Mergers & Acquisitions Process Overview
From the Sell Side
Succession planning is an essential consideration for sellers. In many instances, no one from the next generation is able or willing to take the business mantle and assure the owner or owners of payment commensurate with the value of the enterprise and adequate for their retirement needs. Although the primary next-generation candidates are family members, children often leave and establish their careers. Key unrelated personnel who have demonstrated leadership often do not have the financial wherewithal or financial backing to allow owners to transition comfortably over a long period in and through retirement. Owners should plan for this as they discuss estate planning and retirement goals and objectives with their advisors.
The best-laid plans, as the saying goes, oft go awry. Agreements between and among owners try to anticipate events that may trigger the purchase and sale of the owners’ interests. Sometimes, the agreements are not updated to reflect the current economic reality. Whatever the circumstance, the owners may have a situation in which a sale to a third party is in their mutual best interest instead of a cross-purchase between or among themselves.
Whatever the trigger event or circumstance for the owners, they have created a business that has been at the center of the owners’ and their families’ lives and has become vital to the community and their employees. There is a legacy associated with the business that they want to preserve, and there are employees and customers they want to protect. There are many emotions involved on the sell side.
From the Buy Side
A buyer’s motivation may be strategic growth to acquire a new product line or market. It may be to expand existing business to take advantage of economies of scale. An acquisition may enable a buyer to expand geographically. There may be non-owner key employees the Buyer will want to engage to deepen its bench strength at the Seller’s location and across the Buyer’s enterprise.
Where Do the Interests of Buyers and Sellers Overlap?
Owners have managed their businesses to generate sustainable profit. Buyers want to capture that and repay the purchase investment as rapidly as possible. Aggregating overhead expenses [e.g., accounting, insurance] may create cost savings that enhance the Seller’s earnings. The reduction of owner compensation may also enhance projected seller earnings. Seller earnings, maintained or increased through cost reductions and synergistic growth, are desirable for the Buyer and may serve to increase the purchase price or result in earn-out opportunities.
The legacy of the Seller can be maintained through the reputation and resources of the Buyer. The Seller will become part of a larger, more sustainable enterprise. Client and customer services may be expanded. Key employees may have greater opportunities for advancement, and all employees have the security of knowing the answer to the question, “What happens to me if something happens to the owner?”
How Do the Buyer and Seller Connect?
Sometimes, it’s the old-fashioned way. They talk to each other. It may be at a convention, trade association meeting, or educational presentation where one person will say, “Have you ever considered…(selling/buying)…?” The rest is history.
More often, the owner will want to maintain the privacy of the intention to sell and engage an investment banker who will work with the owner and the owner’s professional advisors to position the Seller to be acquired.
Investment bankers enhance the value of the Seller and smooth the transaction process. Yes, they are compensated as a percentage of the deal, but that means they have every incentive to maximize the return for the owner. The investment banker will confidentially prepare information regarding a potential seller and solicit interest from buyer candidates. Once candidates complete a non-disclosure agreement, specific information regarding the Seller is distributed to the candidates. The investment banker can screen buyer candidates and arrange face-to-face meetings for the mutual exchange of information regarding the business and the respective cultural fit of the Seller and prospective buyers.
After the preliminary financial disclosures and discussions, acceptable candidates are invited to submit letters of intent outlining the terms upon which the Buyer would acquire the Seller. The owner will review the proposed terms and, in consultation with the investment banker and professional advisors, select the buyer candidate that best matches the owner’s deal objectives.
Letters of intent, term sheets, or memorandums of understanding come with various names. Still, whatever it happens to be called in your transaction, it should generally include the following:
- Parties. The Seller and Buyer should be identified, and owners included.
- Binding or Non-Binding sets forth the parties’ understanding of whether the letter of intent will contractually bind the parties to proceed with the intended transaction based on the outline in the letter of intent. In general, because the parties do not yet have a complete understanding or appreciation of each other, non-binding is preferred. Either party may discover something about the other that may make one or the other want to call the whole thing off.
- Deal Structure provides the framework of the transaction: asset purchase, stock or equity purchase, merger, other transaction, and any tax elections associated with a given transaction and perhaps any specific assets or divisions or affiliates to be excluded.
- Purchase Price and Payment sets forth the cash or equity consideration, payment at closing, earn-out payments, and conditions to trigger the deferred payments.
- Employment of Owners
- Employment of Key Personnel
- Restrictive Covenants (non-compete or non-solicitation) and Duration
- Conditions Precedent. These may include buyer financing conditions, requirements for seller subordination to Buyer’s lender(s), and divestiture of excluded assets or affiliated entities.
- Target Close Date and General Conditions to Closing. Typical conditions are approvals from parties’ shareholders or directors undertaking by Seller to cooperate with Buyer’s representatives in conducting a due diligence review of Seller.
- Exclusivity. The Buyer will typically require the Seller to stop shopping for a sale while the Buyer completes its due diligence and works toward closing. This provision prevents the Seller from using the Buyer’s terms to shop for a better deal and usually comes with a break-up fee if the Seller engages in such activity.
- Confidentiality. Although there should be a non-disclosure agreement in place before the Buyer receives any specific information as to the Seller, each of the Buyer and Seller will want to maintain the confidentiality of the transaction until they are each prepared to announce it at the time and manner that will be most advantageous and no one wants to announce a deal that for some reason does not later close.
- Expenses. Generally, the LOI clarifies that each party will be responsible for its transaction fees, costs, and expenses.
- Special Circumstances. Items that relate to the transaction deserve a specific statement as to the parties’ expectation of treatment [e.g., payment of transfer taxes; requirement for extended reporting insurance (tail coverage)].
- Definitive Agreements. Typically, the LOI provides that the Buyer will prepare the purchase agreements.
- Seller’s Conduct Pending Closing. The LOI will require the Seller to conduct its business in the usual and customary manner through the closing. The Seller does not want to make any dramatic changes to its business model if the sale doesn’t close, and the Buyer doesn’t want any changes that could negatively impact the economic model upon which it determined the purchase price and transaction terms.
- Governing Law. The Buyer and Seller may be headquartered in different states, and the LOI will generally provide which law will govern the LOI and the transaction.
Once the terms of the LOI have been agreed upon and the parties execute it, the Buyer will proceed with its due diligence review of the Seller’s business.
Due diligence is intended to prevent the Buyer from acquiring a pig in a poke. Over time, the process and undertaking have become very sophisticated. The advent of digital data sites and artificial intelligence reviews have facilitated the expansion of the lists of documents available for examination by buyer advisors.
Examples of due diligence request lists are published on the internet. References to “bulletproof” due diligence and Excel spreadsheet lists with columns beyond the alphabet give owners heartburn. Some buyers have taken a one-size-fits-all approach to due diligence and assume that the broadest, most all-encompassing request list is the best approach to examining the target seller. Other buyers utilize a more measured approach that aligns the scope of the review to the cost and risks associated with the transaction.
Regardless of the Buyer’s approach to due diligence, the general focus of the documents that will be requested for review deals with the following aspects of the Seller’s business:
- Financial
- Operational
- Legal
- Tax matters
You will see many subsets of these categories. For example, the operational category will include employee benefits and licensing/permitting matters. There will be an overlap with legal regarding vendor, customer, and employment contracts. Financial will overlap with legal regarding loan and lien matters.
Before generating long lists and asking for documents and reports that don’t exist or in a format that the Seller’s system cannot develop, good practice is for the Buyer to have a preliminary discussion with the Seller to:
- Understand the Seller’s system and capacity to generate reports;
- Identify a seller representative who has sufficient knowledge of the Seller’s business to provide the requested information without breaching the confidence that a potential transaction is underway and
- Identify the representatives from the Buyer’s team who will be working with the owner or designated seller representative to respond to requests for information.
The operational, legal, financial, and tax review by the Buyer should be coordinated to avoid siloed, uncoordinated reviews. It is unproductive for the Seller to receive multiple requests for the same document or report, and it is equally unproductive for the Buyer to have different teams of reviewers making the same request.
Some buyers make the mistake of using due diligence review solely to discover issues or liabilities that must be resolved before closing. Without minimizing the importance of that function, well-coordinated operational, financial, and legal due diligence will enhance the post-closing transition of the Seller’s business and employees into the Buyer’s fold.
For example, the owner will want to assure the seller employees that health and welfare benefits will continue and, preferably, continue at levels comparable to the benefit provided by the Seller. Changes by the Buyer may necessitate modification of employment or compensation to avoid employee unrest. In this example, regarding employee benefits, coordinated due diligence would allow the Buyer and Seller to present a comprehensive benefit/employment rollout to seller employees.
It can be daunting, but sellers who plan, organize, and designate a responsible person will work through the due diligence process with minimal disruption to the business.
The Seller will need to conduct due diligence on the Buyer, particularly if part of the purchase consideration is deferred or if part of the purchase consideration consists of equity in the Buyer. In addition to the financial aspect, is the owner comfortable with the cultural fit of the Seller and the Buyer? The owner has to be satisfied with both the objective economics and the subjective feel of the transaction.
Description of What Is Being Acquired
Suppose the transaction is structured as an asset purchase. In that case, there will be a comprehensive description of the purchased assets and typically identification of those assets being expressly excluded (usually non-operating assets, vehicles, or, perhaps, real estate). The agreement will describe the class and number of shares or other equity interest being acquired in a stock transaction. Most commonly, the Buyer will not assume any seller liabilities and will expressly exclude these or require that they be satisfied or otherwise accounted for at closing [e.g., working capital calculations that will either add to or be subtracted from the closing payment].
Purchase Price and Payment Terms
This provision will set forth the cash or securities being paid at closing, any deferred or contingent purchase price, and the conditions for and timing of the deferred payment(s). If the agreement includes an escrow, the amount and timing for distribution from escrow will be included. There will typically be a separate escrow agreement with a third-party custodian if there is an escrow.
Seller’s Representations and Warranties
Notwithstanding the Buyer having conducted due diligence to satisfy itself regarding the Seller’s business, the Seller and owners will be required to attest to and provide schedules of information regarding, at a minimum:
- Organizational structure, ownership, and authority to proceed with the transaction;
- Accuracy of financial statements and tax returns and timely and current filing of all tax returns;
- Current assets may be separately scheduled with Seller attesting as to the condition and the sufficiency of the assets to carry on its business;
- Retirement and welfare benefit plans [ERISA] and absence of liabilities;
- Cyber security and absence of any data breach;
- Absence, or schedule, of any pending or threatened litigation;
- Absence, or identification, of any material changes in the Seller’s business;
- Absence, or identification, of any liens or encumbrances;
- Schedule of the Seller’s employees, compensation, and employment terms or agreements;
- Identification of any broker or finder;
- Schedule of the Seller’s insurance; and
- Catch-all provisions that the Seller has not excluded any material items from its disclosure schedule responses and that all such responses are complete and accurate.
Buyer’s Representations and Warranties
These are generally minimal and related to the authority to proceed with the transaction. If equity is involved, there should be a separate subscription agreement addressing the details of the buyer equity being issued.
Conditions Precedent to Closing
- Regulatory compliance, if any
- Satisfaction of liens or encumbrances
- Absence of any material changes in the business and no new or threatened litigation
Covenants Before Closing
These covenants require the Seller to conduct its business in the ordinary and usual course before closing.
Restrictive Covenants for the Owners and Seller
These prohibit competition with the Buyer and prohibit the solicitation of the Seller and Buyer’s customers and employees.
Indemnification
Indemnification allocates the risk [cost of the risk] between and among the Seller and its owners on the one hand and the Buyer on the other, associated with the business acquired not meeting the Buyer’s expectations based on the Seller’s representations and warranties. Parties endeavor to limit/allocate the risk with:
- Baskets [no seller liability until the basket or threshold indemnified claim amount is reached, and once reached, this basket either acts as a deductible and Seller is responsible for claims over that amount; or once reached, Seller is responsible for claims back to dollar one];
- Caps set the limit on the maximum seller liability [usually with exceptions for tax, litigation, ERISA, or other known or specific liabilities];
- Indication as to when or whether the “materiality” of a claim will apply to determine whether a breach has incurred or whether materiality will be excluded in crediting claims toward the basket;
- Limitation on the time for claims to be made; and
- Offsetting liability by the amount of any insurance covering a given claim.
Negotiating the acquisition agreement may be a good context for the expression: “Don’t let perfect be the enemy of good.”
Seller and Buyer have a mutually agreeable deal summarized in the letter of intent. They are memorializing the deal in the acquisition agreement. As each party progresses through the acquisition document, the thinking shifts from “good deal” to “perfect deal.”
From the Buyer’s side, the perfect may be: “I’m paying you $x for this business, and I expect $x of value with no diminution.” From the Seller’s side, perfect may be: “You have looked at every document, email, text, agreement, financial statements, and tax return that the business has ever generated, so you know the business better than I do, and I should not have any liability because something arises after closing.”
Fortunately, the baskets, caps, and carve-outs for certain liabilities allow each party to return to a middle ground so that each party has no more than an acceptable risk. In many instances where the business has a risk, the risk can be addressed with insurance, which benefits both parties.
For example, in insurance agency/brokerage transactions, it is common for the Seller to obtain extended reporting (tail) insurance to address the risk associated with error and omission claims. Other tail coverage is available for employment practices liability and cyber insurance. If a transaction is large enough, it may support the purchase of representation and warranty insurance.
Ancillary Closing Documents
In addition to the acquisition agreement (typically, the asset purchase agreement or stock purchase agreement), the parties will execute and deliver related documents at closing, and these may include:
- Escrow Agreement. If a custodian is holding part of the purchase consideration, this will identify the amount of escrow, the custodian’s investment authority, the time and manner in which distributions may be made for payment of indemnification claims, and the time for payment to the owners/seller;
- Employment Agreements for the Owners;
- Employment Agreements for Key Employees;
- Bill of Sale (and title transfer documents);
- Assignment of Contracts;
- Assignment of Intellectual Property;
- Lease of Real Property. If real estate is being conveyed, deed and title transfer documents will be provided;
- Seller’s Certificate is an attestation by an authorized officer attesting to the identity of the Seller’s officers and their authority to act on behalf of the Seller and attesting to the accuracy of the representations and warranties at the time of closing;
- Third-Party Payoff Letters and payment instructions (as may be necessary to satisfy any bank or lender);
- In a stock sale, resignations of the Seller’s officers and directors;
- Subscription Agreement. If buyer equity is being issued as part of the purchase consideration, the subscription agreement reflects the terms by which the equity is being issued and should include the operating agreement or other buyer documents that govern the rights, benefits, features, and restrictions applicable to the equity being issued; and
- Other closing deliverables may include evidence of the Seller’s extended reporting (tail) insurance coverage.
Post-Closing Considerations
Reducing the risk associated with a decline in business value will always be important to the Buyer from an economic perspective and the Seller from a reputational and legacy standpoint, and when there is a conditional deferred payment of a portion of the purchase price (an earn-out payment).
Sellers and buyers may utilize the following to protect the business after the closing:
- Employment Agreements. The Buyer will typically require employment agreements with key employees and the owners as a condition to close, and when an earn-out is involved, the owners will want to ensure their continued employment to achieve the payout targets;
- Retention Bonus Arrangements. Sellers may want to carve out a portion of the deferred purchase price as an incentive for employees to remain with the Buyer during the earn-out period;
- Pre-Closing Communications. The pre-closing communication of the transaction to the Seller’s employees is critical. The owner will want to keep the transaction confidential until there is certainty that the closing will occur. Making the announcement too early without details creates an atmosphere of anxiety. Waiting too long puts pressure on employees being asked to sign new employment agreements with the Buyer. Announcing to the Seller’s employees without a comprehensive analysis and comparison of the compensation and benefits available from the Buyer will create an adverse reaction among the Seller’s employees. A well-planned and coordinated presentation to Seller’s employees with time for questions and answers with both Buyer and Seller goes a long way toward employee satisfaction and retention and
- Before the closing, ensure that the appropriate Seller and buyer personnel understand their roles and responsibilities to maintain the continuity of the business operations. Once the deal is announced to the Seller’s employees, communications between the buyer representatives and their seller counterparts will reduce uncertainty and smooth the transition.