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

Before you let your team of due diligence advisers loose in the data room, it’s crucial to reach an agreement about each adviser’s role and responsibilities. Accountants, banks, and other M&A advisers recognize their success depends on their ability to deliver reliable, incisive analysis of a target’s business operations and future prospects. On the other hand, advisers also have an interest in limiting their liability for the advice they give to their clients. When negotiating engagement letters for M&A due diligence services, private equity firms and other buyers should pay careful attention to provisions that restrict their right to seek compensation for losses brought on by bad advice. In today’s post, we review several customary ways in which advisers try to decrease their risk exposure in engagements for M&A due diligence.       

Scope of the Engagement

An M&A adviser will often try to limit its liability by narrowly defining its area of expertise. To some extent this makes sense. Understandably, accountants don’t want to be held liable for having given legal advice, even if their financial review may have legal consequences, such as a modification to the deal’s structure. But private equity firms should ensure that the scope of the adviser’s engagement is not so narrowly construed that it effectively eliminates the firm’s recourse against the adviser. In M&A transactions, this issue is usually resolved by limiting the scope of the adviser’s liability to the contents of a final due diligence report. Anchoring the adviser’s liability to a specific, written deliverable eliminates ambiguity about which statements the private equity firm may rely upon. 

In practice, an adviser issues preliminary drafts of its reports to the firm and other advisers at periodic intervals throughout the due diligence process. The private equity firm, after all, wants to know immediately about any previously unknown risks or “deal killers.” An effective due diligence program helps the firm understand a potential target’s strengths and weaknesses and identify issues that need to be addressed in negotiations with the seller. Periodic due diligence updates enable private equity firms to keep abreast of what its advisers have learned about the target in real time. Without receiving some comfort in the engagement letter that they will only be liable for their final deliverables, M&A advisers may not be as willing to provide potential buyers with provisional reports.

Limitations on Liability

Engagement letters contain a number of provisions that specify the circumstances under which advisers may be taken to court and restrict the amount for which they may be sued. In New York, a court will not infer that an adviser’s liability has been limited unless clearly and unambiguously expressed in the engagement letter. Except for certain exclusions held to be against public policy, however, New York courts will uphold liability limitations in contracts between sophisticated commercial parties.       

There are several mechanisms an M&A adviser may use to limit its liability:

Causation Requirement. Advisers often seek to restrict their liability to losses that are “finally judicially determined to have resulted primarily from” a misstatement or omission. The purpose of this clause is to fix the adviser’s liability to losses directly attributable to errors in its final report. Unfortunately, the phrase “resulted primarily” has no settled sense and raises the specter of Jarndyce and Jarndyce in future litigation. A better drafting choice for a potential buyer is to make the adviser liable for all losses “directly arising from or related to” the firm’s reliance on the adviser’s final due diligence report.  

Restriction on Damages. Engagement letters generally exclude liability for any “indirect or consequential damages.” Consequential damages are losses that do not arise directly or immediately from a contractual breach, but indirectly result from the breach. They can include such claims as loss of revenue and may be recovered if a court concludes that the indirect losses were foreseeable. This provision is often heavily negotiated. Private equity firms argue it’s foreseeable that they may suffer indirect damages as a result of misstatements or omissions in an adviser’s report. Advisers in turn contend that the ultimate investment decision lies with the firm and their risk in the engagement should be commensurate with their fees. In the end, these discussions become relatively less important compared with negotiations over the adviser’s liability cap.   

Cap on Liability. One of the most important provisions in an engagement letter deals with the amount for which an adviser may be held liable. Advisers will typically seek to put a ceiling on their exposure by capping their liability at a fixed amount, at the amount of fees they receive under the engagement, or at some multiple of their fees. The amount of an adviser’s liability cap ultimately turns on a number of deal-specific factors, including the deal’s size and complexity, the importance of an adviser’s findings in the negotiation of essential deal terms, such as price, and the adviser’s transaction fee.        

Definition of Misconduct. The adviser will generally include a provision stating that it will only be liable for losses resulting from its “gross negligence or willful misconduct.” In New York, courts have described gross negligence as acts or omissions that exhibit a reckless indifference to the rights of others or “smack of intentional wrongdoing.” Though not precisely defined by the courts, gross negligence can be thought of as unintentional acts so careless that they ignore the rights of others or appear as though they were intentionally designed to do so. Willful misconduct occurs when a person commits an intentional act with knowledge that the act is likely to result in injury or damage or otherwise exhibits a reckless disregard for its consequences. Advisers’ acceptance of liability for gross negligence and willful misconduct comports with New York common law. New York courts have refused to enforce contractual provisions precluding liability for willful misconduct or grossly negligent acts, finding them to be against public policy.   

Related Posts:   Reviewing a Confidentiality Agreement: What a Potential Buyer Wants

                          Growing the Company through Strategic Acquisitions

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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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Yet another draft confidentiality agreement sitting in your Inbox? Private equity firms, investors, and businesses looking for growth opportunities always seem to be signing a new non-disclosure agreement with another potential business seller. Many times, a seller’s first draft of the agreement will be aggressively one-sided. What sorts of issues does a potential buyer care about in a confidentiality agreement? In today’s post, we’ll highlight some of the terms buyers typically negotiate when marking up a confidentiality agreement received from a potential seller. While some of the discussion focuses on the special situation of private equity firms, much of it applies to any confidentiality agreement related to the purchase or sale of a company. (If you’d prefer to follow the discussion below with a first draft of a non-disclosure agreement in front of you, click here.)

Definition of “Confidential Information.”  The definition of “confidential information” generally comprises all oral and written information furnished to the buyer as well as any derivative products, such as the buyer’s analyses of the seller’s underlying financial statements.   There are, however, several customary exceptions to the definition of confidential information that may be absent from a seller’s first draft. A buyer will generally seek to have the following types of information deemed non-confidential: information that (1) comes into the public domain (other than due to a breach by the buyer), (2) the buyer can demonstrate was already in its possession prior to the seller’s disclosure, (3) is given to the buyer by a third-party that is not itself bound by a duty to keep the seller’s information secret, or (4) is developed by the buyer independently, without any use of the information supplied by the seller.      

Return of Confidential Information.  Most sellers require a potential buyer to return all confidential information if negotiations end without a deal. Buyers in turn often ask that they at least be given the option to destroy the information and usually agree to a seller’s request that the destruction be certified in writing by the buyer. In a time when data rooms are often online and vendor due diligence reports are distributed by email, the physical return of confidential information may be impracticable. 

Permitted Disclosures. If the buyer is going to share confidential information with its financial, accounting, legal, or other advisers, the buyer will identify them in the agreement’s definition of permitted recipients. Of course, distributing confidential information to people not directly under the buyer’s control creates additional risks, but the buyer’s exposure can be diminished by taking some additional precautions.   

Limit Liability for Third-Party Breaches. If the buyer’s advisers have been included among the permitted recipients, then the buyer usually takes measures to limit its liability for any non-permissible disclosures by its advisers. For example, a buyer may insert language stating that the buyer will not be held liable for the disclosure of confidential information by any adviser that signs a non-disclosure agreement directly with the seller. The buyer may try to persuade the seller that the advisers are best positioned to police their respective employees’ use of the confidential information. Moreover, if advisers are contractually bound to the seller to keep the information private, they may have a greater incentive to abide by the agreement’s terms. Alternatively, a buyer may sign “back-to-back” confidentiality agreements with each of its advisers. These back-to-back agreements substantially reflect the terms and conditions of the buyer’s underlying confidentiality agreement with the seller. In the event that the buyer is sued by the seller because of a disclosure by one of the buyer’s advisers, the buyer will have a contractual cause of action against the breaching adviser.

Establishing Breach and Liability for Damages. A confidentiality agreement typically makes the buyer liable for any claims or losses resulting from the buyer’s disclosure of confidential information. It is therefore in the interest of the buyer to limit the types of losses for which it can be held liable. A buyer usually negotiates to eliminate all consequential damages (that is, damages suffered by the seller but only indirectly caused by the buyer’s breach), such as lost profits, from its liability. Another concern of the buyer is how the parties will determine whether a breach causing damage to the seller has occurred.   To protect its right to appeal a lower court’s ruling, a buyer may want to include a stipulation that a breach by the buyer must be “established by a final, non-appealable order issued by a court of competent jurisdiction.” This provision can save the buyer from the unlikely – but infuriating – situation in which it has already been forced to pay damages to the seller, even though an appellate court later rules in its favor.       

Sunset Clause. It may come as a surprise, but many first drafts of confidentiality agreements don’t include a sunset clause specifying when the buyer’s obligations under the agreement end. Given that if the deal doesn’t go through all written and electronic information will be destroyed, a reasonable term ranges from 1 to 3 years.

Non-Solicitation of Employees. When certain key employees are essential to a seller’s business, the confidentiality agreement may include clauses prohibiting the buyer from soliciting or employing the seller’s employees.   Buyers generally tailor their comments on this section to fit their specific needs. If the buyer is a company trying to grow its business by acquiring a competitor, for example, considerable care is taken to ensure the non-solicitation and non-employment provisions don’t unduly interfere with the buyer’s efforts to recruit top talent. If, on the other hand, the buyer is a private equity firm investigating a new business, then the firm generally seeks more limited exceptions. Customarily, the non-employment provision does not apply to any job offer that results from a general advertisement (such as in a newspaper or on the Internet) or occurs after a person has left the seller’s employ (without encouragement from the buyer) and a specified period of time has elapsed.

No Additional Obligations. In order to emphasize the limited nature of the buyer’s and seller’s respective obligations under the confidentiality agreement, a potential buyer often inserts a clause emphasizing that until the buyer and seller have executed a definitive agreement regarding the acquisition, the buyer doesn’t have any obligation to the seller regarding the transaction.

Novation to Acquisition Vehicle. When the potential buyer is a private equity fund, more often than not an advisory entity associated with the fund, rather than the fund itself, signs the confidentiality agreement with the seller. If the deal closes successfully, it’s in the interest of the advisory entity to be released from its obligations under the confidentiality agreement.   For this reason, private equity firms try to include a novation clause under which the advisory arm will be released, and the fund’s acquisition vehicle will assume, all of the buyer’s obligations under the confidentiality agreement upon the transaction’s closing.

Related Post: Negotiating Liability with Your Due Diligence Advisers: M&A Engagement Letters

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The decision to sell a company is usually made only after a host of threshold questions are addressed: Why are the owners selling? What price would they accept? Should the form of consideration be cash, stock, Notes, or something else? Who will manage the business after it is sold? Will the buyer demand that the purchase price be adjusted after the closing? Should there be an earn-out? Answers to these questions can have significant tax and economic consequences, and they are typically examined and renegotiated many times during the course of the sale.

Enhancing Value Before the Sale

There are a number of things companies can do ahead of time to make themselves more valuable in a financing or acquisition transaction. Most importantly, they can assemble a management team that works cohesively to execute a well-considered business plan. Also, before seeking a transaction, a company should resolve any problems, such as contingent liabilities or unprofitable lines of business, which detract from value.

Several other steps that can be taken to enhance the value of a company before a sale are:

• Identify the most profitable product or service lines or distribution channels and focus the company’s resources on them.
• Implement a strategy for growth that capitalizes on the company’s core strengths and takes a wide view of its market and opportunities.
• Identify a profitable market the company is not currently in and develop a plan to enter that market using existing resources.
• Study and learn from the mistakes of competitors.
• Find the measurement tools most closely tied to the company’s profitability, record them and track progress.
• Develop robust information technology systems that manage and record assets and core business operations.
• Resolve any contingent liabilities, difficult customer/supplier issues and other hidden items that detract from the company’s value.
• Prepare financial projections that assume the company’s growth plans are achieved and base the company’s valuation on them.

Pricing the Company

Price is certainly the most important element in the sale transaction. In fact, nearly every issue that arises in a sale transaction relates in one way or another to the price. For example, the structure of the transaction generally dictates how it will be taxed, and taxes of course directly affect the price. In addition, the presence of an undisclosed liability or the possibility of the cancellation of a material contract would make the business less valuable.

Even if there are purchase price adjustments or earn-out provisions, an initial value must be negotiated for the business. For privately owned companies, valuation is generally based on a multiple of annual earnings prior to the payment of interest and taxes. In addition, for smaller companies it is customary to adjust earnings for compensation paid to the owners or members of their families. This adjusted earnings number is thought to reflect the true earnings power of the business more accurately. 

The multiple which is applied to the annual earnings figure can range widely from industry to industry and within companies in the same industry based on size, profitability, and management strength. An established company with good market position, some competitive pressures, and the need for steady management generally receives a multiple of five to eight times restated earnings. An established business with no competitive advantages, stiff competition, few hard assets, and heavily dependent on management generally receives a multiple of three to four times annual earnings. As a rule of thumb, a business should be able to pay for itself in four to five years, assuming that earnings remain steady during the period.

Of course, higher and lower multiples can be paid for companies depending on other economic factors such as interest rates, the general outlook of the economy, and the state of the industry in which the company competes. Also, book value is often used as a secondary measure of value, or as a method of testing the valuation of manufacturing companies. When book value is used, it generally benefits the seller to use fair market value for machinery and inventory, as these items are generally carried on the books at a lower value.

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Buying another company is a tried and true growth strategy. Making an acquisition can achieve economies of scale, increase a customer base or product line, expand into a new territory or eliminate a competitor. The cost of acquiring a company with a new product or technology may be less than the cost of creating it internally. In addition, an acquired business may be more profitable as part of a larger organization with greater resources than as a stand-alone business.

Due Diligence

In the initial stages of an acquisition, it is important, of course, to understand exactly what is being acquired. Every company has its own culture, accounting practices and hidden liabilities. An effective due diligence program can identify the target’s strengths, weaknesses and issues that need to be addressed in the acquisition context. The following checklist of items represent the principal areas of legal due diligence.   The acquisition candidate should be asked whether it has any of these items, and if so they should be studied carefully to assess their impact on its business, value and prospects.

• Agreements among stockholders, such as voting trust, buy/sell, stockholder, or right of first refusal agreements.

• Convertible debt and preferred stock instruments; notes and credit agreements.

• Restrictions on doing business in any territory or with any group of customers and any other material business contracts such as supply or distribution, franchise, license or alliance agreements.

• Pleadings in pending and recently settled lawsuits and summaries of disputes with suppliers, competitors or customers.

• Employment, consulting and non-compete agreements and management incentive agreements or bonus plans.

• Audited and unaudited financial statements, financial and operating budgets or projections and business plans, marketing studies and consultant reports.

• Lists of real and material personal property and eases for real or personal property.

• Lists of proprietary technology including issued patents and patent applications.

• Acquisition, partnership or joint venture agreements and any governmental agency inquiries.

Once an acquisition candidate has passed due diligence and a decision has been made to proceed with an acquisition, a new set of issues must be addressed. These issues concern how the transaction will be structured for tax purposes and how other liabilities of the target will be allocated between the buyer and the seller. These questions require input from an experienced tax advisor.

Tax Issues

The principal tax issues that must be addressed in an acquisition include the following:

• Will the transaction be structured so that the purchaser obtains a new cost basis in the target’s assets or will the purchaser take a carryover basis in the target’s assets (generally, the lower historical asset basis)?

• Will the transaction cause the target to pay a corporate-level tax on all the gain inherent in its assets, including good will and other intangibles? If so, will the economic burden of this fall on the buyer or the seller?

• Will the seller pay tax on the gain inherent in its stock? If so, can that gain be deferred?

Critical Non-Tax Issues

The principal non-tax acquisition issues include the following:

• Will the purchaser inherit all of the target’s liabilities (disclosed and undisclosed) or will the purchaser assume only specified liabilities of the target?

• If the seller’s representations and warranties turn out to be false, and the purchaser suffers losses from undisclosed liabilities (such as environmental cleanup, unpaid taxes, employment discrimination, anti-trust violations, product liability or patent infringement) or some other shortfall in assets or business operations (such as lack of title to assets, receivables not collectible, inventory not saleable or financial statement inaccurate), will the buyer be able to recover a portion of the purchase price from the seller?

• Will the executive management of the target be retained to operate the business?

Structure of the Transaction

After these issues have been resolved, the parties must settle on the structure of the transaction and negotiate other contract issues. The following is a partial list of the most common matters that need to be resolved:

• If part of the purchase price is payable in notes, what will be the terms of the notes? What will be their maturity, interest rate, default and other provisions? If part of the purchase price is payable in stock, what preferences, conversion rights, anti-dilution protection, dividend rates, and registration rights will the securities have?

• Will there be any right to adjust the purchase price based on future operations of the business?

• Will any assets of the target be excluded from the acquisition?

• To what extent will the purchaser inherit the target’s liabilities and obligations?

• Will the seller give representations and warranties concerning the target? Will they be qualified with reference to knowledge and materiality? What sort of indemnification will be given in the event of a breach of the representations and warranties?

What sort of covenants will the parties agree to regarding the operation of the target’s business before and after the closing?

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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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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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