SEPTEMBER 2009

In this issue

Deconstructing the Demand for
On-Demand (SaaS)

Deals Fall Apart:
How Private Company Sellers can avoid Busted Deals in Today’s Market

 

We welcome the opportunity to have a more detailed discussion of the Commercial Technology market.

For more information contact:

Andrew Lustig
Partner
Cooley Godward Kronish
(703) 456-8134

Mark Spoto
Partner
Cooley Godward Kronish
(703) 456-8029

Adam Salassi
Partner
Cooley Godward Kronish
(703) 456-8131

 

Deals Fall Apart: How Private Company Sellers Can Avoid Busted Deals in Today’s Market

by Adam Salassi, Partner, Cooley Godward Kronish LLP
Adam Salassi is a partner in Cooley Godward Kronish’s Northern Virginia office and concentrates his practice on mergers & acquisitions, strategic transactions, venture capital, private equity and financing transactions.

In today’s market, merger and sale transactions are more fragile than ever. Following up on our last article in Inflection Point, this paper will discuss how sellers who decide to put their company up for sale can minimize the risk of a failed merger or sale transaction.

Introduction

Let’s start by framing the situation: As the seller, you have decided to put your company up for sale, and, after much preparation and hard work, have found a willing buyer for your company at an indicated price you are willing to accept. The form of the deal structure is not important for this article; it could be a sale of stock, a merger or an asset sale. In each case, at this point the critical issue from your point of view as the seller is to get the deal done, because a failed sale transaction is extremely damaging to the seller. If the deal busts, your company will carry the stigma of having been rejected by a buyer (and other potential buyers will likely assume the worst about your company, e.g., that there was a negative surprise in the deal process or that your company simply turned out not be what the buyer thought it was). In a failed transaction your company’s relationships with both its customers and its employees will likely be destabilized, and the time and effort spent in the sale process (often with many months of management distraction along the way) will have been wasted. So protecting against deal failure is critical once you have embarked upon a sale process.

Understanding the Dynamics at Play

To get a handle on how this situation can play out, it is helpful for to understand the buyer’s perspective. A buyer generally wants to (i) receive the benefits it has bargained for, that is, it fully expects your company to be able to live up to its representations and the buyer’s assumptions, and (ii) be protected against certain risks that may arise in your company’s business, and against any significant negative surprises. If prior to closing, either of these key buyer requirements are not met, the buyer may walk away from the deal or to use the threat of walking away to negotiate a new, more favorable purchase price or purchase agreement. As a seller, your calculus is reversed: you want to create deal certainty and to minimize the buyer’s ability to terminate the agreement and so you should try to negotiate as many qualifications and exceptions to the buyer’s rights as you reasonably can.

Every deal has a “story” or thesis. Before even beginning the negotiation of the definitive agreement, as seller you should put yourself in the buyer’s shoes and think strategically about what the buyer really cares about achieving in the transaction. The buyer may be interested in acquiring your company to obtain new technology or intellectual property, new product offerings or potential for brand extensions, or it may be most interested in new customers and achieving entry into new markets. In technology transactions and with government contractor companies in particular, the buyer may most interested in your company’s workforce and their collective technical acumen, and R&D talent, the security clearances, specialized defense and intelligence expertise and customer relationships, and so these deals are really about people. Often the buyer is after the revenue streams of your company, which, combined with planned cost reductions and that elusive concept of synergy, will make the buyer stronger financially. In each case, a well prepared seller is ready to negotiate a transaction that will give the buyer what it is looking for, while minimizing the chances that the buyer will be surprised or disappointed.

The key legal areas in which deals fail after a definitive agreement has been signed are (i) breaches of representations and warranties, (ii) failures to satisfy key closing conditions, and (iii) breaches of interim covenants. There are many non-legal reasons for deal failure (in fact most deals fall apart because of something other than a purely legal issue) but the definitive agreement—which is a contract after all—becomes the battleground over whether the non-legal issue gives the buyer the ability to assert a breach or to walk away from the deal. Some of the non-legal issues that can develop are a change in market conditions that now makes the deal look less attractive to the buyer, a change in the competitive landscape that makes your company look weaker than it did initially, or, surprisingly often, a lack of trust and cooperation between the seller’s and buyer’s management. In each instance, something negative has impacted the buyer’s acquisition thesis. When this happens, especially if trust and rapport is lacking between the parties, the transaction can rapidly become a “deal from hell”.

Let’s break these down to examine the ways you as the seller can protect yourself from deal failure.

Legal Protections

1. Disclosure. You should be prepared to adequately and carefully disclose all relevant information about you business. The disclosure you provide will both insure that the buyer has a realistic picture of your company before completing a definitive agreement, and will, even more importantly, serve to qualify the representations and warranties you will have to make about your company and its business. For example, you will be asked to represent that, except as disclosed, there are no claims of ownership against the company’s intellectual property. If you can make appropriate disclosure of potential third-party claims, and the buyer accepts those, then if these claims materialize post-closing it will be the buyer’s issue to deal with them and to bear whatever costs they may impose, rather than yours.
2. Lock down the key assets the buyer is seeking to acquire. This ties in to disclosure—if there is a problem or issue you would prefer not to disclose about your company, take care of it before negotiations even begin with the buyer. Again, think about what the buyer is buying, and make sure that whatever makes your company special is legally protected. If it is your employees, make sure that key employees have signed appropriate proprietary rights agreements and, non-competition agreements (in jurisdictions where they enforceable) and consider retention incentives. If the buyer is acquiring your company for its intellectual property, it is critical that the IP is secured by patent, trademark, copyright or trade secrete protections. For buyer’s that are seeking revenue or new customers, take the time in advance of the deal to make sure that your key customer relationships are strong and that your contracts with them are in force (and, ideally, readily transferable), and that there are no significant problems that will become issues during the buyer’s due diligence investigation.
3. Representation and warranties. As a seller, you will be required to make extensive representations about your business. The purpose of representations is three-fold: to elicit critical information about your company (again, see Disclosure, above); to allocate risk between the buyer and the seller, in that if the representations turn out not to be true, the buyer will be able to seek damages or indemnification from you as the seller; and to give the buyer a way to walk away from the deal entirely. A key part of your negotiation will be to tailor the representations appropriately to your business. You should be realistic about providing reasonable coverage on the representations, but not to allow them to be overly broad or so encompassing that any minor issue could be a breach. The use of appropriate qualifications, such as knowledge and materiality filters on the representations, is a common way to balance the risks, but is also a very common lawyer battle during negotiations. Both you and your lawyer need to be well prepared to explain and defend your positions on representations as being both appropriate and reasonable for your business and industry, and to back up your arguments using precedent transactions and examples of what is considered to be within the mainstream, or “market”, of M&A deal practice.
4. Purchase price adjustments. Be realistic about the valuation of your business going into negotiations. If you and the buyer reach an impasse on valuation, you can often use a purchase price adjustment mechanism, or an earnout or contingent payment provision, to bridge the gap. These mechanisms are usually tied to uncertainties about post-closing performance of your business, and will likely contain either financial targets such as working capital, revenue or EBITDA that your company will be expected to achieve post-closing, or around operation issues such as retaining a key contract or completing the development of a key product. Earnouts are notoriously difficult to negotiate and draft and are often the subject of post-closing litigation, so preparation, clear arguments for why your proposal for the post-closing performance targets should be adopted and careful drafting are extremely important.
5. Conditions to closing. Each purchase agreement will have conditions that you as the seller will have to be satisfied before the buyer can be required to close the transaction. These fall into several common areas:
   • Material Adverse Changes (or “MACs”). A MAC is a clause which says that if, between signing and closing, your company suffers a problem that is material, then the buyer can refuse to close. This is to protect the buyer from signing up to a deal based on a set of facts and understandings about your company that, before closing, are no longer true. You should negotiate hard for a MAC definition that places common risks on the buyer, such as a change in general market conditions, problems that arise due to the announcement of the deal, and changes that affect your company’s industry generally.
   • Regulatory approvals. Many deals are subject to some form of regulatory approval, such as Hart-Scott-Rodino for deals above a certain size, and for deals within a regulated industry such as banking, insurance, communications, and in many instances, defense and intelligence. You should be ready to negotiate for the buyer to bear some of the risk and responsibility for obtaining these approvals, and spell out carefully what each party must do to seek the approvals.
   • Third party consents. Similarly, the buyer will want assurance that your company will obtaining required consents under its material contracts with its customers, lenders or investors, providers of key technology or other assets, and landlords of key property or facilities. It is important to identify two things going into the negotiation: what consents are absolutely required to complete the deal, and what consents are important, or “mission critical” to your company’s business. Some consents, such as from key customers or licensors, may not block the deal but without them the buyer could be left with a company that is not as valuable as what it is prepared to pay. You should have a plan to obtain these consents well in advance of negotiations, and should seek to limit the number of third party consents that will have to be obtained.
   • Financing contingencies. A buyer may try to qualify its obligation to close on its ability to secure financing for the deal. This is very common in leveraged buyout and management buyout transactions. A seller should strongly resist these, as financing may be difficult to secure, and, if the document is not carefully drafted, a savvy buyer can use a financing contingency as a means of escaping from a transaction that buyer no longer wants to do even if financing could have been obtained.
   • Reverse breakup fees. Using reverse breakup fees as a means of compensating the seller if the buyer is unable to secure financing became a common solution to the financing contingency problem, at least before the current market downturn made most merger financing unavailable. Reverse breakup fees are a payment made by the buyer if it is unable to obtain financing and terminates the deal. While these may sound attractive to you as the seller, reverse breakup fees in effect give the buyer an option price to walk away from the deal. Since your company may be significantly damaged if a deal does not go through, you should think twice about allowing the buyer to have a financing contingency in the transaction and using a reverse breakup fee mechanism, as the amount of the breakup fee may not fully compensate you for the true damage your company could suffer due to deal failure. Consider negotiating hard for a higher than standard fee, or to have no fee (and no financing contingency) at all, and to and make it clear to the buyer that if it fails to close the transaction you will be able pursue uncapped damages or specific performance.
   • Interim covenants. A definitive agreement will contain covenants that your company has to follow between signing and closing. You should be careful to make sure that your company can comply with these over the course of what may be a number of months. If you are aware of some future event or requirement that would be outside the normal course of operating your company’s business, such as a major capital expenditure or entering into a collaboration or joint venture agreement, you should negotiate for the ability to do so without having to seek the buyer’s consent. In this area, you needs to protect yourself from the buyer unduly interfering in how the you run your business, but also to take into account the buyer’s need to make sure you don’t do something that would negatively impact the buyer’s expectations for the acquisition or value proposition.

Deal Process Business Practices that Help Deal Assurance

No surprises. Make sure that you have done everything possible to avoid surprising the buyer (and yourself). The last thing a buyer wants once it has committed to buy a company is to have to deal with a changed set of assumptions. If you know that something negative and material may happen during the time the deal is progressing, disclose it early along with your plan for dealing with it. This assures the buyer that you are being candid with them and that you and your management team are up to the task of handling the problem, and, by extension, that you know how to run your business.

Provide smooth due diligence. The buyer will fully investigate your company. In today’s deal market, due diligence is more important than ever and most buyers will take a leave-no-stone-unturned approach. Be ready for it, make sure your information and documents are well organized and easily reviewable, and don’t make the buyer have to ask for things which should have been provided in the first instance. A chaotic and disjointed due diligence process signals risk to the buyer, which will cause it to either lower the purchase price, or to demand more risk allocation back to you as the seller in the definitive purchase agreement, or both.

Provide consistent deal leadership. Have a clear deal leader and chain of command for leading the negotiations. You must be able to provide the buyer with a single set of negotiation points, and you must be clear in establishing your own internal objectives for the deal. You should put together a deal team that understands and shares your game plan and will consistently and cohesively to achieve it. A buyer that is presented with changing deal points and positions will quickly either lose confidence and patience in your deal team, or look to tactically divide and conquer your deal team.

Have realistic valuation and risk assumptions. Work with your financial advisor, lawyer, and trusted friends with experience in your industry to understand what current standard deal terms are likely to be. As part of your strategy, make sure that your going-in position is supportable and leaves room for reasonable compromise. If you have unrealistic valuation expectations, the buyer will feel the need to either beat down your expectations, or will present you with deal terms that contain significant purchase price adjustment mechanisms (e.g., contingent or back-end payments) which are unlikely to be realized. Neither bodes well for a successful transaction.

Know when, and how, to compromise. Following from the points above on setting objectives and having realistic expectations, you have to know when you may be required to compromise on some of your positions, and how to do so in way that advances your other, more important objectives. If you are too rigid for too long, you can easily jeopardize a deal by simply causing the buyer to think that it will never be able to get to a realistic position. Buyers have the upper hand in today’s market and usually have multiple opportunities at any one point in time. A difficult, “dug-in” seller may just be too difficult to deal with, given other available deal options.

Build trust, cooperation and treat the other side fairly. This one is an intangible but is probably as important as any issue in this article. The human qualities and psychological dynamics of a high-pressured deal should be kept in mind at all times during your sale process. If you can build a sense of trust and shared goals with the buyer’s deal team, many problems that can and will come up during the negotiations can be solved. If you and the buyer don’t trust each other and see the transaction as a zero-sum game, then the negotiating positions taken are often much harder and leave little room for compromise. There well may be times in any deal to draw lines in the sand, but those should be chosen very carefully and strategically. If both sides believe that they are dealing with a fair and reasonable party across the table, many, if not most, deals can get done. In today’s market conditions where every deal is much more prone to failure than in the recent past, this point should not be overlooked.

Disclaimer

These materials have been prepared by Cooley Godward Kronish LLP for informational purposes only and are not legal advice. Transmission of the information is not intended to create, and receipt does not constitute, an attorney-client relationship. Internet subscribers and online readers should not act upon this information without seeking professional counsel. The views expressed in this article are of the authors and not those of Cooley Godward Kronish LLP.

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