principles to use. Parties frequently rely on GAAP, consistently applied, so the buyer should become familiar with how the seller has been preparing its statements. This is the area where most disputes arise – from differences in accounting policies, or the buyer identifying something that should be booked as a liability that the seller wasn’t previously accruing for. The parties can minimize these disputes by agreeing in advance on exactly which accounts will be used in the calculation, attaching that as an exhibit, and preparing a sample calculation.
Making the decision to buy or sell a company involves many complex moving parts. We hope this two-part article has successfully addressed many of the questions you might be facing as you look to purchase or sell a business. I am always available to talk with you if you are considering a merger or acquisition either on the buy or sell side.