Now that M&A activity has picked up from the worst of the pandemic lows in 2020 more buyers and sellers are looking to do deals. Buyers can now examine targets through the lens of an economic downturn to see how the business fared.
Regardless of COVID-19, buyers seem to think that nothing could go wrong when buying a business. Overconfidence seems to be the rule not the exception even though studies suggest many buyers do not conduct enough due diligence.
According to the 2020 SRS Acquiom M&A Claims Insights Report, when things go wrong they go wrong most often in the following areas.
1. Purchase Price Adjustments
A purchase price adjustment is an adjustment made to the purchase price after closing. The adjustment is made based on the results of a financial report frequently prepared by an outside CPA firm.
The most common measure used for the adjustment is working capital. Most of the claims in this area are resolved in favor of the buyer. This suggests that sellers overpromise when it comes to the cash available for operations for the new owner.
Buyers should: (i) insist on a purchase price adjustment, (ii) take the time to craft a clear definition of working capital, and (iii) carefully review the business’ historical cash flows.
2. Breaches of Representations and Warranties
The representations and warranties section (“rep and warranty”) of the purchase agreement is arguably the most important section from a buyer’s perspective. This section contains all of the seller’s key promises.
Experience shows that one of the most common areas where there are breaches is the financial realm as we will see below.
Buyers should take the time to understand the biggest risks in the business. Based on that understanding buyers should work with their attorneys to prepare seller reps and warranties that address these risks.
Buyer can also ask sellers to pay for buy side rep and warranty insurance that protects the buyer.
3. Undisclosed Liabilities
Many purchase agreements contain a rep and warranty to the effect that there are no undisclosed liabilities meaning the business’ liabilities have been disclosed in some form or fashion.
This could include taxes, legal judgments, fines, royalty requests, or liens.
Buyers should pay attention to any unusual events that could give rise to these liabilities such as lawsuits, cease and desist letters, and correspondence from federal and state tax authorities.
Buyers interested in additional protection can ask sellers to create an expense fund out of the sales proceeds to provide another source of funds to fund these liabilities.
4. Financial Statements
Financial statements are intended to provide a fair description of the business’ financial condition and results of operations.
Purchase agreements typically contain statements that the financial statements were prepared in accordance with GAAP and fairly represent the financial position of the business and its results of operations and cash flows for certain periods.
Buyers should focus on: (i) the quality of financial statements by hiring a CPA firm to review the financial statements or even going beyond that and asking the CPA firm to prepare a detailed quality of earnings report, (ii) the business’ compliance with tax and regulatory obligations, and (iii) reviewing any declines in collectability of accounts receivable that might suggest a problem.
5. Customer Contracts
Reps and warranties dealing with customer contracts often focus on the key or material contracts of the business. More specifically, purchase agreements require sellers to attest to the fact that the business is not in breach or in default under any of these key/material contracts.
Claims in this area often involve situations where the business did not provide the product or service as required by the purchase order or contract.
Buyers can protect themselves by: (i) including as many important contracts as possible under the concept of material contract, and (ii) selectively contacting customers to verify the absence of problems.
6. Intellectual Property
Intellectual property reps and warranties typically address ownership and possession of all right, title and interest in and to the business’ intellectual property, free and clear of all liens and right to use and licensed intellectual property. As a corollary, sellers give reps and warranties that there are no IP lawsuits or demands challenging the business’ IP.
Claims in this area tend to arise from not owning the intellectual property necessary to operate the business, or defective technology.
Buyers should examine: (i) all marks, patents, copyrights claimed to be owned by the business, and (ii) licensed IP, to ensure there are no red flags and that the combination of owned and licensed IP is sufficient to operate the business as planned.
How YK Law Can Help
Our team of M&A lawyers works with both sellers and buyers. We monitor deals and analyze market standard deal terms. We help sellers obtain the best price. We help buyers my making sure they don’t make costly mistakes. Call us to discuss your goals before you buy/sell.
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