Executing Smaller Deals and Negotiating Key Legal Provisions

23:00How does it impact the actual purchase agreement? Would you change things and provisions in there? Basically, you're going to add a whole like two or three extra pages at the back, typically going over how indemnification claims are done, what risks there are. And so then there's a lot of things you're negotiating for. You're really almost negotiating like a separate insurance policy on top of the actual mechanics of us buying and selling the company. So for example, we'll have reps and warranty survival periods. how long do these reps and warranties survive for the buyer to bring a claim? So when can the seller really be scot-free on the boat in Lake Como without having to worry about this?

23:39General reps and warranties, 12 to 18 months, 24 months sometimes, with fundamentals being around six years. Sometimes they'll link it to statute of limitations. It can vary depending on the deal and depending on the leverage that the parties have. So really, you're looking at How long can the buyer make a claim, which is tied to survival periods? And that will vary between fundamental and general reps. Are you familiar with fundamental or general? You want me to break that down? Yeah, let's do that. So fundamental are really the big things. I own the company. The company is in existence. Taxes are typically in fundamental reps and other similar statements.

24:19Your general reps are going to be things about, here's my contracts, here's my top customers. depending on where the value is in the company. So is this a heavy IP company? We could put IP in fundamental or general. And so you end up negotiating what is in that fundamental category and what is in the general category. And with that comes additional protections and limitations and with respect to that downside recovery mechanism. So oftentimes, general representations and warranties, there will be a cap, a maximum that the buyer can pull back from the seller with respect to breaches of those general statements.

25:00And often that's tied to how much money they're holding back on the deal or how much money they put at the escrow. Not always, but most of the time. We'll only go after this money that's set aside with respect to all the general stuff. I liken this to when you're buying a house, if the seller told you, yep, the heater's good and the locks were just changed. I own the house. That's fundamental. The heater's good. Yeah, you can go after the escrow for the heater. But if you didn't own the house, I get my whole money back. There is no cap or they were capped at the purchase price of the deal. Got it.

25:29So we have these two types of reps, fundamentals, generals, indemnities. What are specific indemnities? As part of the reps and warranties process, you'll go through that. You'll look through the 10 pages. You'll go through it with your lawyer, your accountants. You'll be like, oh, actually, here where it says we've always classified our employees and independent contractors correctly or under applicable law, we realized going through due diligence that there was a a couple independent contractors that we hired a few years ago that may have been misclassified. In other words, they may have been should under applicable law classified as an employee.

26:03And so you'll go on the disclosure schedules and you'll say X in that rep will say except as set forth on schedule Y, or X or number, everyone was classified properly. So you go on the disclosure schedules, and you'll say we don't need these three might not be classified correctly. So now I guess going back, if those folks turn out to had been misclassified, and the buyer suffers damages, there's an exception there to that rep. And so they don't get coverage unless we specifically talk about it and negotiate it within the contract. So that's why those schedule of exceptions or disclosure schedules typically can be very important.

26:37And buyers and sellers need to look at them very carefully because it impacts the risk a lot. It can be painful because it is signing up to the dotted line of due diligence, but specific indemnities then get negotiated based off of what known liabilities we think are out there. And so then from there, okay, we have these three potentially misclassified folks. What's the order of magnitude? How much potential damages could be there? So then you work with us, you work with our employment experts to look at, okay, what does the loss say? How much would we owe them? Oh, we could potentially owe them overtime.

27:11We could potentially owe them for benefits and then fines, etc. And so you'll work with the specialists to figure out what that number is. And the parties will negotiate, Do we cap it at that number? Do we set aside, basically make a separate new holdback escrow to capture those specific indemnities, those specific issues? And of course, the buyer's trying to make that specific indemnity as broad as possible. So they'll probably, if I'm drafting the first draft, it's... You've had misclassification issues. You know that. On a few employees, we should get it all covered because we don't know what else is out there.

27:42But we know that this is something that you've overlooked before. And the seller's going to come back and say, no. The exceptions only applies to the general reps exception to that only applies to these three folks. So you're covered under the general reps with respect to other people. And so that should be under the normal general reps. And the normal general reps have a lot of caps, limitations, things like that, where the specific indemnities are usually outside of all of that. And so it's uncapped or capped at purchase price with no deductibles, limits, holdbacks, etc. We'll negotiate that fight about that.

28:14That always gets interesting. Why we pay the big bucks? It's not dollars up front. You're negotiating over like probabilities of dollars on the back end that roll of the dice materialize and we see it often. You are negotiating for value when you're dealing with that. Maybe you're not changing the top line purchase price dollar on the deal, but it is real dollars or at least real probability for real dollars later on. What are disclosure schedules and why does everybody hate reviewing them? Disclosure schedules, maybe we can circle back to what reps and warranties are. So reps and warranties often have...

28:46They'll start off with accept as set forth and it typically is numbered in association with the number of the reps. So accept as set forth on section one of the disclosure schedule, companies in good standing, and in the state of its incorporation, all states where it needs to be. And so you'll put together all of those schedules into what's called a disclosure schedule. And so some of the reps not only just have exceptions to the reps, but they will be like an affirmative statement. So the rep will say, set forth on schedule three is all of my material contracts, including but not limited to contracts that have consideration over 250 ,000 contracts that where you bought and sold a company.

29:28And so you have to go in and list all of your contracts there. Same thing with employees. You typically have a rep that says, attached as Schedule 6 is the employee census. You'll need to go and fill all that information out. Sometimes it's bolstering the reps and warranties or really getting the seller to sign on the dotted line with respect to the materials they gave you in due diligence. Other times it's, tell us all of the exceptions and you got to go through it all and think about it and work with your team to try and cover your downside as much as possible. And so they are super painful because you start negotiating the reps and warranties on the very first time you review the agreement.

30:10And it doesn't get set in stone until the night you sign before, sometimes even the day you sign before. So and those reps and warranties are constantly being expanded and shrunk. And getting them right is a massive process or deal. But they do have significant implications on the back end of what kind of coverage. So if you're sloppy about them, it can be painful. It might be easier when you're actually getting trying to get the deal done, but it can be painful on the back end. Yeah. I didn't even think about putting them together. I just thought about reviewing them was a pain in the ass. Yeah.

30:43Reviewing is a pain. Oftentimes, when we're working with sellers, we are working with the sellers to prepare them and put them together. Yeah. And reviewing them is just as painful. But reviewing them is 10x easier than putting them together. Another good point on disclosure schedules generally is like a practice tip is oftentimes sellers reach out to us, they have an LOI at hand. And then it's okay, we have to go and clean up. Not only do we have to go and like, okay, let's start preparing your disclosure schedules. When we do that, we find all the hair. It's hair that we can clean up and that the buyer is going to demand us to clean up.

31:17But now we're doing it while we're trying to negotiate. Not only is there obviously time sensitivities to that, and it's way easier to clean up issues when you're not trying to negotiate a deal and under a time crunch, and you have a little bit more of a free time. But also it can hurt you and put you on a bad negotiating spot. So big tip to our sellers is if you're thinking about selling or you know like I need to be selling in the next year or two, or that's where I'm looking to get out, reach out to an M &A lawyer and get your accountants involved and loop them into that process to start thinking about and preparing and getting your house in order beforehand.

31:53Go and get your data room beforehand, get it together, get it cleaned up. And it's going to help not only simplify that whole disclosure schedule preparation process, but it's also going to allow you to clean up your issues without time crunch, without someone looking over your shoulder and potentially deducting purchase price later on or making it a big issue that you're now negotiating with 10 different lawyers on a call about or having to talk about versus, Oh yeah, we found this a couple years ago. We cleaned it up. It's done. All about the prep. Yeah. How about caps? Yeah, caps and baskets and deductibles.

32:30And maybe we can talk a little bit about the carve-outs from those. Really, these are limitations on the seller's indemnification obligations. So cap is what we mentioned before. What's the maximum amount of money that I'm going to have to come out of pocket to you for these old claims? Inherently, some of this stuff should have been priced in or you know you're getting into a little bit of this when you're buying the company and you've done due diligence as well. So caps really are thresholds or maximums on how much I'm going to have to come out of pocket. So for general reps and warranties, we're often seeing those tied to the amount that's held back or put into escrow.

33:05For fundamentals, we typically see purchase price. And then sometimes you have a quasi in-between grouping. We call them intermediate set of reps and warranties. For example, if you have a heavy IP company or heavy government contractor, we'll put government contracts reps or intellectual property reps into that middle bucket and they'll have a 40 % or 50 % cap. Whereas the value in the business is what we're thinking about when we're negotiating that. Baskets and deductibles are interesting. So this is like the deductible that you think about through car insurance. Can the buyer come after us for$1 ,000 just because this...

33:40So this is like, no, the buyer has to pay some sort of deductible or it's called a basket. There has to be some sort of minimum threshold before they can bring a claim. And so this will be like maybe a percent, half a percent, some sort of threshold. And a basket is what we usually call a tipping basket. And so that will mean once you have enough losses to get to that tipping basket, you get$1. So the buyer now has incurred... let's just say the basket's$50 ,000, has incurred$50 ,000 in damages, they can bring a claim to you from$1. So they'll bring you a claim for$50 ,000. A deductible, which is typically always smaller than the basket, means that the buyer is only getting what's above that deductible.

34:22So they have$50 ,000 in damages. There's a$25 ,000 deductible. They can bring a claim for the$25 ,000 above the threshold. Okay. So when you define your basket, you're defining how much more they can actually exceed. Yeah. So you're defining basically what's the minimum amount of losses that the buyer has to suffer? What's the minimum pain the buyer has to suffer before they can come after you? When you're negotiating that, you'll be negotiating not only what that threshold is, but whether or not that threshold is a deductible, meaning completely out of pocket from the buyer, or is it a tipping basket, which is once we get to that, then the basket tips over, the buyer can come after you from$1.

35:03Alright. Other limitations? There's certain limitations that sellers will ask for and buyers push back on. Non-exhaustive lists, duty to mitigate. So the buyer has to try and... If the buyer has losses, the person comes up to them and says, we own this, try to negotiate it down or try to see what they can do with respect to the claim to reduce the claim to the extent reasonably possible. There's also sometimes duties to go after insurance first. So even though you didn't get a rep and warranty insurance policy, this claim, this damage may have been covered by the company's general insurance policies that it had.

35:40And so go after the insurance first. And then if the extent you're not able to recover anything or the extent you weren't able to recover all of your damages, then you can come after the buyer. Is that a carve out from limitations? I would say that would be like a limitation or a covenant that the buyer would agree to. A carve-out from the limitation would be like fraud. If the seller was fraudulent, then the cap doesn't apply, the basket doesn't apply, we can get all of our money back and you'll indemnify us for all of it. Fundamentals are typically a carve-out from limitations as well. Typically, the basket does not apply to breaches of fundamental reps.

36:16Did you own the company or not? And if I have suffered damages because you didn't own the company, I'm not going... I'm not dealing with the basket deductible. I'm going straight after you. Fundamentals will typically have, like we mentioned before, an upper threshold cap. There will be carve-outs from some of those limitations. Okay, I think my brain has had enough around the reps and warranties and indemnification I can handle. The other big pillar we had was around capital adjustments. Working capital adjustments, I don't know how in-depth we need to go into here. They are tricky. This is another one where it's get your accountants involved early because we do see a lot of cash-based accounting companies.

36:56agreeing to working capital adjustments. And as you can imagine, calculating accruals and calculating prepaids on a company that doesn't calculate those regularly is really difficult. It can be really painful. And it makes the whole process really hard to negotiate. Getting those advisors involved early can help you, number one, negotiate your LOI, you don't have to deal with it. Or two, get them ready and get them moving on figuring out, okay, let's figure out what expenses we prepay. Let's figure out what expenses we pay after we've received the service? Are we paying our month on the first day of the month or on the last day of the month?

37:29And just going through that, figuring out what kind of unique line items on their balance sheet that they have. Do they have restricted cash? So they put cash in a separate account that is subject to a letter of credit, like a big deposit on a lease. That's technically the company's cash, but there's conditions on it and it's not free to be moved. We run into a lot of that with the smaller to medium-sized deals. And so to the extent you can get ahead of it, it can be huge. Yeah, it sounds like there's a lot of little things that go into it. Getting the accountants in, it sounds like earlier, the better.

38:02Even as you're taking this deal to market, having a good sense of what that's going to look like. What on the legal side? What are the key terms, clauses you end up having to consider and negotiate? It is a quasi-legal accounting business exercise. So we are working extremely closely. we'll be on calls, three-way calls between business folks, the accountants, and the legal going over all of this. Because we need to figure out what those unique items are and then how to be negotiating for it. And you see it sometimes where situations where you have maybe a general practitioner on the opposite side of you that has given maybe the seller good advice, helps form the company, has been giving them general good corporate advice the whole time, but they're not M &A deal lawyers.

38:46But the company trusts them, so they have them run their M &A process. And so then all of a sudden we're sitting on the other side as the buyer's counsel were saying, we have all this stuff to deal with and we need to negotiate it. When you're dealing with sophisticated folks, they'll get all of that and it will all be one way versus if you're going up, for example, restricted cash. If you're going up against maybe another sophisticated big M &A law, it's okay, we have all this restricted cash. It's supposed to be cash-free, debt-free. In other words, we're supposed to get a dollar-for-dollar adjustment for every dollar of cash that we have on the books.

39:13Should we be getting a dollar-for-dollar adjustment on that? The seller is going to say, of course. And if you have an unsophisticated buyer's counsel, I was like, okay, that makes sense. It's a dollar. But then the lease comes around and they take that deposit back. So now the buyer doesn't get the benefit of that cash. They're left holding the bag, if you will. So what we would try and negotiate is, let's put that money in a holdback. So we'll give you the purchase price adjustment as a holdback. And then as soon as that lease is up, whatever money we get back, then we'll release to you. So there's a lot of little things that we work in tandem with the accountants and the business folks that brainstorm and figure out where the middle ground is, that can be really important.

39:51Another thing you'd see on working capital adjustments too is, especially with these companies where it's all over the place, is you'll see people try and negotiate for thresholds or what they call callers. So it's if the working capital is between X and Y, there won't be an adjustment. So instead of just having a hard line in the sand, like a single dollar line in the sand, they'll negotiate a little bit more flexibility between the parties too. Because they just know that it's not going to be perfect. And here's what our deal is. And so some folks, some buyers really like having dollars and working in capital adjustments.

40:27Other buyers don't like it. They think it's, we should get every dollar we're entitled to. It's interesting. And sellers are the same. That's like some real differentiated business culture, right? Do we want to nickel and dime this out? Or do we want to do that? It is interesting kind of seeing the differences between folks. and you never know what decision is going to be made. Can we talk about deferred revenue? Where does that fit in? So deferred revenue is you get a payment up front for a year's contract. And the contract's technically monthly, but they pay their annual fee up front. We're not recognizing that revenue.

40:57Of course, I'm not an accountant. So this is just how I understand the concept. We're not recognizing that revenue until we actually earn it. But we have the cash in the bank. It is treated as a liability, maybe on the balance sheet. Is that considered indebtedness? Really, it's we just need to provide them services. So what's the cost of providing those services? And so for things like software, it can be relatively low. Oftentimes, especially in software company deals where you have these licensing arrangements where there's a lot of deferred revenue, it's heavily negotiated, whether that's treated as indebtedness, whether it's treated as working capital, whether it's not taken into consideration at all.

41:34There's a lot of M &A accounting rules too about when that deferred revenue comes over, how much of it can actually be treated as a liability. But you have to think about it. At least the buyer is saying, they're selling all this. They're getting the cash. They're taking the cash before the closing. And now we're stuck servicing all of these contracts for post-closing contractual periods. That's one point that gets negotiated a lot in working capital adjustments. Then you got this other piece with accrued bonuses and vacations. Yeah, so accrued bonuses and vacations, that's another thing that gets negotiated a decent amount.

42:06And that's one of those points where it's really hard if the seller isn't accruing those on their books. they just pay them. They're running a cash-based system. They just pay them each month or they pay them when the person leaves. So you have to figure all of that out, which can be difficult, but doable. Some folks, they try to get that as working capital as a line item on the balance sheet. Other investors, other buyers, they'll try to treat that as a transaction expense. So all of your accrued payroll, all of your accrued bonuses, you pay that out from before the closing, that's on your dime.

42:37And then we'll take care of everything afterwards versus some buyers say, we'll throw it in with working capital, we'll come out in the wash. You can see the logic and the reasoning on both sides. But it goes back to what we said before of, is it nickel and diming? Or are we going to be a little bit more lax with that? And often it will come into, how much is it? How big is the deal? How much is it in the deal? And so you got to look at that as well. Get your accountant, get your lawyer involved in this one. Yeah, get your accountants, get your lawyers involved early. That's, I think, is the key bullet point coming out of this talk.

43:07It is a funny one because it's an overlooked item, especially if you're doing smaller deals or newer to doing M &A. You really don't think about capital working adjustments, which tend to be pretty significant depending on the business type, especially. And they're huge. And because the smaller deals, they typically don't have large legal teams. I can't tell you how many of these medium-sized deals, like big companies, sometimes even$40 million, where it's, we have a bookkeeper. We have a third-party bookkeeper that helps us with our books and our taxes each year. And then getting those folks who are not used to dealing with the pressure and the intensity of an M &A transaction, the real dollar-for-dollar adjustments to the amount, it can make things extremely difficult.

43:49So by getting them in early, you can either maybe get a specialized accounting team involved, which I would recommend on the legal side for sure. Like getting a specialized legal team, but you can maybe get a specialized accounting team. And just having them, everyone get together and work together. Okay, let's figure out what our issues is before we jump overboard here and start entering the market. You got any other advice for people doing small deals? Get your house in order. Start thinking about the process before you get the LOI in. It's a hard thing to do. I'm a deal guy at heart. And that's really hard to do.

44:22It is really hard to do. But it's possible. And when it happens, which is unique, those deals go by so much smoother than when we just... Here's the LOI. And we have all this stuff we need to clean up. We haven't told our accountant yet. We're trying to close in four weeks. So get your house in order, stay organized, get your information clean, get your data room set up, have your business records orderly and have your attorneys help you with that. If you know and you sure need to think about a process, especially if you don't have the best accounting records, you don't have a large accounting team, you don't have a legal team, get those outside advisors together and working together ahead of time.

44:58We see a lot of clients, they don't want to pay the expense, especially without a deal on the table. But it's kind of like the old adage, an ounce of prevention is worth a pound of pain. And it does end up being more economical in the long run. Great advice. Anthony, what's the craziest thing you've seen in M &A? I've been in some crazy negotiations. I've definitely... I think crazy things to me are when we see... Especially when I represent the sellers, we see sellers walk. And it's like, wow. That's when you know that they have the actual negotiating leverage when they're willing to walk. Bringing it back full circle.

45:29dealing with just good general attorneys, like good people, but that don't do M &A all the time, you end up fighting about really weird stuff and negotiating over provisions that you've used the same language and 30 other deals and no one's ever marked it up and you end up spending multiple hours and multiple revisions on this language because this person is just not used to this language and it's new. So I feel like those are the craziest situations. Definitely when we see people actually walk and dealing with kind of lawyers. You might have a really good doctor that you go to all the time, but if you need an organ transplant, you should probably go to a specialist in that situation, or where we run into the crazy situations.

46:08Yeah, it's probably advantages you get over it too. Yeah, that's right. Hey, Anthony, this has been a great conversation. Thanks for taking the time. You're helping me become a better M &A scientist, as I always say, so I value that. Plus, I don't think I'm getting billed for this, so this is even better. But those of you who want to continue, reach out to Anthony on LinkedIn. Mentioned M &A Science. He'll hook you up with the discounted billable rate. We'll do the best we can. Yeah. The M &A Science special. This has been great. Thank you so much for taking the time to do this and having this conversation.

46:39Yeah. Thank you so much. It was a pleasure. Those of you still tuning in. Until next time, here's to the deal.

46:55Thank you for taking the time to explore the world of M &A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M &A function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email, Kisan, K-I-S-O-N, at mascience.com. or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter.

47:40Again, that's mascience.com. Here's to the deal.

48:04Thank you.