Also by Scott Ehrlich (Partner, Sklar Kirsh)

In any transaction where a business changes hands, a buyer generally wants to make sure that there is no unpleasant surprise after making payment. Equally, a seller does not want to be concerned by a potential claim from the buyer after the sale. Therefore, various mechanisms have been developed to protect the parties in an M&A transaction. This blog explores some of those mechanisms, particularly in a typical middle-market M&A transaction.

In almost all middle-market M&A transactions, a buyer and a seller will be represented by attorneys, accountants and other relevant professionals. In many transactions, investment bankers will facilitate deal negotiations as well. Attorneys play a key role in contractually protecting their buyer and seller clients from potential liabilities of the target business. As there are many potential pitfalls and areas of concern, the attorneys will seek input from the accountants and other professionals to identify and quantify the potential exposure upfront.

What are some of the common ways to limit post-transaction exposure?

DUE DILIGENCE

It is customary, and certainly recommended, for buyers to perform due diligence on the target company before consummating a transaction. While even the most thorough due diligence will not identify all of the potential issues, it will surely shed some light on certain issues. In extreme cases, negative findings from due diligence are hard to overcome and a deal gets withdrawn.

The facts and circumstances of the company’s business are likely to dictate the nature and scope of due diligence. However, at a minimum, there should be legal, financial and tax due diligence as these areas are common across any business. While it is not as intuitive, one should not forget about reputational due diligence or background checks on the other party as well. If the other party to the transaction is known for bringing claims post-closing, this may be a red flag for many business people.

In addition, it may be beneficial for the seller to perform preemptive due diligence on its own company. The primary benefit is to be prepared for what the buyer will discover as part of its due diligence. Early disclosure of adverse items that will surely come up during a diligence review reduces surprises and allows management to prepare and correct where possible. Also, the seller’s due diligence will likely help eliminate, manage or mitigate certain exposure prior to the transaction. For example, a seller may engage an advisor such as accounting firm to look at its own ”Quality of Earnings” to preemptively prepare a counter for potential negative adjustments to EBITDA that the buyer may raise.

PURCHASE AGREEMENT

The parties to a transaction will allocate risk via a purchase agreement. Both the buyer and the seller will seek to have the other side make expansive representations on various areas. Of course, the party being asked to make the representations will try to limit the representations being made and ultimately the liability for inaccuracies.

Typically, a purchase agreement will include the rules and parameters of recovery for any misrepresentation. While the parties can generally negotiate however they want for such indemnity, there are certain commonly applied concepts:

  • Basket: Serving the same purpose as a deductible in an insurance policy, this limits a party’s ability to claim nominal damages/losses, unless the aggregate of such damages exceed a certain amount.
  • Cap or limit on indemnification: This is to provide the maximum amount of indemnity a party can claim in a transaction.
  • Survival periods or time limits: This is to prevent a party to have an unlimited amount of time to make a claim. Note that in some deals, the representations do not survive closing.
  • Fundamental representations: Certain important representations can be carved out and may not be subject to some or all of the other limitations, such as basket, cap or time limits.

There are many other items the parties will try to negotiate. Another important factor is what level of materiality should be used. For example, a seller may represent that the company timely files tax returns in all jurisdictions. Without “material” in it, the seller may be in breach for not filing a tax return in a jurisdiction, even if there is minimal or no tax liability.

When making representations and disclosures, the definition of the term “knowledge” can be important. Even if a person making a representation may not have directly known about such representation being false, but with a reasonable level of investigation he/she should have known, depending on how “knowledge” is defined, it may be considered a breach. In some cases, a buyer may have already known that a certain representation is not true at the time of the transaction. While the buyer may be normally barred from making a claim on the breach of such representation, it may contract for the “benefit of the bargain” of the negotiated representation regardless of information it may have obtained during due diligence, referred to as “sandbagging.”

Further, a party can have every conceivable protection available, but if the other party providing indemnity is a shell company or not credit worthy, such protection will be useless. As such, the party receiving indemnity rights will try to be as expansive as possible when it comes down to who is providing such indemnity.

Last, but not least, the parties will try to negotiate what types of damages are included, such as consequential, special, incidental or punitive damages. The parties may negotiate what happens in case of fraud, misfeasance or malfeasance, which often are not subject to limitations on indemnify discussed above.

ESCROW/HOLDBACK

For a buyer who has a claim against a seller under the purchase agreement, it may be difficult to chase the seller and get properly and timely compensated. Conversely, most sellers are very reluctant to pay back a portion of the proceeds once cash is already collected. Thus, the parties traditionally negotiate and set aside a portion of the transaction consideration in a third-party escrow to use it against potential claims. On other occasions, the buyer may hold back a portion of the consideration until a specified time and/or event. The amount(s) and length(s) of such escrows and holdbacks are heavily negotiated by the parties.

SETOFF

Similar to the holdback concept, when the buyer has a payable against the seller, such as a seller note or an earnout, the ability to offset a claim against such note may negate the need to chase after the seller. In the case the seller received an ownership interest in the buyer, a question arises whether the buyer can setoff against the equity, because the value of the equity may fluctuate making it not as easy as a note.

REPRESENTATION AND WARRANTY INSURANCE

More recently, representation and warranty insurance has replaced escrow/holdback and setoff to become the preferred method to provide certainty for both the buyer and the seller, and to shift the risk of post-transaction exposure from the seller. While a typical R&W insurance policy does not cover every claim (insurance policies do not cover known or disclosed breaches or other specifically excluded items, or post-closing agreement such as a non-compete), it will surely provide a peace of mind for the parties and a ready source of recovery for the buyer. Additionally, in a transaction where a seller is remaining with the company post-closing as a minority investor and/or an employee, a R&W insurance policy avoids the unpleasantness of a buyer bringing a claim against its partner or key employee.

REGULATORY MEANS

In some cases, there are ways to limit the both parties’ exposure by various regulatory means. For example, many states have a process in place where the person buying/selling business can obtain a tax clearance certificate. If such certificate is obtained, the tax risk within the scope of such certificate should be minimized.

These are some of common ways to protect the parties to an M&A transaction, and there are many others. In negotiating these and many other terms of a transaction, the party who has more leverage in the transaction often has the upper hand. Having a solid team of experienced M&A advisors will enhance a party’s negotiating position and result in creative ways to protect the parties and bring the M&A transaction to a successful closing.

If you have any question about the above content, please reach out to your business advisor or a member of GHJ’s Transaction Advisory Practice or Sklar Kirsh’s team.

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POST WRITTEN BY

Curtis Kim

Curtis Kim, CPA, has more than 15 years of accounting experience with a concentration on a broad range of income tax planning matters, including domestic and international reorganizations, mergers and acquisitions, divestitures, joint ventures, technology transfers and tax-efficient capital…Learn More