After a seller has found the right acquirer, both the seller and buyer sign a letter of intent or non-binding term sheet. But is the deal done? Not even close. Now the hard work begins. Through all the transactions I have led representing buyers and sellers, I’ve learned that, for both sides, there are usually at least four deal points that warrant further discussion after the initial terms.
Covenant Not to Compete. The details of this component are critical on both sides of the deal. If you’re a buyer and paying a premium for the business, you will want this language to be as broad and comprehensive as possible. You will argue for the covenants to go well beyond the initial term of the earn-out or employment agreement (i.e., three-year term = five-year non-competition).
If you are a seller, these expanded covenants might make sense if you have no immediate plans to get back into the business, post deal. Otherwise, you do not want to be restricted from reentering the industry even as an indirect competitor for too long. Many times a one-year tail after the initial term of the earn-out or employment agreement has expired is sufficient to both parties. The buyer should have some protection so the seller cannot turn right around and directly compete with the buyer.
Termination for Cause. Again, the buyer will likely want to make the language as broad or vague as possible. But you know the saying, “You’re fired because we don’t like the way you part your hair.” If you’re the seller, an advisor can help you narrow the scope of the buyer’s ability to fire you for cause (e.g., limited to fraud, gross dereliction of duties). If it is without cause, then at a minimum, a severance package should be in place.
Representation and Warranties. Even companies with the cleanest of balance sheets must consider this. On balance sheets, anything can be represented, including the unforeseen (e.g., natural disasters).
If you’re a buyer, you want these reps and warranties to be as broad as possible and the amount of indemnification to be unlimited or at least the amount of the purchase price.
If you’re a seller, you do not want to represent or indemnify the buyer for things that are out of your control, such as natural disasters. You will not want to provide unlimited indemnification for the business. And you will want your advisor to negotiate something that is no higher than the total amount of the purchase price.
Indemnification Amount. A materiality basket should also be put in place so that both sides do not “nickel and dime” one another after the transaction. If you are a seller it is wise to not agree to an unlimited amount, as there are some things that are just out of your control.
It’s important to recognize that a basket and the total indemnification amount are two different items. A basket is usually an agreed upon amount or a percentage of the indemnification. The indemnification is usually a fixed amount, a percentage of the purchase, or sometimes the entire purchase price, which is what the buyer will pursue. The seller should always work to negotiate and agree to less than an unlimited amount.
As the seller, it’s important to have an advisor who has been on both the buy and sell side, along with legal counsel, to guide you on what is fair to represent or vouch for the business.
Steve Pomeroy is the founder of Big Change Advisors, an M&A consulting firm in Los Angeles focusing on middle market companies in the IT services space. Since 1992, Big Change leaders have completed over 36 transactions including M&A, Capital Sourcing, and Public Offerings representing over $800 million in total transaction value. Big Change Advisors donates a percentage of all fees to help serve the homeless through the Los Angeles Mission. To request a free consultant, contact us.
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