Why Price Isn't Everything When Selling Your Company in a Merger or Acquisition

Although it is tempting to sell your company for the highest purchase price, price isn't everything when selling your company in a merger or acquisition. True, a $25 million offer looks sweeter than a $20 million offer. However, here are three important issues other than price to consider when selling your company.

1. Type of consideration

Is the buyer paying you in stock, "boot" (e.g., cash), or some combination? An all cash purchase provides a clean exit for you and your shareholders and shifts all of the post-closing risk to the acquirer. An all stock purchase ties you to the future performance of the acquirer, and the post-closing risk is shared by you and the buyer. Stock purchases send a signal to the market that the acquirer believes its stock is undervalued. However, the acquirer's stock usually decreases in value upon the announcement of the deal in all stock transactions.

When the consideration consists of stock and cash, the IRS places limits on how much of the consideration can be "boot" for the transaction to be treated as tax-free.

2. Earnout

An earnout is a portion of the purchase price that is carved out for the seller to earn over time post-closing. Earnouts are used in about 25% of mergers and acquisitions and often used to bridge differences in valuation between the seller and the buyer. The earnout is tied to financial or operational metrics that you must meet in order to receive some portion of the purchase price. Common earnout metrics are EBIDTA, sales, and revenue goals.

The amount of the earnout is how much of the purchase price is at risk for the seller. For example, in a $25 million transaction, an earnout of $5 million means that the consideration that changes hands at closing is $20 million. You may or may not ever receive the remaining $5 million. The deciding factor is performance after the deal is consummated. Earnouts typically last 24 to 36 months, sometimes longer. The longer the earnout period, the higher the risk that you will not see the entire earnout amount.

The key to successful earnouts is to negotiate metrics that you have a high deegree control over achieving. As the seller, factors like achieving cost or revenue synergies in the combined entity are difficult to influence and should be strenuously avoided as earnout criteria. In order to maximize your chances of reaching earnout goals, you want to maintain control and continuity over your operations. To minimize conflict, make sure that the conditions governing the payment of an earnout are clearly defined.

3. Escrow

Escrow is an amount set aside from the purchase price to deal with liabilities that may arise after the deal has closed. Usually 10% to 15% of the purchase price is placed in escrow for 12 to 36 months to mitigate the buyer's risk of:

• Post-closing changes to net working capital and the balance sheet, and

• Liabilities arising from breach of the representations and warranties in the purchase agreement. Such breach could include claims against the seller for intellectual property infringement; litigation or fines arising from violations of securities law, employment law, or environmental law; breach of contract; and delinquent taxes.

You must carefully negotiate the terms of escrow because post-closing disputes over escrow arise in about 40% of all mergers and acquisitions. Terms such as the amount of escrow, the duration, deductibles, and how claims are paid deserve close attention. The relationship between escrow and indemnifications should also be considered.

Conclusion

Your board of directors has a fiduciary duty to take reasonable steps to obtain the highest possible purchase price for the shareholders to consider. However, that does not mean that you have to accept the highest price. Get advice from an experienced investment banker or mergers and acquisitions advisor, and your M&A attorney working on the deal, to help you negotiate these terms.

There are definitely more than three factors that demonstrate why price isn't everything when selling your company. What other factors would you cite?

Douglas Y. Park

Twitter: @DougYPark

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Due diligence mistakes by sellers in mergers and acquisitions

What due diligence mistakes do entrepreneurs make in selling their company? With only 16% of all letters of intent eventually consummated in the sale of a company, the due diligence process is where many deals break down. Due diligence can involve a 25+ page list of requests for information. The buyer uses due diligence to manage risk, adjust its offering price, and decide whether to go through with the deal. Although buyers often fail to look at the right factors during due diligence, what mistakes during this critical phase of mergers and acquisitions can you as a seller avoid?

Here are four common mistakes sellers make.

1. Failing to do due diligence on the buyer.

This is the biggest mistake, and it happens all too often. Sellers often neglect to conduct due diligence because they are preoccupied with how to satisfy requests for information. However, sellers should investigate buyers in order to increase the chances that the merger or acquisition will achieve its desired goals. Although sell side due diligence is not a formal part of the process, there is nothing stopping you and your investment banker or lawyer from looking into the buyer.

For strategic buyers, you want to know about the acquirer's corporate culture, its top management team, details about its plan to integrate your company, and its track record with acquisitions.

For financial buyers, you want to learn about the private equity firm's operational style, its exit plan, and its track record with acquisitions.

2. Failing to prepare for due diligence.

A seller who is unprepared for due diligence can kill the chances of the deal being completed. At the very least, get ready by taking the following steps:

• Get your finances into order.

Have five years of cash flow statements, balance sheets, and income statements. Although you do not have to have audited financial statements, your books should be in auditable condition.

• Organize all contracts and legal documents.

This includes supplier and customer contracts; pending litigation and government investigations; intellectual property documents such as license agreements, patents, trademarks, and copyrights, and trade secrets. Prepare litigation documents, including complaints, answers, and arbitrations and mediations.

• Have operational data ready to present.

The buyer will want to see information on product quality, human resources, sales and marketing metrics, and customer satisfaction. Depending on the type and size of your business, the buyer will ask to visit your facilities. Expect the buyer to want to speak with the top management team.

3. Failing to cooperate with the buyer.

Sellers sometimes hesitate to provide a piece of information to the buyer. Worse yet, a target might outright refuse to provide information or access to management or production facilities. The desire to hide something is often based on the assumption that the issue, whether financial, legal, or operational, will kill the deal.

Yet, this lack of cooperation raises a red flag to buyers and can became a deal breaker. An acquirer expects a target to have issues. The issue that you are trying to hide might not be a deal breaker. But the fact that you are hemming and hawing might cause greater concern than what you are hesitating to reveal.

Trying to hide something from the buyer is a futile exercise. If the deal closes, the buyer will find out about any problems and you will take a hit through the escrow or the earnout.

So long as the request does not ask for a trade secret (think the formula for Coca-Cola), and is not unreasonably burdensome, you should comply with due diligence requests. There are other limited exceptions, but not very many. The tone of the buyer's due diligence should not overly aggressive. If it is, that may portend your future relationship with the acquirer.

4. Failing to clear disclosures with your attorney.

Before you hand over sensitive information, make sure you consult your mergers and acquisitions attorney. Disclosures should comport with the terms of the Non-Disclosure Agreement between you and the buyer. You should expect to give out some sensitive information. There are limits though. For example, you don't want or need to hand over your entire customer list. Telling the buyer that your top three customers account for 25% of your sales is sufficient. You can redact documents as appropriate, but first build that into the Non-Disclosure Agreement.

Don't give away a trade secret. It is enough that the acquirer knows you have one. Telling the acquirer is not worth the risk that the deal will fall through and that the buyer will steal the trade secret. It is better to avoid litigation than to expose yourself unnecessarily.

When in doubt, ask your attorney.

Conclusion

Due diligence can be challenging for sellers because of the litany of requests received. By understanding the points of risk and what buyers will ask, sellers can avoid common due diligence mistakes during the sale of their company.

Douglas Y. Park

Twitter: @DougYPark

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Palo Alto Business Attorney Douglas Y. Park, Principal of DYP Advisors, offers business informed legal services to make mergers and acquisitions run more smoothly. Drawing upon its experience in small and middle market transactions, the firm will initially focus on deals with a purchase price of up to $250 million.

Mr. Park explains the motivation behind the new initiative.

Mergers and acquisitions are complex transactions that require business and legal judgment. Our experience with both the business and legal issues helps companies, boards of directors, shareholders, and executives achieve their objectives.

These services address critical issues that these constituencies face during the merger and acquisition process:

• Buyers and sellers want financial and legal risk to be appropriately distributed between the parties. These risks appear in the purchase price, form of payment, and other terms of the purchase agreement.

• The board of directors, particularly of the selling company, wants to fulfill its fiduciary duties to its shareholders and avoid expensive litigation.

• Shareholders of the target company want to make sure that the buyer has offered a fair price, the board has met its fiduciary duties, and majority shareholders have acted appropriately.

• Executives want to address concerns over continued employment, severance payments, and stock options.

Moreover, both buyers and sellers need skilled, efficient counsel during the due diligence process to ensure that no surprises arise after the deal closes. Negotiations over the structure of the transaction and the purchase agreement involve strategic, financial, and operations questions. Legal counsel must therefore have a strong understanding of these subjects to give advice that increases the chances of success.

Soyeun D. Choi, Of Counsel to the firm and a specialist in business transactions and intellectual property, works with Mr. Park on all aspects of mergers and acquisitions. Ms. Choi was recently named a 2011 Northern California Rising Star by Super Lawyers magazine.

Mr. Park is teaching Preparing Your Company For Merger or Acquisition at Stanford University during Fall 2011.

ABOUT DYP ADVISORS:

DYP Advisors provides business informed legal services that help executives, boards of directors, and investors address issues in corporate governance, corporate law, and strategy. The firm applies its deep experience in business and law to these central challenges. Our cost effective, high value added services give you an edge over the competition. More information about the firm can be found at http://www.dypadvisors.com.

The original release is available at: http://www.prweb.com/releases/2011/10/prweb8883050.htm.

Fiduciary Duties During The Sale of a Company

As always, the board must observe its duty of care and the duty of loyalty. The duty of care requires the directors to gather the necessary information to decide the appropriate buyer. The duty of loyalty means that the board cannot act in their self-interest, such as preserving their jobs, rather than in the interest of the shareholders. In addition, the duty of disclosure, which is “the application in a specific context of the board’s fiduciary duties of care, good faith and loyalty" [see Note 1], requires the directors to provide full and materially accurate information to shareholders so that they can make an informed decision about which offer to accept. [See Note 2].

Revlon Duties To Shareholders

When a change of control becomes inevitble, the board of directors' fiduciary duties shift from focusing on the corporation's survival and effectiveness of its policy to the interests of the shareholders. In the landmark case Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), the Delaware Supreme Court held that once the board decides to sell the company, the duty of the board changes from preserving the corporate entity to maximizing stockholder value. Once the company is up for sale, it is in Revlon mode and the board's Revlon duties are as follows:

...the directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for stockholders at a sale of the company. [See Note 3].

The board of directors' fiduciary duties run squarely to the shareholders rather than to the corporation.

The contours of Revlon duties have subsequently been clarified. The 2007 In re Topps Company Shareholder Litigation case included allegation that Topps' board of directors violated its Revlon fiduciary duties by favoring the one group's bid through its misusing the standstill agreement to prevent Topps' stockholders from considering an alternative bid that they could find more favorable than the other group's bid. In ruling in favor of the plaintiff shareholders, the Delaware Chancery Court explained:

The so-called Revlon standard is equally familiar. When directors propose to sell a company for cash or engage in a change of control transaction, they must take reasonable measures to ensure that the stockholders receive the highest value reasonably attainable. Of particular pertinence to this case, when directors have made the decision to sell the company, any favoritism they display toward particular bidders must be justified solely by reference to the objective of maximizing the price the stockholders receive for their shares. When directors bias the process against one bidder and toward another not in a reasoned effort to maximize advantage for the stockholders, but to tilt the process toward the bidder more likely to continue current management, they commit a breach of fiduciary duty. (Emphasis added.) [See Note 4].

Implications of Revlon Duties for Mergers and Acquisitions

Revlon duties require the board to take reasonable steps to maximize shareholder value in the sale of a company. This obligation has two significant implications for mergers and acquisitions.

1. The winning bid will be higher.

In the absence of Revlon duties, the board could, for example, choose to stop the bidding process early on by enacting deal protection and lock-up devices. A process that forecloses bidding fails to maximize shareholder value compared to a competitive buying process. [See Note 5].

2. The winning buyer will pay a higher premium, reducing the chances of success for the merger or acquisition.

When faced with multiple bids, the selling shareholders are likely to choose the highest price most of the time. The sale is the last opportunity for the shareholders to obtain a return on their investment, so they will be motivated to accept the highest premium for their shares. Many shareholder suits brought regarding the sale of a company focus on the board of directors' alleged failure to uphold their Revlon duties.

A high premium raises the bar that the buyer must exceed in order to successfully create value through the deal. For instance, a buyer who pays a 25% premium versus a 15% premium has that much a higher hurdle to jump in order to realize a positive return. When the premium paid is higher, the management of the surviving company will have to achieve greater cost and strategic synergies.

Thus, while the selling shareholders may benefit from a bidding process through which the board satisfies its Revlon duties, the likelihood of a positive outcome may be reduced. The irony is that where a large portion of the consideration is the buyer's stock, the selling shareholders will have to bear the risk that the merger or acquisition will destroy shareholder value.

Douglas Y. Park

Twitter: @DougYPark

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Note 1. Malpiede v. Townson, 780 A.2d 1075, 1086 (Del. 2001).

Note 2.  Malone v. Brincat, 772 A.2d 5, 10 (Del. 1998).

Note 3. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986).

Note 4. In re The Topps Company Shareholders Litigation, 926 A.2d 58 (Del. Ch. 2007).

Note 5. Revlon, 506 A.2d at 182-184.

Douglas Y. Park, a Palo Alto Business Attorney, will teach Preparing Your Company for Merger or Acquisition through the Stanford University Continuing Studies Program during Fall 2011.

“Because merger or acquisition is the most common exit strategy for startups, an entrepreneur or executive must understand the key issues involved in selling their company. The process of selling a company through M&A is a complicated process that requires planning,” Mr. Park said.

To maximize a company’s success during the M&A process, the topics include:

• Business, psychological and emotional factors in exiting through M&A
• Critical steps in the merger and acquisition process
• Different M&A structures
• How to make your company an attractive target for buyers
• Strategic, business, and organizational fit with potential M&A partners
• Legal considerations.

This course is intended for entrepreneurs, managers, and those who understand that M&A can take a company to the next level. Classes will consist of lectures, discussions, and guest speakers.

The course begins on September 27, 2011. Classes will be held on eight consecutive Tuesday evenings from 6:45 pm to 9:00 pm on the Stanford campus. For further details, including registration information, please visit the class page on the Stanford University Continuing Studies website.

About Douglas Y. Park:

Douglas Y. Park of DYP Advisors, located in Silicon Valley, has nearly twenty years of experience helping executives and investors achieve their strategic, financial, and operational goals. He specializes in solving problems in strategy, corporate governance, and corporate law. Mr. Park taught at the School of Business and Management, Hong Kong University of Science and Technology in strategy, entrepreneurship, and organizational behavior. He also taught a course on startups at Stanford. He received an AB magna cum laude with highest honors in Sociology from Harvard College, a PhD in Strategy and Organization from Stanford Graduate School of Business, and a JD from the University of Michigan Law School.

For more information, please visit http://www.dypadvisors.com.

The original release is available at: http://www.prweb.com/releases/paloaltobusinessattorney/mergersandacquisitions/prweb8734692.htm