1. Introduction
2. Price and structure of the acquisition / purchase
3. Representations and warranties of the buyer and seller
4. Covenants of the buyer and seller
5. Conditions to closing
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
9. Representations and warranties of the buyer and seller

As I explained in the last post, indemnity is one of the most contentious issues in a purchase agreement.   A buyer doesn’t want to inherent ANY pre-close risk while a seller at some point in the future wants to relax and know someone isn’t going to the knock on the door and ask for all the money back (or even more). A compromise invariably gets worked out, and it involves indemnity caps and baskets.

Indemnity Caps, in Theory

A cap is simply a limit for what a seller is liable for, for pre-close issues.   From a buyer’s perspective, there should be no cap.  The seller was liable for EVERYTHING before the buyer entered the picture and it should remain that way for anything that happened before the close.  That doesn’t sound unreasonable, doesn’t it?  That means that if a company was sold for $3 million and the new buyer had to pay a settlement of $5 million for a product liability issue that occurred pre-close, the seller would have to give back all the purchase price, PLUS $2 million.  There goes the retirement. However, if the seller had not sold the business, they would still have to have paid the $5 million settlement.  So really, nothing has changed. Right?

From a seller’s perspective, there absolutely should be a cap.  They are almost invariably selling to a larger entity that may be more likely to attract lawsuits (the deeper pockets lawsuit rule of thumb).  It is also possible the new owners mismanage the company enough that customers, employees, etc. decide to sue for something that happened to have occurred pre-close.  Using the example above, the $5 million settlement may have been much less if the lawsuit involved the original seller only, who at at the time didn’t have much in the way of liquid assets, and it is entirely possible the lawsuit wouldn’t have even happened at all under the seller’s ownership.

Both perspectives are valid, so it is up to the attorneys, intermediaries, buyer and seller to work out a compromise.

Indemnity Caps, in Practice

Caps are common in some form in about 80% of deals (according to a study published by the American Bar Association).  Sometimes liability is capped at the purchase price, and often it is capped at less than purchase price.  A typical range for a cap is 20% to 50% of the purchase price.

It is also common to “carve out” certain types of reps and warranties that have no caps.  Fraud, taxes, ownership and authority to do the sale are common cap carve outs.  In other words, the buyer is saying, “Hey, I kind of see your point on the other stuff, but I want you COMPLETELY on the hook for fraud, paying your taxes, whether you actually own the company you are selling me, etc.”  It is hard to argue with that logic, thus the cap carve outs.

I’ve had ownership issues pop up during a transaction (“Oh, I forgot that I promised my sales guy 5% of the company.  I never got around to actually doing that, so how do I give him shares right now, just before close?”).  Fortunately, I’ve never run across a situation where a transaction closed, and someone popped up later claiming that they actually own all or part of the company.

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.  This post covers Indemnification.

1. Introduction
2. Price and structure of the acquisition / purchase
3. Representations and warranties of the buyer and seller
4. Covenants of the buyer and seller
5. Conditions to closing
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
9. Representations and warranties of the buyer and seller

Indemnification, in its most simple definition, describes how to compensate someone for any loss that they may suffer during the performance of a contract.  The indemnitors indemnify the indemnitees for all losses, expenses, damages and liabilities arising out of breach of a representation, warranty, covenant by the other party in the purchase agreement.

The indemnity section is one of the mostly hotly contested sections in a purchase agreement, for good reason.  This is where a buyer wants not only clearly drafted language defining the damages, they also typically want an escrow account (also called a hold back) set up so they know they will actually get paid for the damages.

Escrow

Business owners should realize that in most cases there will be around 10% of the purchase price held back in an escrow account to be used for damages or the appearance of any previously unknown liabilities (or any number of things, such as final reconciliation of the books at closing, inventory at close, etc.).   In a study done by the American Bar Association of middle market transactions, they found approximately 80% of transactions used an escrow account.  The other 20% probably were probably using seller notes or another structure which allowed the buyer access to seller funds.  In other words, if you are selling your company and you get an all-cash-at-close offer, don’t expect to walk away with all cash at close.

The same study shows that 71% of the escrow/holdback accounts are between 6 and 15% of the purchase price.  16% are below 6%, while 10% are above 15%.   The average was right about 10%.

How long to expect your money to be held back?  12 to 18 months is the norm.

It is also important to realize that the buyer’s claim against the seller is rarely limited to the amount held in escrow.  The escrow merely provides easy access to a set amount, and the buyer will likely have to sue for the rest.

How much is the seller ultimately on the hook for?  In next blog post I’ll cover caps and baskets in order to describe the indemnity limits.

1. Introduction

2. Price and structure of the acquisition / purchase

3. Representations and warranties of the buyer and seller

4. Covenants of the buyer and seller

5. Conditions to closing

6. Indemnification

7. Termination clauses and remedies

8. Miscellaneous

9. Representations and warranties of the buyer and seller

Covenants within the purchase agreement are promises, or agreements between the buyer and seller. Conditions to Closing typically provide an escape hatch for a buyer to legally walk away from the deal at the last minute if certain conditions are not meet.

Covenants, usually a seller’s obligation to a buyer, may be a promise to conduct the business in an ordinary course between the time of signing and closing, or it may be an agreement to cooperate with the buyer on an outstanding tax issue in future after the close. Here are some other common covenants:

- The seller agrees to pay their taxes

- The seller agrees to settle outstanding liens

- The seller agrees to cooperate on future employee issues

It can be important to pay attention to the conditions of closing in the purchase agreement. It may be boilerplate text about the buyer being able to walk away should he find out any of the seller representations are false, but the covenants may also contain financing contingencies or other conditions that would be critical to know about.

For example, a financing contingency means that the seller could expend significant time and expense in working through due diligence and signing an agreement, yet the buyer could fail to get financing. In that case, with a financing contingency in place, there would be no consequence for the buyer. You can’t always get rid of financing contingencies, but you can work to minimize the risk, and you should at least be very aware of the contingency and an idea of what the odds are for financing success.

I always identify financing contingencies at the letter-of-intent stage, and ideally you should force the buyer to have financing commitments in place before the definitive agreement stage, but of course it is possible for a lender to back out at the last minute.

Financing contingencies are very common for smaller deals as they often relying on an SBA loan. For larger deals it is on a case by case basis.

For us, I’ve had two financing contingencies in the last year. In one, the private equity fund that our seller had signed with put in a condition on financing. When I asked about where they expected to raise the debt from, they said it was actually from their own fund, they just called it debt instead of equity. No problem. The other deal was also a private equity fund, and they failed in the due diligence phase to produce financing. Unfortunately that killed the deal with that buyer.

Now, you can look forward to automated calls to pester business owners with the same message.  On behalf of the business intermediary industry, I apologize.

The following is an email I received today.  Hopefully it will be used as described when there really is a buyer, but I predict it will used to generate business listings when there isn’t a buyer.

Do you have people who want to buy a business but not enough businesses that are for sale to show to them?

We can help.

The very first six brokers we showed this to came on board instantly after seeing a demo because they said it was the perfect way to get more flower shops, carpet cleaning companies, restaurants, etc. that their clients were looking to acquire.

There are two ways to generate leads.

First, let’s say you have a guy that wants to buy a flower shop somewhere in the state. You just use our software program and type in “flower shop” and the city/state and it will pull every single name and number within seconds. Then, you record a message along the lines of, “Would you be interested in selling your flower shop? I have a buyer right now that would be interested in buying it. For more detail, please call 702-555-1212.”

Then, hit a button and it calls every single number the software found and delivers the message. (Some brokers have asked me about reaching the decision maker. The best way to do this is send the messages early in the morning before they open so the message goes to voice mail).

If you want to do a mailing, the software will also format everything to print as mailing labels. No more buying lists.

The second way is to have the software scan craigslist for businesses for sale, extract their numbers, and call with a message, “Hi, this is Tim. I’m interested in buying your business for cash. Please call me at 702-555-1212.”

Our software package is a one-time cost of $397 (with a monthly $20 maintenance fee).

The software can also extract email addresses.

Also, once you buy the software, you have re-sell rights. Every broker told me they have several clients who would love to have it for themselves. Flower shops, restaurants, bars, carpet cleaning…..the list is almost endless for the types of businesses that can use this.

I will sell it to only one business broker per city on a first-come, first-served basis.

To see a demo, please email me back or call me at 702xxx

Thanks,

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.

1. Introduction
2. Price and structure of the acquisition / purchase
3. Representations and warranties of the buyer and seller
4. Covenants of the buyer and seller
5. Conditions to closing
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
9. Representations and warranties of the buyer and seller

Reps and Warranties are statements of fact that a seller makes to a buyer (and vice versa) about all aspects of the company, and pledges that they are true. Even the most diligent of a buyer’s due diligence will not uncover and mitigate all of the risk that a buyer takes when buying a company.  Thus, through the Reps and Warranties, the buyer is asking the seller to disclose in writing (and memorialize in the formal agreement) every aspect of the company from taxes, contract, ownership, finances, legal issues, intellectual property, etc.

Disclosing everything in the reps and warranties is critical, as an omission of a liability or significant fact can give an unhappy buyer a cause of legal action for breach of contract.  It is well worth the effort to go through the list carefully and spend some quality time thinking about each item.  In fact, a good deal attorney will force the seller to sit through a final walkthrough of all the reps and warranties, trying to uncover every little thing that could be out there and get them into the agreement.

Lawyerese becomes critical in reps and warranties, and a good deal attorney is important to have.  For example, the buyer’s attorney will typically draft the reps and warranties, and one warranty may state that “all contracts have been performed in all respects and conforms with all federal, state and local laws, regulations, etc.” The seller’s counsel may add a “knowledge qualifier” so that it now states “To the best of the Seller’s Knowledge, all contracts have been performed in all respects and conforms with all federal, state and local laws, regulations, etc.” They may also add a “materiality qualifier” so that it becomes: “To the best of the Seller’s Knowledge, all contracts have been performed in all material respects and conforms with all federal, state and local laws, regulations, etc.”

By adding these qualifiers, a buyer would have a much tougher time coming after the seller later.  For example, they would have to prove not only that a contract wasn’t performed, but that the seller had knowledge of that fact.  Proving that the seller had prior knowledge is extremely difficult to accomplish, so by adding that clause it completely changes the legal exposure of both the buyer and the seller.

Deal attorneys can (and will) spend a great deal of time negotiating the reps and warranties, and the qualifiers on the reps and warranties.

An example is that we were getting ready to close and the final documents had been prepared.  Our sellside attorney did the final reps and warranties check with the seller and I was a little bored while listening in on the conference call.  One of the most basic representations is ownership.  Does the seller (or group of shareholders) actually own the company he is selling?  The attorney was asking questions around this area and asked the seller about the ownership of the patents he was selling with the business.

All of the sudden the call got a lot more interesting when the seller exclaimed: “Oh my gosh, I forgot that I don’t actually own the patents!”.  A scientist that worked for the company was the inventor and the owner of the patents.  The scientist still worked for the company and would continue, so the seller knew he could work something out, but he just forgot to do it.   Whoops. Kind of a big thing to work out at the last minute, but he was able to work out in a matter of days a time-limited royalty arrangement for purchase of the patents.

During that process he also realized that the scientist was working with some of his own equipment in the laboratory, and we were about to sell that equipment out from under him.  I’m sure the buyer would have worked something out in this case because it wasn’t a lot of equipment, but much better to specifically exclude that equipment in the purchase agreement than to work it out later.

1.        Introduction

2.       Price and structure of the acquisition / purchase

3.       Representations and warranties of the buyer and seller

4.       Covenants of the buyer and seller

5.       Conditions to closing

6.       Indemnification

7.       Termination clauses and remedies

8.       Miscellaneous

Let’s start with the first few in this blog post:

1.       Most legal contracts, including most business purchase agreements, start with an introduction to layout some definitions, or “recitals”, and to describe the intentions of the parties.

2.       The next section lays out the most significant details of the business transfer.  It not only defines the purchase price, but also the structure of the acquisition.  For example, it defines whether the transaction is a stock sale, asset sale or merger, and also describes many of the mechanics of the deal that will enable that structure.  This section will detail the cash payment, escrow requirements, timing of payments, and any earnout provisions.

If it is an asset sale, this section contains a description of the assets purchased (referencing exhibits or schedules) and liabilities assumed.  If there is to be an adjustment of price depending on the final closing of the books (adjustments for inventory, bad debt, working capital, work in process, etc.) then this is also described in this section.

The price section can be refreshingly short in the case of an all cash deal, to quite lengthy in the case where there are notes, contingent notes, working capital adjustments, earnouts, etc.

This is the section where you find out that the deal you sketched out on a napkin actually took two pages (and a lot of money) for the attorney to describe legally.  It is always best to attempt to keep everything as simple as possible, because even the deals that start out fairly simple tend to grow in complexity.

Equity Purchase

Let’s start with the easy example.  Say you sell 25% of your company for $2 million.  That means your company is worth $8 million, correct?  Not much algebra there.

Capital Investment: Classic Pre-money / Post-Money Valuation

Now let’s say that someone offers to invest $10 million in your company for 50% of the company.  What is it worth then?  Well, after the investment the company will be worth $20 million, but really the enterprise value of the company itself will be $10 million (the same value as before the deal), with $10 million of invested cash on the balance sheet.  In venture-capital-speak, the pre-money valuation will be $10 million while the post-money valuation will be $20 million.  Another way to look at it is that the owner did own 100% of a $10 million dollar company, and now owns half of $20 million company but he still owns $10 million of value.

A Mix of Equity Purchase and Capital Investment

Now here is the tough one.  We recently had a buyer make a compelling offer to our fast-growing client: “I’ll pay you $2 million and I’ll invest another $10 million in the company to fund growth and then we’ll both own 50%”  (By the way, I changed the numbers from the actual deal).  It wasn’t until later that the question came up: “Um, what does that make the company worth?”.  It was an interesting deal because no one actually cared but the attorneys and accountants – the seller and buyer were happy with the statement above.

The first cut at this may be, “Well, the buyer just paid $12 million total for half the company, so it’s obviously worth $24 million”.  In fact, that is exactly what the attorneys said.  Those guys are really bright on legal matters.

However, the day after the close the buyer would own half the company and therefore half the balance sheet, which now has another $10 million in cash on it.  In other words, he would have 50% of the company and rights to $5 million in excess cash, which theoretically he could take home.  So really, he paid only $7 million for half because he still “owns” $5 million.  That would indicate it is valued at $14 million.  In venture-capital-speak the pre-money  would be $14 million, and the post-money would be $24 million.  Or another way of saying it, the enterprise value of the core business is $14 million, with $10 million of excess cash on the balance sheet.  This method, however, is really a short cut and doesn’t use much math.

Taking it even further, what is really going on with the ownership of the company?  The owner is selling some of the company to the buyer for $2 million, however the buyer is also being issued new shares for the $10 million investment they are making.  At the end of it all, including dilution, they both own 50%.  How much of the company is the seller selling, and how many new shares should be issued?  Now this is deal algebra.

To work this out I set up some equations with variables like shares sold, new shares issued, 50% ownership, enterprise value, etc. and solve them simultaneously.  To make it easy I assumed 1,000 shares existed in the company although that wasn’t actually the case.  One key constraint is that the share price for the shares sold and the shares issued is the same.  In other words, the buyer is buying some shares from the owner, and some from the company treasury but is paying the same per share price for both.

For this example the owner would sell (143 shares) 14.3% of his company to the buyer for $2 million and $14,000 per share.  714 new shares would be issued, also at $14,000 per share.   This would mean both the buyer and seller own the same number of shares at 857 shares.

The Actual Algebra – for Those that Care

For those that actually want to look at the math, here it is:

First, let’s assume 1,000 shares are originally outstanding.  Then let’s say:

X = Shares sold by seller to buyer
Y = New shares issued to buyer
Z = Total amount of shares outstanding post-merger
P = Price per share

We know the buyer will own 50%, so I set up the equation:

X+Y = Z/2

We also know that the price per share (the same for both shares sold and newly issued shares) is:

P = 2,000,000/X   (or X=2,000,000/P)
P = 10,000,000/Y (or Y=10,000,000/P)

Substituting these into the X+Y=Z/2 equation:

2,000,000/P + 10,000,000/P = Z/2 Or

Z * P = $24,000,000

Z is the total shares after the merger, so Z * P is the “post-money” valuation of $24 million.    The enterprise value, or pre-money valuation, is always the post-money less the investment cash, so the pre-money would be $24 – $10 million or $14 million.

We also know that the pre-money valuation is the share price (which doesn’t change pre to post-money)  times 1,000 shares:

$14,000,000 = P * 1,000

So

P = $14,000 / share

Using the equations above for X and Y in terms of P, we can easily calculate:

X = 2,000,000  / P = 143 shares are sold to the buyer (you can also think of this as 14.3% of the company is sold to the buyer for $2 million)

And

Y = 10,000,000 / P = 714 new shares issued to the buyer for his investment of $10 million

A quick check is now the seller has 1,000 – 143 = 857 shares.  The buyer now has 714 new shares + 143 shares he bought from the seller = 857 shares.  Dang, it worked.

There are obviously numerous ways of solving this, but that is how I did it.  I have some cap table spreadsheets I dug out, but none of them could handle both an equity purchase and investment at the same time, so it really did come down to algebra.

If you got this far, do me a favor.  I would be curious if anyone actually got any use from this algebra exercise.  If you did, drop me a note at ney [at] compasspointcapital.com and let me know.

So that is pretty clear – if you are small and use a broker – no fee.  It is also pretty clear that if your company has $1 million or more in earnings, you will want to use an M&A firm or investment bank and you will not only pay a upfront fee, you also may have to pay a monthly retainer (for very large companies).

But let’s talk about that middle ground, where it really isn’t clear what is what.  In this space business brokers often call themselves mergers and acquisitions advisors and M&A advisors call themselves investment banks.  Some high growth companies with $500K in earnings may well need a good M&A advisor because of the complexities of the business, while a car wash with $1 million in earnings could be sold by a no-fee business broker.

Here’s a couple of things to remember when considering whether you need to pay an upfront fee:

1. Like many things, you get what you pay for
2. However, be sure to ask what exactly you are paying for

What you want to pay for, and what it makes sense to pay upfront cash for, are products and services which help you sell your company and get the best price.  This assumes you agree with the notion that professional marketing of your company increases the chance of getting it sold and with the best price.  These services should ideally be performed (just ask) primarily by professionals, not the broker or dealmaker whose primary payday should be selling the company.  Examples of items you should not mind paying an upfront fee for:

• A professionally prepared selling prospectus (the book).  By the way, there is a big difference between a professionally prepared book and a fill-in-blanks template that some firms use.
• Sales and marketing materials.  Executive summaries, photos, videos, blind web summaries, letters of introduction, etc.
• Marketing research to uncover strategic and financial buyers.   Good research entails using many resources and is very time consuming – and it consists of more than running a list based on SIC or NAICS codes.
• Actual marketing costs of mailings, telemarketing, etc.  (As opposed to a business broker that typically only pays for a web listing service.)

What you don’t want to pay for with your upfront fee are commissions paid to salespeople for signing you up.  Some firms pay up to 50% of the upfront fee to salespeople to sign you up, and that is money that isn’t  being used to prepare and market your company.  What is worse, often those same salespeople are the ones that have complete authority to sign you up, creating an incentive to say all the right things to get the fee.  However, they are not actually responsible for selling your company.

This business model has led to the rise (lots of new clients and fees) and eventual collapse (only sold a small percentage of clients) of some large M&A firms, most notably the Geneva Group.   There are similar companies out there today, often using telemarketing and a seminar strategy.

The best thing you can do is ask directly about how the upfront fee and commissions work.  Where does that money go and what is it used for? I was in Brazil recently and the prospective client really drilled me about fees and commissions.  He was focusing in on the flow of money and where the incentives would be in my firm.  That rarely happens in the US, but it should.  Ask.

The two M&A sites I’m familiar with are PEGBASE (www.pegbase.com) and AxialMarket (www.axialmarket.com). In both cases the business model is completely opposite of bizbuysell.com and the other business listing sites. For both of these sites the buyer pays to use the site, not the seller. Both consist mainly of private equity buyers, however Axialmarket also contains strategic buyers.

AxialMarket describes itself with the statements, “AxialMarket provides technology-enabled tools and analytics to help intelligently connect qualified buyers and sellers of privately held companies. Since 2007, AxialMarket’s deal management and deal origination platforms have been used by many of the most active lower middle market financial buyers, strategic buyers, and M&A Advisory firms to source, manage, and execute private M&A transactions across a broad range of industries, geographies, and transaction types. “ PEGBASE describes itself with the statement, “PEGBASE is a consistently formatted M&A Investment Opportunities clearing house that reaches key M&A players in the most efficient and useable manner”.

We have a very complete list of PEGs, but AxialMarket tends to be more up to date with what kind of portfolio companies the PEG’s own, and exactly what they are looking for. That is one of the benefits of charging a fee, the PEGs and strategics are not going to want to waste that money and will spend some time creating an accurate profile on the AxialMarket website. The downside is that because it is fee based, they don’t have a complete list of PEGs and definitely not a complete list of strategics. For example, for the lower middle market we typically find strategic buyers that are not specifically looking for an acquisition, but will take a look at opportunities presented to them.

I’ve been impressed with the Axialmarket interface. It shows you what types of buyers fit your opportunity, and you can easily filter different buyer types (such as PEG platform, add-on, etc.). You can “mouse over” a buyer and instantly see a profile.

Like the business-for-sale websites, sites such as AxialMarket and PEGBase are a great tool to use to help find buyers, but it shouldn’t be the only tool. We’ve found the best results come from using every tool – both technology based as well as traditional mail and telephone.

Let’s think about that from the point of view of a business buyer. A serious buyer is going to start looking for businesses, and very quickly they are going to find out that the place to look is on the web. No one uses newspaper ads or journal ads any longer for small businesses (although we still do for larger ones). A few quick searches on the web, and they are likely going to wind up on one of the top sites. The top sites are at the top of the Google natural rankings and the top sites also advertise more heavily than the other sites. Really, it is pretty tough not to end up on the top sites within a few days of starting your search.

I’ve done some searches for clients, and as a “buyer” I’ve also realized pretty quickly that the same businesses are listed on many sites, and the common denominators are the top sites.

So what point is there for a broker or M&A advisor to market their clients on 20 sites? Not much, except being able to tell your clients you are marketing on 20 sites. In my opinion it is better to get on the top sites but also use other marketing channels, even good old US Mail and the telephone, to find buyers.

Now there are some differentiation features of some of the websites. For example, mergernetwork.com is for larger companies, businessesforsale.com has better exposure to international buyers and bizben.com is a great site for California businesses.

So which are the best? Well, I wouldn’t just advertise on one or just do your searching on just one, you do want to pick a few – but you don’t need 20. Bizbuysell is owned by the Wall Street Journal and they also purchased Bizquest.com so they are definitely the heavy weight in the industry. You definitely want to use them as a business buyer or seller.  Businessesforsale.com has a bit more traffic than bizbuysell.com; however, they are ranked number one in the UK and Australia and much of their traffic is generated there.  Here are some traffic stats from web traffic stats company Alexa. I’ve compared to Bizbuysell a dozen of the top sites.

The above chart measures the traffic of Bizbuysell.com vs. Businessesforsale.com as well as mergernetwork.com, bizben.com and bizquest.com.  Although businessesforsale.com is ranked a little higher than bizbuysell.com on the Alexa ranking site, I would rank bizbuysell.com higher in the US for US companies.  If a company could be acquired by an overseas company then businessesforsale.com would certainly be a place to advertise.

The above chart again graphs bizbuysell and businessesforsale.com for reference, and compares them to businessbroker.net, businessmart.com and acquireo.com.  None of these sites generate the web traffic that bizbuysell and businessesforsale.com do.