Well Capitalized

Most Important M&A Negotiation Terms

October 13, 2020 MCM Capital Partners
Well Capitalized
Most Important M&A Negotiation Terms
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Well Capitalized
Most Important M&A Negotiation Terms
Oct 13, 2020
MCM Capital Partners

What are the most important terms in negotiating the sale of a business? We sat down again with deal attorney Brent Pietrafese of Calfee, Halter & Griswold for a deep dive into legal due diligence. Among other things, we discuss:

  • Protections business owners retaining minority stake in the new business should focus on during negotiations
  • Most heavily negotiated terms in M&A transactions
  • Key terms for entrepreneurs when negotiating a post-transaction employment agreement
  • Non-compete clauses in acquisition documents and employment agreements
  • Advice for business owners who may be negotiating the sale of their company in the near future

 

Show Notes Transcript

What are the most important terms in negotiating the sale of a business? We sat down again with deal attorney Brent Pietrafese of Calfee, Halter & Griswold for a deep dive into legal due diligence. Among other things, we discuss:

  • Protections business owners retaining minority stake in the new business should focus on during negotiations
  • Most heavily negotiated terms in M&A transactions
  • Key terms for entrepreneurs when negotiating a post-transaction employment agreement
  • Non-compete clauses in acquisition documents and employment agreements
  • Advice for business owners who may be negotiating the sale of their company in the near future

 

hello and welcome to another episode of Well Capitalized I'm your host Bobby Kingsbury managing director at MCM Capital Partners today with we have with me again Brent Pietrafese from Calfee Halter and Griswold will be discussing the most common commonly negotiated terms in M&A process and gonna walk us through some timelines as well so Brent thanks for joining us again today I guess you know we've been with us before but might as well provide a little bit more of your your background again for maybe Trevor's time viewers happy - happy to- so I've been at Calfee for 17 years I'm currently the co-chair of M&A practice as well as our family office practice I spend probably two-thirds of my time doing M&A and mostly in the private equity world and the other third is general corporate transactions contracts capital raising succession planning and the like thank you I appreciate it so just to kind of get into it from a high-level standpoint can you talk to us generally about the M&A process from a legal standpoint how long it takes so it usually depends on when when legal gets involved there's a lot of different factors that impact you know when we come to the table but generally speaking you have two separate timelines you know depending on whether or not you've got a investment banker involved and while an investment banker can bring you know additional people to the party and they can help organize a transaction when they're involved it typically does extend the timeline a little bit because you've got a couple of additional steps so when investment bankers involved they will typically come in help you build out a book of in confidential information memorandum about the business they will then solicit indications of interest from from different parties to see you know where people may come in on valuation so there's a process there that takes time to look at those and sort through those then they will take a subset of those to propose a letter of intent all the while behind the scenes they're helping to build out a data site and help with the diligence process once you get to the letter of intent stage they will then pick you know typically their best offer and then that process would start so then you know you negotiate with one party purchase agreement other ancillary documentation and you get to a closing you know following that that whole process is probably six months I would say best case scenario I've seen him go longer I've seen some shorter but you know usually that's a it's a rough estimate there yeah I think that's a little bit longer than most business owners think the process will take you know when hiring investment bank it you know takes a little bit of time to get all the information to write the book and then bring the parties to the table and there are some pros and that you know they will force you on the front end to go through the diligence process build a data sight so you're not trying to do that while negotiating a purchase agreement and things like that and so it's helpful from that perspective it's also costly as you know to hire investment banker so the flip side of that is if there's not a banker involved you usually cut out a lot of that first step and you really move primarily to a letter of intent stage negotiate a letter of intent make sure you understand the primary business terms then you'll start the diligence process again there wasn't a probably a lot of work typically done on the front end so that it may take a little bit of while a little bit of time to get that up and running once that's up and running and the buyer has access to a data room they'll be able to work through that process negotiate sort of dual-track negotiating the purchase agreement and then you get to a closing I'd say that process anywhere from you know three months I've seen you know that happened as quick as three months or as or as long as three months as quick as a month yeah depending on you know the situation interesting so I think you know talking about the the letter of intent stage and one of the first things probably negotiated aside from purchase price or in conjunction with purchase prices whether the deal is going to be an asset deal or a stock deal and as a business owner can you tell me why why we care what's what's the difference so from a legal standpoint the primary difference is in an asset transaction you can cherry-pick the assets you're gonna buy and the liabilities are going to assume so I can go into a situation as a buyer and say I want these particular assets from the seller I only want to assume certain you know operating liabilities or certain contractual liabilities that are known that I understand and I can value or evaluate the risk of and then you move forward in that basis and then anything that's left over remains with the seller entity so it's there's a typically a seller the shell entity with its left will retain those assets and those liabilities the benefit for the buyer is you understand what you're getting there's not a lot of unknowns it also streamlines the diligence process somewhat from buyer's perspective because if you're not worried about taking out a bunch of historical unknown liabilities you're not doing as much diligence typically from you know on the stock side the main difference is you're taking the entire organization so you're taking all the liabilities all the historical liabilities you're taking all of the assets whether they're you know part of the business or not or the part of the business that you want to buy or not so it's really you're taking on the entire enterprise so that's the primary legal difference from a tax perspective and I am NOT a tax lawyer but we'll have somebody come yeah but from a high level stamp high level standpoint you know when you're buying assets you get a step-up in basis in those assets so you can immediately start depreciating or amortize those assets post-closing whereas if you're buying stock you know that only the only ability to do that is your basis is what you paid for it you only get the benefit of that when you go to exit the enterprise you know at some point in the future so there's a there's a huge benefit to a buyer there but there is from that standpoint and it on the tax basis there is kind of a a step in between you know for certain legal entities specifically an S corporation called a 338 H 10 election can you you know it's kind of just high-level touch base on a 338 H 10 so effectively you know it's a you get the best of both worlds type situations so if you are a and there's a lot of rules that go into this you have to make sure you consult with your tax advisor and lawyer about whether or not it's applicable to your situation but it's such a good lawyer generally generally speaking you know if you are a corporation you can buy another corporation and for tax purposes only that acquisition will be treated as an acquisition of the assets of the underlying company of the target company so you get the the same step-up in basis you would get if you were buying assets but from a legal standpoint you are buying the entity where that's helpful is in a situation where you can't buy assets because there's some reason there's a lot of contracts that you know can't be assigned or there's some permits that can't be assigned and you need to buy stock so that you don't have to go through that process but you still want the benefit of the step-up in basis so that's one way to do that now there's a little again there's a lot of rules around that so you need to make sure you understand those I appreciate that you know one of the purposes of doing these these videos is to educate business owners and address their their concerns and their and their fears and a common fear especially in a leveraged recapitalization where a business owner retains a meaningful portion of the business will be forward but generally they are giving up control hmm you know so you know from a business owner if I was a business owner going into that situation what what protection do I have as a minor as a minority shareholder so you've got certain statutory protections that are afforded to minority shareholders so you know the majority can't steamroll minority shareholders and do things that are completely to the disadvantage of the minority you typically don't want to rely on those so what typically happens is you negotiate you know an equity holders agreement depending on the type of entity if you're a corporation will be a stockholders agreement if you're at LLC it's a operating agreement it's a partnership it's a partnership agreement that lays out you know the rights of the minority shareholders and their and the rights of the majority shareholders in a contractual form that can be negotiated and as a minority owner there's certain things you really want to focus on in that document things like supermajority provisions that allow you to have a say when the company is taking certain high-level major strategic decisions so things like selling the business or taking on excessive additional debt or moving into a new line of business there are certain you know protections that you want to make sure that you have a vote in when those actions are being taken so that's one way to protect and have a say as a minority owner a couple of the provisions is you know there's a thing called a pre-emptive right so if the company's gonna go out and raise capital you want to make sure that you have the ability to participate in that capital race you can maintain your relative ownership percentage so you don't get diluted without having the ability to participate now if you don't participate it's your choice and you'd be diluted but you want to make sure you have at least the ability to say yes or no based on you know whatever the facts are at the capital time the other is a drag along right and the commensurate tag-along right so the majority is gonna want to be able to drag you along and make you sell your equity if they want to sell theirs and in certain situations but the flip side of that is if the majority exits the business you want to be able to participate in that exit so you have a what's called a tag-along right that says you know if you majority are gonna go sell you're a majority stake I'm gonna raise my hand and I'm gonna be part of that deal on the same basis and sell my stock on the same basis in which you're selling yours so in that scenario with the drag along rights is there any situation where I as minority shareholder you know if I disagree with the majority shareholder and say you know what I think it's wrong that we're selling the business right now it's an opportune time I don't think we're maximizing shareholder value I don't know when that situation might happen but it might occur mmm what is there any protection for a minority shareholder there and in that standpoint or now if you've negotiated it as part of the the supermajority provisions that would be one area where you'd have protection but typically speaking on a drag along situation you're waiving your right in advance you're waiving your right to say that and that's the whole point that's why the the majority wants it that they can when they think it's time to sell they can sell and you're along for the right now you you get treated the same way so there's no you know there's a disincentive to the majority to do things that are bad for the shareholders because it would be bad for them too so you have some protection there that you're being treated the same way as the majority but you really are waiving your right to to raise your hand and say no I don't want to do this okay I appreciate the clarification what are some of the in your experience in your 17 years of experience what what have been the most common or heated terms in in certain negotiations in the in the acquisition Docs yes it's usually around the reps and warranties although that has gotten a little bit easier with the advent of rep and warranty insurance which we won't go into that here that's a whole nother you could do a whole nother video on rep and warranty insurance but for people who aren't aware when you're selling your business you're gonna make representations about the business you're gonna say all different kinds of things around how the business has been operate historically if it's been in compliance with laws that all of your material contracts are in full of a force that you have the ability to sell stock or assets a litany of things and so what goes into those reps is is usually heavily negotiated to make sure that you know the seller can make the representations and that the buyer is getting the representations that it needs and wants to mitigate risk yeah because we're relying on that business owners representation right now you could because you know you they go hand in hand with diligence you're gonna do your diligence but at the same time you want somebody the seller or the sellers to go on record is saying you know these things have happened or not happened in my business and if I'm wrong about those things that I will indemnify you to the extent that you suffer a loss as a result of those things being false now I want to get off topic here because there's a few more but the buyer would get indemnified how does the buyer get indemnified as a business owner my just cutting a check or how does that happen so there's a couple different ways usually there will be some kind of a hold back at closing so it'll be an escrow some amount of the purchase price will put an S its third party escrow account or it'll be just held back by the buyer with a contractual obligation to pay it at some point in the future and in those instances that's typically the first source of recovery when there's an indemnity claim so if you breach as a seller if you breach the contract you said something that wasn't true in a representation a warranty or you breached some other provision of the contract that is the first pot of money that the buyer would be able to go after beyond that depending on the severity of the breach the seller could be coming out of pocket and writing a check there's usually limitations that are put into the purchase agreement to protect the seller from having you know huge losses but that being said to the extent that the loss is related is something that's fundamental to the business whether you owned it you had the ability to sell it there was no liens on your assets those types of things you know typically you're at risk for the entire purchase price if not more I think getting back to the common negotiate terms whoa what about things like restrictive covenants or condemned indemnification mm-hmm so those you know as we talked about so obviously indemnification is a big one there's a because sellers want to know what they're potentially on the hook for down the road and make sure that they understand the risk so the limitations around the indemnitor are usually hotly negotiated usually there's a basket or an indemnity threshold that says we can't come after you for small stuff we can only come after you once it reaches a certain level of materiality you doll it usually a dollar amount what typically is that dollar amount and a called a twenty five million dollar transaction depending on the type of basket or cat you know indemnity basket if it's a dollar one or if it's a threshold it's anywhere between half a percent and a percent typically of the purchase price and then there's a cap so a maximum amount that you could be out-of-pocket that applies to just sort of the general reps and warranties and that's depending on the deal and the size deal and the parties you know those can range from call it 5% to 25% you know given that size deal and then you know you to the other point the restrictive covenants is or another area because again that sort of sellers go forward obligations and they want to understand what they can and cannot do going forward and obviously a buyer doesn't want to finance a seller to go right back into business and compete against them so those are pretty heavily negotiated so you know what boxes are put around the seller going forward from a non-compete a non solicit and a confidentiality perspective and I think that's a very good transition into I think it is especially leveraged recapitalization another heavily negotiated item is an employment agreement mm-hmm what are some of the most common terms heavily negotiated in an employment agreement so you know the things would be in any an employment agreement right so salary benefits are two big ones understanding what that looks like and you know a lot of times a seller has been the primary owner and has just been taking distributions from the business you know when they needed them or never had an employment agreement right wait so you know an important thing for a seller to consider is what is their value to the business if they had to go out and hire somebody to do their job in the in the open market what would you have to pay that person and you know that's probably what a buyer is going or the range of what a buyer is going to want to pay you is from a salary perspective and we see that a lot in our negotiations an employment agreement is you know business owned or entrepreneurs making significant money dropping a lot to the bottom line and they're taking salaries you know on a call it twenty and twenty five million dollar business anywhere from five hundred thousand to eight hundred thousand dollars and generally for for us you know just to your point we're looking at what is market for that size business we have to normalize salary and you know it that is an additional add back to EBA which business owners you know typically might not think about you know that $400,000 $500,000 Delta and salary you're getting paid a multiple on that right so you can either take it upfront in a purchase price or it can be taken away from for me but da so yeah and that you know because that's not something intuitively a lot of sellers think about is an area where there's a lot of negotiation to your point and there's you know not always a meeting of the minds at the front end so that's an important area to flush out you know in the letter of intent indication of interest stage so you don't have those tough discussions once you've set a purchase price right and then I I think probably some other things that maybe you can touch on our an incentive comp plan you usually you know generally business owners didn't have that prior especially for themselves right you know and that's a lot of you know especially a private equity buyer wants to make sure that the management team and the seller are aligned with their interests so they will put in place an incentive comp plan that will reward them whether it's with actual equity phantom equity or some hybrid for the you know appreciation of the business over time so that again interests are aligned and they want to you know drive value of the business because they're gonna participate as an owner what in the employment agreement to what what about the you know as a buyer I think about some some of the other things like it especially a non-compete you know if a business owner you know we're gonna partner with them moving forward and if they decide to leave and start something else it severely hinders the business that we just right we just bought and then severance would probably be another thing can you touch on those sure they're not compete in the employment agreement is important and you need to sort of relate it to the non-compete that you're gonna get as part of the acquisition document the non-compete in the acquisition document is is a fixed period of time that starts at closing typically it's five years and it's based on the way that the business was operated at closing so if the seller walks day - they're still bound by that five-year non-compete but it's limited to what the business was when it's sold in most instances it's important to have a non-compete in the employment agreement because a lot of times you're going to partner with this person for a longer period of time and they may outlive that five that five year window and you want to make sure that you have a tail or the buyer wants to make sure that they have a tail non-compete that extends beyond the employment period for all the reasons you just articulated you don't want somebody you know who's in a material position to go out and compete with you so you want to have some non-compete at the end and again that at that point is based on what the business was at that time which it may have certainly and hopefully did evolve over that five-year span to something different than what it was when you bought it when the buyer bought it so you want to make sure that the non-compete is covering you know the most recent iteration of the business so that's an important piece to think through and then the severance is is somewhat tied to the non-compete because typically sellers want to be paid a severance and in a lot of instances it's not surprisingly the same duration as the non-compete right so if you're getting a one-year non-compete they want to you know one-year severance that's paid out over that year and a lot of times it makes sense for the buyer to do that because you're paying to keep that guy out of the business for that period of time and those you know those numbers can be negotiated right so it's if you're gonna get at six years six months severance in a one-year non-compete or something like that so for for the final question I'm gonna put you on the spot here for four minutes is there any for a business owner listening is there any tips or I don't want to say tricks but things for them to think about when on a negotiation standpoint going into an M&A transaction things to watch out for to you know either cover themselves think that that they should know going in that maybe we haven't covered today um yeah I think we've covered a lot of the big picture questions you know I think this is a good opportunity is any to say you know you don't want to try to do this on your own you want to make sure you've got a good team around you who's been through this process before good lawyer good accountant good if you're gonna use an investment bank or a good investment banker because there's a lot of things that you aren't gonna think about and obviously we couldn't cover everything in this video that they will have dealt with and do deal with on an everyday basis and are equipped to handle and think about and be strategic around to make sure that you're getting the best deal possible not only from a financial standpoint but from a risk allocation standpoint because it's so easy in a lot of instances to be blinded on the front end by the dollars I'm getting how much am I getting a closing how much my putting in escrow what's my comp look like what's my equity look like and those are all important don't get me wrong but there's a lot of things that people don't think about from a risk allocation standpoint which is what you know a lot of the documentation is designed to do is allocate risk right I go for basis between a buyer and seller that sellers don't necessarily appreciate because they've never lived through it to know what the potential downsides are that's where having a good lawyer who's been through those situations can you know use a little bit of foresight and say hey you know I've seen this happen where you know if you agree to this particular provision you're gonna be potentially putting yourself at a lot of risk down the road where somebody's either gonna claw back that escrow or claw back some of that purchase price or claw back some of your equity and we want to avoid that so I think that's the best thing a a potential seller can do is hire a good team yeah well I appreciate that Brent that's very very helpful and I'm sure you know as we continue these episodes business owners gonna have certainly more questions as it relates to the legal side I'd love to to have you back at some point happy to do it we appreciate your being yeah thanks for having me thanks Brent alright thank you for taking the time to watch another episode of well-capitalized please subscribe to our channel below if you have any additional questions please leave them in the comment section thank you