Mergers & Acquisitions Archives - The Law Offices of Jeff Petersen

Charging Bull sculpture in New York City

THE M&A MARKET IS POISED FOR AN UPTICK IN 2024

January 22, 2024/in Mergers & Acquisitions, News /by The Law Offices of Jeff Petersen Team

During the course of the pandemic, middle market M&A had an unprecedented level of deal activity due to a variety of factors, chief among them low interest rates, the large influx of capital into private equity, and a common belief among sellers that tax rates would soon increase with the Democratic party controlling the executive and legislative branches after the 2020 elections.

That robust activity encountered numerous headwinds last year, however, with the Federal Reserve increasing interest rates to combat inflation that had been persistent with continuing supply chain issues and elevated energy prices. For 2023, U.S. private equity deal volumes have been initially reported to be down 27% from their 2021 peak, and down 19% from 2022. U.S. corporate M&A transactions for deals greater than $100 million are expected to be down 38% in 2023 compared to the 2021 peak and down 9% from 2022.

Toward the end of last year, with interest rates stabilizing, supply chain issues finally seeming to resolve, and with pent up deal demand after a sluggish end of 2022 and into 2023, the M&A market showed signs of increased activity across the board. Private equity deal volume in 2023 increased in each successive quarter after a very sluggish start. Bloomberg recently reported that both major and boutique investment banking firms are staffing up for 2024 in anticipation of increased M&A activity. A number of M&A deal sites have reported an uptick in activity on their platforms across a broad range of industries. And Ernst & Young recently projected in its Deal Barometer that U.S. private equity deal volume would be up 13% in 2024, with corporate M&A activity increasing by 12%.

All these favorable market conditions should provide a significant boost for middle market deal activity, which weathered the adverse conditions of the past year fairly well, given the lesser impact of higher interest rates on deals in that range. The general expectation on interest rates for 2024 is that the Federal Reserve will cut rates by 75 to 100 basis points, which will afford buyers in that space even greater flexibility to do deals.

In addition to more favorable market conditions, fast-growing industry segments like Artificial Intelligence and its ancillary businesses provide additional fuel for deal flow to increase this year and beyond. Technology in general helped sustain deal activity during 2023, accounting for nearly one-third of private equity activity by value for the past year. Much like the stock markets for 2023, then, technology was the driving force. Not to be discounted from a sector analysis is health care, which accounted for 10% of private equity activity by value, a significant increase which is expected to grow in light of an aging population and strong performance by companies in the field.

For middle market M&A, manufacturing and distribution will as always continue to be strong segments in 2024, with a large number of attractive prospects that combine long-running track records of performance, strong reputations in their industries and opportunities to achieve significant efficiencies through scaling and technological optimization. Look for manufacturing and distribution deals to be very robust in 2024 as buyers come off the sidelines to acquire strategic fits.

And of course, demographics continue to be favorable for the middle market, with a significant number of business owners in the baby boom generation poised to sell their companies and retire. Again, pent up demand on both the buy side, with some buyers choosing to remain on the sidelines for the past 18 months, and the sell side, as owners waited for better deal conditions to re-emerge, should serve to further increase deal flow for this year.

In sum, although 2023 saw a slight downturn in middle market M&A activity given the historical heights that preceded it, all signs point to a return to form in 2024, with both buyers and sellers eager to engage in M&A transactions.

M&A trends for 2022

December 22, 2021/in Mergers & Acquisitions, News /by The Law Offices of Jeff Petersen Team

The road ahead for Mergers & Acquisitions

2021 saw robust mergers and acquisitions activity. As the year came to a close, there has been no sign that this trend of increased M&A activity will slow down. So, what trends should business owners and M&A attorneys look for in 2022? Hindsight is 2020… well, it’s 2021 but who’s counting?

The drivers of increased M&A activity

Looking back at the year 2021, the greatest drivers of the increased M&A activity were COVID’s impact both on business owners’ choice to retire or sell, and on their choice to grow into new markets through well-priced sales of companies who struggled during the shutdown and supply chain disruptions that followed. Increased liquidity affected M&A volume driven by PPP loans, EIDL loans and low-interest rates making capital less expensive. And the change in the world of work from analog to digital, accelerated by the remote work surge that has bolstered SaaS, digital security, and other remote-work facilitation hard and software companies.

Looking forward to 2022

It is challenging to predict the trends that will define the coming year. One thing COVID has taught the business community is that the unexpected can throw a wrench into the best-laid plans at any moment. While we can look at the past year to see how certain language and activity is affecting the M&A markets right now, these are inferences, not a crystal ball to predict the future. One way to look at the coming shifts is to look at the changes in volume of certain terms in SEC filings in M&A transactions that have closed over the past 2 years. As we look at the 2022 market trends we can see that there are upticks in reported language in those SEC filings of M&A closings as reported in Bloomberg Law’s article here. The trends indicate that certain terms are appearing more in the last quarter of 2021 than in previous years by notable amounts.

“Remote work”

“ESG”

“Climate Change”

“Crypto”

And because this is now year 3 of the pandemic and we show no signs of moving past it, “COVID” and “vaccine” rank among the terms which have seen marked upticks in the latter half of 2021.

According to other surveys from MiBiz,”automotive, energy, financial services, technology and media, and health care rank as the top five most-active sectors for [2022]”.

Environmental, Social, and Corporate Governance (ESG) and its impact on M&A volume

In addition to shifts in the interest in ESG and climate-friendly business, the Private Equity activity in 2021 has been strong. Despite impending tax legislation and increased antitrust scrutiny, business owners continue to seek to diversify their portfolios by acquiring companies that give them access to new products, services, and technologies. With PE funding more accessible than ever, the M&A landscape seems to be robust and headed for another bull year.

The fact that the Biden Build Back Better legislation appears stalled for the foreseeable future means that increased business taxes are now pushed off into the future means that businesses who acquire or merge will not face the kind of tax bracket jump that they would have under the proposed bill. This roadblock removal may stoke the fires of the already hot M&A market.

Overall the 4 major players in the 2022 M&A market can be culled down to:

1: A hot Private Equity Market

In 2021, PE transaction value rose more than 55%

2: ESG forces

Businesses may consider purchasing or divesting assets to align with ESG. Practically speaking environmental factors will affect the future of business and strong ESG will allow businesses to better adapt to those shifts.

3: Remote work

Digital transformation of analog processes means more investment in SaaS companies and other cloud-based initiatives. From cyber security to remote teams management, digital is the way forward.

4: Inflation

The sharp spike in inflation may mean a temporary slowing of M&A activity, though the inflation between 2007 – 2009 did nothing to curb Mergers and Acquisitions. This inflationary bubble is likely to dissolve with low interest rates still in place once the supply chain issues resolve.

To sum it all up:

The M&A market is not slowing down. Successful M&A strategies will involve specific industry targeting and an awareness of the elevated valuations that exist in certain market sectors. Increased deal complexity will necessitate better assessments of risk and liability as well as stringent due diligence processes and targeting of the correct funding sources for each transaction.

SANDBAGGING CLAUSES IN M&A AGREEMENTS

November 10, 2021/in Mergers & Acquisitions, News /by The Law Offices of Jeff Petersen Team

Agreement For The Sale Of A Business

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 Sandbagging Clause?

A sandbagging clause refers to a provision in an M&A agreement that addresses whether a buyer’s pre-closing knowledge about the cause of a subsequent loss will have on the buyer’s indemnity claim. The colloquial term “sandbagging” refers to whether or not the buyer can know about the facts giving rise to the loss and still claim indemnity, or “sandbag” the seller by moving ahead with knowledge of a material issue.

There are two types of sandbagging clauses, a pro-sandbagging clause that allows the buyer to have knowledge of the facts giving rise to the loss and still receive indemnification, or an anti-sandbagging clause, which prohibits buyer from receiving indemnity if it knew of the facts giving rise to the loss.

Although it may seem counter-intuitive to allow for pro-sandbagging clauses where a buyer can recover despite closing with knowledge of the problem, there are good reasons for such a clause to be included. One is that prohibiting buyer from recovering would provide a disincentive to conduct thorough due diligence, as the buyer would not want to discover facts that could later bar indemnification. Anti-sandbagging clauses will also give rise to disputes regarding buyer’s knowledge before closing. Perhaps the buyer’s best argument, however, is that listing the problematic matter in the disclosure schedule is the best way to address any post-closing issues, as the parties can negotiate appropriate provisions ahead of time if necessary, e.g., buyer can either accept the disclosure and bear the risk going forward, or require that seller provide express indemnity for the matter so listed.

A seller’s rebuttal on this issue is that a pro-sandbagging clause would allow the buyer to discover an issue in due diligence and not inform the seller, which could provide a disincentive to the buyer to raise the issue ahead of time and address with the seller in the agreement.

M&A Agreements & Pro-Sandbagging Clauses

In terms of market prevalence, pro-sandbagging clauses are far more common in M&A agreements, generally due to the fact that buyers hold the keys (i.e., money) to the deal and are generally not inclined to restrict their rights on important issues like indemnification. Although recent statistics show that it is quite common for M&A agreements not to address sandbagging at all, that should not be taken as an indicator that the concept is often ignored. Many state laws themselves provide an answer as to whether a buyer can “sandbag” the seller if the agreement does not address the issue, and buyers will generally choose a state law that is pro-sandbagging.

Although a seller will generally be faced with an agreement that will allow for sandbagging, either by express clause or application of state law, being armed with that knowledge will help the seller focus more intently on its due diligence process, and negotiate appropriate provisions for any items that do arise. And those sellers in a strong negotiating position can look at an anti-sandbagging clause as a good “get” in negotiating the transaction.

Law services in Chicago and San Diego - A lawyer's hand, pen and overlay

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

October 24, 2020/in Mergers & Acquisitions, News /by The Law Offices of Jeff Petersen Team

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 The Law Offices of Jeff Petersen Team

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 The Law Offices of Jeff Petersen Team

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 The Law Offices of Jeff Petersen Team

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 The Law Offices of Jeff Petersen Team

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.