CHAPTER 20

The Proof Phase, or the Final Days

Confirmatory Due Diligence, the Definitive
Agreement, and Closing

Confirmatory Due Diligence

Confirmatory due diligence (as opposed to pre-Letter of Intent (LOI) preliminary due diligence), drafting and negotiating the Definitive Agreement and finally closing the deal generally transpire over the course of some 60 days following the seller’s acceptance of the successful (thus far at least) buyer’s LOI. This chapter will address that process while avoiding becoming unnecessarily technical, but by necessity will repeat certain points made elsewhere in this book.

Confirmatory due diligence during the final 60 days before the a deal closes tends to fall into three major areas:

• Financial

• Legal

• Operational

Financial Due Diligence

Financial due diligence is conducted by the buyer’s accountants as they carefully review the seller’s financial records. Financial due diligence is pretty much that simple. The buyer essentially is taking advantage of his last opportunity to confirm that the company’s actual financial performance “track” with the seller’s representations of that performance as communicated throughout the negotiated auction period. I know I am repeating myself, but this is a point well worth repeating: Dangers lurk in the buyer’s confirmatory due diligence if the seller has failed to complete a comprehensive audit (or at least a review) with his own CPA, or possibly another CPA, in advance of confirmatory due diligence. At the very least, the seller should ensure that a review is conducted of all his financials and accounting practices before the buyer issues an LOI and starts even his preliminary, much less confirmatory, due diligence to address and correct problems before the buyer happens upon them.

Legal Due Diligence

Legal due diligence involves a review of seller’s documentation of legal agreements with customers, suppliers, landlords, lenders, taxing and licensing authorities, employees, subcontractors, and health and safety regulators, etc. While conducting legal due diligence, the buyer’s attorneys and advisors also will ensure that patents, trademarks, copyrights, titles, and so forth are in good shape. Legal due diligence usually is conducted simultaneously with the drafting of the definitive sales agreement, because these relationships and contracts usually are incorporated within the Definitive Agreement (while the seller affirms that they are what they have been purported to be), and are all-inclusive. A good part of legal due diligence is simply aggregating much of the legal documentation supplied to the buyer by the seller as schedules and appendices to the Definitive Agreement.

Operational Due Diligence

Operational due diligence includes:

• Reviews of the seller’s important technologies and processes and fixed assets

• Meetings with key customers

• A review of the accounting systems that the seller has created and their overall effectiveness (as opposed to the content of their financials)

• Meetings with executive management and sometimes key customers

• And more

The Definitive Agreement

Also known as the Asset Purchase Agreement or Stock Purchase Agreement, among other names, the Definitive Agreement is the final binding agreement of the Middle Market merger and acquisition (M&A) transaction. In terms of its preparation and content, the Definitive Agreement tends to become fairly lengthy, given all of the documentation referred to and incorporated within it, as well as its various appendices and schedules. Other legal issues would include:

• Incorporating previously agreed-to business terms in a legal format that satisfies counsel’s concerns that they are easily understood, agreeable to both parties and enforceable.

• Establishing the seller’s limits on the indemnification of the buyer, in the event of post-transaction surprises or discoveries that otherwise might be considered the seller’s responsibility following settlement. The maximum amount of indemnification most buyers would request would cover the total purchase price; for various reasons, seller indemnification limits usually though are much less than that.¹ Furthermore, indemnification limits should be related to the actual conditions and risks in a particular deal, not arbitrarily assigned because of custom or tradition or because that is (“the way we have always done it”). This is equally true for the issue immediately following.

• Establishing categories of potential buyer claims and estimating a minimum dollar value per category, as well as an agreed aggregate dollar value of those potential claims, before any can be asserted, often known as “buckets or baskets.”

• The degree of certitude—whether “absolute knowledge” or “to the best of the seller’s knowledge”—with which the seller states that his representations and warranties, or certain of them, are correct will make a great deal of difference subsequently, should problems arise as far as what the buyer can claim is concerned.

• Whether all liabilities are included in the balance sheet. (Unlikely they will or can be).

• Whether the financial statements present everything consistently with past reporting practices or with GAAP or both.

• Provisions for settling differences.

• Jurisdictional establishment.

• Rights and remedies of seller and buyer, respectively, in the event of default.

• Escrow agreements:

• Standard hold-backs range from 10% to 20% of total deal consideration before earnouts.

• One to two years constitutes a standard duration for most escrow hold-backs.

• While most escrow hold-back agreements are set at a 12- to 24-month period, sellers often may be better off seeking a shorter hold-back duration than a lower hold-back percentage, because statutes of limitations for civil claims often do not expire for two years. In other words, sellers may tend to be more exposed by time than amounts escrowed, but a highly experienced attorney’s counsel is absolutely critical on all such decisions.

• Whether or not interest will accrue—and if so, at what rate, etc.—on escrow accounts also must be negotiated; the funds escrowed belong to the seller, after all, and there is without doubt a time value of money attached to escrowed funds. Even so, many escrow agents will not pay interest on escrowed funds.

• Sometimes, it may be suggested that the seller accept a promissory note from the buyer in lieu of separately escrowed funds. This is rarely acceptable to the seller, as it eliminates some of the formality and impartiality of a third-party escrow agent, but should the seller in fact find such an escrow note acceptable for any reason, the seller should be entitled to receive interest on it.

• Escrow agreements arise in both stock and asset deals; in stock deals, however, escrow agreements tend to involve larger hold-backs for longer durations, as the transferee’s potential liability to the buyer may be greater when the buyer acquires the seller’s business entity as opposed to simply the assets of the business.

• Confirmatory due diligence should be complete when the Definitive Agreement is signed. Closing should not ordinarily be subject to further due diligence.

The Final Days: Investment Bankers and Attorneys

Most of the issues that pop up during or prior to closing are legal in nature. Should business differences arise during this period, an experienced transaction attorney who was uninvolved in negotiating the original business terms will defer to the investment banker, and then they likely will collaborate on how the matter should be addressed.

As I have said often in this book, during the final days, the transaction attorney is the team leader. The investment banker, if necessary, ensures that the transaction attorney is apprised of the business terms (and context) negotiated by the investment banker up through the executed LOI.

This is where the services of an experienced transaction attorney are so critical. Inexperience will tend to lead to either overkill (usually as a result of relying on standard templates and static rules rather than the practical application of experience and knowledge on an issue by issue basis) and deal problems as a result, or in the alternative missing important provisions.

The Critical Importance of Speed in the Final Days

This book has argued for deliberation and orchestration at the expense of speed throughout most of the negotiated auction. Successful Middle Market M&A transactions take time if an optimal number of prospective buyers is to be identified and courted throughout the auction. In the final days prior to closing, however, all due haste should be taken to close the deal. Keep people moving! By the time a deal closing is imminent, nerves on both sides tend to be frayed and minds may change quite quickly. Sellers anticipating their big payouts grow anxious to be done with the deal and take their cash to the bank. Buyers, reviewing every last detail, actually may begin to worry: “Have I done the right thing?” Nor will the world around the seller and the buyer stop revolving to allow them to close their deal. In fact, experienced investment bankers may wonder whether or not the world lies in wait for precisely such moments so as to throw huge wrenches into the gears.

Evidence of major industry downturns affecting the seller, the buyer, or both may be reported in the final days before a deal has done. The seller—or the buyer—might lose one or more major clients, or gain some. A world-changing incident such as 9/11 can occur. Anything can happen, and as Murphy’s Law reminds us again and again, anything that can happen will happen, and at usually the worst possible time. Everything can change overnight. The author has experienced far too many “near-death experiences” in the final days prior to closing, where a moderate delay would have imploded the deal. Occasionally, a transaction has closed within weeks of a crash in the seller’s (or the buyer’s) industry. In such cases, a slight delay would have resulted in a deal that was deader than the proverbial doornail.

The Closing and the Surprise at Closing

West Palm Beach, FL—December 2000

My client Bob’s complexion grew more and more gray as the interminable day proceeded.

We had been shuffling settlement papers since 8:00 A.M. in the offices of the buyer’s attorneys; it was now 3:00 P.M. Our conference room looked over the Intracoastal Waterway and Palm Beach. Out there, a beautiful afternoon unfolded as if to exponentially increase the torment and the tedium we were experiencing in the room. I suspected that Bob really, really wanted to scream. I know I did. Luckily, we were too tired to give in to our impulses.

“We’re just about finished here,” said the buyer’s attorney, “but where is your counsel’s legal opinion that the seller is in good standing with the state of Maryland with respect to all filings and business licenses at the state and county level?”

For reasons I cannot recall, my client’s attorney was not in attendance at the settlement. Perhaps he was out there, in another stultifying conference room, deliberating issues arising from hanging chads in the presidential election.

After a few minutes, we tracked down the seller’s attorney. Thankfully, he was not in Florida but back in Maryland on standby in case we needed any help. And we do. We explained our predicament and ask for a copy of the attorney’s legal opinion on the matter.

“Legal opinion? Sorry, Dennis, but we’re just the seller’s transaction attorney, not its general counsel. We can’t do a legal opinion. And besides, this is the first time the buyer’s counsel has even asked for one.”

Bob was looking really, really gray now. I knew he had high blood pressure and a heart condition, as well as a truly intense disposition, and he was not feeling particularly well at this point. I scanned the conference room, wondering if there were any portable defibrillators nearby.

Somehow, we got through it all. We completed the settlement, and color and life returned to Bob’s face by the time we sat down to a settlement dinner that night. I wonder, sometimes, how many years a closing takes off one’s life—but, then again, I have been to too many to be here today if somehow we did not survive despite it all.

P.S. Bob’s doing great these days, wealthily retired, exercising his way back to nearly robust health, and enjoying his grandkids, farm, and yacht.

 

If only closings were noneventful confirmations of all the six or eight or longer months of concentrated effort that went into the deal at hand. Some closings do seem anticlimactic, but many of them are far from it. There is always something that comes up at the last minute that seems like a deal-killer, engenders all the posturing that is associated with deal-killers (people stomp out of the room, etc), but usually isn’t. Unless something really drastic comes up at the last minute, the sheer momentum of emotional commitment (the parties never admit it, but it is powerful and always there) will carry the day. And if something important enough to actually put the deal in real jeopardy does come up, then some advisor has probably dropped the ball.

This is not to say closings are easy. They aren’t. They are more likely to be boring, exhausting, and time consuming—and the indirect cause of the deaths of several small-sized trees necessary to provide paperwork that probably no one will ever look at again. Closings remind me of the way I once heard an FBI agent describe his career. He described it as years of sheer boredom interspersed by moments of pure terror.

I don’t mean to make light of settlements. The closest times I have ever consistently come to actually, and I do mean actually, seeing clients suffer from apoplexy or worse, have been at this point when, from their inexperienced point of view, it looks like it could all blow up. It sometimes does, of course, but not usually. However, if the client has already mentally started his new life in Arizona or wherever and some young attorney says there is no way we can close because your lawyers can’t give a legal opinion as to whether you are in good standing with the state, since they aren’t your general counsel, he might just be a little upset.²

Chapter Highlights

• The 60-day or so exclusivity period following the buyer’s execution of the LOI allows the buyer to undertake confirmatory due diligence, draft the final binding agreement and the Definitive Agreement, and prepare for final negotiations.

• Through a comprehensive final review of seller financials and other relevant documents, confirmatory due diligence addresses:

• Financial issues

• Legal issues

• Operational issues

• Legal due diligence principally entails a careful review of:

• All contractual relationships

• Seller representations and warranties

• Escrow agreements

• Indemnification limits and buckets

• Business terms as translated into “legalese”

• Escrow agreements parameters generally:

• Specify a 12- to 24-month escrow duration (though sellers may prefer to limit such periods to 18-months or less, in light of statute of limitations issues)

• Involve set-aside amounts ranging from 10% to 20% of the total transaction value price (wholly independent of earnout arrangements)

• May be negotiated in either stock or asset deals

• The seller’s Middle Market M&A investment banker and transaction attorney each bring a discrete and complementary expertise to final negotiations and the closing of a transaction; however, during the deal’s final preclosing days, the seller’s lawyer most definitely is the team leader.

• Going through this process with an inexperienced transaction attorney is like being guided up Mt. Everest with somebody who has never been there themselves.

• Speeding the process is critically important during the transaction’s final days.

• Almost inevitably, one or more surprises will surface at the closing.

Notes

1 In certain industries, conventions have apparently been developed for indemnification maximum. For example, in government contracting, over the last few years the norm has tended to be around 25% to 50% of the total purchase price. I suspect this has as much as anything to do with a small community of lawyers who do these deals over and over again until what is initially random eventually becomes convention. The American Bar Association, by the way, has published a detailed analysis of transaction norms and statistics dealing with percentages of indemnifications and many other worthwhile reference points (it can be found on their Web site), and that is a document that should be in the library of every transactional attorney and investment banker.

2 It should be noted here that the settlement and execution of the closing documents may or may not be simultaneous, although in my experience they usually are.