Understanding risk is very important in M&A. Every aspect of a business incurs risks, therefore it is important to understand which risks are acceptable and within your zone of tolerance, which risks can be easily mitigated, and which risks are outside of your zone of tolerance. I have extensive experience in overseeing over $10 billion of deals since starting Dean Street Law, so I want to share with you important strategies to address the common, and sometimes overlooked, risks in M&A.
Key M&A Risks:
Lack of Business Knowledge: One of the biggest risks when buying a business is the lack of knowledge of the business. Oftentimes a seller will have premium knowledge of the business while a buyer will have to conduct due diligence to effectively gain knowledge on the business and better understand the risks associated with the acquisition.
Inadequate Transaction Documents: The second largest risk when buying a business is when parties knowingly or inadvertently cut corners when drafting their transaction documents. They may try to use an artificial intelligence program to draft transaction documents, find examples online, or draft them themselves. M&A transaction documents are complex and should be drafted and reviewed by an attorney who specializes in M&A. Each provision needs to be reviewed forwards, upside down, backwards, sideways and how it would hold up in various scenarios for clarity, interpretation, effectiveness, to understand each party’s position and for durability (i.e. would it hold up in court?).
Risk Mitigation Strategies:
Pre-LOI Due Diligence: An effective due diligence strategy is crucial to bridge the gap in the buyer and seller's knowledge of the business, mitigate potential risks and maximize opportunities. I emphasize the importance of extensive due diligence before and after signing the Letter of Intent (LOI) to ensure that buyers are fully aware of what they are committing to. In our Acquisition Insights Course and Template bundle, we have a pre-LOI due diligence checklist. In our Acquisition Insights course, we talk about what you can do in pre-LOI due diligence to make sure the business is worth investing in before you incur transaction costs as a buyer.
Post-LOI Due Diligence: Similarly, post-LOI due diligence strategy is extremely important. The buyer should engage an attorney immediately after they've entered into the LOI if they haven't sooner so that they can provide a due diligence request list to kickstart legal due diligence while the buyer is completing initial business and financial due diligence. Work with your attorney to determine which key areas of due diligence warrant the deepest investigation.
It's most cost effective to have due diligence staged if you have the time to do so. If you have at least 90 days, you can stage business due diligence before engaging financial due diligence experts for quality of earnings, QofE light, or other types of financial due diligence. Once the highest level of financial due diligence, or a sufficient amount of financial due diligence that you feel comfortable with has been completed, then you would have your lawyer begin their due diligence of the business. That way, you are completing the highest levels of due diligence that are most likely to impact the transaction before incurring additional transaction costs.
In the Acquisition Insights Course and Templates bundle, we provide a post-LOI due diligence request list as well. It is about 13 pages long and comprehensively covers top aspects of legal due diligence. When we work with clients one-on-one at Dean Street Law, we customize your due diligence request list based on the target acquisition company and the specifics of the acquisition to best support the client's due diligence strategy.
Effective Transaction Documents: The number one thing that will happen if something goes south is to have effective transaction documents. The parties will look to them for support on how to resolve the issue. The transaction documents set forth the expectations of the parties and make it clear what will happen if something goes wrong. If an attorney is drafting an agreement, each sentence will be carefully crafted so that it is clear and easy to understand, and in the event of a dispute, it will sufficiently support the client to mitigate risk.
For example, if there is an undisclosed pre-closing liability discovered post-closing, the seller should have the responsibility to resolve it unless agreed otherwise. However, if the transaction documents don't include the obligations of the parties, the buyer may not be able to recover post-closing. Effective and efficient transaction documents address the material discrepancies in knowledge between the buyer and the seller. In addition, representations and warranties in the purchase agreement and other transaction documents create obligations of the seller where they attest that the business the buyer thinks that they are buying is the business that the buyer is buying.
Indemnification Provisions: Indemnification provisions are provisions within the transaction documents whereby one party agrees to defend and hold harmless the other party from any damages, costs, or expenses related to certain events. Usually, it's market that the buyer will indemnify and hold the seller harmless for anything that happens post-closing, whereas the seller will indemnify and hold harmless the buyer from anything that happens pre-closing.
There can be a significant amount of negotiation in an indemnification provision that may include baskets, caps, duration limitations, and more. This is an important aspect of the transaction as the parties will negotiate and lean more heavily on legal counsel in this regard. Representation and warranty insurance may assist the parties in navigating the responsibility of future claims that can be made, however it usually only makes sense from a cost perspective on larger transactions. Generally, twelve to 18 months is the standard duration of survivability for representations and warranties in lower middle market M&A transactions. However, fundamental representations and warranties may survive for longer periods, such as tax liabilities surviving for the entire look-back period when the IRS to audit and reassess taxes.
Set-Off and Clawback Provisions and/or Indemnity Escrows: To protect the buyer in the event of any issues post-closing, include either set-off and clawback provisions against a seller note and/or a clawback escrow to be withheld from the disbursement of funds at closing. Generally, a clawback escrow will be significantly less than the set-off and clawback rights that may be associated with the seller note. Set-off and clawback provisions for the seller note may be for a portion or the entire principal amount of the seller note and generally are negotiated to last for twelve to 18 months post-closing but may last for the entire term of the seller note. If there are any known issues where the parties expect that claims may be made post-closing, I would recommend a clawback escrow. The parties may negotiate to utilize one or both of these measures so that there are mechanisms for resolving any amounts that are subject to indemnification without escalating to litigation.
In a risk mitigation strategy, it is vital to both identify material risks and create a strategy for the identified and unidentified risks. Implement that risk mitigation strategy throughout the transaction documents and most importantly, have remedies and rights to recover in the event of certain eventualities. Risks are unavoidable in M&A transactions, so risk mitigation will continue to be an important legal strategy for success. As the M&A landscape evolves, I expect buyers and sellers will both become more savvy with respect to risk mitigation in their transactions.
Want to learn more about risk mitigation strategies? The Acquisition Insights course provides video lectures, lessons, written materials, checklists, and more that delve further into risk mitigation. The Acquisition Insights Course and Templates bundle provide access to our pre-LOI due diligence request list, post-LOI due diligence request list, battle-tested template LOIs with videos on how to customize them and so much more. Apply to work with Dean Street Law where we can provide custom-tailored deal support and you can feel confident in your risk mitigation strategies.
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