October 2020 - The Law Offices of Jeff Peterson

FLORIDA MAN BEING SENTENCED FOR WIRE FRAUD IN CONNECTION WITH TRADING COMPANY

October 30, 2020/in News /by Jeff Peterson

The United States Attorney’s Office for the Southern District of Florida issued a press release about a Kissimmee, Florida resident being sentenced to more than seventeen years in prison after having been convicted at trial of wire fraud.

Previous Records

Michael John Alcocer Roa had previously been convicted at trial by a jury of five counts of wire fraud, in violation of Title 18, United States Code, Section 1343. U.S. District Court Senior Judge Patricia A. Seitz sentenced Alocer to 210 months’ imprisonment, to be followed by 3 years of supervised release. He is also subject to a potential restitution order.

The press release asserted that Alcocer set up a Florida corporation called Inovatrade Inc. (“Inovatrade”) in October 2008 and between 2008 and 2011, Alcocer told people they could trade foreign currencies at Inovatrade, set up managed accounts in which others could trade foreign currencies on their behalf, or earn guaranteed interest payments of approximately 15% per year or greater. Alcocer represented during this time that Inovatrade maintained all its clients’ accounts segregated, safeguarded, and protected in a trust account.

Excuses and Cash Outs

The U.S. Attorney’s Office went on to state that based on those and other representations, Inovatrade received over $7 million from customers, who were sent detailed account statements over time. But when individuals requested to withdraw their money from Inovatrade, many were unable to do so, receiving instead a litany of excuses from Alocer.

The press release stated that financial records associated with Inovatrade and Alcocer introduced at trial showed little to no actual trading took place in the Inovatrade accounts, and that Alcocer cashed out and transferred millions of dollars of that money from the Inovatrade accounts to personal accounts in the United States and in Panama.

The U.S. Attorney’s Office press release can be found at the following link:

https://www.justice.gov/usao-sdfl/pr/kissimmee-resident-sentenced-more-17-years-wire-fraud

Jeff Petersen is an attorney licensed in California and Illinois representing clients in a wide variety of regulatory enforcement actions. She can be reached in California at 858.792.3666 and in Illinois at 312.583.7488.

TEXAS OIL COMPANY PAYS $5.4 MILLION TO SETTLE SEC SUIT

October 29, 2020/in News /by Jeff Peterson

The SEC entered into a settlement on its recently-filed securities suit against defendants Southlake Resources Group, LLC (“Southlake”), Cody Winters, and Nicholas Hamilton. The defendants consented to entry of the SEC’s proposed final judgments without admitting or denying the allegations in the SEC’s complaint.

Joint Ventures

The SEC alleged that from approximately June 2010 through approximately September 2014, Winters, directly and through Southlake, a company he owned and controlled, raised more than $5.2 million from more than 70 investors in 26 states by selling interests in several oil-and-gas joint ventures. None of the offerings were registered with the Commission, and none of the individuals that Winters and Southlake employed to cold call potential investors, including Hamilton, were registered with the SEC as a broker or associated with a registered broker.

Misinformation On Productions and Revenue

The SEC further alleged that in written offering material provided to investors, Winters and Southlake made untrue and misleading statements and omissions of material facts regarding, the use of offering proceeds, projections for oil-and-gas production and revenue, and commingling and loaning investor funds. In addition, the SEC alleged that in each offering, Winters overstated the projected well costs by almost 100% and omitted to disclose to investors Southlake’s actual cost and profit information.

Finally, the SEC alleged that at Winters’ direction, Southlake engaged in conduct contrary to written representations to investors about the use of offering proceeds. For example, Southlake took undisclosed profit and overhead payments from the offering proceeds and used offering proceeds to acquire working interests for itself in undisclosed transactions.

The consent agreement with the SEC required the company to pay back $5,235,650 collected from investors, plus $285,761.70 in interest, as well as penalty payment from Winters and Hamilton of $160,000 and $50,000, respectively.

Jeff Petersen is an attorney licensed to practice in California and Illinois representing clients in a wide variety of SEC investigations and enforcement matters. He can be reached in California at 858.792.3666 and in Illinois at 312.583.7488.

MANHATTAN TAX ATTORNEY AND CPA INDICTED FOR TAX EVASION

October 29, 2020/in Corporate Transactional Law, News /by Jeff Peterson

The United States Attorney’s Office for the Southern District of New York announced that Manhattan tax attorney Harold Levine and Florida certified public account Ronald Katz were charged in Manhattan federal court in an eight-count Indictment with engaging in a multi-year tax evasion scheme involving the diversion of millions of dollars of fees from a Manhattan law firm, and the failure to report that fee income to the IRS.

U.S. Attorney for the Southern District of New York Preet Bharara said in the release: “As tax professionals and partners at professional firms, both Harold Levine and Ronald Katz knew better. But as alleged, they engaged in a multi-year scheme to divert and evade taxes on millions of dollars of fee income.”

The Indictment alleged that Levine, a tax attorney and former head of the tax department at a Manhattan law firm, participated in a scheme with Katz to divert from the law firm over $3 million in fee income from tax shelter and related transactions that Levine worked on while at the firm. In addition, per the Indictment Levine failed to report that fee income to the IRS on his personal tax returns, and Katz received and failed to report to the IRS over $1.2 million in fee income.

The Indictment alleged that as part of the fee diversion scheme, Levine caused tax shelter fees paid by a firm client to be routed to a partnership entity he co-owned with Katz and thereafter used approximately $500,000 to purchase a home in Levittown, New York, then took improper tax deductions on the home as rental property.

The Indictment also alleged that Levine made false statements about the purported rental property when questioned by IRS agents concerning his involvement in certain tax shelter transactions and the fees received for those transactions, and urged a third party to make false statements to the IRS about that property.

Levine and Katz are scheduled to be arraigned on October 31^st.

Jeff Petersen is an attorney licensed in California and Illinois representing clients in a wide variety of regulatory matters. He can be reached in California at 858.792.3666 and in Illinois at 312.583.7488.

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DEFINING A SELLER’S KNOWLEDGE IN AN M&A AGREEMENT

October 24, 2020/in Mergers & Acquisitions, News /by Jeff Peterson

Representations and Warranties

In an agreement for the sale of a business, there will be a number of representations and warranties by the seller across the spectrum of the company’s business, including its ownership of assets, its financial condition, its compliance with a variety of laws (among others, employment and environmental laws), and the existence of any adverse material events. If anissue arises post closing that violates the representations and warranties, then the indemnity provisions in the agreement will dictate that the seller must compensate the buyer for any resulting loss, including payment of attorneys’ fees, settlements, judgments, etc.

Because a breach of the seller’s representations and warranties can result in a costly indemnification obligation, the seller will be keenly interested in limiting its exposure to the extent possible. One way to do this is with a knowledge qualifier for certain representations and warranties, i.e., language which limits the extent of the representation and warranty on a specific matter to the actual or constructive knowledge of the seller.

Actual vs Constructive Knowledge

As an initial matter, the distinction between actual and constructive knowledge standards is an important one in this context. Actual knowledge of course means that the seller must actually know about the circumstances giving rise to the breach of the representation and warranty in order to be held liable for that breach. Constructive knowledge, on the other hand, will dictate that a breach will occur if seller either knew or should have reasonably known about the facts giving rise to a breach. Obviously, a seller much prefers an actual knowledge standard, as it precludes delving into the factual circumstances to determine whether a reasonable party should have known about the underlying facts of a breach.

To examine the effect of knowledge qualifiers in the M&A context, we’ll use the example a representation and warranty pertaining to existing lawsuits against a company, as well as any present basis for a legal claim to be brought in the future. This very common representation and warranty is generally bifurcated by a knowledge qualifier as follows: (1) the first clause relating to existing lawsuits is unqualified with regard to sellers knowledge; and (2) the second clause, pertaining to any current facts giving rise to a basis for a potential claim, is qualified or limited by the actual or constructive knowledge of the seller.

Breaking Down the Knowledge Qualifiers

Let’s begin by analyzing the first clause and the lack of any knowledge qualifier. If there is an existing lawsuit against the seller as of the time of closing, whether seller knows it or not, the seller will have breached the representation and warranty on absence of lawsuits unless that lawsuit is listed on a disclosure schedule to the agreement. The allocation of risk in this regard makes logical sense, because the suit has been filed before closing based on conduct of seller, and should be seller’s responsibility. In addition, with regard to the issue of knowledge, a lawsuit is a public record and generally needs to be served promptly after filing, so in most circumstances, seller is going to be aware of such litigation. And, if due to a quirk of timing, the seller is not so aware, a buyer is not willing to take on that liability by using a knowledge qualifier.

As for the second clause, however, the existence of any basis for a future claim, generally speaking this clause will be subject to an actual or constructive knowledge qualifier. The allocation of risk here is that if the seller did not actually know (under an actual knowledge standard) or reasonably know (under a constructive knowledge standard) of the basis for a subsequent claim, the seller will not have breached the representation and warranty, and will not owe an indemnity obligation. The reasoning behind the general use of the qualifier here is that a seller cannot be held to know everything about the company, and that some dividing line should be drawn with respect to unasserted claims.

The trend in M&A is for a constructive knowledge standard to be used as the knowledge qualifier. The buyer’s argument in this regard is straightforward: they are unwilling to make the substantial investment in purchasing a company or its assets while allowing a seller to avoid liability based on lack of actual knowledge of its errors or misconduct. Indeed, buyer
will argue, such a standard rewards neglect, in that an unknowing seller will escape liability while a more diligent company would have been aware of the
issue.

Defining Constructive Knowledge

There are a variety of ways to define constructive knowledge in an agreement. One common way is to define knowledge by connecting it to what specific individuals in the company, often the selling principals and officers or directors, knew or should have known in the exercise of reasonable diligence. A seller will want to pay careful attention to this definition to ensure that the constructive knowledge standard does not become overly broad so as to open the door too wide to potential liability. Seller and its attorney should also carefully review the agreement to confirm that knowledge qualifiers are being used appropriately throughout the representations and warranties to limit their scope.

A seller’s indemnity obligation is generally the chief source of liability after closing, so careful review of knowledge qualifiers during the drafting process is a key way for seller to effectively manage this potential exposure.

MATERIALITY SCRAPES IN M&A AGREEMENTS

October 23, 2020/in Mergers & Acquisitions, News /by Jeff Peterson

Consequences of violations of Representations and Warranties

In an agreement for the sale of a business, there will be a number of representations and warranties by the seller across the spectrum of the company’s business, including its ownership of assets, its financial condition, its compliance with a variety of laws (among others, employment and environmental laws), and the existence of any adverse material events. If an issue arises post-closing that violates the representations and warranties, then the indemnity provisions in the agreement will dictate that the seller must compensate the buyer for any resulting loss, including payment of attorneys’ fees, settlements, judgments, etc.

What is a materiality scrape?

A materiality scrape is a provision in the agreement that provides that when determining either: (1) whether a representation or warranty in the agreement has been breached; and/or (2) the amount of any loss resulting from such breach, all materiality qualifiers in the agreement are disregarded (i.e., “scraped”). The practical effect of such a provision is to “read out” any materiality qualifiers in the seller’s representations and warranties, such that seller will be liable for any breach and/or any loss resulting therefrom.

Obviously, a seller would prefer to have materiality qualifiers in the agreement to limit its indemnity obligations. The buyer’s argument in favor of a materiality scrape, however, is generally twofold: (1) if the agreement has an indemnity “basket” (i.e., a threshold amount of loss which must be reached before seller has a duty to indemnify), then a materiality threshold is already in the agreement, and the scrape prevents doubling up on materiality hurdles; and (2) excluding the materiality threshold precludes future disputes over what is and is not material.

Arguments against a materiality scrape

The seller has two chief arguments against the use of a materiality scrape. The first is that utilizing such a provision will result in both buyer and seller getting in the weeds about every possible flaw in the company. Pre-closing, seller will be incentivized to list every matter it can think of in the disclosure schedules, not matter how minor, while post-closing, buyer will be incentivized to assert every claim no matter how trivial to reach the basket amount. Seller can also argue that a materiality scrape leads to absurd results. A typical M&A agreement contains a number of provisions that utilize a materiality standard, for instance, a representation and warranty that the seller has made no material misrepresentations in conjunction with the agreement. Reading that qualifier out of the agreement essentially nullifies the governing legal standard for stock purchases that has been in place for decades.

How can buyers and sellers compromise?

The last point segues nicely into how a buyer and seller can compromise on the matter. One way to do so is to exclude the materiality scrape from applying to certain representations and warranties. Another is to use an indemnity basket which excludes the entirety of the basket threshold amount from seller’s indemnity obligation, rather than a “tipping basket” which requires that, once the threshold amount is met, seller indemnify buyer from dollar one of the loss. Lastly, the parties can agree to use a “single scrape”, i.e., nullifying any materiality qualifier in determining the amount of damages, but not when determining whether a breach has occurred in the first instance. Using one or more of these types of provisions will better allocate the risk among the parties, and a seller coming into a deal prepared to negotiate this issue will be in a far better position to achieve a more desirable result.

INDEMNITY PROVISIONS IN AGREEMENTS FOR SALE OF A BUSINESS

October 20, 2020/in Mergers & Acquisitions, News /by Jeff Peterson

Business Agreements

When business owners receive an agreement for the purchase of their business, it is easy to feel lost in a sea of legalese. The agreement generally can be anywhere from 40 to 100-plus pages, covering a broad range of representations and warranties, tax matter procedures and so on.

Although it is obviously imperative to have experienced counsel guide a business owner through this process, it is also helpful for the owner to understand certain fundamental components of the deal, to be able to analyze the risk profile and assist the attorney in negotiating a final agreement that protects the owner to the fullest extent possible.

Indemnity Provision Component

One such fundamental component of the deal is the indemnity provision, which is a mutual obligation of the buyer and seller to defend and hold one another harmless from certain acts or breaches of the agreement. When a party’s indemnity obligation is triggered, that party will have to pay attorney fees and costs of defending any claim, as well as paying for any monetary loss, arising from that claim, including a settlement, judgment, fine or penalty. In other words, the indemnity provision is (generally speaking) the one way that a seller will have to pay money back to the buyer from the sale of the business. Because of this, it is vital for a seller to understand the mechanics of indemnity, and the ways in which indemnity obligations may be limited.

As an initial matter, a seller’s indemnity obligation generally applies to the following: (1) a breach of the seller’s representations and warranties in the agreement; and (2) a breach of the seller’s contractual obligations in the agreement.

The first prong is the source of most post-closing indemnity claims. In the sale agreement, a seller will typically make a lengthy series of representations and warranties, from basic items such as attesting to full and unimpaired ownership of the equity and assets of the company, to highly detailed representations and warranties regarding compliance with employment or environmental laws, and an absence of claims for violating any such laws. If there is any legal violation that seller is aware of, that will be listed on a disclosure schedule to the agreement. In typical sale agreements, there are twenty to thirty such representations and warranties, covering the full spectrum of the business. Therefore, unless an item of potential liability is specifically excluded, any breach of the representations and warranties that the business has been run in compliance with the laws, is not encumbered, and is not subject to any claims, can serve as the basis for an indemnity claim by the buyer.

Because of this, it is important for a seller to thoroughly review all the representations and warranties with counsel and identify any potential gaps in compliance and/or future claims. Once identified, seller and counsel can address the matter with buyer’s team and negotiate provisions to address the matter. In most cases, the parties are able to reach agreeable terms on the issue, but identifying it ahead of time and being able to decide whether or not to proceed is invaluable for a seller. It is far better to decide to proceed with a known risk than it is to be surprised later.

Indemnity Protections

A seller can also have certain protections built into the indemnity section of the agreement to limit the indemnity obligations in most instances. For example, the use of baskets and caps are typical in sale agreements, both of which limit a seller’s obligations.

Indemnity Basket

An indemnity basket functions like a deductible of sorts; i.e., until the amount of buyer’s loss reaches X dollars, the seller does not have to make payment for any indemnified loss. Most agreements use what is called a tipping basket, so that when the loss threshold is met, the seller owes indemnity on the entirety of the loss from dollar one.

Indemnity Cap

An indemnity cap is an even more important tool for the seller. A cap will limit the amount of money a seller has to pay for indemnified claims post-closing, subject to certain exclusions. In most mid-market deals, the typical indemnity cap ranges from 5-15% of the total purchase price. Say for instance the indemnity cap is 10% of the purchase price; in such event, if the purchase price is $20 million, the seller’s total indemnity obligation would be limited to $2 million, again subject to certain exceptions. The logic behind this limitation is that the seller needs a certain level of assurance that once it sells the business, the buyer is not going to come back with a slew of claims to essentially claw back the entirety of the purchase price, while still remaining in control of the business.

The limited exceptions to the applicability of the cap track this logic as well. For example, fraud is the main exception to applicability of the indemnity cap. This makes logical sense in that, if the seller has actively defrauded the buyer about the state of the business, the seller should not be able to hold buyer to an indemnity limit that was negotiated on the presumption all parties were dealing in good faith. The inapplicability of the cap to what are deemed “fundamental representations” like unencumbered ownership of equity and assets is logical as well – if the seller does not truly own what it is purporting to sell, then the buyer should not be bound by any cap, as it truly did not receive what it paid for.

Important Provision For The Seller

Lastly, a common protection for the seller in the indemnity section is that indemnity will be set forth as the exclusive remedy for breaches of the agreement, subject to common exceptions for fraud or for a party seeking equitable relief. This is an important provision for seller, because it prevents a buyer from making an “end run” around the carefully-negotiated indemnity provisions and seeking relief from the seller which is not subject to the baskets and caps, among other things.

The various permutations of an indemnity section in an agreement for sale of a business are too involved to address fully here, but identifying some fundamental components of how indemnity works can help facilitate communications with counsel when that large stack of deal documents hits the seller’s inbox.

NEGOTIATING FAVORABLE TAX TREATMENT OF EARNOUTS

October 19, 2020/in Mergers & Acquisitions, News /by Jeff Peterson

What is an earnout?

If a company’s owners are negotiating a sale of their business, one facet of compensation the buyer may propose is an earnout, i.e., a contingent payment tied to a benchmark for the company’s performance post-sale.

An earnout is generally a tool of compromise between buyer and seller – if the parties cannot agree on a purchase price, using an earnout is a way to protect the buyer on the downside if the company does not perform as well as anticipated post-closing, while providing an upside in earnings for the seller if the agreed benchmark is met. The range of calculations for arriving at an earnout is infinite, but in general, the earnout will be some multiple of a financial metric or a fixed or variable number based on some measure of company performance. A seller, if confident about the company’s future, may view an earnout as a way to realize more money on the sale of the business than settling for a fixed number that is lower than what seller is willing to accept.

Risk Factors

With all that being said, there is always a degree of risk involved in agreeing to contingent compensation which may or may not be realized, so most sellers are not inclined to agree to an earnout that will comprise too substantial a portion of the overall purchase price (with exceptions, as with all things). Another potential drawback to using an earnout is that it can result in less favorable tax treatment. If the transaction documents provide that the entirety of the earnout constitutes ordinary income to the seller receiving the payment, then seller will be taxed at an ordinary income tax rate, rather than at the preferred capital gains rate that could otherwise be available to seller.

Restructuring The Earnout Benefits

In light of this, it is important for a selling owner of a company to consider structuring the earnout so that the preferred capital gains rate can be attained on as much of the post-closing proceeds as is allowable under applicable law. A common method by which a buyer and seller do so is by agreeing on a separate payment that will constitute reasonable compensation to the individual for his or her post-closing services, and will thus be taxed at an ordinary income rate. Then the earnout monies that are separate from such reasonable compensation amount will be categorized in the deal documents as “deferred purchase price” being paid for the company’s equity or assets, and thus will be taxed at the same rate for the initial payment at closing. Taxation for a sale of equity will be at the capital gains rate, and for a sale of assets, as the facts allow and when structured correctly, the capital gains rate will predominate as well. Thus, the selling party will attain a preferred tax rate on the post-closing compensation that is separate from the set ordinary income.

As with most facets of a large-scale M&A transaction, the legal considerations in structuring the earnout terms correctly are far too varied and involved to cover in depth here, but there is great benefit in knowing beforehand that the structure of the earnout can result in vastly different tax treatment, and that advance planning and utilizing proper terms can help a seller achieve a much better position with regard to after-tax proceeds on a sale.

NEGOTIATING AN ENGAGEMENT AGREEMENT WITH AN INVESTMENT BANKER

October 18, 2020/in Mergers & Acquisitions, News /by Jeff Peterson

A company looking to sell its business will often engage an investment banker to assist in the process.

Such a firm can be an invaluable asset to a prospective seller, assisting the company in preparing for sale, providing a rolodex of suitable buyers, helping negotiate the terms of the deal and facilitating the transaction all the way to a close. The right investment banking firm can help a company sell its business for substantially more than it otherwise would have.

Before an investment banker will engage with a selling company, however, it will require a written agreement setting forth material terms such as the scope of the investment banker’s engagement, the term of the engagement and the compensation it will receive. Negotiating the key terms of this engagement agreement is important for the selling company, as it will dictate the range of services the investment banker will provide and be compensated for, how and when it will be paid, and the types of transactions for which the investment banker will be paid even after the engagement has terminated. We discuss each of these issues below.

Things To Lookout For In The Scope Of Engagement

With regard to the scope of engagement, it is important not only to mutually determine what the investment banker will do for the company, but also what the investment banker will not do. The “Transaction” for which the investment banker will be entitled to fees must be precisely defined so that the investment banker cannot claim a fee for a transaction where it did not provide services. For example, if the engagement is for the sale of the company’s equity or assets, then the investment banker should not be able to claim any fees for a debt financing the company arranges itself in the interim. But a broad definition of “Transaction” could lead to such result.

The term of the engagement will also be addressed in the agreement.

The investment banker will require exclusivity in just about all cases, as it will not want to compete with other firms to sell the company. A term of one year is fairly standard, with investment bankers preferring to have sufficient time to locate a buyer and process the transaction. And we will discuss later in this post the protections in the engagement agreement for the investment banker in the event a deal it has brough to the table does not close by the end of the term.

The compensation owing to the investment banker will also be addressed.

Two main components of this compensation are a retainer and an overall success or transaction fee. Many investment bankers require a retainer for the engagement, which is a non-refundable fee paid at the outset of the engagement. The selling company should try to negotiate the retainer out of the engagement completely if it can, and if that can’t be done, the retainer should be a minimal part of the overall contemplated compensation, as well as being creditable against the success fee.

What is a success fee?

The success fee is generally a percentage of the purchase price of the company. The range of percentage charged for a success fee can vary greatly based on deal size, so it is important to confer with an attorney or other adviser with knowledge of the industry to ensure the fee listed in the engagement agreement is commercially reasonable. The investment banker may also seek to impose a minimum success or transaction fee, which guarantees a floor on payment to the investment banker at close of sale regardless of the sale price. Any minimum fee is obviously not desirable for a seller, as it imposes an obligation to potentially pay significantly more to the investment banker than the purchase price would otherwise dictate. The company can push back on this with a logical argument the investment banker’s sales pitch will lend some support to, namely, “If we’re such a great company, as you’ve been telling us, and you’re so good at your job, why do you need to charge a minimum fee?” The investment banker’s rebuttal is likely, among other things, that they cannot control what happens to the company between time of engagement and time of sale, and the minimum serves as downside protection in the event due diligence or other matters result in sale at a lower price than the parties anticipated. If the company is to agree to any such fee, it should have a high degree of confidence about the purchase price it can obtain. The seller should also use language giving it broad discretion to choose not to do a deal in the event the only offer obtained is prohibitively low.

What is a fee on any contingent compensation owing on a deal?

If there is money to be paid after the closing, which can include a return of money escrowed for indemnity claims, an earnout to be paid, or payments pursuant to a seller note, the investment banker will want to include that in its fee. Although doing so makes some logical sense, as post-closing payments are part of the overall compensation to the selling shareholders, a seller will want to ensure it has no obligation to make payment until actual receipt of any contingent monies.

Some investment bankers will use language in their engagement agreements imposing an obligation on the sellers to pay at closing a fee on all contingent compensation that may be owing after closing. But doing so imposes obligations on the sellers to pay: (1) before they ever receive the money, and (2) the full amount of the contingent compensation, which may never be realized. As to the last point, say a buyer makes an indemnity claim, and the escrow amount is reduced by $2,000,000 as a result. If the investment banker fee is 3%, the seller will have paid $60,000 in investment banking fees on money it never actually received. For this reason, negotiating terms that contingent payments will be paid promptly after the money is received, and only to the extent that contingent payments are actually received, can prevent a seller from having to make premature and excessive payments.

What does the engagement agreement address?

Finally, the engagement agreement will address what fees may be owing to the investment banker for a transaction that closes after the engagement agreement is terminated. This is often referred to as a “tail period” for the engagement. Here, the investment banker is seeking to ensure the seller does not attempt to either stall a transaction until after the term, or pretend not to be interested in a prospective purchaser introduced by the investment banker, only to contact that prospective purchaser after termination to consummate a deal.

In general, a one-year tail period is acceptable to cover the consummation of a deal with a prospective purchaser the firm has introduced to the seller. Careful attention will have to be paid to this clause, however, to preclude the investment banker from casting too wide a net here – for instance, by defining a sale giving rise to its fee to include a deal with any buyer during the tail period, even if that buyer was never introduced to the seller by the investment banker.

The investment banking relationship can definitely be a beneficial one for a selling company, but given that the sale of a business is the single most important transaction the company will ever have, it makes sense to review all agreements material to that sale carefully to ensure appropriate safeguards are in place.

ADDRESSING IMPORTANT DEAL POINTS IN YOUR LETTER OF INTENT

October 17, 2020/in Corporate Transactional Law, News /by Jeff Peterson

A letter of intent for the purchase of a business sets forth the major deal points for that transaction, including the purchase price, the structure of the deal (asset purchase, stock purchase, etc.), whether an earnout will be utilized, and so forth. The letter of intent is almost always non-binding, meaning that deal points may be modified as the parties mutually agree during the course of due diligence and drafting final documents.

The fact that the letter of intent is non-binding and chiefly addresses business points of the deal sometimes lulls business owners into a sense of complacency on the legal aspects of the deal, with the mindset being that the lawyers can hash out the legal terms later. This mindset can be bolstered by the boilerplate language used in letters of intent on legal items such as indemnification, where the letter of intent may just generally state that the parties will indemnify one another pursuant to standard indemnity terms.

Why Boiler-Plate Shouldn’t Be Ignored

Business owners would be well served, however, by taking the time and using counsel to put some concrete terms around the important legal aspects of the deal. Although the letter of intent will be non-binding, having these terms addressed will set the expectations for both sides of the deal, and without a major issue arising during due diligence, it will be difficult for a buyer to justify making significant changes on these legal items. On the contrary, if important items are not addressed, a seller is left to try to negotiate mid-deal, where the buyer has an exclusive period of 90 days or so where the seller is unable to sell to anyone else (generally one of the only binding terms in a letter of intent), and seller is incurring significant costs like attorney and other adviser fees. This circumstance gives a seller less leverage to negotiate important legal terms.

So what are these important legal points a business owner will want to address in that letter of intent? Indemnification is one major item. Rather than say indemnity will be provided pursuant to “standard terms”, the letter of intent should address several things, including: (1) an indemnity basket or cap for the seller, as well as the survival period for indemnity claims; (2) the exceptions to the basket, cap, or standard survival period; and (3) the use of any escrow or setoff for indemnity purposes.

The Indemnity Basket

An indemnity basket functions like a deductible, where generally the business owner is not liable to indemnify buyer until losses exceed a set threshold amount. Then, once that amount is met, the seller is liable for indemnification for the entire amount of any loss. An indemnity cap is a limitation on the amount seller will owe for indemnity, generally an amount in the range of 10-20% of the purchase price. One can see that having an indemnity cap limiting the amount of the indemnity obligation would be crucial for a seller. Lastly, it is important to address the survival period for representations and warranties, which governs for how long a buyer may make an indemnity claim for breach of representation and warranty. Generally speaking, this survival period is between 12 and 18 months.

The most common exception to the application of the basket or cap, or to the survival period, is for fraud perpetrated by the seller. For example, if a seller has willfully concealed a problem with the business resulting in a loss, it is fair and reasonable to say that loss should not be excused or capped, and that if the loss arises after say a one-year survival period, the defrauding seller should not be able to avoid liability for the loss.

Escrow Equal to Cap on Indemnity

Finally, buyers generally like to set up an escrow where a portion of the purchase price will sit for the survival period to ensure payment of any indemnity obligation that may arise. Typically, the escrow amount will equal the cap on indemnity. If an earnout is contemplated, buyers may also demand the ability to “set off” any amounts owing on an indemnity claim against any earnout payments owing to a seller. Say, for instance, that seller claims $200,000 in damages for an indemnifiable claim and has an upcoming $500,000 earnout payment to a seller. The buyer in this case would unilaterally deduct the $200,000 from the payment owing and remit only $300,000 to the seller.

With all the possible permutations in the indemnity provision, one can see that it’s helpful at the outset to nail down items like the amount of the indemnity cap, the use of an escrow, etc. Doing so will also reveal whether the buyer is contemplating inserting exceptions to the cap or survival period that are outside commercial norms. Finding this out sooner, and addressing it before a buyer is in the thick of the deal process, will provide a better negotiating position.

What About Earnout

Another important item to flesh out in the letter of intent is how the earnout will be treated. Generally speaking, an earnout will be tied to EBITDA or some other measure of financial performance, i.e., the seller will receive X amount of money based on company performance. Defining clearly in the letter of intent how that benchmark is measured is crucial. Will certain revenues be excluded, how is the time period for such benchmark calculated and will any adjustment be made for deals booked prior to the cutoff where revenues have not been collected yet? Each particular scenario will raise its own questions, but much better to address those specific questions upfront.

Lastly, on the earnout, a seller has the ability to categorize a portion of any earnout as deferred purchase price rather than income, which results in preferred capital gains tax treatment on that portion of earnout as opposed to an ordinary income tax rate. The resulting difference in proceeds can be substantial, so it is well worth putting in the letter of intent what the amount of fair compensation for services provided will be, with any earnout monies over that amount to be treated as deferred purchase price.

Selling a business is a complex and time-consuming process in the best of circumstances. Given that, it makes good sense to address the important issues at the initial stage in detail to provide a clear forward path. Whoever said an ounce of prevention is worth a pound of cure may not have worked in the M&A space, but they were right on the money when they said it.