The process of selling a company is a long and complex one, but it all boils down into the final contract between the seller and the buyer. Corum dealmakers took a detailed look at what should go into a final M&A contract—and what should stay out of them. They walked through the 10 Critical Terms in Any M&A Contract, plus the Top 6 M&A Contract Mistakes, with stories straight from Corum’s 30 years of selling technology companies. This is the most important document of your company’s life – and possibly yours, as well. Plus the Corum Index, and key deals, trends and valuations in the Horizontal, Infrastructure and Consumer tech sectors.
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Hello, and welcome. This is Nat Burgess, President of the Corum Group, and I’ll be your moderator today. We’re going to do our monthly update. We do a research report on trends, valuation reports, and we’re going to cover that ground, but today we’re also very excited to dig into contracts. We have 300 transactions behind us, we have a dozen dealmakers who have been through a lot of different twists and turns in the contract process, and what we’ve done is distill that experience down into ten critical terms that you want to see in any M&A contract, and also the top six M&A contract mistakes. That’s going to sandwich our monthly research report from Elon and his team.
In addition to having 25 years of experience in M&A, I’m also an attorney, licensed in the state of Washington, so I’ve had a lot of fun helping to guide this session, but don’t fear, we’re not aiming this at attorneys, we’re aiming this at the CEOs who are going to manage the attorneys and the contract process.
Ten Critical Terms in any M&A Contract
So now let’s jump into our ten critical terms, starting with our Chairman, Ward Carter, who’s going to talk about allocating risk for the seller in contract assignments.
1. Change of Control or Assignment Clauses
Complications arise when the seller’s customer license agreement includes a change of control or assignment clauses. Since you can’t revise existing customer contracts, you’ll need to negotiate with the buyer to minimize the impact of this assignment process. Structuring the deal as a stock transaction instead of an asset sale may circumvent the assignment requirement. If not, negotiate language in the purchase agreement to limit the approvals required before closing to a smaller universe of high-value customers, which the buyer is most concerned about anyway. The remaining assignment can come after the deal closes. Get out in front of your customers as early as you can, and face-to-face if possible, to sell them on the virtues of the merger and why this is in their best interests. Stress the need for their timely agreement while tempering any ideas they may have about using this to renegotiate contract terms. On key accounts, engage execs from the buyer to assist you.
Thanks, Ward. Now let’s go to Russ Riggins, who was a 21-year partner at a Big Five accounting firm and is now working on deals with Corum. He’s going to talk about providing accurate financial reps and warranties in the M&A contract.
2. Financial Reps and Warranties
One of the most frequent areas that can cause problems in the M&A contract is financial information and related representation. Here is some helpful advice on financial reps and warrants. Make sure the buyer understands how your books and records are maintained early in the due diligence process. This eliminates surprises in the drafting of the contract. Working capital and how it is calculated is in most contracts. Discuss this early in the process, as this too could become problematic if left to the last minute. Be realistic and conservative with your budgets for the coming year. You do not want to be in the middle of negotiating a contract when the parties learn that you’re going to miss your budget for the year by a significant amount. You could be facing a change in the deal structure at the last minute. Finally, work with your accounting advisor to understand where you may have financial exposure, either in the accuracy of your numbers or in liability. This will become useful information when negotiating reps and warrants.
Thanks, Russ. So, in your contract, you’re basically guaranteeing your past results and that’s what Russ was focused on there. You’re also going to have a potential price adjustment based on the balance sheet that you deliver at closing. Let’s go to Jeff Brown next to discuss that issue.
3. Dividing Up The Balance Sheet
So, you thought you negotiated the price for your company. But think again. The contract determines how the balance sheet will be treated and that treatment will result in a price adjustment. There’s lots of value in your balance sheet, and the way that it is divided up will impact the amount of money you put in your pocket or leave for the buyer. The two popular methods for dividing up a balance sheet are called “locked box” and “completion” accounts. The locked box method is more popular outside the US. Neither method is intended to alter the amount saved for the business, but in practice it can, and here are some pitfalls. Structure language that says the transaction will be done on a cash-free, debt-free basis when the normalized level of working capital is not enough. Sounds like the seller gets all the cash and pays all the debt, but that’s not exactly true. Every business needs a certain amount of working capital, and that amount may change with seasonality, product price, or margin cycles. So what’s normal? Also, be sure you and the buyer are using the same accounting math. The buyer may want to reclassify some of your short-term differed revenue as long term and a liability, resulting in a balance sheet adjustment against you. There are some other pitfalls, too, so watch carefully.
Thanks, Jeff. Very seldom do you see a true cash-and-carry deal. The seller is going to maintain some liability to the buyer and that’s going to be reflected in part in escrows and hold-backs. Let’s go now to Rob Schram to talk about those issues.
To satisfy potential future indemnity claims that are detailed within the indemnification section of the agreement, a portion of the purchase price is withheld in the form of an escrow or holdback. The difference between those is whether the funds are held by a third party of the buyer. Escrow terms describe the percentage of the consideration withheld, the duration of the obligation known as a survival period, how and by whom the escrow is to be funded, and so forth.
To prevent death by a thousand cuts, often a basket provision is included that details the minimum amount of damage the buyer must sustain before the seller is required to pay for losses. Finally, a cap provision places a limit on the aggregate of claims drawn against the escrow. Some liabilities, for example, IRS audits, taxation, intentional fraud, etc, remain uncapped. Generally, we see escrow amounts in the range of 10-15% and a survival period of 12-24 months. The exact numbers depend on the inherent risk and the likelihood of liability, but skillful negotiation around factors like an independent board of directors, solid financials, good corporate governance, etc, serve to mitigate risk and increase buyer confidence. One of the advantages of having multiple buyer candidates in an orchestrated engagement is that escrow, like all structural elements of the deal, can be negotiated and we’ve seen escrow completely taken off the table to sweeten the buyer’s LOI and win the deal.
Thanks, Rob. So back in the late ‘90s, we did a lot of stock deals, and we learned a lot about how to ensure liquidity for our clients. We’ve now got to dust those archives off because the IPO market is back and we’ve had several deals in the last year that involved publicly traded stock. So now let’s go to Dan Bernstein to talk about how to ensure liquidity when you’re receiving stock.
5. Ensuring Liquidity When Receiving Stocks
Taking on public stock in a transaction does not mean that you can immediately liquidate it. Stock has to be registered by the company before it can be sold on a public exchange. Companies can complete a shelf registration, basically register stock to put on the shelf until they need it, and then issue it as a fully registered stock. More likely, your stock will be unregistered, leaving you with the option of selling it in a private 144A placement to an accredited investor at a discount to the market and with stiff fees. Or, rely on the issuer to register the stock after you get it. If you take unregistered stock, you should insist on either piggyback registration rights, which requires the issuer to register your sharers with the next register in shares, or that they file to register your shares, because the issuer has to remain in compliance with FCC regulations that may bar them from registering shares during a certain period. It can’t guarantee when your stock will be registered and tradable.
Thanks, Dan. It’s great to be facing this problem again, and some of our clients have spent a lot of money recently taking stock and watching it appreciate.
Let’s now move on to managing dissident shareholders. Jon Scott from Amsterdam now was my client once, and we had quite the adventure managing dissident shareholders in the company that he was the CEO of. We got through that successfully, he’s basically got the battle scars to prove it, and some knowledge here that will be helpful to anyone facing this issue. Let’s go to him now.
6. Managing Dissident Shareholders
Shareholder approval thresholds can be an issue. Typically the buyer will require that a specified percentage of the shareholders have signed off on the deals before closing. You want to keep this at a realistic level in sales and purchase contracts: 80 or 85%, but never higher. If you have multiple shareholders with some inactive or ex-employees, you may have one or more than will vouch for approving the contract by trying to exercise their appraisal rights to stop the deal. These might be disgruntled employees or shareholders who have an unrealistic evaluation in mind for their very small portion. You also don’t want the buyer to use this as last-minute leverage to lower the valuation of the transaction or extract more favorable terms. I was in one transaction where we literally did not know if the dissident shareholders were going to walk into the shareholders' meeting and try to stop the transaction.
Good advice from Jon. We’re now going to go to Elon Gasper, our VP Director of Research to talk about disclosure schedules. I want to be clear, by schedules, in this context, we mean attachments or documents. These can cause significant delays, so let’s hear now from Elon on how to avoid those delays.
7. Disclosure Schedules
Disclosure schedules always take longer than anticipated and those delays can kill a deal. Recently we worked on two transactions where this was critical. One closed and the other did not. In one, the experienced PE buyer noted that disclosure schedules are always the longest pole in the tent. We worked with legal to harvest a list of schedules from the draft purchase agreement and held hours of meetings with the client, setting up a realistic timetable, itemizing the needed tasks to over 100 pages of requirements, with input from 11 people. Even swamped by due diligence and running the business, that deal closed on time at the target valuation.
In the other case, the buyer had a 45-day window to complete the transaction. The sellers were initially optimistic about the disclosure schedule. Then, due diligence matters took priority. A week before closing, it seemed evident that it wasn’t going to be possible to finish the schedule. We asked for more time, but structurally it wasn’t available. The window closed, and the deal fell apart. If the disclosure schedules had been completed, then we would have closed that deal, too.
So, get in early and push the buyer for an early draft of the purchase agreement. That will give you a disclosure schedule roadmap. Then get resources allocated early and get those schedules done.
Thanks, Elon. Good advice indeed. We’re now going to move on to earnouts. Your contract may actually have some contingent payments or earnouts. In order to achieve those, you’re going to want to make sure you have control over the moving parts in the equation. To discuss that now, let’s welcome John Simpson.
Earnouts are frequent components within contracts. They trade a payment to the seller for part of the total transaction price based on the company’s future performance. In other words, the seller is required to hit financial targets, such as annual revenues, EBITDA, or customer growth, typically over 1-3 years. Often, earnouts bridge gaps between the buyer and seller proposals for the total sale price. The earnout’s key contractual terms for the seller include control of resources, attainable targets, and clear definitions of expectations. Without these, a seller might not be able to meet the goals. We once created a 50-page earnout rule book governing how the seller could and would be in control of achieving his earnout. Using those rules, he did meet his goals and got fully paid.
Thanks, John. So, let’s now turn to the variables between signing and closing. We’ll talk more about this later, but signing is not closing. When you sign the deal, there may be some things that could impact the value or other elements of the deal that can happen that are out of your control that happens between signing and closing. Mark and I have worked closely on a half-dozen cross-border deals in the last few years. He’s based in our Stockholm office, and in his section here, he’s going to focus on the currency issues that can arise. Over to you, Mark.
9. Currency Issues
We often say that nothing good happens between signing and closing. As time lingers on, there are many internal and external factors that can affect the deal, even though ideally many elements have been pre-negotiated in the LOI or term sheet. We managed a deal two years ago, in France, with VMC, based in Texas. The deal got locked in dollars, however, it was important to our client’s VCs that the price be fixed in Euros since that was how their distribution to their LPs would be paid. The problem was that the investors weren’t in a position to fund a hedge, and the M&A contract locked down the balance sheet, preventing the company from investing in a hedging strategy on behalf of the shareholders. We solved the problem by renegotiating the balance sheet locked up in the contracts so that the company could hedge the deal consideration and lock in an Euro value. Cross-border deals will always expose either buyer or seller to foreign currency movement and how the balance sheet is treated is always a critical part of the contract. These terms will impact value if there is a price adjustment up or down caused by missing or exceeding the defined target. These terms can also prevent the company from taking steps that are necessary for running the business.
Thanks, Mark. Now for our final point, we’ll turn to Jim Perkins who will talk about how to motivate a buyer to close the deal. Over to you, Jim.
10. Motivating the Buyer To Close the Deal
Signing the contract is an important step, but it’s not the final step. It is possible to sign the contract and never close the deal. You will need to avoid contingencies to close it. Most important, you will need to create urgency to close. Ideally, you will sign and close simultaneously, but most often there are items that need to be addressed between signing and closing. If these items will take more than a week, you might be better off postponing until these items have been addressed and negotiated away.
Buyers often ask for a six-month lockup from signing with the reasoning that they are committed to the deal and want to make sure there is enough time to manage all of the moving parts and get to closing. The problem is, the schedule will extend to use all of the available time and then be extended again. You’ll want to set a deadline and work towards it and have enough teeth in the agreement that you have other options if you get stalled on your way to closing.
Thanks, Jim. This is a recurring theme today, and it’s no accident. Buyers usually put a lot of pressure to get to signing because then they have the deal locked up and at that point, you lose a lot of leverage, so we’re going to revisit that point in a little bit.
In summary, we’ve now had our ten tips for an M&A contract so that when you get that 100-page document, you can now zero in on the elements that are going to be most critical to you, and make sure you manage the lawyers through that process.
Corum Research Report: Intel Makes Big Move For Altera
We’re going to revisit contracts at the end of this section, but I’d now like to transition over to our monthly Corum research report.
Thanks, Nat. We begin with the public markets, showing divergence between tech stock holding double-digit gains for the year, with the NASDAQ hitting a new high last week, and broader indices, such as the Dow sinking to late 2014 levels, only recovering a couple of percents yesterday and today. Germany’s DAX index, which we noted last month for hitting an all-time high, has since entered correction territory, sliding back more than 10%.
These can all be seen as signs of the aging of this bull market, now the third-longest on record. Still, the factors that have driven its attendant tech M&A boom maintain momentum. PE and corporate coffers are loaded. Buyers need to demonstrate growth and keep up with overlapping cycles of innovation, particularly social, mobile, and cloud, and capital remains readily accessible, though rates are starting to climb again. All in all, we urge execs considering their strategic options not to hesitate to take advantage while we still have these highly favorable conditions for M&A sellers.
Our Corum Index reinforces reading this as a seller’s market, showing increases in all metrics except for a lower number of VC and total transactions, but more value for the month, as more dollars chased fewer deals.
Among the megadeals, we covered Verizon’s purchase of AOL last month. British data center provider Telecity was picked up by larger US rival Equinix for just over $3.5B. Telecity ditched its prior engagement to buy Dutch competitor Interaction, walking away from that deal to elope with Equinix instead.
HP sold the majority stake in its Chinese data networker, H3C, to Beijing-based UNIS, which looks to expand its leadership in China’s server market for $2.3B. Rumors about Intel acquiring Altera were confirmed this month with the daring price of $16.7B, making it Intel’s largest buyout ever, as cloud and chip consolidation trends swell the infrastructure segment to over half the megadeal value this year. That’s a big change from last year, when it was one of the smallest, reminding us again how M&A moves in waves.
What are some factors sustaining this one, Amber?
Infrastructure Software Valuation Metrics
Megadeals in the infrastructure space are being driven by the demand for network management and cloud solutions, as well as the security solutions to protect them. That clamor for cloud solutions is why EMC spent $1.2B for cloud management company Virtustream, advancing EMC’s transformation strategy to help clients move to the cloud.
Megadeals have shown themselves the importance of smaller transactions in the continuing consolidation wave, which was focused in May on managed cloud and collaboration services, despite the decline in overall infrastructure valuation multiples.
There was also a distinct interest in the world of software development. At an aggressive 5.5x revenue, CA technologies bolstered its cloud management possibilities by grabbing agile software development company Rally for $480M.
Collaboration and communication services have been popular targets since Q1 as well. Avaya acquired Esna Technologies to deploy its real-time collaboration solutions and let mid-size enterprises, as well as end-users, move across applications and devices.
Cisco bought Tropo for its collaboration portfolio. Tropo is an API platform designed to embed communications into applications. Added into Cisco’s existing infrastructure, this enables it to extend its collaboration technologies to third party applications and endpoints.
Aaron, how has the consumer market performed since Q1?
Consumer Software Valuation Metrics
The consumer market is trending positively, with both multiples having grown since the first quarter, especially EBITDA ratios, now at historic highs.
Tech giants focused on smart timing. While Apple was gearing up its new watches, Google pocketed 1-year-old mobile scheduling iOS app-maker Timeful to respond to Microsoft’s earlier purchase of Sunrise calendar app earlier in February. Microsoft itself clocked in its fifth mobile application of the past year with Wunderlist, the Germany-based mobile task planning application. These moves look like a competitor’s battle. Microsoft was recently reported to be eyeing Salesforce, which in turn also joins time management mania by buying smart calendar Tempo. Time will tell, but we certainly expect this space to have more M&A activity in the near future.
And how have the horizontal markets been spending their time?
Horizontal Software Valuation Metrics
Horizontal sales multiples remain steady while EBITDA multiples have dipped slightly since Q1. The space remained active for M&A, especially for targets in the areas of eCommerce, HCM, and data analytics. Pitney Bowes picked up the New York-based cross-border e-commerce company Borderfree for $448M, building out its international shipping services business and enabling e-retailers to display overseas delivery pops in the online checkout.
In another e-commerce deal, HCM solutions provider HighJump bought cloud-based e-commerce platform Nexternal, combining omnichannel e-commerce SaaS with warehouse management systems.
In the HR sector, Towers Watson spent $140M to get employee health benefits management SaaS company Acclaris. This is the second acquisition by Towers Watson this year, following their acquisition of Saville for $64M in April. Saville provides online assessment tools for corporate HR departments.
Across the globe, Australian accounting software provider MYOB paid $10M for Wellington-based payroll and benefit vendor ACE Payroll, strengthening their position in New Zealand.
In one of April’s megadeals, integration and analysis SaaS company Informatica was taken private by Permira and CTC investment board, for $5.3B, a 4.4x revenue multiple. Pennsylvania-based big data firm ColdLight was acquired by PTC for $100M. ColdLight technologies detects patterns in data collected from embedded sensors to figure out when a specific component might be nearing failure. This acquisition, along with two others earlier this year, helps PTC expand its IoT business.
And that’s it for our update report. Back to you, Nat.
Top 6 Contract Mistakes
Thanks, Elon, and now back to my favorite topic: contracts. We covered the top ten things that are critical that you have to have in your contract earlier, and now we’re going to move on to the six mistakes that can kill your deal.
1. Don’t hire an inexperienced attorney.
Being an M&A attorney is like being a family doctor, you have to be familiar with many branches of medicine in order to diagnose everything that appears in your office. Likewise, the M&A attorney needs a basic understanding of tax law, contract law, employment law, accounting, governance, etc. Just like the doctor, the lawyer also needs specialists on call for things outside their general domain, so ideally your M&A lawyer is not only experienced but also with a firm that has domain specialists for when the issues get narrow and complex.
2. Don’t draft documents heavily in your favor.
We lived through this recently. One of our clients made this mistake and almost lost not only the deal but also their company. Our client was running out of cash. The buyer was there, but couldn’t draft documents fast enough to meet the targeted schedule, and they didn’t know that the schedule was driven by running out of money. Their response was to let the seller draft, they were relying on us to create an efficient, fair, balanced contract. Unfortunately, two of the board members at our client company decided to take advantage of the situation by crafting ridiculously one-sided terms. Seller friendly contract, no escrow, no liability beyond 30 days, no real reps and warranties, and without sharing it with us, they sent it directly to the buyer! My cell phone rang immediately. The initial reaction was “we’re done here.” Creating a one-sided document basically sends a message that we think the buyer is stupid or we want to play games with the buyer regarding our position. Either way, life is too short. A smart buyer will just walk away. Fortunately, in the recent example, we were able to regain credibility with the buyer by kicking the two offending board members off the M&A committee and starting over. Address the issues. Don’t avoid conflict. It’s natural human behavior to avoid conflict. Most people are conflict avoiders. Good dealmakers are conflict seekers. We don’t go out to create conflict, but we find it, we identify it, study it, figure out how to manage it. Sometimes it’s sloppy work that creates a bad contract, but often the bad contract is the result of avoiding what should have been a good negotiation. If you’re clearly at odds with the buyer on an issue, and you draft around it rather than resolving it, guess what? That issue will pop back up later and bite you.
3. Don’t let the issues die with the lawyers.
Lawyers have a tremendous role in these deals, they have to figure out thousands of legal points and technical points and basically make the deal work. Often, lawyers will be negotiating with each other and they’ll reach an impasse. They’ll reach business issues that they’re not authorized to compromise on or to make material changes on the deal at all. When that happens, they can sit there negotiating for weeks, or if they’re experienced and you’re managing the process correctly, they will identify those issues as business issues, put together a list, escalate them to the business people, and help structure a negotiation where those can get solved.
4. Avoid duplication of work during due diligence.
Questions on the due diligence list will require a response. Many of those same questions will pop up again as reps and warranties in the contract, again requiring at least study. Then they will pop up a third time because those are going to disclosure schedules. In other words, as you go through this initial diligence response, don’t just dump data on the buyer and consider it done. What you’re doing instead is building an organized archive, and later on, when you’re reviewing the accuracy of the reps and warranties of the contracts, both creating the disclosure schedules that go with the contracts, you’ll be able to zero in on precisely the documents that you need in order to create an accurate response without duplicating work.
5. Leave contingencies to closing.
Here I’ll echo what Ward said and Jim said and basically what our recurring theme of urgency here is. When the purchase agreement, the contract is signed, the deal isn’t done, it isn’t done until it closes. Signing and closing are two distinct events. Usually, there are contingencies that have to be satisfied at the signing, but before closing. It is possible as Jim pointed out to have a simultaneous signing and closing, and that is ideal, but in the rush to lock down an acquisition target, the buyer will push hard to get the deal signed, even though there are loose ends that still have to be satisfied before closing. As the seller, your goal is to have no contingencies. As a fallback, you might accept a few contingencies, like a simple assignment of the lease, or getting an employment agreement signed. If the contingencies are more complex and unpredictable, you should consider delaying the signing. For example, what if you have a dozen contracts that have to be assigned by customers to the buyer? In the heat of the moment and under pressure from the buyer, you might sign the contracts and then get stuck for months trying to get the assignments done. This is hard on companies and hard on people, and deals come unraveled. You’re better off either negotiating away the contingencies or delaying the signing. This, frankly, is harder than it sounds. Buyers want to lock you up, they’ll complain that you aren’t committed, that you aren’t being fair. Hold the line; you don’t want to get stuck in limbo. That concludes our contract section.
We have several questions that have come up. I’m just going to take one because we are just about out of time. The question is, “Isn’t this the job of the lawyers?” Interesting.
As the CEO, you need to manage the lawyers, they work for you. Their job is to inform you of risk so that you can make informed decisions. But you still have to make business decisions, and you still, as CEO, have to take risks. That means understanding the critical issues, understanding the traps, and really working with the lawyer to work with you to make the deal you want happen.
We’ll take the additional questions via email.
Thanks for joining us, we’ll see you next time.