For Sellers

You Want What? (Part of a series)

For company CEOs new to selling their companies, the demands made during the purchase process by buyers can be surprising and unsettling. As part of a series, Minuteman Ventures presents one of those issues here.

Indemnity Allocation Among Selling Shareholders

Indemnity clauses are common to all acquisition agreements, no matter how 'clean' the selling company believes it is.

Even if seller has a perfect record on collecting receivables, managing environmental waste and avoiding litigation, buyer will insist on the ability to reclaim part (if not all!) of the purchase price for representations and warranties breached by the seller after closing.

In the unfortunate case where indemnity payment is due to the buyer, who bears the payment?

The answer seems obvious, but no so fast.

In the case of a single shareholder, or a few shareholders each holding a material portion of the seller's equity, the selling shareholders would normally bear the liability on a pro rata basis.

Buyer would typically agree to such an arrangement, under the thinking that each selling shareholder has sufficient resources post-acquisition to stand up to the liability.

But ownership structures differ. Some companies have many employee shareholders, the result of a) seller stock derived from previous acquisitions, b) broadly distributed stock options, and c) the establishment of an Employee Stock Ownership or Bonus Plan. The result may be many shareholders in the selling company holding very mall percents.

These small shareholders neither controlled the business prior to acquisition or during any 'performance period' immediately following the acquisition. Why, then, should they have to bear a pro rata share of the liability for indemnity. Which is exactly the way the buyer is thinking.

While the input of legal counsel is essential, Minuteman Ventures suggests that seller undertake certain actions at the start of the selling process:

Back to the Top ^

Understanding the Buyer's Lender

The price may be right. So might the terms. But private company owners that plan to exit via sale to a mid-market buyer ought to scrutinize the source of the buyer's acquisition capital.

Companies that the seller sees as sizable might still have to borrow funds to complete the deal. In that instance, buyer and seller become interrelated partners to completion of the deal.

The buyer's lender(s) will want to review in detail the seller's financial records and risk areas, making for two levels of diligence the selling company management must endure. The data requests may not be as well coordinated as seller desires.

Buyers who need to borrow acquisition capital can either receive added monies from existing lenders or, if the borrowings exceed $50 million, may instead net funds from a syndicated deal that could exclude the buyer's existing lender. As part of the syndicate, one lender manages the entire loan and sells pieces of the loan to other lenders, lowering the exposure to any one party.

Whatever the buyer's borrowing route, sellers should strive for maximum 'transparency' to the lead lender - gaining a direct route to a lending representative. The reason for this is clear - deals that otherwise seem on track in negotiation may not be attracting the interest of syndicated lenders that buyer needs to close the transaction.

For deals contingent on the expansion of an existing credit line or closing of new debt facility, seller may consider agreeing to a 'phased' letter of intent (LOI). Phase one speaks to price, major terms, no-shop clause and conditions to close. This initial LOI, however, would contain a financing 'out' for seller if, by a certain date, seller cannot be convinced that the probability of a successful financing is sufficiently high to warrant continued negotiation.

Back to the Top ^

Earnout Tips

Sellers, prepare for an earn-out, those controversial deal clauses that attempt to bridge valuation gaps between acquirer and acquiree.

Should the parties not agree on valuation, they may opt for structuring post-closing performance-based goals that can result in additional value for sellers. One earn-out example is an agreed multiple of seller's earnings before interest and tax in the year following acquisition.

The controversy stems from execution of the earn-out. Differences can arise from the degree of control that buyers exercise over sellers post-closing, interpretation of accounting policy, imposition of corporate overhead costs and possible 'misalignment' between continuing seller managers and the new owners.

To maximize the likelihood of having the selling firm attain its performance goals and therefore earn the earn-out, consider these:

Back to the Top ^

Making S Corp. Receivables Count

Many S Corporation sellers that utilize the cash basis of tax accounting defer recognition of their income at year-end by delaying the billing of invoices for the last few months of the fiscal year. The seller funds working capital through drawdown of its line of credit, in the process building up receivable balances well past normal periods, often over 90 days.

For deals closing in February (for fiscal year sellers), those purposely aged receivables may not have been collected at closing. Do not assume that the buyer will give full credit for those receivables in calculating the net worth that is to be delivered at closing by the seller. A buyer may want to expand the escrow amount to cover all uncollected receivables in this category or to otherwise recognize that these receivables are at risk (even though the seller believes collection of the receivables are in the normal course of business).

Sellers should be clear in identifying the receivables in question and verify their collectibility, in the process making the buyer feel more at ease with their assumed risk (and less justified in wanting to expand the amount held in escrow).

Back to the Top ^

'Big' Is Not Always Better

Many companies start their business life as a C Corporation. Along the way, to take advantage of the pass-through of corporate income and losses to individual shareholders and avoid a corporate level tax, they may elect to recategorize their corporate structure as a Subchapter S Corporation.

That 'event,' though, triggers the recognition by the C Corp. of taxable income resulting from the presumption that the company assets are sold at that time!

This is called the Built-in Gain (BIG) tax. The amount of the BIG is the net (net of the asset's basis) fair market value of the assets (both 'tangible' ones like plant and receivables and 'intangibles,' soft assets such as patents and goodwill) in excess of the fair market value of corporate liabilities at the time of the switch to S Corp. status.

Even though gain is recognized, tax on the gain is deferred to the firm's eventual sale, or the sale of the assets in the normal course of business. If the S Corp., or assets, are sold within 10 years of the switch from C Corp. status, tax on the BIG comes due. The BIG tax is forgiven if the 10 year mark passes.

As a planning point, the S Corp. shareholders should quantify the value of company assets forwarded to the new corporate structure. Don't wait until the time of sale. Upon the change in corporate structure, get an independent appraisal of company assets or at least adopt and record the Board's best judgment of firm value. In that way, tax surprises can be minimized.

Back to the Top ^

Seller, Educate Thyself

Industry- and company-centric statistics, both for historic and future purposes, could be: burn rate (total cash consumed over given period, or relative to revenue or other standard), labor multiples (the multiple of direct labor needed to reach profit or cash flow breakeven), headcount need to support revenue goals, and pipeline prospect revenue v. annualized last quarter sales.

While an investment bank or M&A intermediary can advise you on this, company management should start as early as possible in the process to generate a metrics report. In fact, try to go back at least one year to create a trend line for chosen metrics.

Back to the Top ^

For Buyers

Talk About It

Just like the selling of your products, executives in the buying company need to 'sell' employees of the seller on the merits of the transaction.

Where possible, salesmanship in this form needs to take a particularly human quality rather than an impersonal business one. Speak to the emotion that selling employees may well feel toward the loss of certain colleagues, the departure of their prior company's owners, and the coming strangeness of new systems, people and priorities.

At the same time, reinforce the value of the acquisition, highlighting these attributes:

Good M&A communications from the buyer also require structure and speed. Be sure to adhere to the following points:

Back to the Top ^

Different Metrics for Different Folks

Acquiring corporations need to be mindful of the type of transaction being contemplated before imposing their performance metrics on the acquired company. Transactions are either 'autonomous,' (i.e., non-integrated operations), 'integrated' (i.e., the acquirer assimilates the acquiree) or 'consolidated' (i.e., two companies form a new entity, mutually operated). Buyers should adapt metrics in line with the transaction model.

'Autonomous' deals indicate the need for separate metrics, consolidated only at the corporate level. 'Consolidated' models require an assessment of the respective company strengths. Parties from each firm should be represented on the group to build a common information model.

Most deals are of the 'integrated' variety, however. Buyers must assess during the pre-closing stage what drives the selling company and the culture that underlies those business drivers. Asking for revenue tracked via channel partner, when the seller does almost all direct sales, suggests the buyer is not listening and is creating make work for seller employees that remain. Listen to the pulse of the seller, then work with their people to determine those metrics that the buyer truly needs to know, and the best way to obtain them.

Back to the Top ^

Beware the Bank

Buyers should carefully review the accrual policies of acquired firms, especially smaller ones, regarding sick pay and vacation. These obligations can amount to a significant liability. This becomes particularly so when unused sick and vacation time can be 'banked,' or carried forward to future years, allowing employees to reap relatively large sums upon their departure from the company.

Carefully review the seller's employment policies, specific employment contracts and vacation/sick pay ledgers by employee to ensure that the booked liability matches the legal obligation. An undisclosed liability may lurk. Avoid capping the indemnity amount for this particular liability if possible!

Back to the Top ^

Acquired IP More Than Just Accounting Concern

Intellectual property (IP) assets are coming front and center for acquirers whose teams are lead by senior finance executives. First, as heralded in 2001 with adoption of new FASB rules on business combinations, companies now only amortize certain intangible assets, no longer taking annual charges for goodwill.

The IP emphasis deserves much greater than just an accounting perspective. The finance function on the diligence team needs to look much closer at their 'IP Acquisition Strategy and Practice,' focusing on the following: