Due Diligence: A Smart Spin in Risk Allocation, Part 2.5 of 3

I finished the 1990 Bob Cook Memorial Mount Evans Hill Climb on the wheel of that year’s winner, Olympic road cycling gold medalist Alexi Grewal. The “hill” climbs 7000 feet in altitude in only 27 miles from Idaho Springs to 14,130 feet near the summit of Mount Evans, the mountain that dominates the Denver skyline. I was thinking about my accomplishment, and its relation to risk allocation in the buying and selling of businesses, as I watched the finish of the USA Pro Cycling Challenge, the first professional road stage race in Colorado since the Coors Classic ended in 1988.
 

Professional stage racing returns to Colorado with the USA Pro Cycling Challenge.

I’ll get to your puzzled look in a minute. In the last two posts, I’ve said risk allocation is as important as valuation, and introduced the role played by warranties and representations in business sale risk transaction. I planned those as the first two of a three-post series that would culminate with indemnification as the ultimate risk allocation device, but on the finishing straightaway of Sunday’s stage, I realized a flaw in my logic.

The best possible risk allocation comes from verifying facts so that enforcement of the contract is never necessary. “Trust, but verify” as President Reagan advised. In mergers and acquisitions, due diligence is an overused and misunderstood idea. Some folks say they have to “do” diligence, as if it was an item in an M&A checklist, instead of an integral part of the process.  (It's also a song, but that's another story.)

A break-away that did not last.

Diligence, when done properly, is the job of both buyer and seller. Diligence should challenge the assumptions of a business transaction, from strategic goals and organizational fit, to facts about financial performance and the existence, or nonexistence, of liabilities. A seller conducts diligence on itself in order to cure (when possible) or explain (when not) matters that might otherwise get the seller sued. When post-closing performance by a buyer is a critical (for example, when a big chunk of the purchase price is paid in a note or in buyer stock), then the seller also has check out the buyer.

The buyer’s examination of the seller, what people think when they hear “due diligence,” begins with a lengthy list of requested information as the buyer starts checking facts and checking under rocks. What it finds matters. It is much easier, and certainly less expensive, for a buyer to renegotiate a deal, or even walk away, than it is to enforce the buyer’s risk allocation rights after closing.

You, like Levi Leipheimer, will play it smart for the ultimate win.

So, where does my Mount Evans story fit in? It’s true that I crossed that finish line right behind Grewal; however, if in good due diligence fashion you checked my registration, you would see that my racing classification started the race 30 minutes before him. The seller who reports a certain level of profits, but doesn’t tell the buyer that the business pays substantially below-market rent under a lease that ends with the sale, is guilty of more than glory-days boasting. The buyer who uncovers that fact before paying an artificially high purchase price can smartly avoid risk by restructuring or passing on that deal instead of suing the seller afterward.

Warranties & Reps in Risk Allocation in Business Sales, Part 2 of 3

My last post cautioned against fixating on purchase price to the detriment of risk allocation in the sale of a company. I believe sellers should leave closing without a nagging concern about keeping the purchase price just paid to them. This second part of my series on risk allocation in M&A is about warranties and representations, often referred to as “warranties and reps” or even just “reps.”

The difference, if any, between warranting and representing in a business sale is technical, and a matter of some dispute among legal experts. Since you live in the real world, I won’t bother with the details, but will encourage you, instead, to focus on responding to both warranties and reps and on limiting the buyer’s remedies for their breach, the subject of the last post of this series.
 

Warranties and reps may seem the Badlands of a sale contract


No law requires a seller to make any representation or warranty when selling a company; it’s purely a matter of negotiations. Custom and relative bargaining power drive those negotiations. While a deal can be “as is,” without any warranty or rep, typically the seller will at least say he or she owns what is being sold.

An ownership rep in a stock deal might look something like this:

Seller owns all of the Shares, free and clear of any restrictions on transfer (other than any restrictions under the Securities Act and state securities laws), Taxes, Security Interests, options, warrants, purchase rights, contracts, commitments, equities, claims, and demands.

In a deal with insiders, an owner selling stock to a key employee for instance, the reps might not go much beyond ownership. The buyer knows the company well, and has low bargaining power relative to the seller, who is likely taking some risk selling to someone who is probably paying over time.

Contrast that to a cash buyer who is unfamiliar with the business. That buyer will demand extensive reps about the past, present, and even future of the company. Pages and pages of reps will constitute the bulk of the transaction agreement. Purchase price is a good predictor of reps—a premium price typically bears more extensive reps than a bargain basement deal. In addition, because stock deals are riskier to buyers, those contracts have tougher reps than asset deals.

Unknown or unquantifiable risks dictate the M&A risk allocation dance. Known liabilities or fixed obligations are handled in pre-closing negotiations, which leads to Disclose-Disclose-Disclose as a selling lawyer’s mantra. “Disclosure Schedules” attached to the contract are where sellers identify known or anticipated problems that buyers have to live with. Of course, a buyer can respond by demanding a purchase price reduction, but since the deal hasn’t been signed, the seller has options, including walking away. Knowing this, a buyer who has likely spent some serious bucks just getting the deal to this point tends to be more reasonable BEFORE closing.

The post-closing shocker, the discovery of a substantial and previously unknown liability, is a different matter. The take-it-or-leave-it option is gone; deals are hardly ever undone. The buyer has no reason to be reasonable, and likely has the stronger negotiating position, including control of unpaid purchase price through a promissory note, holdback or escrow.

Another classic rep puts the challenge of the unknown in perspective:

The Company has complied with all applicable laws (including rules, regulations, codes, plans, injunctions, judgments, orders, decrees, rulings, and charges thereunder) of federal, state, local, and foreign governments, and no action, suit, proceeding, hearing, investigation, charge, complaint, claim, demand, or notice has been filed or commenced against it alleging any failure so to comply.

“How can anybody say that?” is often a seller’s initial response, followed closely by something like “I don’t know of any laws, or at least any important laws, that we’ve violated.” Known problems can be handled by the Disclosure Schedules, but should the seller be responsible for the unknown? A seller with (a) great confidence in the business, or (b) a belief that what happens on his or her watch is his or her problem, might accept this rep.

Other sellers, however, might argue that unknown legal violations, or at least unknown and immaterial violations, are part of the risk of being in business. Those sellers will take the position that unlikely risks should go with the business. Those sellers may want the rep limited to known, but undisclosed problems, by inserting a phrase like “to the best of Seller’s knowledge.” Knowledge qualifiers are part of the game, but they should be more precise than that. What does a seller have to do to meet the “best” standard, and if the seller is a company, not a person, what does a company “know?”


Fuzzy language has no role in M&A. (Thanks to daughter Olivia for her photo)



Limiting the rep to material violations is another option. “Materiality” qualifiers are also part of the process, but they beg the question, what’s material?, and often get undone in “basket” clause of the indemnification section.

As you can tell, a seller needs to put substantial thought into negotiating reps and warranties, and creating Disclosure Schedules, however, you can’t stop there. The indemnification section prescribing a buyer’s remedies is most critical part of the risk shifting mechanism in an M&A contract, and it will be the subject of the final post in this series.

Keeping Your Hard-Won Purchase Price. Risk Allocation in Business Sales, Part 1 of 3

Purchase price is everything in business sale transactions. From the initial inquiries of a possible buyer to the heated battle over EBITDA in a letter of intent, purchase price is the primary, if not only, focus of many sellers of human-owned business. Investment bankers or business brokers who facilitate the sales process do little to dampen the price fixation; after all, they get paid a percentage of the deal. So, I get to be Mr. Downer and ask: “What about indemnification?”


Purchase Price is Great, If You Get to Keep it.



Most first-time sellers of a business are shocked to learn that fabulous purchase price they just negotiated is at risk for years, if not forever. Even worse, they could potentially lose it all and more. Yes, you can sell a business for $10 million and end up paying the buyer $15 million in damages. But it doesn’t have to be like that; the risks of the business can and should be clearly allocated by the sales contract.

Risk allocation occurs in all kinds of business contracts. Earlier this summer, I covered one aspect of risk allocation—indemnification against one’s own negligence (I screw-up, you pay) --in the context of a lease provision that was upheld by the Colorado Supreme Court. In this mini-series, I discuss a much broader, and inevitable, question: what liability does the person who sold a business have to the person who bought the business?

Unfortunately for anyone who has ever read a fifty-page, single-spaced, purchase agreement typical of many middle-market business deals, the answer comes around page 40 (just before you get to the really good miscellaneous stuff, like a Construction section’s “Including means including but not limited to” and “words of the masculine or neuter gender shall include the masculine, neuter and/or feminine gender”). The seller usually stalls somewhere between pages 2 and 8, where the purchase price and terms of payment are described, and quits for good in the high 20’s/low 30’s; a two page representation and warranty on ERISA compliance often does them in.

My most valuable advice to sellers: after you read how you get the purchase price, flip immediately to the indemnification section where you learn when you have to give back the purchase price. Even if you never read the next two installments of this mini-series you will be ahead of most sellers. Leave the middle 30 or 40 pages of warranties and representations to your lawyer to walk you (and your leadership team) through in the process of preparing “disclosure schedules,” which I’ll cover in Part 2 before explaining in Part 3 why a carefully drafted indemnification section is a seller’s best friend.