Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

Where earn-out compensation represents a significant portion of the seller’s consideration in a purchase transaction, the buyer is required to use reasonable efforts to achieve the purposes of the earn-out. That is the law in Massachusetts, as per a recent Federal appeals court decision, and any other State where Justice Cardozo’s memorable opinion in Wood v. Lucy, Lady Duff-Gordon is still quoted. 

PerkinElmer, a publicly traded lab equipment company, acquired the business and assets of Sonoran Scanner, a private company engaged in the computer-to-plate (CTP) printing business. Sonoran’s main product was a $500,000 machine that offered a high-speed digital alternative to the costly and time-consuming analog process required by conventional plate technology printing. Like many good ideas, this one ran low on funding. The founder had invested $3.5 million of his own funds, but the company had no sales.  Out of cash, the founder sought a purchaser to undertake the continued development and marketing of the CTP technology.

PerkinElmer paid $3.5 million at closing (most of which went to creditors) and agreed to certain earn-out payments if sales targets were met over a 5 year period. PerkinElmer would pay $750,000 if at least three CTP machines were sold in the first year following closing, $1.5 million (less any previously paid earn-out amounts) if at least ten machines were sold by the end of the second year, and additional amounts if certain gross margin targets on sales of CTP machines were met. The additional earn-out payment (over and above the $1.5 million) during the five year payout period was a maximum of $2 million.

Sadly, the CTP business, as operated by PerkinElmer, was a failure. Only one CTP unit was sold and there were no earn-out payments.  The founder blamed the failure on PerkinElmer.  Unfortunately, the purchase agreement contained no express covenants regarding how the business was to be run during the earn-out period.  

The Court of Appeals held that the acquisition agreement contained an implied contractual term requiring that PerkinElmer use reasonable efforts to develop and promote the CTP technology, citing the famous 1917 case from the pen of then Judge Cardozo known as Wood v. Lucy, Lady Duff Gordon. In this case, Otis F. Wood, a New York advertising agent, signed on Lucy, Lady Duff-Gordon, otherwise known as "Lucile" (her couture label), to market garments and other products bearing her endorsement for a period of one year.  The contract was exclusive, and gave Duff-Gordon half of all revenues that Wood was able to generate. Wood's only duties under the contract were to account for monies received and secure patents as necessary - there was nothing requiring him to exert any efforts (although if he did nothing, there would be no revenues to share). Around the same time, Duff-Gordon came up with an idea to market a line of clothing "for the masses," and she broke the exclusivity provision by endorsing products sold by Sears Roebuck.  Wood sued, and Duff-Gordon defended on the grounds that no valid contract existed with Wood since he had not made an express promise to do anything.  The issue for Judge Cardozo was whether to find that Wood had made an implied promise to exert efforts to achieve revenues, thereby making the contract enforceable.  Cardozo held that Wood did make such an implied promise:

We are not to suppose that one party was to be placed at the mercy of the other. . . . [The] promise to pay the defendant one-half of the profits and revenues resulting from the exclusive agency and to render accounts monthly was a promise to use reasonable efforts to bring profits and revenues into existence.

Although the context was different (the Cardozo case was an exclusive representation agreement), the First Circuit in Sonoran Scanner held that PerkinElmer had made a similar implied promise to use reasonable efforts to achieve the earn-out, even though the contract had no such language.  The court was swayed by the fact that the potential earn-out compensation was “substantial” (potentially $3.5 million) in relation to the up-front payments made by PerkinElmer (also $3.5 million).  Also relevant was the fact that most of the $3.5 million closing payment was paid to creditors and did not benefit the founder. Finally, there was no language in the agreement negating an obligation by PerkinElmer to use reasonable efforts or conferring absolute discretion on it as to the operation of the business.

Drafting tip: if you are representing the buyer, and don’t want to get hit with an implied obligation to use reasonable efforts to achieve an earn-out, be sure to put in a clause giving your client full discretion as to the operation of the business during the earn-out period. 

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The DVD releases of future Disney films featuring Marvel superheroes undoubtedly will contain bonus items for the cinephile. If a single viewing of a movie doesn’t sate your appetite, you’ll probably be able to watch it again accompanied by the director’s audio commentary. The Walt Disney Company’s S-4 registration statement regarding its proposed merger with Marvel Entertainment, Inc. contains a director’s commentary of a different stripe. The SEC filing includes a six-page section titled the “Background to the Merger” that describes the terms of Disney’s first proposal to Marvel, subsequent negotiations among their legal counsel, and explanations for why Marvel eventually agreed to the deal. We’ll break down this behind-the-scenes look at the talks. Keeping in mind that Disney and Marvel are both Delaware corporations, it’s difficult not to read this section – with its emphasis on the transaction’s deal protection terms – as a preemptive apologia of the Marvel directors’ actions in light of their Revlon duties to maximize shareholder value in the sale.

Disney-Marvel Negotiations: The Director’s Cut

Negotiations between Disney and Marvel focused on two transaction documents: the merger agreement and a voting agreement with Marvel’s CEO Isaac Perlmutter, who owns about 37% of Marvel’s shares through various affiliates. On August 11, Disney’s lawyers emailed their initial drafts of the merger agreement and voting agreement to Marvel’s legal counsel. According to the S-4, Marvel objected to several deal protection mechanisms contained in Disney’s proposal:

• a “force the vote” provision requiring Marvel to put the Disney deal before Marvel’s shareholders, even if Marvel’s board of directors received a superior bid for Marvel by a third party;
• a break-up fee equal to 4% of the transaction value if Marvel ended the deal;
• a  soft lock-up provision that would proscribe Marvel’s board from dropping its recommendation of Disney’s offer unless a third party made a superior offer to Marvel; and
• a demand that Mr. Perlmutter agree (i) to vote his Marvel common shares in favor of the Disney transaction and (ii) to veto any other transaction with another prospective buyer for a period of 18 months after the termination of the merger agreement.  

After two weeks of intense negotiations, a number of substantive terms remained outstanding. Disney continued to insist on a “force the vote” provision in the merger agreement and refused to concede on any of the deal protection measures contained in its first draft of the Perlmutter voting agreement. On August 27, Marvel’s special transaction committee informed the company’s financial and legal advisers that it would not recommend a transaction to Marvel’s board that included a “force the vote” provision or an 18-month tail on Mr. Perlmutter’s voting agreement because they considered these terms to be improper restrictions on the Marvel board’s ability to consider or enter into transactions with other potential buyers prior to the consummation of the Disney deal.   

During the ensuing days, Marvel told Disney that it would be willing to agree to a break-up fee equal to 2.9% of the transaction value in return for concessions by Disney on the other requested deal protection measures. 

In response to Marvel’s counteroffer, Disney agreed:

• to remove the “force the vote” provision;
• to let Marvel terminate the merger agreement in favor of a superior proposal if the board decided that “failing to do so might reasonably be expected to be a breach of its fiduciary duties;”
• to reduce the break-up fee from 4% to 3.5% of the transaction value;
• to allow Marvel’s board to change its recommendation of the Disney transaction to Marvel’s shareholders if it concluded that it had a fiduciary duty to do so; and
• to eliminate the 18-month tale on Mr. Perlmutter’s voting agreement (so that a termination of the merger agreement would constitute a termination of the voting agreement as well). 

Marvel’s Board of Directors Meeting

Marvel’s board of directors convened a meeting on August 30 to consider Disney’s revised proposal with its financial and legal advisers. During the course of the meeting, Marvel’s outside legal counsel advised the board on the agreements’ deal protection measures and the board’s fiduciary duties under Delaware’s general corporation law in the event that it received a possible superior proposal from a third party after the signing of the Disney merger agreement. Marvel’s lawyers also analyzed the procedure for considering alternative bids for the company under the merger agreement, the situations in which the board could terminate the merger, and the conditions under which the break-up fee would be payable to Disney. In the end, Marvel’s attorneys concluded that Disney’s deal protection measures “provided the Marvel board of directors with sufficient flexibility to entertain bona fide alternative proposals, were consistent with the Marvel board of directors’ fiduciary duties and were not coercive to Marvel stockholders.”

The following day Disney and Marvel signed the merger agreement and Mr. Perlmutter and Marvel entered into the voting agreement with Disney.

Critic’s Corner

Of course, the “Background to the Merger” section only summarizes discussions between Disney and Marvel. The disclosure contained in Disney’s S-4 stresses the companies’ haggling over the deal protection terms, but negotiations over the purchase price and the proportion of cash and stock that made up the purchase price were probably not mere subplots to the main action. Nevertheless, the narration of Disney’s and Marvel’s back-and-forth over the deal protection terms at times resembles Kabuki theater more than the Hollywood blockbusters the marriage of the two companies is likely to spawn. While it’s well known that a board’s fiduciary duties under Delaware law to maximize the sale price of a company does not impose any “legally prescribed steps that directors must follow to satisfy their Revlon duties,” Delaware courts have done a fairly decent job of coloring in the outlines of directors’ obligations to shareholders in the sale of a company since the 1986 landmark ruling. The story told by Disney’s S-4 raises questions about what purpose the inclusion of terms likely proscribed by Revlon in the first draft of a merger agreement serves. For example, how useful are such terms as bargaining chips when making an initial offer to a potential seller’s board of directors? When a buyer agrees to eliminate these types of deal protection measures in subsequent negotiations, has it really conceded anything of value? 

The Sequel

Nowadays, it seems that almost every profitable movie has a sequel in the works before it has even finished its run in the cinemas. We see no good reason why this blog post shouldn’t follow suit:

Much of the discussion in the S-4 regarding merger negotiations between Disney and Marvel addresses what actions the Marvel board would be permitted to take if it were to receive a “superior proposal” from a third party. But without an explanation of what constitutes a superior proposal under the merger agreement, any discussion of the proposed merger signifies very little. When we revisit the Disney-Marvel merger in a later post, we’ll take a closer look at the merger agreement’s definition of a Superior Proposal.

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Are earnouts in today’s M&A market still primarily serving to bridge the valuation gap between buyers and sellers? Or do we need a different explanation for the prevalence of earnouts in recent, large M&A deals? Buyers and sellers are negotiating in what is arguably the most uncertain economic climate of the past decade. Whereas in the past, the caricature of a cautious, risk averse buyer bargaining with an optimistic seller may have served as a useful – if crude – illustration of the buyer-seller valuation gap, it’s unlikely there are many Panglossian sellers out in today’s market. What is more, the idea that the valuation gap arises from a buyer’s superior knowledge about market and industry conditions doesn’t seem as plausible when applied to large deals between sophisticated players. 

Earnouts have been a common term in acquisition agreements for high-growth businesses and small companies. By making part of the purchase price contingent on a target’s ability to meet future earnings targets or reach designated milestones, a buyer can reduce its exposure to the risk that the target doesn’t fulfill the seller’s rosy predictions. At the same time, a buyer can promise to reward the seller if the target’s post-sale performance equals the seller's projections of its pre-sale prospects. An earnout, the theory goes, enables wary buyers and eager sellers to bridge the gap between their respective valuations of the target’s future profitability. 

What accounts for this disparity in valuations? Professor Brian Quinn quotes the abstract of a recent paper by Roberto Ragozzino and Jeffrey Reuer concluding that the use of earnouts “increases with information asymmetries surrounding mergers and acquisitions.” In their article, the authors argue that earnouts appear more often in acquisitions where the target is a new company or for other reasons doesn’t have access to the buyer’s superior market and industry knowledge. For acquisitions of small, private companies by buyout firms and strategic buyers like public corporations, Ragozzino’s and Reuer’s empirical findings make sense. But for this M&A season’s rash of earnouts, especially those appearing in large transactions, we may need to abandon our reliance on the explanatory power of a presumed valuation gap. 

The cost of capital for buyout firms and other acquirers has risen considerably. On top of that, buyers are operating with an informational deficit. Even if they feel they may have a strong grasp of a target’s industry and confidence in its business model, the outlook for the general economy over the next 12 to 18 months is foggy at best. More important, unlike the M&A boom period of a few years ago, buyers do not have to push past as many elbows to bring a potential seller to the bargaining table.   Buyers, that is, appear to have a negotiating advantage in today’s market. Earnouts help buyers negotiating with poor information under current economic conditions in two ways. First, it allows them to limit their financial exposure to new investments in the event the economy doesn’t revive in the short- to mid-term. Second, it allows them to defer a significant portion of the purchase price to a time when the cost of capital should be cheaper. 

It’s true that earnouts in private equity deals have always served as a risk management tool. Yet, in the past earnouts generally served to protect buyers from a target’s failure to compete successfully in its industry, not from a continued or worsening recession. Now, however, private equity firms and other buyers are not merely hedging against business and industry-specific variables. They’re signing up for a broader insurance policy against future market conditions. The prevalence of earnouts in today’s market cannot be entirely attributable to a valuation gap; it would be wise to take a close look at the negotiation gap as well.  

Related Posts:  

Valuation of a Private Company

Growing the Company through Strategic Acquisitions

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Does Merck-Schering’s reverse merger structure avoid triggering the change of control provision in Schering’s distribution agreement with Centocor? Only time will tell. But The Wall Street Journal reports that William Weldon, CEO of Centocor’s parent company Johnson & Johnson, admitted his company was “analyzing the situation” and “was not sitting back and doing nothing.” In our previous post, we summarized the Merck-Schering reverse merger deal structure. Today, we’ll review the Schering-Centocor distribution agreement’s change of control definition and inquire whether imprecise contract drafting may benefit Johnson & Johnson.

Ambiguity of “Change of Control” in the Schering-Centocor Distribution Agreement

The Schering-Centocor distribution agreement appears to offer two competing definitions of what would constitute a change of control. Section 8.2(c) of the agreement provides that either party may terminate the agreement if the other party suffers a “change of control.” The section begins by stating that if Schering or Centocor is “acquired by a third party or otherwise comes under Control of a third party,” then the “party not subject to such change of control” has the right to terminate the distribution agreement. The first two clauses of Section 8.2(c) indicate that Schering would suffer “such a change of control” if: (i) a third party were to acquire it or (ii) a third-party, directly or indirectly, were to own more than 50% of its voting rights, have the right to receive more than 50% of its profits, or otherwise control its management decisions. But at this point Section 8.2(c) continues in an unexpected way: it offers another competing definition of change of control.        

Without any reference to the first two clauses of Section 8.2(c), the remainder of the section purports to define the elements that constitute a “Change of Control.” According to this definition, a change of control under Section 8.2(c) would occur upon (i) a merger or other reorganization in which Schering was not the surviving corporation, (ii) any non-affiliate of Schering’s becoming a beneficial owner of more than 50% of Schering’s outstanding common stock or the combined voting power of Schering’s outstanding securities, (iii) certain extraordinary changes to Schering’s board of directors, or (iv) Schering’s liquidation or dissolution. What are we to make of this second definition?   

A court would most likely determine that the meaning of a “change of control” under the distribution agreement is ambiguous because the two definitions offered are susceptible to different reasonable interpretations and may have two separate meanings.  Unless a court determined that both the first definition and the second definition were coextensive, it would likely rule that the two change of control definitions are irreconcilable. In that case, the court may have to resort to extrinsic evidence of the parties’ intent at the time of contract to resolve the ambiguity. 

Effect of Contractual Ambiguity on Reverse Merger Structure

Given the distribution agreement’s ambiguity, what effect does this have on the ostensible protections afforded by the Merck-Schering deal structure?

First, as Robert Willens at CFO.com points out, although legally Schering will become the parent corporation of Merck, from a financial accounting perspective Schering will be the acquired entity. Generally, in a business combination involving the exchange of equity interests, the acquiring company is usually the one that issues the securities. But the Financial Accounting Standard Board’s SFAS No. 141, which provides accounting guidance for business combinations, notes that in reverse acquisitions, the company issuing equity securities is often the target. SFAS No. 141 states that the acquiring company in a merger will usually be:

• the merging entity whose owners as a group receive the largest portion of the voting rights of the combined entity,
• the merging entity whose owners have the ability to elect, appoint, or remove a majority of the members of the combined entity’s board of directors,
• the company whose former managers dominate management of the combined entity, and
• the entity that pays a premium over the pre-merger fair value of the equity interests of the combined entity. 

Merck, as Willens points out, seems to fit these criteria perfectly. If the dispute over which definition controls comes down to the intent of Schering and Centocor at the time they entered into the agreement, then Johnson & Johnson could argue that the broad “acquired by” language in the first definition was meant to cover transactions like the Merck-Schering merger. Although Merck will be a wholly owned subsidiary of Schering after the merger, Merck will have effectively acquired control over Schering’s operations. 

Second, as we discussed in our previous post, before Merck merges with Schering’s subsidiary, Schering must cause its board of directors to resign and appoint Merck’s directors to Schering’s board. Interestingly, the second change of control definition in the distribution agreement precludes certain extraordinary changes in Schering’s board of directors. While the definition allows changes in Schering’s board of directors that occur as a result of ordinary course shareholder and board actions, such as the periodic nomination and election of directors, it explicitly excludes directors whose initial assumption of office results from (i) an election contest or (ii) “other actual or threatened solicitation proxies or consents by or on behalf of a person other than the [board of directors]” (emphasis added). 

The drafters of this clause probably intended it to prohibit extraordinary changes to Schering’s board of directors resulting from tender offers or other hostile takeover techniques. Nevertheless, we do not know the content of pre-merger negotiations between Merck and Schering. It’s possible that the record would show that Merck’s conduct towards Schering arguably violated this provision by seeking to place its directors on Schering’s board. Remember, Schering has agreed to put Merck’s board of directors in control of the surviving Schering corporation before Merck becomes Schering’s subsidiary in the second and final step of the merger. 

The inevitable negotiations between Schering’s and Johnson & Johnson’s lawyers about the distribution agreement will depend on which side thinks the contract’s ambiguity gives it an upper hand.

Related Posts: Merck-Schering's Reverse Merger: Change of Control Provisions in Material Contracts

           A Duty to be Forthright: Negotiators Beware!

           Pharma Contractual Dispute: Biogen and Elan to See Each Other in Court

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Merck & Co. structured its acquisition of Schering-Plough Corp. as a reverse merger to avoid tripping a change of control provision in an important distribution agreement. This has received a lot of attention, not surprisingly. The distribution agreement (for the rheumatoid arthritis drug Remicade^®) brought in $518 million for Schering in the first quarter of 2009, constituting 18% of the company’s sales. In today’s post on the deal’s structure, we’ll summarize some of the terms of the Merck-Schering merger agreement and consider the importance to the M&A process of getting consents to change of control provisions in a target company’s material contracts.

Change of Control Provisions in Material Contracts

Generally, receiving consents or waivers to change of control provisions in material contracts is set out as a closing condition to an acquisition or merger. Indeed, determining which of a target’s contracts contain change of control provisions constitutes an important part of the pre-acquisition legal due diligence process. For some transactions, failure to obtain the appropriate consents may materially affect the value of the target company or may interrupt the target’s business operations if the deal were to go through. 

Take the case of a company whose sole assets comprise a group of television broadcasting stations. These stations rely on programming contracts they have with national network and cable television producers in order to provide most of their viewing content to their audiences. If the acquisition of the company by another corporation were to allow the television producers to terminate the programming agreements, the company’s broadcast stations may go off the air once the transaction is completed.     

Many counterparties insist on change of control provisions in important contracts on the grounds that they are reaching an agreement with a specific company and do not think it reasonable that they should later be bound to an unknown third party by the same terms. That’s the most likely rationale behind the change of control provision in Schering’s distribution agreement with Centocor, a subsidiary of Johnson & Johnson. As the creator and developer of the lucrative Remicade^® and other arthritis medications, Centocor agreed to share profits from international sales of some of its drugs with Schering in exchange for Schering’s distribution of the drugs outside of the United States. But if Schering suffers a change of control, the distribution agreement allows Centocor to terminate the agreement, causing all rights to profits from worldwide sales of the drugs to revert to Centocor. 

Last year, Remicade^® alone generated over $2.1 billion in sales for Schering. A great deal of money is at stake here. Merck, the potential acquirer of Schering, is a major pharmaceutical rival of Johnson & Johnson. The normal M&A process of procuring waivers to change of control provisions in material contracts does not seem to have worked. Instead, Merck and Schering decided to use the business reorganization technique known as a reverse merger for an unusual purpose: to avoid a change of control.          

The Reverse Merger Deal Structure

The Merck-Schering merger agreement contemplates a two-step transaction involving Merck, Schering, and Schering’s two special purpose, subsidiary holding companies, Blue, Inc. and Purple, Inc. In step one of the merger, Blue will merge into Schering and each share of Schering will be converted into the right to receive (i) 0.5767 shares of the surviving Schering corporation and (ii) $10.50 in cash. In step two of the merger, Purple will merge into Merck and each share of Merck will be converted into 1 share of the surviving Schering corporation. 

After the completion of these two steps, the surviving Merck corporation will be a wholly owned subsidiary of the surviving Schering corporation. Yet, the shareholders of pre-merger Merck will own approximately 68% of the surviving Schering corporation and shareholders of pre-merger Schering will own around 32% of the surviving Schering corporation. Although Merck will become a subsidiary of Schering, Merck’s pre-merger shareholders will together possess a supermajority of the voting and economic rights (or beneficial ownership) of Merck’s new parent company, Schering. 

One peculiarity of the Merck-Schering reverse merger transaction structure is that between steps one and two Merck finds itself in a slightly precarious situation. After the completion of step one, Schering’s pre-merger shareholders will have received shares of the surviving Schering corporation and a cash payout, but Merck’s pre-merger shareholders will not yet have seized control over the management of the surviving Schering corporation.  

The merger agreement has come up with a way to protect Merck’s shareholders during this governance gap. Simultaneously with the completion of step one of the merger, Schering has agreed that its board will cause all of its directors (other than 3 specified exceptions) to resign and to elect the members of pre-merger Merck’s board of directors as the directors of the surviving Schering corporation. Even before pre-merger Merck’s shareholders acquire their supermajority share of the beneficial ownership of the surviving Schering corporation after step two, they indirectly will have already taken the helm of the surviving Schering corporation through the election of their own directors to the new parent company’s board.        

In our next post on the deal, we’ll analyze the change of control provision in the Schering-Centocor distribution agreement and assess whether Johnson & Johnson has any colorable arguments that Schering will indeed undergo a change of control if the Merck-Schering reverse merger closes.

Related Post:  Can Merck-Shering's Deal Structure Avert a Change of Control?

                          Pharma Contractual Dispute: Biogen and Elan to See Each Other in Court

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In our third and final post today on noteworthy deal protection provisions in the KKR-Sum Total merger agreement, we review Sum Total’s remedies for a breach or termination of the agreement by KKR. (Our first post covered the agreement’s “go shop” and “no shop” provisions and KKR’s break-up fee; our second post discussed the absence of a “financing out” for KKR.)

No Reverse Break-Up Fee

Sum Total is not entitled to a reverse break-up fee if KKR breaches or terminates the agreement under any circumstances.     

Specific Performance

The merger agreement pointedly provides that specific performance constitutes Sun Total’s “sole and exclusive remedy” for breaches of the merger agreement by the KKR merger vehicle or of the guarantee by Accel-KKR Fund III, L.P. Sum Total’s only recourse, in other words, is to get a court order compelling KKR to complete the merger. Sum Total has even agreed that if a court declines to enforce the specific performance remedy and awards monetary damages instead, the company may only collect its court ordered award if KKR is no longer willing to go ahead with the merger. 

The remedies section of the merger agreement appears to have been drafted in the shadow of the Delaware Chancery Court’s ruling in United Rentals v. Ram Holdings. In that case, the target company United Rentals moved for summary judgment on its claim that it was entitled to specific performance from a Cerberus-led private equity fund consortium under the terms of their merger agreement. The court, however, found that the priority of the two remedies provided to United Rentals under the merger agreement -  a reverse break-up fee and a right to specific performance - was ambiguous. Determining that neither United Rentals nor Cerberus was able to demonstrate that its proposed interpretation of the merger agreement was the only one that would be reasonable as a matter of law, the court resorted to extrinsic evidence by applying the forthright negotiator principle to divine the parties’ intent at the time of contract. The remedies section of the KKR-Sum Total merger agreement appears to be closely drafted to memorialize the parties’ intent that Sum Total’s only remedy is specific performance and that KKR’s right to specific performance does not preclude it from seeking its break-up fees.     

NB: The merger agreement also gives Sum Total the right to force the shell holding company serving as KKR's merger vehicle to compel Accel-KKR Fund III, L.P. to finance the purchase price of the merger.

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Following our post earlier today in which we reviewed KKR's break-up fees and the "go shop" and "no shop" provisions in the KKR-Sum Total merger agreement, we now examine the absence of a “financing out” in the agreement.

No Financing Out

In private equity buyouts, the acquisition vehicle tends to be a shell holding company with no assets. At the closing of highly leveraged cash-for-stock mergers, the holding company is funded by an equity investment from the funds participating in the merger and by senior and mezzanine, or “bridge,” loans from a syndicate of banks. Upon receipt, the holding company immediately transfers these funds to the target company for distribution to the target’s shareholders to complete the merger.   (The movement of these funds as they’re wired from entity to entity is mapped out in painstaking detail beforehand by the accounting firms in a chart dubbed the “funds flow.”) 

Although private equity firms usually have obtained signed letters from the banks committing their funds to the transaction before they enter into a merger agreement, firms always face the danger that, at some point between signing the merger agreement and closing, their lenders renege on their financing commitments or increase the costs of borrowing. To protect themselves against the possible loss of debt financing on acceptable terms, private equity funds in years past have negotiated a “financing out” in merger agreements by setting the continued availability of financing from their bank syndicates as a condition to closing the deal. 

The merger agreement does not have a “financing out” for KKR because the firm is financing the Sum Total merger solely with an equity investment from Accel-KKR Fund III, L.P., a fund dedicated to investing in mid-market technology companies. With no fear of a third-party’s failure to make good on its loan promises, KKR faces very little risk that it will not be able to come up with the cash to complete the transaction. 

Guarantee from KKR Fund

In fact, it is Sum Total who bears some risk that the KKR fund may fail to contribute cash to the shell holding company serving as KKR’s merger vehicle. The merger agreement gives Sum Total additional comfort by having the right to force the merger vehicle to compel the KKR fund to finance the purchase price. Sum Total also has a direct guarantee from Accel-KKR Fund III, L.P. for the holding company’s (and its subsidiary’s) obligations under the merger agreement. In effect, Sum Total’s contractual right to force the KKR fund to finance the transaction serves as an alternative, extra-judicial means of enforcing its right to specific performance under the agreement.

Sum Total’s right to specific performance will be the subject of our third and final post on the deal protection terms in the KKR-Sum Total merger agreement.

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A signed merger agreement with Accel-KKR in hand, Sum Total’s board has a month to go to the market to find a better deal. On Friday, Sum Total Systems, Inc. announced that Accel-KKR had offered its shareholders $3.80 per share in a definitive merger agreement filed with the SEC. For this deal at least, the private equity fund has foregone the LBO model, financing the entire $124 million price tag with an equity investment from a KKR fund focused on mid-market technology companies. By the time the markets closed on Friday, Sum Total stood at $3.83 a share, a 22% jump from the previous day’s closing price of $3.13. Trading volume for Sum Total’s shares skyrocketed to 5,759,368 on the day, compared to an average daily trading volume of 330,000 shares. 

Investors seem eager to become beneficiaries of an anticipated bidding war. While Sum Total’s board of directors has recommended the KKR merger, the company’s shareholders have yet to vote on the deal. According to the website Mergers Unleashed, a JPM Securities’ analyst report affirmed its $5 per share target value for Sum Total’s stock after Accel-KKR announced the merger deal. KKR has laid its cash and deal terms on the table, now it’s time to see whether anyone else will sit down and ante up.  

Over the course of the day, we’ll take a look at some of the noteworthy deal protection measures in the KKR-Sum Total merger agreement: 

“Go Shop” Period and "No Shop" Provisions

The Sum Total board of directors has a one-month “go shop” period (ending just after midnight on May 24) to solicit competing offers for the company’s shares. From May 24 until the company’s shareholders approve the merger, Sum Total’s board may not engage in any discussions with other parties regarding the sale of the company. This “no shop” provision has a customary fiduciary exception that allows the company’s board to entertain unsolicited written acquisition proposals so that Sum Total’s directors can fulfill their Revlon duties under Delaware corporate law to bargain for the highest price obtainable for the company’s shareholders. Though the Revlon court observed that “no shop” provisions are a legal deal protection measure under Delaware law, the court held that an absolute “no shop” prohibition on a company’s board of directors “when a board’s duty becomes that of an auctioneer for selling the company to the highest bidder” is impermissible.     

Even if it receives a better offer, Sum Total can’t terminate the agreement without first going back to KKR. If the board considers approving a merger agreement with another buyer, Sum Total must give KKR detailed information about the proposal, negotiate a potential counteroffer with KKR, and permit KKR to present a revised merger agreement to the board of directors for their consideration. KKR has found some relief, it seems, from the Revlon restrictions placed on their ability to lock-up the deal by negotiating a right of first refusal if a competing bidder proposes a higher price.    

Break-Up Fee

If the merger agreement is terminated because the Sum Total stockholders don’t approve the deal, the company breaches certain of its covenants (including the no shop restrictions), or the board changes its recommendation without entering into a merger agreement with another buyer, Sum Total must pay KKR a $4.95 million break-up fee. If the company terminates the agreement because the board has authorized the company to execute a merger agreement with another buyer offering the company’s shareholders a better deal, then KKR’s break-up fee is reduced to $3.1 million.  

Update:  Other aspects of the deal protection measures in the KKR-Sum Total merger agreement are discussed in:

No "Financing Out" Required: KKR's Equity Financing of the Sum Total Merger

Sum-Total's Remedies Under the KKR Merger Agreement

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The private equity sponsors behind the Clear Chanel acquisition – Bain Capital and Thomas H. Lee Partners -- are looking at the possibility of paying a $500 million reverse termination fee to Clear Channel if they are forced to walk away for lack of bank financing. Maybe the sponsors can recover some of this from the lenders who promised to provide the financing – time will tell. The banks committed to provide about $16 billion of new debt, which they may struggle to sell given turmoil in the leveraged loan market.   And even if they do manage to sell it, they might face a mark-to-market hit of about $2.5 billion. Lawsuits recently begun in New York and Texas may clarify whether the banks are responsible for causing the deal to break.

The sponsors will have a hard time arguing that a material adverse change in Clear Channel’s fortunes has occurred, given that the company reported a 52 percent rise in fourth-quarter earnings. Assuming that some or all of the break-up fee has to be paid by the sponsors, who really has to foot that bill – the limited partners in the funds or Bain and THC?

An LBO partnership agreement typically provides that deal expenses, including “broken deal” costs, are paid by the investment partnership, namely, the limited partners. However, these costs are typically offset against the management fee paid by the fund to the sponsors. That provision makes the sponsor ultimately responsible for broken deal costs, but caps the exposure at the amount of the management fee. 

The impact of this situation can be seen in Blackstone’s recent 10K filing. There, in the MD&A section, Blackstone described certain shortfalls in management fee income that occurred during 2007. Prominent among the causes for this shortfall was a reverse termination fee that was paid when Blackstone terminated the acquisition of a subsidiary of PPH Corporation. Here is the relevant portion of Blackstone’s MD&A section:

"An increase in fund management fees of $47.2 million, as a result of $4.68 billion of additional capital raised for BCP V during the year ended December 31, 2007, was entirely offset by increased management fee reductions of $47.4 million. The increase in management fee reductions was due to increases of $38.2 million of broken deal expenses, which included a $24.2 million reverse termination fee incurred in connection with the termination of BCP V’s planned acquisition of a subsidiary of PHH Corporation, and $9.2 million of placement fees paid for additional capital raised by BCP V."

No wonder Bain and THL are suing the banks left and right.

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A recent spate of private equity cases has turned on the question whether the buyer has the right to walk away from a deal and pay a fixed price, known as the reverse termination fee.  Rather than be spurned, the target clutches at the specific performance clause in the merger agreement, and tries to push the deal through.  This year, so far, of the seven announced private equity deals for public companies, all have had reverse termination fees.  Moreover, each of the seven deals explicitly barred specific performance of the agreement.

As a result, private equity sponsors have the option to walk away from the deal for a fixed cancellation price.  In this environment, where guaranteed financing terms just aren't available, probably no other structure is possible for a leveraged deal.

 The recently announced deal to buy Getty Images, the pictures and video distributor, for $2.4 billion including debt, marks this trend.  The private equity firm, Heller & Friedman, rejected specific performance language and even added "no recourse" language directly in the merger agreement.  No recourse language typically states that the seller cannot directly sue the private equity firm for damages or specific performance. In Getty Images the merger agreement language states:

 
“[Getty Images] acknowledges and agrees that it has no right of recovery against, and no personal liability shall attach to, in each case with respect to [The Reverse Termination Fee Liability Limitation], any of the [Hellmann & Friedmann] Parties (other than [Acquisition] Parent to the extent provided in this Agreement and the Guarantor to the extent provided in the Limited Guarantee), through [Acquisition] Parent or otherwise, whether by or through attempted piercing of the corporate, limited partnership or limited liability company veil, by or through a claim by or on behalf of [Acquisition] Parent against the [Private Equity Fund] Guarantor or any other [Hellmann & Friedmann] Party, by the enforcement of any assessment or by any legal or equitable proceeding.”

It seems that parties have become disenchanted with the idea of specific performance as a remedy.  The courts have been reluctant to decree a merger, perhaps due to the significance of the remedy.  After all, how does one order the merger of two parties when one of them has changed its mind?  A merger requires willing parties on both sides to make things work.  Money, careers and even communities hang in the balance. The remedy itself seems unrealistic in the context of business combinations.

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As this website predicted on November 24th, the Delaware Court of Chancery on December 21, 2007 found that the sole and exclusive remedy of United Rental was the $100 million break up fee specifically provided for in the Merger Agreement with entities controlled by Cerberus Capital.

The exchange of drafts and the meetings between the parties indicated that the breakup fee was intended to preclude any other remedies, including specific performance..  United Rental’s case was based on the fact that the contract continued to have language providing for equitable remedies like specific performance, even though other sections said that this remedy was superseded by the breakup fee. In deposition, the Cerberus attorney conceded that it would have been “clearer” to delete the specific performance section altogether.

Given the relatively clear cap on exposure in the Merger Agreement, one would expect that the opinion of the Delaware court would stick closely to the express contract language and the law of summary judgment. In fact, most of the opinion does that. But the court ultimately relied on an interesting though obscure principle of contract interpretation called the “forthright negotiator principle.”

According to the court, under the forthright negotiator principle, “the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because the evidence in this case shows that defendants [Cerberus] understood this Agreement to preclude the remedy of specific performance and that plaintiff [United Rental] knew or should have known of this understanding, I conclude that plaintiff has failed to meet its burden and find in favor of defendants.”

“The forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

The only support for this principle cited by the court was a section of the Restatement of Contracts. 

The very interesting history of these contract negotiations indicates that the parties never explicitly resolved the issue of whether the $100 million breakup fee was the sole and exclusive remedy. The court found that because the parties never clearly drafted any agreement on the termination fee, it would award judgment to the side that most clearly and consistently articulated its subjective understanding of the agreement to the other side. In this, the court found that the Cerberus attorney was more consistent in his statements that the termination fee was intended to preclude specific performance. The attorney for United Rental, the court found, implicitly agreed with the Cerberus position during oral contract negotiations.

The case came down to this fact: “Though URI, through [its lead attorney], had many opportunities throughout the negotiation process to clearly vocalize its understanding of its rights for specific performance under the Merger Agreement, URI consistently failed to communicate this to Cerberus representatives.”

The very interesting implications of this decision for the manner in which merger negotiations are conducted will be the subject of future postings here.

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In the investment world, there is no shortage of firms where everyone drinks the koolaid, believing the firm is a truly unique organization with values and a culture shared by no one else. Most times, the koolaid drinking is done in private, at partners’ meetings or golf retreats where the steady gaze of outsiders does not interfere with the collective daydream. It is therefore jarring to see the drinking done in public, especially in so formal a setting as a prospectus for an initial public offering.

The Summary section of the IPO prospectus of Blackstone Group contains the following announcement:

We Intend to be a Different Kind of Public Company

While we believe that becoming a publicly traded company will provide us with many benefits, it is our intention to preserve the elements of our culture that have contributed to our success as a privately-owned firm. In particular, as described below, we intend to continue to manage our business with a long-term perspective, to focus at all times on seeking to optimize returns to the limited partner investors in our investment funds and to retain our partnership management structure and culture of employee ownership of our business. 

Because our businesses can vary in significant and unpredictable ways from quarter to quarter and year to year, we do not plan to provide guidance regarding our expected quarterly and annual operating results to investors or analysts after we become a public company.

The logic here appears to be that one fosters a long-term perspective on business by refusing to provide guidance to investors about quarterly and annual operating results. But then, it is not really evident how these things are connected.  Is it really true that by not disclosing its quarterly and annual profit expectations, which Blackstone surely prepares internally, the firm will better manage its business for the long term?

It seems one thing to believe in the long-term perspective, after having drunk deeply from the bowl.  It is another thing to prominently feature the belief in an IPO prospectus.  But then, it was only a statement of intent. 

And what of the belief itself? Do private equity firms really manage their investments with a “long-term perspective”? Happily, Christina Padgett of Moody's Investor Service has recently written on this subject. In a recent report, Ms. Padgett wrote:

While Moody's would agree that leverage is likely to impose discipline and provide higher equity returns, the current environment does not suggest that private-equity firms are investing over a longer-term horizon than do public companies, despite not being driven by the pressure to publicly report quarterly earnings"

The report goes on to note that Celanese US Holdings, a chemical business owned by Blackstone Group, borrowed money within a year of the acquisition to pay a dividend to the private-equity firm, removing more than 95% of the cash equity originally invested in the deal. 

Blackstone's investors at least can breath a sign of relief, knowing that the firm has a sharp eye for the short term as well as the long. 

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Contract parties very often want to pre-select the court in which any lawsuit arising under the contract must be brought. Issues of convenience and perceived fairness typically underlie the desire for these clauses. To be enforceable, forum selection clauses must be clear and unambiguous. 

A recent case from the Delaware Court of Chancery illustrates what happens when a forum selection clause is badly drafted. 

A manufacturer of microbial degradation and mold control products sued the investment banker it hired to assist with acquisitions. The manufacturer believed that the investment banker misused confidential information in the course of their relationship. The engagement letter tried to select the Southern District of New York as the sole forum in which litigation could be brought. The manufacturer sued in Delaware and the investment banker moved to dismiss the action.

Here is the defective forum selection clause:

“Any lawsuits with respect to, in connection with or arising out of this agreement shall be brought in a court for the Southern District of New York and the parties hereto consent to the jurisdiction and venue of such court for the Southern District as the sole and exclusive forum, unless such court is unavailable, for the resolution of claims by the parties arising under or relating to this agreement.” (emphasis added).

Because both the manufacturer and the investment banker were Delaware corporations, and no federal question existed, there was no basis for subject matter jurisdiction in the Southern District. That court was “unavailable”.

The investment banker argued that the parties “intended” to select any court located within the territory of the Southern District, not just the federal court called the Southern District of New York. But that’s not what the contract provision actually said, so the Delaware Court of Chancery ruled against the banker. For a forum selection clause to work, the parties must use “express language clearly indicating that the forum selection clause excludes all other courts before which those parties could otherwise properly bring an action.”  If the contractual language is not crystal clear, “a court will not interpret a forum selection clause to indicate the parties intended to make jurisdiction exclusive.”

The lesson? Use a proper forum selection clause, like this one:

Each party agrees to personal jurisdiction in any action brought in any court, Federal or State, within the County of New York, State of New York having subject matter jurisdiction over the matters arising under this Agreement. Any suit, action or proceeding arising out of or relating to this Agreement shall only be instituted in the County of New York, State of New York. Each party waives any objection which it may have now or hereafter to the laying of the venue of such action or proceeding and irrevocably submits to the jurisdiction of any such court in any such suit, action or proceeding.

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In a recent case from Delaware’s chancery court, the clear language in a merger agreement, controlling dispute resolution matters, was enforced by the court even where the method specified wasn’t the best way to resolve the dispute. The case underscores the importance of thinking carefully about the implications of arbitration clauses, and especially how two or more arbitration schemes relate to each other.

Matria Healthcare entered into an agreement to acquire CorSolutions Medical for $445 million. Both companies were engaged in the disease management business. Nearly 5% of the purchase price ($20.3 million) was set aside in an escrow account to satisfy claims that the closing net working capital of CorSolutions fell short of a minimum target. The escrow account was also available to satisfy claims under the indemnification provisions, including breaches of representations and warranties.

Whether a claim fell under the working capital adjustment or the indemnification claim was critically important, as indemnification claims were subject to a threshold of $4.45 million, while claims for a working capital adjustment were not subject to any threshold. There was an important procedural difference as well. Claims concerning the closing net working capital were to be resolved solely by a specific accounting firm. Indemnification claims were to be resolved in accordance with the Commercial Arbitration Rules of the American Arbitration Association, which give the parties the ability to challenge and investigate claims.  

The parties saw ahead of time that disputes involving, for example, misrepresentations could fit within both arbitration schemes. They decided that any matter relating to the closing working capital had to be resolved by the accounting firm mechanism, even though the matter could also be raised as a misrepresentation under the AAA procedure.

Shortly after the closing, a messy dispute arose involving a customer of CorSolutions. The customer instituted an audit of a CorSolutions disease management program. Matria dealt with the matter after the closing by negotiating a resolution with the client that involved, among other things, a cash payment of $1.5 million and amendments to the customer contract. Matria applied the $1.5 million payment as a debit to the closing working capital and asserted a claim against the escrow account.

The dispute could have been raised as both a working capital adjustment and a claim for indemnification. CorSolutions thought the working capital arbitration was too narrow a context to allow a full airing of the issues, and it asserted that the AAA was the only proper place to hear the dispute. It also, of course, wanted the claim to be subject to the $4.45 million threshold for indemnification claims.

The court agreed in substance with CorSolutions, but ruled in favor of Matria, on the strength of the clear hierarchy of arbitration contained in the merger agreement. Even though the dispute was one that typically would be subject to an indemnification threshold, the clear hierarchy of arbitration procedures forced the claim into the working capital adjustment, for which there was no threshold. Clever drafting by Matria’s attorneys.

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The indemnification provisions of a purchase agreement function like an insurance policy. Each party (buyer and seller) stands behind its warranties and agrees to make the other party whole if there is a loss that is attributable to or covered by the misstatement or broken promise. 

In some cases, the indemnification may take the form of protection against the claim of a third party. For example, if the seller warrants that the business may be conducted without infringing the intellectual property of any third party, and that proves not to be true, then the seller must hold the buyer harmless against the claim made by the third party. In other cases, the indemnified matter may be a direct loss suffered because the quality of the assets transferred is not as represented. For example, if the seller’s receivables are warranted to be collectible in full, and there is a shortfall in collection, the buyer can recover the shortfall from the seller.

Like an insurance policy, the first question is how long the coverage lasts. The indemnification sections will say how long the representations and promises will remain in effect. This is generally a year or two after the closing, although certain representations, such as those covering taxes, employee benefits and environmental laws, will last longer as the laws they cover carry exposures that may last many years.

Next, like an insurance policy, the indemnification clause will usually have a threshold or deductible for making any claims at all, on the theory that small or minor claims do not warrant invoking the indemnification process. The size of the deductible will generally vary according to what is considered material in the transaction. A small deal may have a deductible of $10,000 while large deals can have deductibles of $100,000 and more. This issue is usually negotiated in the term sheet. Finally, an indemnification clause may have a cap on the total value of claims that can be made for indemnification, usually expressed as a percentage of the purchase price.

In an asset purchase transaction, the indemnification protection that a buyer gets will cover three events: a misrepresentation or breach of a warranty made by seller; a breach of any covenant or agreement made by the seller; and any liability that seller agreed to retain. For the seller, the indemnification covers the first two items and any liability that buyer agreed to assume but was nonetheless imposed on seller. Indemnification extends to any costs or expenses (including reasonable attorneys fees) that the protected party incurs as a result of the claim or loss, such as the costs of defending against a third party claim and the cost of asserting a claim against the other party to the deal. In fact, the only legal liability added by the indemnification clause is this obligation to pick up costs and expenses, since in the absence of the clause, the aggrieved party would still have a claim for breach of contract in case the other party breaches a warranty or covenant.

The procedures for exercising indemnification claims involve giving the other party notice of the claim and the opportunity to take over the defense of the claim, in the case of a third party liability. The party providing the indemnification generally has the right to settle the matter and both parties must assist in the defense of third party claims.

Related Posts:  What is Indemnification? Part 1 and Part 2

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The buyer of a company will often make specific promises regarding hiring and retaining employees of the business. If so, the purchase agreement will identify the buyer’s obligations in this regard and identify the benefit plans, severance obligations, and accrued bonus and vacation rights of the transferred employees. For example, the buyer may agree to grant service credit to employees for purposes of vesting in benefits, even though these credits may not be required by law.

The purchase agreement will specify the circumstances under which the agreement can be terminated.  Both parties will be able to terminate if the other party breaches the agreement and fails to cure the breach after being given the opportunity to do so. Also, the contract can be terminated if the closing does not occur by a defined date. This may occur, for example, if a third party or governmental approval is needed but can’t be obtained, or if financing can’t be obtained within a defined time period. This outside termination date is usually negotiated in the term sheet.

As the parties generally conduct the transaction across the borders of several states, the laws of one state will be chosen to govern the contract. Also, the courts of a specified jurisdiction will be chosen to hear disputes arising under the contract. In lieu of court adjudications, the parties may elect to implement an alternative form of dispute resolution, such as mediation and arbitration.

The purchase agreement will often have a number of things attached to it, such as schedules of information, forms of notes, or equity instruments delivered as part of the purchase price and allocations of the purchase price. These items are specifically incorporated in the purchase agreement and often constitute part of the items delivered by the parties at the closing.

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In private equity transactions, the most important thing that needs to happen before a closing occurs is the buyer needs to raise the financing needed to pay the seller the cash portion of the purchase price. Sometimes this is stated as an express condition, meaning that if financing cannot be obtained, the private equity firm will not be in breach of the agreement. If it is not an express condition, then the private equity firm will be in breach of contract if the financing cannot be raised. But because the private equity firm generally forms a special purpose entity for the sole purpose of completing the acquisition, there isn’t a company against which seller can assert a claim. For this reason, even where financing is not stated as an express condition, as a practical matter there is a financing condition in most private equity transactions.

Smart sellers sometimes require that a buyer provide firm financing commitments from equity and debt sources before a binding purchase agreement is signed. Alternately, sellers may demand that the buyer place cash in escrow that becomes forfeit in case financing is not raised by a stipulated date.

Buyer’s obligation to complete the purchase of the business is subject to the fulfillment of a number of standard conditions. These conditions may include further due diligence in case certain matters are left for review after the contract is signed. The more conditions loaded into the contract, the less the contract is a firmly binding agreement. Some contracts can have so many conditions and due diligence requirements that they amount to no more than an option to purchase the company. 

The standard closing conditions are as follows:

Continued Truth of Warranties.  The representations and warranties of seller in the purchase agreement must continue to be true and correct in all material respects. In essence, seller must reiterate the representations at the time of the closing.

Performance of Covenants. Seller must perform in all material respects all covenants and obligations and comply with all conditions required by the purchase agreement to be performed or complied with prior to the closing date.

Material Adverse Effect. No event, occurrence or circumstance shall have happened that has had or could reasonably be expected to have a material adverse effect on the business or prospects of the business. This section gives buyer one last chance to cancel the transaction if something material and unexpected happens to the seller between signing the purchase agreement and the closing.

Permits and Consents. Seller must obtain all of the consents, approvals and clearances that it’s required to get before the closing, such as third party consents under contracts that require such consents in order to be assigned.

No Litigation. There must not be any litigation or proceeding pending or threatened to restrain or invalidate the sale and purchase of the business. Such proceedings might include a governmental antitrust action or securities law matter.

Authorization. All corporate action necessary to authorize the execution, delivery and performance by seller of the purchase agreement, and the consummation of the transactions contemplated thereby, must have been duly and validly taken by seller. This is generally performed even before the agreement is signed, although sometimes shareholder approvals are not obtained until after the agreement is signed.

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The first covenant given by seller is the promise that it will operate its business only in the “ordinary course” and “consistent with past practice” between signing the purchase agreement and closing. The covenant goes on at length about specific things that seller will and will not do during this period without the permission of buyer. The purpose of these sections is to make sure that no significant or unusual transactions are undertaken without buyer’s knowledge and consent.

Seller agrees to give the private equity firm and its representatives access to its books, records, facilities and employees between signing the purchase agreement and closing. This is often necessary to bring in lenders for the transaction and let them complete their due diligence and investigation of seller and its business. 

Seller and its affiliates, including principal shareholders of seller, typically agree not to engage in the same business for up to three to five years, sometimes longer. This non-compete restriction will include owning any equity interest in any entity that is engaged in the same business being sold and otherwise participating in, managing, controlling, operating or financing any entity that is engaged in this business. The geographic territory of the restriction is generally limited to the area in which seller conducts the business as of the closing date. Also, seller and its affiliates are not allowed to solicit or hire employees of the business to work for them or solicit customers or suppliers to the business. Seller and its affiliates also agree not to use confidential information, such as trade secrets and customer list, of seller after the closing.

These non-compete and confidentiality covenants are very important to a private equity buyer, as seller and its affiliates would otherwise have the ability to set up an effective competing business immediately after the closing. Buyer is given rights to specifically enforce these provisions against any party that breaches them. It is also important to make these covenants assignable to any person the private equity firm may later sell the business.

Often, special covenants regarding trademarks and trade names are included in the purchase agreement, as seller may need to change its name or take other actions to ensure that buyer has the exclusive right to use the purchased trademarks and goodwill. Other times, special covenants regarding the employment of seller’s management team and work force will be included in the agreement.

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Representations and warranties serve two functions. They are part of the due diligence process where the private equity buyer looks at all material information about the target’s business; representations and warranties reflect the results of this investigation. They are also the insurance policy that the seller gives the private equity buyer about the truth and accuracy of the business information. The “representations” are assertions that the information furnished is correct and the “warranties” are legal obligations to stand behind the statements financially.

The subject matters of the representations and warranties cover all major facets of a business. Although the representations are worded in absolute terms, in practice the seller creates a schedule of exceptions and attaches them to the purchase agreement. These exceptions contain information about the company’s business and assets that deviate from the standard representations. Accordingly, these exceptions are important to the private equity buyer and their disclosure often provokes further negotiations.

Many representations overlap one another. For example, a representation that the seller has no liabilities other than those disclosed in its financial statements overlaps with the representation that there is no litigation pending against it, since the litigation may be treated as a liability required to be disclosed in the financial statements. Also, some representations are more important than others, such as those involving the seller’s financial statements. Finally, special attention will be devoted to representations in areas of special importance to a seller. For example, a seller with extensive real estate holdings will give representations on these matters that are far more detailed than sellers whose only real estate is rented office space. In the end, the seller must give detailed representations in every area remotely relevant to its business, with special focus on those areas where the seller generates its revenues.

Sometimes, a representation is qualified “to the knowledge” of the seller, meaning that seller is only responsible for a breach if it knew that the representation was false. Because it is difficult to prove whether a company knew a fact or not, the “knowledge” qualification is granted sparingly.

The following outlines the principal representations made by a corporate seller of business assets, the subject matters covered by the representation and a comment on why the representation is included in the purchase agreement.

2.1 Valid and Binding. 

The purchase agreement is a valid and binding agreement of seller, enforceable in accordance with its terms.

This confirms that all internal approvals (board of directors and shareholders) have been given for the deal. Seller has no legal defenses to enforceability of the contracts. This representation is typically confirmed through a legal opinion from seller’s attorneys.

2.2 No Consents. 

No consent or approval is required to be obtained by seller in connection with its execution or performance of the purchase agreement.

This identifies any third party consents that may be necessary to complete the deal.

2.3 Financial Statements. 

The financial statements of seller identified and furnished to buyer are accurate and complete in all material respects, are consistent with the books and records of seller (which have been maintained in all material respects in accordance with good business practices), have been prepared in accordance with generally accepted accounting principles consistently applied and fairly present in all respects the financial condition and results of operations of seller as of the dates thereof and for the periods covered thereby.

This is the most important representation, as financial statements are the lynch pin of private equity transactions.

2.4 No Undisclosed Liabilities. 

Seller has no liabilities or obligations except as identified in a schedule, disclosed or reserved against in its latest balance sheet, or incurred in the ordinary course of business consistent with past practice since the date of the latest balance sheet.

This is an important catch-all representation on liabilities. It forces seller to specifically identify any liabilities not properly reflected in its financial statements.

2.5 Taxes. 

Seller has filed all tax returns required to be filed and has paid all amounts required to be paid on such returns.

This provides specific verification that taxes have been reported and paid.

2.6 Title to Assets. 

Seller has good, valid and marketable title to its assets; seller owns its real property free and clear of liens; and the assets being conveyed to buyer constitute all of the assets (tangible and intangible) used in connection with the operation of the business as presently operated by seller.

The last part of the representation confirms that seller is transferring all of the assets used in its business, and there are not other assets held by other parties that are used in the business.

2.7 Intellectual Property. 

Seller owns or has the right to use all of its intellectual property; the transfer of this property will not alter or impair any such rights or require any consent or approval; the intellectual property is subsisting, in full force and effect, has not been canceled, expired, or abandoned, and is valid and enforceable; and seller’s business does not infringe upon, misappropriate or otherwise violate any intellectual property rights owned or controlled by any third party.

Intellectual property is a unique class of assets that gets its own set of representations. Buyer can independently verify the validity of patents and trademarks, but not even seller may know whether its business infringes the intellectual property of others.

2.8 Contracts. 

None of seller’s contracts are in default and the transactions contemplated by the purchase agreement will not require the consent or approval of any other party to the contracts.

This identifies all of seller’s contracts and certifies that the contracts are enforceable and no consents are required to transfer them. Consents can be time-consuming and expensive to obtain.

2.9 Employee Plans. 

Seller’s employee benefit, savings, welfare and pension plans comply with law and there are no unfunded pension liabilities.

Benefits have their own federal laws and regulations and it’s customary to break benefit plans out into their own section.

2.10 Labor Relations. 

Representations about seller’s relations with labor unions and the existence of organized labor activities at seller.

This is the place for seller to identify any union activities at its plants, even if no union has been formally recognized.

2.11 Litigation. 

There is no litigation pending or, to the best knowledge of seller, threatened against seller or any of its properties.

Pending litigation is easy to identify and has usually been reserved against on the balance sheet. A buyer is interested in learning if any litigation has been threatened, which may not be reflected in the balance sheet.

2.12 Compliance with Laws. 

Seller has complied with all laws applicable to its business.

The representation is generally easy for the seller to give. Issues can arise where the business operates in a heavily regulated area.

2.13 Absence of Changes. 

Since the date of the last balance sheet, the business has been conducted in the ordinary course consistent with past practices and there has not been any unusual transaction.

This brings disclosure about the business current since the last balance sheet date and requires the seller to identify any transactions outside the ordinary course since that date.

2.14 Inventory. 

Seller’s inventory consists of merchandise of a quality and quantity usable and saleable in the ordinary course of business consistent with past practice, except to the extent of normal obsolescence or to the extent written down or reserved against in accordance with GAAP, and is fit for its intended purpose.

This ensures that the quantity and quality of seller’s inventory is acceptable. The representation implies many subjective determinations about obsolescence and GAAP reserve policies that are more art than science.

2.15 Suppliers. 

Identifies the top suppliers to the business and represents that none of them changed its method of doing business with seller nor indicated that it intends to do so.

Buyer wants to know that it will continue to have a stable source of supply from the key suppliers to the business.

2.16  Accounts Receivable. 

Seller’s accounts receivable arose in the ordinary course of business, are legal, valid and binding obligations of the respective debtors enforceable in accordance with their terms, are not subject to any counterclaim, set-off or defense and have been accurately and fairly reflected in the latest balance sheet.

This representation is a statement that the receivables are collectible in full at their stated amount subject to any reserves established in the most recent balance sheet.

2.17 Related Party Transactions. 

No affiliate of seller is, or in the past has been, a party to any transaction or contract with seller or the owner of an interest in any person which is a competitor or supplier of the business.

An important representation that identifies any transactions or relationships that may not be at arm’s-length.

2.18 Environmental Matters. 

Seller has complied with all environmental laws and has not treated, stored, disposed of, arranged for or permitted the disposal of, transported, handled, released, or exposed any person to, any hazardous substance.

Environmental law compliance is typically treated in a separate section, even though it is covered under the representation that seller has complied with all laws.

2.19 Disclosure. 

All information furnished by seller has been true and correct in all material respects.

This is a catch-all representation saying that the materials and disclosures furnished by seller during due diligence have been accurate in all material respects.

 

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The sale of a company to a buyer typically begins with a term sheet spelling out the major terms of the transaction and setting out a timetable for due diligence, document preparation, and closing. The parties then negotiate a definitive purchase agreement containing representations and warranties, covenants controlling actions before and after the closing, and indemnification provisions. The time between contract signing and the closing is devoted to obtaining consents of third parties, waiting for clearance under the Hart-Scott-Rodino Act, securing financing to pay the purchase price, or concluding other tasks that are required to be completed before closing.           

One of the key issues in the sale of any company is who will manage the company after it is sold. Sometimes the answer is quite simple, as where the prior owners intend to retire. Other times the answer is more complex, as where the prior owners are required to remain involved in the company to ensure a smooth transition or to secure an earn-out.

Most of the time, the current senior managers of the target company are very important to sustain a core business, such as relationships with customers, product development, or brand name. In that case, the buyer may insist that these people sign independent employment contracts. They in turn acquire substantial influence over the transaction and may even have an impact on the sale price.

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