In the current environment of turbulent operating results for so many sellers, one of the things that the M&A world is seeing at an elevated level today is complex and sensitive post-sale contingencies, which may offer longer connections after the deal is closed, between buyer and seller. This has always been an area of interest and concern for sellers with any contingent “back end” relationship with the buyer – but today it takes a step up in importance, due to the increased commonality of longer term connections, in the average transaction.
The following is an outline of some of the common issues to be explored and tightly structured between buyer and seller before today’s deal completion.
One of the areas commonly discussed between buyer and seller is the intent of the buyer for holding the company into the future. Sellers commonly prefer to know that the buyer they will enter into a deal with is not doing the transaction purely for the potential benefit of “flipping” the company – with sale to a new buyer, at a higher price, in the near future. Almost every buyer will assert at the outset that this is not their intent, and yet they prefer to maintain flexibility, just in case an exciting opportunity of this nature comes along. We have done many transactions where our sellers felt that this was an important issue, and where they worried about this possibility, because they felt that it COULD be the plan of the buyer – because either a) the buyer might be willing to talk to long time adversaries, which the seller would not consider, or b) there was potential for movement in their industry for much higher values in the future. We have found that in these cases it may well be acceptable to the buyer to insert a “claw-back” provision, which says if the entity is re-sold during the next few years, for an increased price, the buyer agrees to share a portion of such “win” with the exiting seller. Normally when this is done, the time period forward is not terribly lengthy (it may be just 1-3 years post sale), and often any resulting residual benefit to the seller will decline in future years, fairly rapidly. None-the-less, it can be an important and potentially a very valuable protection to the selling shareholders.
The most common, and probably the simplest item requiring protection post sale involves security the seller may be able to obtain with respect to any notes receivable taken as part of the selling proceeds. There are any number of security mechanisms to better protect such notes, but one of the simplest (and most effective) may be a guarantee by an able third party. This may be as simple as a personal guarantee from an individual buyer (and his wife, if you want to clearly enforce it), or a guarantee by an able and strong parent company for the corporate buyer.
Some years ago we sold a painting contractor to two individuals, and we accepted a note for a significant portion of the consideration. The buyers themselves were not wealthy, so their personal guarantees would not have been terribly meaningful by themselves. However, because the notes were an important part of the aggregate consideration, we would not accept just the personal guarantees of the parties, alone. We could have and would have turned to alternative buyers, without further support for the guarantees. One of the individuals involved had a wealthy and successful father, who was willing to guarantee the note.
A few years later the son of the guarantor wished to leave and re-sell his ownership interest to move on to other endeavors, but we would not release the father from his guarantee, unless he either repaid the obligation in full, or secured asset pledges adequate to protect our seller’s note. We ended with the obligation paid in full, but would never have achieved that without the required outside party’s guarantee.
There are any number of other protections the seller may seek to protect a note. There are protections which allow for acceleration of the note in the event of certain events – like taking on of new outside debt, or if new acquisitions are to be made, or if a seller employee is terminated before the payments are complete. Penalties often may be built into the debt if payments are late or if professional fees must be incurred by the seller to collect. Sellers may require that they have a Board position until the note is repaid, or that at least they have the right to ongoing, timely financial information from the buyer. We have even seen transactions where default on any principal repayment voided the seller’s non-compete, so the seller could, if desired, re-initiate business with old customers in a new company, if he felt that he could recapture greater proceeds through that mechanism.
There are a wide array of creative and effective mechanisms to protect back end note proceeds, and it pays to consider such alternatives extensively. No note is ever as good as cash at close. If the seller MUST accept a note, they are well advised to secure it with every possible means.
A fair number of transactions today, especially in the smaller, closely held business venues, will encounter proposals for a portion of the proceeds to be paid on an
“earn-out” basis, if certain operating targets are met during the years after sale. This can be a decent way to maintain some potential “upside” to the transaction, but it requires some fairly cautious negotiation, to protect the seller. Earn-out formula benefits typically work much better, and have far less chance for later misunderstanding or litigation, if those formulas tie to a targeted sales number, or even a targeted gross margin. Buyers tend to prefer to tie any such proceeds to their net income, to reduce risk. If an earn-out is to be tied to net income, however, it becomes critically important to carefully define what is to be included in net income for purposes of such earn-out calculation. Often net income for purposes of an earn-out calculation will exclude such items as:
• Management or director fees taken by equity firms or other new ownership parties
• Depreciation expense on major new capital enhancements added post-sale
• Income or losses on corporate acquisitions added post-close
• Income or expense due to changes in accounting policies
• Income or losses on non-arms' length transactions with new corporate affiliates
These and any other items likely to potentially “distort” financial measurement of performance should be clearly and carefully articulated in defining the measurement criteria.
It also is often advisable to stipulate the dispute handling mechanism in the event that the parties disagree at a future date re: how the tally is to be made. Commonly a buyer’s CPA will have to produce an analysis of the calculation, the seller’s CPA should have the right to review all records to see that they agree, and, if they do not, both parties should be required to agree on a third party to be chosen to re-tally the earn-out amount due.
Non-compete disputes can be another area where post-sale dispute mechanisms may benefit for peaceable resolutions of any disagreements. Depending on the seller’s future intentions, it may well be worthwhile to build into the agreement some means to peaceful solution. We have seen agreements where the buyer had a right to participate with the seller in new ventures, which were close to the selling company’s business. We have seen agreements where sellers agreed that if they were to “take” business from an old customer to a new venture, they agreed to pay a set amount for such business, based on sales or margins from prior years’ activities. If the seller intends to retire and play golf for the foreseeable future, this may not be an issue worth consideration. However, if new ventures are likely in the future of the exiting seller, it is worth the time to plan to avoid problems.
The last major element we commonly see as a “back-end” issue relates to retained royalties or license fees, if the seller holds future rights to income from such items. Normally if we design a post-close royalty or license fee, we will require some set minimum payment under such agreement, in order to keep it active. That way if the buyer simply ignores the potential development of future sales in the stipulated arena, the seller at least retains the right to seek other avenues to nurture such sales. We have also designed agreements where they buyer specifically agreed to $X promotional expense, to support the sales of such product. Additionally, we have had provisions where agreement was in place for a reduced “sub-license” fee for any later resulting off-shoots of the original product licensed. A strong intermediary, or a savvy intellectual property attorney can give you good support on how to protect the back-end for these types of arrangements.
Today’s buy/sell agreements become even more complicated than in the past, due to more frequent long term connections and post-closing matters between buyer and seller. It is worth the time in advance of the deal to carefully explore and detail acceptable mechanisms to avoid future litigation or problems. Both buyer and seller will end up much happier with a net peaceful result, with minimum cost and infrequent surprises in their futures.
Deborah Douglas, Managing Director and Author
DouglasGroup.net
'Ripe: Harvesting The Value of Your Business'
‘Cashing In! Selling Your Company for Maximum Price'
Subscribe to:
Post Comments (Atom)
Posts
No comments:
Post a Comment