Author Archives: Bob Holmen

Fortis Insight: Controlling Defense of Third Party Claims [This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights.]

buy generic Pregabalin When a third party claim arises following the closing of an M&A transaction, which party controls the defense and resolution of the claim can impact the cost of the claim.  Funds held in escrow to cover post-closing claims are at risk if the buyer has full control of the defense, but the selling securityholders are paying the costs.  Of course, sellers recognize this, and in analyzing data from almost 400 transactions in the past three years where Fortis Advisors has served as shareholder representative, over 80% of the time the seller reserves the right to participate in the defense or has a limited right to assume control of the defense.21

Minbu Defense of Third Party Claims

northward Data source:  Forsite M&A Deal Tool.

That said, we do note an interesting trend in the data:  over the past three years the percentage of M&A transactions where the seller was able to reserve a full right to assume defense has dropped from 10% to 3%, while the percentage of deals where the seller has no right to even participate in the defense has increased from 6% to 14%.  Are sellers becoming more aggressive in retaining control of claims?  We will follow the data and report on this further in the future.

Fortis Insight: Purchase Price Adjustment vs. Indemnification Claims

[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights]

In M&A transactions, it is important for sellers that the transaction agreements specify whether certain disputes are purchase price adjustments or indemnification claims.  Without specificity, the buyer may be able to elect the remedy that maximizes recovery for the buyer at the cost of the selling shareholders.

Merger and acquisition agreements often contain clauses calling for a post-closing adjustment in the purchase price based on the difference between an estimated working capital analysis calculated at closing and the actual closing working capital amount calculated post-closing.  In analyzing data from over 500 transactions where Fortis Advisors has served as shareholder representative (summarized in our Forsite™ M&A Deal Tool), 63% of all M&A transactions include post-closing adjustment provisions.

When analyzing actual working capital post-closing, disputes can arise over the proper treatment of certain assets and liabilities under GAAP.  If the parties agree to modify treatment from seller’s past practice, that can result in a working capital adjustment in favor of the buyer.  Typically, that adjustment is dollar-for-dollar, meaning that downward adjustments made to the closing working capital will directly reduce the purchase price for the acquired company.

However, M&A agreements also contain representations and warranties made by the seller as to the accuracy of financial statements delivered to the buyer as part of the diligence process or the closing process.  A dispute over treatment of assets or liabilities under GAAP could also be deemed to breach seller’s representations and warranties on the financial statements.  While resolving the dispute as a “working capital adjustment” rather than a “breach” would seem in the best interests of the selling securityholders, in fact it often is better to handle the matter as a breach.

Often limitations apply to buyer’s ability to recover for a seller’s breach of any representation or warranty under the M&A transaction agreements.  For example, the agreements may include a negotiated “basket” or deductible that must be met before the buyer can recover from the seller.  The agreement also may include a cap on the total amount buyer can recover.

Accordingly, the seller, on behalf of the selling securityholders, should negotiate for language that explicitly limits working capital adjustments to changes in working capital amounts applying the seller’s accounting principles.  Any other claim or dispute regarding the financial statements should be analyzed as an alleged breach of a representation or warranty, and be handled subject to any limitations on buyer’s ability to recover.

Fortis Insight: Monitoring the Earn-Out

[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights]

When negotiating an M&A transaction, often the buyer and seller bridge the gap in negotiations over the acquisition price by establishing an earn-out to enable the seller to reap greater rewards if as the seller’s products and services grow under the buyer’s new ownership.  However, after closing, it can be very challenging for the seller to gain insight into the acquired business and asset progress toward achievement of earn-out objectives and milestones.  To address this, sellers are increasingly negotiating post-closing information rights.

We have analyzed data from over 500 transactions where Fortis Advisors has served as shareholder representative, as captured in our Forsite™ M&A Deal Tool.  While 80% of all deals with earn-outs include some form of information rights for the seller, generally those rights are limited to annual written statements—only 26% of deals require more frequent reports, and 30% of deals provide for in-person meetings to review progress toward achievement of contingent payments.

In order to enable the selling securityholders to monitor and, where possible, maximize return on earn-outs, the seller should negotiate rights for the shareholder representative to (1) receive meaningful periodic (ideally no less than bi-annual) reports of progress toward achievement of contingent payment, and (2) if possible, require periodic in-person meetings to discuss the progress.  Finally, the shareholder representative should have rights to review buyer records reasonably sufficient to calculate the metrics upon which the contingent payment is based.

Fortis Insight: Eliminating Reliance on Pre-Closing Statements

[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights]

It is common practice to include an integration clause in contracts, stating that the contract represents the entire agreement between the parties.  That said, in disputes between parties to M&A transactions, buyers often attempt to establish liability based on pre-closing statements made by the seller as part of the due diligence process.  In response, sellers attempt to add a disclaimer regarding any pre-closing statements; however, based on recent case law, that disclaimer may not be enough to eliminate post-closing liability.

We have looked at data in our Forsite™ M&A Deal Tool from over 500 deals where Fortis Advisors has served as shareholder representative, and determined that in 47% of all M&A transactions, the seller includes a representation that it is not making any other representations other than those set forth in the merger agreement.  Only 25% of merger agreements include a statement from the buyer that it is relying solely on its own investigation and the express representations and warranties set forth in the merger agreement.  Accordingly, in a majority of all merger agreements, neither the seller nor the buyer disclaim extra-agreement reliance, opening the door for post-closing claims based on pre-closing statements made outside of the merger agreement.

The Delaware Court of Chancery recently weighed in on this issue, making it even more difficult for sellers.  In FdG Logistics LLC v. A&R Logistics Holdings, Inc., the Court held that a seller’s representation that it was not making any representations outside of the merger agreement was insufficient to prevent the buyer from bringing a fraud claim based on extra-agreement statements.  Because of the strong public policy considerations on anti-fraud, only the buyer directly including a non-reliance provision will serve to fully integrate the representations and warranties in an agreement and insulate the seller against claims based on pre-closing statements.

While fraud claims at some level can always overcome the language of an agreement (e.g., if the buyer alleges fraud in the inducement, pre-closing statements are critical in determining the merits of the claim), the best practice is to negotiate for the buyer to include a non-reliance statement—a seller’s disclaimer will not be sufficient.

Fortis Insight: Retention of the Attorney-Client Privilege

[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights]

Most executives negotiating merger agreements understand that communications with their respective counsels are protected from disclosure under the privilege afforded attorney-client communications.  However, not all executives understand that it is their respective companies which own the privilege rather than the individual executives.  Further, unless expressly stated in the merger agreement, upon consummation of the merger, the buyer now owns and controls the privilege, allowing the buyer to access the privileged information on the merger transaction.

In 2013, the Delaware Court of Chancery confirmed this principal in Great Hill Equity Partners IV LP v. SIG Growth Equity Fund I LLLP, 80 A.3d 155 (Del. Ch. 2013).  The court found that absent express language in the merger agreement excluding attorney-client communications from the transferred assets, the buyer will own the attorney-client communications post-closing.

Since that ruling, we have noticed a sharp increase in the number of merger agreements containing language retaining for the seller all pre-closing attorney-client privileged communications related to the merger transaction.  In mining the data in the Forsite™ M&A Deal Tool, which includes deal points from over 500 recent M&A transactions, we found that in 2013 only 14% of merger agreements included an express retention by the seller of attorney-client communications.  That rapidly climbed to 44% in 2014 and 52% in 2015.

While the buyer may argue against such a retention clause, and the seller may have reasons to not argue for retention, we nonetheless expect the frequency of such retention language to increase as this issue becomes a standard negotiation point in merger transactions.

Fortis Insight: Aligning Buyer & Seller Interests

[This insight was written by Bob Holmen for Fortis Advisors.  Additional insights may be found at Fortis Insights]

In analyzing data from over 500 transactions where Fortis Advisors has served as shareholder representative, we find that many disputes could have been avoided if only the buyer and seller had created proper alignment on all post-closing matters.

For example, many acquisitions include accounts receivables as an asset of the acquired company.  Ninety-eight percent of all merger agreements require that the seller represent to the buyer that the financial statements “fairly present” the seller’s financial condition (per Fortis Advisors’ Forsite™ M&A Deal Tool).  In addition, many buyers require the acquired company’s shareholders to guaranty ultimate receipt of those receivables.  To the extent collections fall short, the buying company may have a claim against the selling shareholders for breach of the fair presentation representation, or may have direct recourse against escrowed purchase funds to the make the buyer whole.

This structure can create a natural misalignment of interests:  the buyer has no need to collect on receivables if the buyer can make itself whole through recourse against the escrow.  In addition, the buyer may be incentivized to compromise receivables for the benefit of customers to curry early favor post-acquisition.  This can be compounded by customers who do not feel loyalty to the buyer, and thus may slow down payments on prior purchases.

This dynamic can be corrected through alignment of interests.  Selling shareholders should consider negotiating incentives for the buyer based on subsequent collection of receivables (offset, if possible, by reduced recovery on failure to collect).  For example, assume the purchased assets include $1.5 million of receivables with expected collections (after reserves) of $1.2 million.  Consider providing the buyer 50% recovery on collection shortfalls (under $1.2 million) in exchange for providing a bonus ($100,000?) once the buyer reaches $1.2 million in collections.

Other structures can accomplish the same result.  The key is ensure both the buyer and the selling company’s stockholders are better off if the buyer fully collects on receivables.

There is No Such Thing as a Free Lunch

Hamburger and potato freeI have counseled a number of companies in need of early stage funding to consider Kickstarter or similar campaigns, in which individuals contribute money to a company in exchange for very little (e.g. a t-shirt or a hand-written postcard that says “thank you”).  To the extent a company creates an effective campaign, the money need not be repaid nor does the contributor receive equity in the company—it’s free money.  Except when it’s not.

Recently a clever entrepreneur that I know launched a company to develop, market and sell a new electronic consumer product.  The product (which I will not describe to protect the innocent) was a break-through device that I, and many others, were interested in obtaining.  The entrepreneur created Kickstarter campaign to pre-sell the product.  In exchange for each $100 contribution to the campaign, the company promised to ship one of the products when ready.  The entrepreneur estimated that the product would retail for around $100 (with costs of goods at $50).

The campaign was a smashing success, with over 2,000 initial products sold (raising in excess of $200,000).  The entrepreneur then raised some equity capital on the strength not only of the $200,000 “free” seed money raised through the Kickstarter campaign, but also based on the big demand for the product.  Money in hand, the entrepreneur went about creating the product and building the company.

As (always) happens, the product took longer to develop and was more complicated to build than first imagined.  By the time the first commercial version was ready, the cost of goods had ballooned to $200, with a target retail price close to $400.  With time and volume, the company expected the price to drop substantially–maybe not all the way down to the initial $50/$100 range, but hopefully under $100 for cost of goods and under $200 at retail.  Because of the extended development time and increased costs, the company was also out of money and needed to raise a new round.

When new prospective investors analyzed the company, they saw a big problem:  the company “owed” its first 2,000 production units to the initial funders on Kickstarter.  Not only did that represent a $400,000 expense on cost of goods, it also would take up several months of initial production and shipping (at an estimated cost of $250,000 between outside production costs and inside burn rate).  Thus, the first $650,000 of new investment would have to go to pay for the past:  paying the costs of the “free” money raised on Kickstarter!  Needless to say, the funding did not get done.

While this is an extreme example of what can happen, it is a good reminder of the saying “money must be fed”:  no matter how one raises funding for a company, that money expects something in return.  Entrepreneurs have to make sure that they can provide those returns if they want to build a successful company.

Paying for the Past

credit cardsMany companies asking for investment have incurred debt in advance of receiving angel or venture funding.  Standard business debt (e.g. equipment financing or short-term payables) typically is not an issue for investors.  However, when the debt is money borrowed in lieu of (or lacking access to) investment capital, and the lender expects to be repaid, this can create difficulty in obtaining new investment capital.

I have seen entrepreneurs fund the initial stages of their companies through credit cards, home equity loans (their own or a family member’s), unsecured loans based on personal credit, and funds borrowed short term from friends.  These entrepreneurs often need to pay back the debt as soon as the financing round closes.  I’ve also seen companies in its early stages “borrow” money from employees by paying them in IOUs rather than cash, accruing the amounts owed on the books with an expectation that these amounts will be paid once the financing is in place.  This can create a legally-binding contract for payment to these early employees.

As a general rule, new investors do not want to see cash go out the door to pay for the past.  Investors are already sensitive as to how much of the financing round will go to pay the costs of the fundraising (typically legal fees, which can run from $10,000 to $100,000 depending on the amount raised, complexity of the transaction, involvement of multiple law firms and identity of those firms).  The last thing they want is to see hundreds of thousands of dollars (or more) being used to pay down debt, accrued salaries and other obligations.  Depending on the level of debt, this alone can dissuade a new investor from participating.

Entrepreneurs need to be creative in the early stages of building a company, cobbling together whatever sources of funds they can to create the next Google, Facebook or Linked-In.  While cobbling, the entrepreneurs need to be aware that the promises they make to people in the early stages can impact their ability to raise subsequent necessary funds.