If you are thinking about selling your company you may think that agreeing on the basic terms with the purchaser (especially the price) is the hard part. You may think that once you have a term sheet you can hand it over to the lawyers for implementation. After all, it’s been done a million times, so there should be clear and tested standards which ensure that the transaction is implemented smoothly, efficiently and at reasonable cost.
Unfortunately, this is only the theory. Reality often looks different. Negotiations over the (share) sale and purchase agreement (“SPA”) and ancillary documentation often take forever, with mark-up over mark-up of drafts being exchanged between lawyers and one conference call following the other (Zoom is still working on its penetration of legal circles :-)). The corresponding costs (primarily legal) quickly spiral out of control. And when you finally get to the signing, the agony isn’t over yet. The SPA will likely have lots of openings which allow, and de facto incentivize, the purchaser to start digging and find something that allows him or her to reduce the purchase price or demand damages. As long as what he or she finds is higher than his/her “discovery” costs it might be worth it from his/her perspective. Taking a step back, however, the whole exercise may still be futile if one factors in the fees and opportunity cost incurred by both sides from negotiation until final determination of any payment amount.
Why are contracts still done this way? As often in life, there are many possible explanations (from the aim of the purchaser to get the “best deal” to a general risk averseness and the desire to “cover all angles”), but we find that one explanation sticks out: unhelpful precedent. With this we mean that the advanced principles and concepts used to implement the sale of a company have generally been developed in multi-billion euro/dollar transactions — where they often make sense. Where a purchaser spends $10 billion for, e.g., a large automotive supplier, it makes a significant difference if the business at the time of handover has working capital of $500 million or $470 million. Add a few more of these figures and you get to a “moving target” of a hundred million $ and more. Naturally, this is a volume that is worthwhile negotiating over (and adjusting for after closing). The fees for the (best) lawyers/accountants will be small in comparison, and also opportunity costs (primarily from diverted management attention) may be manageable.
BUT: The average sale of a start-up that we want to talk about here is not a multi-billion dollar transaction (exceptions confirm the rule :-)), but has a price tag of, say, anywhere between $5 and $50 million (there are lots of smaller deals and quite a few bigger ones as well of course, but the small ones are generally fire sales or acquihires and follow special rules, and the number of bigger ones, even if significant, still pales compared to the $5–50 million bracket). When the headline price for a business is, say, $30 million, the “moving value target” that, fraud aside, can realistically be fought over before and after closing will hardly exceed a few hundred thousand dollars. Still, the executives on the purchaser side and (most) lawyers advising on the deal often feel they need to work with the “cutting edge” concepts and legal templates developed for the big deals. For lawyers (and accountants who help with the closing accounts and the purchase price adjustments — see below for details) this entails the welcome benefit of higher fees, and for the executives of the purchaser in particular the (often deceiving) feeling of having covered all angles.
In this blog post, we want to make the case — for the typical mid-size transaction — for the “slim and simple SPA”. It’s not only the founders (and other sellers) who benefit from this approach, but in most cases also the purchaser. This is because there are alternative mechanisms available that, while much simpler and easier to handle, give the purchaser nearly as much certainty and financial safety if things go awry as the elaborate, but expensive and time-consuming concepts developed for the big deals. We’ll discuss the two (from our perspective) most common (and painful) mechanisms under 2) and 3) below, but want to start with a quick word on a further set of typical SPA provisions that can make all the difference between a smooth sale and a bumpy ride — representations and warranties. Since much of this is a bit technical we’ve added some brief takeaways for founders considering a sale of their company at the end of this post — feel free to jump straight there if short of time!
1) Representations and warranties
Representations and warranties (often also referred to as “guarantees”) given by the seller(s) are the single most important protection of the purchaser. No purchaser will sign an SPA, even on a small deal, where he/she isn’t given guarantees that the sellers actually hold their shares and are entitled to sell them (assuming the transaction is structured as a share deal as in the majority of cases), that the company holds or licenses the intellectual property (“IP”) it needs for its business, is not subject to legal disputes (except those disclosed), has the licenses it needs to operate, etc. Normally, there is no way around scrutinizing and ultimately agreeing on a comprehensive set of guarantees, but there are a few simple rules which help sellers to keep their risk, including the risk of later disputes and litigation, manageable:
- Make sure you only give guarantees you feel comfortable with. It’s worth spending time with the catalog of guarantees that the purchaser will likely put in front of you and mark it up diligently. Where you are not certain, qualifications like “the sellers/founders are not aware that…” or “to the sellers’/founders’ best knowledge there are no…” may be a better compromise than striking a clause outright. Your lawyer will be able to give detailed advice on what is acceptable/standard and what is not.
- Push hard for a cap (limit) of your potential liability. In a best case, the cap will be set at 10–20% of the purchase price, but up to 50% may also still be acceptable for founders/director-shareholders, with some fundamental representations (e.g. on IP) potentially exempted or subject to a higher cap. Also, try to make the liability “several” rather than joint, which means the purchaser will have to demand damages from all sellers proportionately rather than having the option to chase one seller for the entire damage. If the purchaser objects, an escrow account (or the reasonable increase of an already agreed escrow) may be a suitable compromise. Under no circumstances should sellers accept a liability that exceeds the aggregate purchase price for all sellers and the portion of the purchase price received by the respective seller.
- Make sure you have adequate “de minimis” and “basket” clauses in place. De minimis requires each damage to exceed a certain materiality threshold (say, $10k), so that the purchaser does not waste everybody’s time for only marginal benefit. The basket (also called “threshold”) shall ensure that the purchaser only (really) starts digging if damages (which each exceed the de minimis, otherwise they don’t count) are expected to exceed a certain threshold (say, $100k). If possible, the basket allows the purchaser to demand only those damages that exceed the threshold (“excess amount”). The alternative is the compensation for ALL damages if the damages exceed the threshold (“first dollar”).
2) Purchase price adjustment vs. locked box
In a significant number of mid-size company sales the purchaser successfully pushes for a purchase price adjustment mechanism. The idea behind this is that the purchaser usually bases his/her offer price on certain assumptions on assets available in the acquired business. He/she may say: “we offer $30 million on a cash and debt free basis and assuming adequate net working capital in line with historic levels”. Then the purchaser requests the most recent financials and sees that there is net debt of, say, $1 million and that net working capital is lower by $100k than it has historically been, following which it is agreed to lower the headline purchase price that is inserted in the SPA to $28.9 million. So far so easy.
Thereafter things get complicated. The purchaser now demands an elaborate purchase price adjustment mechanism based on which any higher/lower debt and net working capital in the business at closing (i.e. when the shares are transferred and the initial purchase price is paid) are adjusted for relative to the starting position (= $1 million debt, $100k working capital shortfall). The SPA will therefore contain elaborate definitions of cash/debt and working capital as well as a mechanism on how to determine these numbers at the time of closing, which may well include a full audit and a dispute settlement mechanism if the parties cannot agree. The parties will then go through the motions of determining the correct closing accounts with the help of their lawyers, accountants and auditors. In the end, possibly after months of back and forth, the resulting adjustment may be, say, $100k to be repaid by the seller(s) — or, also a possibility, to be paid by the purchaser in addition to the purchase price already paid. This may seem fair at first sight, but becomes quickly unreasonable if one considers that the costs associated with determining this number may easily amount to $80k and more, and that highly skilled founders/executives will likely have spent many hours and days with the matter instead of growing the business or creating something new.
Here is the alternative: The company is sold as a “locked box”, i.e. without a purchase price adjustment mechanism. Especially the purchaser may object and, supported by his/her lawyers, push for the “traditional way” to account for the fact that at signing he/she does not (yet) know what exactly he/she is getting. But: the buyer’s legitimate interest can also be taken into account in a much simpler, cheaper and less time-consuming way. If the sellers guarantee the most recent balance sheet (which should not be older than about 4–6 weeks*) and that until closing they have and will not take money out of the business (often referred to as “leakage”) and not do anything else outside the ordinary course, the purchaser will basically have what he/she wants: the certainty that the last balance sheet will not have changed materially when the business is handed over and which in any event will have changed only to a degree which the purchaser should be able to assess and the risk of which he/she is willing to take on in principle. If after closing, during the regular integration of the business, the purchaser discovers that the most recent balance sheet was wrong or that things happened after its date outside the ordinary course, he/she can request compensation from the sellers — maybe not every dollar that would have been payable in case of a purchase price adjustment, but at the same time the buyer will also not have incurred the risk of having to pay a higher price and all parties will have saved substantial cost and effort in connection with setting up and agreeing on closing accounts.
3) Taxes and similar charges
In almost all transactions, taxes (in a wider sense) are another highly sensitive topic for the buyer because of the great variety of charges which may be applicable (think VAT, income, payroll, land, stamp, customs, social security, to name just a few) and the significant potential risks (e.g. imagine it is later established that most freelancers of the company are in fact to be considered employees and hence payroll tax becomes payable for many years back). The seller(s) will therefore in many cases have to accept a separate indemnity for historic tax risks, which is not subject to the limitations that apply to guarantees or that has its own limitations (e.g. a much higher cap and longer expiry periods).
The indemnity itself is quite standard and generally not a problem when it comes to avoiding post-closing costs and friction, with one exception: While taxes for periods ending before the closing date are easy to establish (one day the tax authority sends a tax return for the relevant period), things are more complicated for the tax period during which the transaction closes (the so-called “straddle period”). How allocate taxes payable for the year 2018 if the transaction closed on 31 May 2018?
One solution, which indeed quite a few purchasers demand, is the preparation of interim accounts ending on the closing date to precisely allocate in particular those taxes that are based on income, revenues, payroll and the like. Sounds familiar? Correct, we’d be back at the challenges around price adjustments. But also here there is an adequate alternative: If the purchaser gets a comprehensive set of guarantees on taxes as of the signing date, possibly with additional covenants obliging the sellers to handle taxes according to applicable law until closing, he/she will normally have the certainty that everything is in order also in the straddle year, and if it’s not, can demand damages. The difference to the interim accounts automatism is that the purchaser will only start looking into a tax matter if a problem arises, and will then focus on this matter only.
When considering a sale…
Founders/sellers should not be intimidated by the legal requirements, but approach them head on to keep the SPA as simple and straightforward as possible. Here a few simple rules:
- Carefully select your lawyer and get him involved already at the term sheet stage. There is hardly a legal area (criminal law aside maybe) where a good lawyer makes as much of a difference as in M&A.
- Pay attention to the legal fine print already at the term sheet stage. Words like “debt and cash free basis” may mean that the purchaser has a purchase price adjustment in mind. If in doubt, clarify that it’s locked box and that you will provide sufficiently recent financials.
- Make sure that your lawyer prepares the first draft of the SPA and discuss the critical clauses (including guarantees, limitations, covenants, tax indemnity) with him/her in detail.
- When negotiating the terms of the sale, keep the costs (including opportunity costs) of notorious clauses in mind. It may be better to accept a slightly lower purchase price than fight through an extensive purchase price adjustment later on.
Obviously, this post only covers a small portion of issues arising in connection with (share deal) SPAs and can hardly do justice to the huge number of different situations, interests and legal requirements which may play a role. We still hope that it provides some useful guidelines when approaching SPAs in the mid-cap segment. As always, we are curious to hear about your experiences!
*Caveat: this assumes that there are no conditions to closing which take a long time to fulfill, e.g. antitrust clearance. If there are, avoiding a purchase price adjustment may be difficult, but even then there are ways to “ease the pain”, e.g. by agreeing on acceptable ranges rather than a dollar-for-dollar adjustment of every moving target.
Illustration from unDraw