The Dynamic Duo: Your Banker & Legal Counsel
Entrepreneurs need to focus on the banker and counsel relationship to ensure that they are working in sync to anticipate, plan and execute for the inevitable changes that occur throughout the negotiating and drafting process.
When the time comes to sell your company, most entrepreneurs begin by formulating detailed processes and plans to hire the right banker who will hopefully extract the highest value for their company. Given the banker’s role in effectively articulating the company’s story as well as negotiating the letter of intent with potential buyers, this makes plenty of sense.
Unfortunately, not enough entrepreneurs spend time finding the right M&A counsel who will guide them through the equally arduous process of taking an executed letter of intent to the closing. My experience in private practice as well as in my own company has shown that most business people see M&A counsel as a commodity, someone who simply manages the mechanical process of contract drafting.
If selling your company were like selling a car, they might be right. However, the true value of any deal is not just in the basic purchase price but in the more nuanced areas like tax, escrow holdbacks, and indemnification, which are inherent in almost every deal. Entrepreneurs may be surprised years down the line to see much of their anticipated payout taken from them if these items are negotiated or drafted poorly.
However, choosing technically sound counsel is not enough. Entrepreneurs need to focus on the banker and counsel relationship to ensure that they are working in sync to anticipate, plan and execute for the inevitable changes that occur throughout the negotiating and drafting process. These changes often have a profound impact on overall deal value. Below are some of the most critical issues that require alignment between the banker and counsel and how these issues can impact transaction value:
Deal Structure & Taxation
M&A counsel is similar to the quarterback of a larger team of legal specialists, including tax. Counsel and the bankers have to be in lock step about the legal structure of any potential deal and how the corresponding tax implications may impact other deal terms and overall transaction value.
For example, let’s say the seller agrees to a deal where they receive cash and stock. Has the deal been structured to qualify as a tax free re-organization? If not, the sellers may owe tax on the value of any stock received in a deal even if that stock is not liquid. This negative tax implication may wipe out any cash received resulting in a deal where the seller’s proceeds are now heavily weighted in the buyer’s stock. This result may be something the seller did not anticipate.
There are, of course, other structural issues to consider. However, the legal implications that flow from mundane tax issues like deal structure can dramatically shape how the sellers view a potential transaction. If the banker and counsel are communicating properly, they should be able to pre-empt this type of issue, ensure that the deal is structure in a more tax advantageous manner, and revise any deal points to mitigate any adverse tax implications to the seller.
An earnout provision allows the seller to receive additional economic gain only if the business achieves a certain level of earnings or other pre-defined metric. Buyers love them and sellers hate them. Whether or not they can be agreed upon depends on many things, particularly the seller’s confidence from a business perspective that they can achieve the earnout.
The problem with earnouts, aside from the fact that they often do not get paid, is the difficultly in defining and drafting terms which both sides can easily administer. If a buyer can create enough ambiguity in the earnout to justify not paying the seller, it is likely they will.
If an earnout has to be included in a deal, it is critical that the negotiating banker understand from counsel what are the most effective and easily enforceable earnout structures so that the banker can negotiate to those specific points. It is counter-productive for the banker to be negotiating an earnout that cannot be converted to drafting language detailing seller payout instructions in a clear and concise way.
Escrow Holdbacks & Indemnification
Escrow holdback or other clawback mechanisms are standard deal terms designed to (a) compensate the buyer for direct claims or (b) indemnify the buyer from third party claims. Third party claims often result from material breaches by the seller of various representations and warranties in the merger agreement.
In the case of a holdback it is usually a negotiated amount held back from the seller and placed into escrow for a set period of time. In the case of a clawback, it is a percentage of merger consideration received by the seller subject to clawback by the buyer in the event of a future claim. Since these mechanisms are usually the buyers’ sole remedy in the event of a material breach by seller (except in case of fraud or willfull misrepresentations), buyers usually negotiate this provisions aggressively. Poorly drafted escrow and indemnification provisions may substantially impact seller’s ability to receive full transaction value.
It is very important that the banker and counsel are on the same page when these are negotiated during the letter of intent. Counsel will be responsible for conducting due diligence on the buyer, identifying any potential legal issues or potential third party claims. If counsel is aware of an issue that may result in a post-closing claim for indemnification, then the bankers need to be aware of this issue to mitigate any negative financial impact on the seller during negotiations.
More importantly, if counsel believes there is a low likelihood of any potential claims after conducting due diligence on the buyer, then the banker can then use that against the buyer to (a) either reduce any attempts by buyer for aggressive escrow or indemnification provisions or (b) “reluctantly” accept these provisions in exchange for buyer’s concessions on other more meaningful deal points.
Bottom line, the banker is in a much stronger and more flexible negotiating position with respect to escrow and indemnification provisions if they have a clear sense of any red flags as a result of counsel’s due diligence.
When selecting M&A counsel, the banker will often have a list of counsel that they have worked with in the past. It is in the seller’s best interest to study that list carefully and interview as many candidates as possible. If the banker and counsel have a history of working together, this can only help the seller and the overall transaction process. The banker and counsel should not be a mirror image of each other but should be able to work in a complimentary manner to ensure that all issues from the negotiation of the letter of intent through to closing are handled efficiently and effectively.