SUCCESSFULLY SELLING YOUR COMPANY

It Takes More Than a Great Price to Make a Good Deal

There is an old saying that a person who uses himself for his attorney has a fool for counsel. Likewise, a selling owner who uses himself as his financial advisor in negotiating an acquisition has a fool for an acquisition consultant/investment banker. There is no way that a typical selling owner/entrepreneur could have an accurate knowledge of their company's value or a remote grasp of how the representations, warranties and indemnifications must be creatively structured to minimize their risk.

There is an incredible consolidation taking place in many industries. Many deals are happening fast and apparently painlessly for selling owners. Unfortunately, this is usually a sure sign that a company is being sold at a discount price with the seller often having significant post-closing exposure in non-financial areas.

My Firm represented a heating and air conditioning equipment distributor on the Pacific Coast. An aggressive but realistic price of $11 million was established for the seller. A major strategic acquirer in this industry made an offer of $9.5 million. As I discussed their offer and justified the validity of our price, I stated they could make a very attractive return on investment at my transaction price. The acquirer's CFO stated that they could buy many companies at a much lesser price. He further stated they had consummated 8 deals during the past year and that none had been consummated at my multiple of earnings level. When I inquired as to how these sellers were advised, the CFO said that 5 were not advised by a financial advisor and 3 had used their local CPA firm in that capacity. Subsequently, this distributor was sold at its target price of $11 million in an all-cash deal. The point is that sellers who are not properly advised almost always sell at a vastly discounted price. Furthermore, a selling owner must be patient to get the price they deserve.

When a middle market company (transaction price up to $100 million) is bought by an acquirer, a smaller company is typically being sold to a much larger acquirer. The acquirer usually has done numerous deals and knows how to structure deals that work to the acquirer's utmost advantage. A selling owner should realize that in any transaction where one party is much larger and more familiar with a process than the other, it is usually that party who obtains the better deal. This is never more true than in acquisitions. This unfortunate situation has become the "norm" in the industry. "Norm" terms put selling owners in extreme jeopardy after the deal is done. In a worst case scenario, if the representations, warranties and indemnifications are not properly structured and limited in scope and duration; the impact on a seller can be catastrophic. The seller can lose an amount up to or exceeding the total deal price due to post-closing events that the seller knew nothing about when the deal was closed. In middle market acquisitions, that is the "norm"; it is what an acquirer is used to getting. It is up to your financial advisor to stop them. Furthermore, regardless of the amount the acquirer collects from the seller under the indemnification provisions, the selling owner's covenant not to compete will still be in effect. Correspondingly, a selling owner could lose up to or in excess of their total deal proceeds due to the post-closing discovery of unknown liabilities and they would be unable to work in their industry to earn a living due to the restrictions in their covenant not to compete.

The following are some of the issues that can trigger a seller's post-closing exposure.

Unknown liabilities - These include product liability, contract and employee claims. Included in this area are many issues that have occurred, or will occur, that an innocent seller acting in good faith will not have any knowledge of at closing. In spite of this, if the "norm" reps, warranties and indemnifications are agreed to, the seller could have post-closing exposure up to or exceeding the deal price. If the seller is not able to shift the liability for these issues to an acquirer or significantly limit his/her exposure, they retain full responsibility for these issues potentially for many years after the acquisition is completed. The seller is not only responsible to the claimant but also to the acquirer as an indemnified party. In many situations, latent employee dissatisfaction can be triggered by an acquirer's conduct after a closing. Although the events creating the claim might have occurred before the closing, they would not have become an issue except for the acquirer's actions. Consequently, a liability that did not exist at the time of closing becomes a post-closing liability for the seller. Similar types of issues exist in the product liability area. Often, claims due to damage caused by equipment sold years before the acquisition do not arise until after a sale. The seller's exposure for these claims depends on the negotiated reps, warranties and indemnifications, along with other protections that the seller should put in place. The only liabilities which the seller should be responsible for are those of which they are aware. The financial implications in this area are enormous to a selling owner.

Environmental claims - Environmental problems found on a seller's property might have been caused by others, whether a previous occupant or by disposal or drainage from another company. If the acquirer receives a clean report from either a Phase I or a more detailed Phase II environmental audit, the seller should use this as justification to restrict any post-closing liability that they have to an acquirer. A satisfactory environmental audit should be all the security that an acquirer needs to adequately assure themselves that the property(s) are clean.

Accounts receivable - Often an acquirer feels that the collection of prior receivables should be the responsibility either directly or indirectly of the seller. This is pure hogwash. A sophisticated acquirer can determine their exposure for bad accounts receivable during the due diligence process before closing. If they have any significant collection exposure, it should be negotiated as a deal price reduction before closing. In no case should a sophisticated seller accept any liability for the acquirer's subsequent collection of receivables. This removes any pressure from acquirers to use reasonable efforts to collect receivables.

Inventory - Acquirers often expect the seller to be directly or indirectly responsible for inventory that is not sold within a normal period. During the due diligence process, the acquirer should evaluate the seller's inventory, inventory controls and levels. If there is an excessive amount of damaged, slow-moving or obsolete merchandise, this should be addressed prior to the closing in the form of a reduced transaction price. Once a deal is closed, the inventory should be solely the acquirer's responsibility. To do otherwise is to give the acquirer a blank check. Many acquirers will gladly take advantage of this loophole.

As a seller evaluates the importance of the representation, warranty and indemnification issues, they should remember that negative developments from poorly-structured deals can place them in jeopardy for an amount in excess of the transaction price. Any money that can be claimed against the seller will reduce the transaction price for the company and increase the acquirer's return on investment. If that sounds cynical, you are not familiar with the reality of corporate acquisitions. Make sure that you are advised by a knowledgeable professional capable of forcefully negotiating with a larger acquirer to structure a deal that eliminates or severely limits your exposure to post-closing liability.

For more information, contact George Spilka as shown above.