Minimizing Seller’s Post-Closing Risk in M&A Transactions

By: Patrick Just, Investment Banking Associate

Not all M&A deals are created equal, even when comparing deals with identical proceeds. Putting pricing and structural differences aside, an often-overlooked but important element of M&A transactions is the degree of ongoing risk borne by the seller after the deal “closes.” The most common financial adjustments that occur after signing the definitive purchase agreement include (i) closing balance sheet adjustments, (ii) earnout payments and (iii) indemnity claims.
The final stages of negotiations are often centered on both the buyer and the seller seeking to minimize their respective risk associated with the transaction. A quick Google search for “post-closing M&A disputes” will yield an abundance of technical literature on the subject. The top links feature the language employed by lawyers to protect their clients’ future interest, and the forensic accounting methods CPAs use to assess damages. Saving that level of detail for the attorneys and CPAs, this article will demonstrate how these issues can be minimized by addressing them early on through a well managed, competitive marketing process.
A strategic business-sale process endeavors to generate competition between bidders not only to maximize price, but also to improve terms. The byproduct of competition -- leverage -- is the most powerful negotiating device in an investment banker’s tool box. The key to minimizing post-closing financial risk is addressing the material issues early in the process while the seller holds the greatest competitive leverage. If these issues are not addressed until exclusive one-party negotiations are staged, the opportunity to obtain optimal terms is lessened.
A seller typically grants exclusivity upon signing a prospective buyer’s Letter of Intent (“LOI”) to purchase the company. Commonly covered items in the LOI include purchase price, structure (mix of cash, stock, seller financing, and earnout, if any), terms, employment matters, and closing contingencies. Too often, sellers sign an LOI that fails to address many of the key provisions that commonly trigger post-closing adjustments.

Experienced advisors understand the leverage they can exert to address additional issues early and will seek to get as much seller-advantaged detail as possible into the LOI. While knowing when and how hard to press these issues can be more art than science, establishing key terms with regard to the following issues at the LOI stage can significantly improve a seller’s ability to rest easy after a transaction’s close:
 
Closing Balance Sheet Adjustments
Almost all deals come with closing balance sheet adjustments. Day-to-day changes in working capital are inevitable and must be considered. Sellers need to avoid buyers aggressively using closing balance sheet adjustments as a means to claw back some of the agreed upon purchase price.
Most transactions are structured on a “cash free, debt free” basis. Generally speaking, this means that the buyer does not pay for cash or marketable securities, and does not assume any long term debt. On the day of closing, any excess cash and cash equivalents on the balance sheet will increase the purchase price dollar-for-dollar, while the seller will be responsible for paying off all long term debt. Receivables, payables and working capital related items typically remain with the company (i.e., the buyer) as necessary components of the ongoing balance sheet.
Additionally, the LOI should clearly outline the method for making any closing balance sheet adjustments. Most transactions use an agreed upon Net Working Capital Benchmark (“NWCB”). Net working capital is calculated by deducting anticipated current liabilities from current assets (net of cash). The NWCB is calculated by taking a historical analysis of net working capital and determining the appropriate “benchmark” to reflect normal operating balances. This is intended to capture any short term changes in current assets or current liabilities and to protect the buyer from aggressive collections on receivables or overextending payables prior to closing. For every dollar that the closing day net working capital exceeds or falls short of the NWCB, the final purchase price is adjusted up or down, as the case may be. Consider the following examples:
 
In this example, the agreed upon NWCB is $805,000. In Scenario A, the company may have finished (and invoiced) a large project before closing, resulting in an abnormally high AR balance. That additional balance sheet value delivered to the buyer is captured by a $550,000 positive adjustment to purchase price. In Scenario B, the Company has a larger-than-normal payables balance. The seller could either pay this down (depleting cash) prior to the closing day, or have a $600,000 reduction in purchase price. The net effect in cash proceeds to the seller is $0.
There are many applicable variations relating to closing balance sheet adjustments. The key for sellers is to understand the methodology that will be used prior to signing the LOI.
Earnout Payments
For most sellers, “earnout” is a dirty word and their advisors will typically counsel they avoid them. However, based on the 2011 ABA Private Transaction M&A Deal Points Study, an estimated 38% of private transactions include some form of earnout; primarily because it may be the only way to bridge a perceived valuation gap between buyer and seller. With the average earnout length equaling 36 months, the earnout is typically the longest lasting contingent payment/adjustment outside of fundamental reps and warranties (such as fraud).
The duration and materiality of earnout payments subjects these agreements to frequent dispute. Additionally, calculation of exact earnout terms is often complicated, especially when considering unforeseen changes in the business over time. If a seller enters into an agreement that includes an earnout, he or she should (a) be prepared to accept the risk that no amount is paid and (b) make the earnout calculation as simple as possible.
If the LOI includes an earnout as part of the transaction proceeds, the seller should seek clarity on the following issues prior to agreeing to exclusivity:
  1. Metric(s) for Earnout: A general rule of thumb for earnout metrics is - the higher up the income statement, the better (from a seller’s perspective). Earnouts based upon top line sales are more difficult to dispute than any other performance metric (such as gross profit, earnings or EBITDA). After the transaction closes and the seller loses control of managing expenses, problems may arise if a profit-based earnout is used.
  2. Excluded Items: Earnouts are sometimes based on sales from specific customers or current product lines. By limiting the earnout to specific business channels, the earnout creates an inherent conflict of interest that increases the possibility of a post-closing dispute. For example, if new ownership has the opportunity to avoid a sizeable earnout by selling to an excluded customer (even a less profitable one), the decision may be influenced by the earnout rather than by usual profitability concerns.
  3. Collars and Flexibility: Earnouts that have sizeable financial consequences upon meeting a specific performance goal often cause problems. For example, consider an earnout providing the seller with an additional “$1.0M in proceeds for each year that sales exceed $20.0M over the next three years.” This carries a large financial consequence to the new owner for the last dollar of revenue needed to cover the hurdle, which could lead to “managing revenue” to hit within a specific period, or “sandbagging” if the hurdle is met early in the calendar year. The payment schedule for earnouts, regardless of the metric used, should be well thought out and scaled within a certain range. Below is a sample schedule that could be applied to address this conflict:
 
Simplicity and aligned interest are paramount to avoiding earnout related disputes. The most successfully designed earnouts are ones that the buyer would be happy to pay.
Escrow / Indemnification
Waiting to address escrow and indemnification issues until the lawyers’ drafting of the definitive purchase agreement is fairly common in M&A transactions. Understandably, buyers are reluctant to provide assurances on these issues prior to conducting more thorough due diligence. However, in a competitive bidding process, these issues can be addressed at the LOI stage while the seller has greater leverage.
Depending on competition for the deal and detail of information presented to date, some or all of the following issues can be preliminarily agreed upon in the Letter of Intent:
  1. Escrow Amount: Most transactions require an 8-15% “holdback” of the purchase price in escrow for potential claims against ordinary representations and warranties that may arise after closing.
  2. Survival Period: The amount of time buyers are allowed to make claims against the seller’s ordinary representations and warranties (typically 12-24 months).
  3. Indemnification Threshold: A minimum level of potential losses from claims made by the buyer before making a claim against the escrow. Having a threshold of 10-20% of the escrow amount can help avoid “minor” post-closing disputes.
Sellers who discuss these terms at the LOI stage can attain some comfort on key post-closing issues prior to granting exclusivity to one suitor. While most LOI’s are non0binding, it is far more difficult for buyers to re-trade specific terms in the LOI absent legitimate due diligence concerns than just negotiating above-market escrow/indemnifications. Moreover, sophisticated buyers increasingly seek to maintain their “transaction reputation” and do not want to be known for re-trading deals. Obtaining assurances on these highly contested post-closing issues can help sellers execute a transaction with greater certainty regarding potential financial adjustments.
Note:
Mergers and acquisitions are complicated transactions that require an in-depth understanding of a company’s specific circumstances. There is never a “one size fits all” approach. These concepts are meant to serve as a guide to the issues that a seller should consider addressing before committing to exclusivity with a prospective buyer. Key to executing a desired transaction is working with a team of legal, accounting and investment banking professionals to design and implement a successful sell-side process.
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