Nov. 6, 2019
The essential role for seller’s counsel in M&A negotiations
While the expense associated with sophisticated M&A counsel may seem excessive, especially to first-time sellers, the reality is that having a legal expert on your side of the negotiation table is typically well worth the cost.
In mergers and acquisitions transactions, one common and sometimes costly mistake made by cost-sensitive sellers is negotiating without sophisticated legal counsel or delaying the involvement of counsel until after major terms have been settled upon by the business principals. While the expense associated with sophisticated M&A counsel may seem excessive, especially to first-time sellers, the reality is that having a legal expert on your side of the negotiation table is typically well worth the cost. The seller's need for expert counsel throughout the entire transaction stems primarily from: (1) the inherent conflicting incentives between buyers and sellers; and (2) the myriad of complex economic, legal and tax issues which have a direct impact on the seller's economic position and obligations before and after closing. Each of these factors is discussed below.
In general, the business-savvy M&A buyer desires to (1) employ a buyer efficient tax structure (frequently at the seller's expense), (2) pay as little as possible for the target company (and defer a sizeable portion of the purchase price to a post-closing period), (3) leave the liabilities of the target company with the seller and (4) allocate a substantial amount of the risk associated with the acquired business to the seller. The seller usually (and unsurprisingly) has opposite motivations. Furthermore, buyers are in many cases able to treat M&A transactions as zero-sum or winner-take-all games because the buyer and seller may never interact post-closing.
Of course, it would be going too far to say buyers have no motivations to treat sellers fairly, or that buyers and sellers will never have overlapping incentives. For example, oftentimes the buyer must motivate seller management and employees to remain engaged and productive post-closing. Nevertheless, such factors are outweighed by the inherently opposed incentives of the parties which make guidance of sophisticated legal counsel necessary.
For better or worse, M&A transactions are by their nature complex, with many pitfalls for the unwary. The following is a non-comprehensive list of structuring questions that should be discussed carefully by seller with counsel prior to the negotiation and signing of any letter of intent.
• What form or forms of consideration will be used in the transaction? Counsel will be able to advise the seller how the consideration mix will (or should) impact the transaction structure and tax consequences and how it may be modified to achieve the seller's goals.
• Will a portion of the purchase price be subject to post-closing adjustment (e.g., a working capital adjustment) or an earn-out (i.e., be contingent on performance or the occurrence of certain milestone events post-closing)? Counsel will be able to advise whether these concepts are appropriate and, if so, the proper structure thereof.
• Is it possible (and desirable) to structure the transaction as a partially or fully tax-free reorganization, thereby deferring any applicable seller party taxes?
• Leaving hybrid tax structures aside, if taxable, an M&A transaction will either be structured as a sale of stock or assets for tax purposes. The former is often (but not always) better for sellers in a U.S. corporation taxed under subchapter C of the Internal Revenue Code (a "C" corporation), as it generally results in a single level of tax to the selling shareholders. The latter is often (but not always) better for buyers of a C corporation as it generally results in a stepped-up basis (rather than a carryover basis) in the acquired assets, which in turn provides valuable depreciation and amortization opportunities for the buyer post-closing. This structuring (i.e., a stock or asset sale for tax purposes) directly impacts the amount of consideration to which the seller will be entitled and is critical for the seller to understand prior to signing a letter of intent.
Representations and Warranties; Indemnification
• Representations and warranties are statements of fact that are made by the seller to the buyer regarding the business being acquired as of certain dates. To the extent those representations or warranties prove false post-closing and the buyer suffers a loss as a result, buyers are almost always contractually indemnified by sellers to cover such loss. To fund and provide certainty regarding these obligations, the buyer typically proposes reserving a portion of the purchase price via a holdback (in which the buyer retains a specified amount of the purchase price) or an escrow (in which a third-party retains a specified amount of the purchase price).
• However, while representations and warranties coupled with indemnification obligations are customary in private-company M&A transactions, the specifics regarding the amount subject to the holdback or escrow, the duration of the holdback or escrow, the period of time during which claims may be made by the buyer post-closing, as well as caps and other limitations on this structure (and exceptions to those limitations) vary significantly across transactions. Sophisticated M&A counsel will be able to assist the seller in understanding market trends and data, and whether the specific transaction at hand justifies treatment in accordance with "market" norms or if differences merit certain adjustments to what may be deemed "customary."
An often-contentious subject is that of post-closing covenants not to compete and covenants not to solicit or interfere. These covenants directly impact the right of seller management, seller employees and others to earn income and to engage in certain commercial activities post-closing. Competent counsel will be able to advise the seller about the appropriate scope of these restrictive covenants given business factors and legal constraints.
The treatment and/or continued employment of management and employees should be discussed internally, and seller should understand the buyer's intentions on this topic, even if some details are not specifically addressed in the letter of intent. This is a sensitive matter and an important one for the seller to discuss thoroughly with counsel.
In closing, sellers should keep in mind that an attentive, experienced legal advisor is invaluable to the M&A negotiation process given the conflicting incentives of the parties and the complexities involved. Sellers that choose to proceed alone or with ill-equipped counsel do so at their own peril.