Students need to be prepared to argue either side of the law when discussing a legal issue. That way, you can learn the law from all angles and see every corner of an argument. In today’s episode, Domenic Rinaldi is joined by two expert attorneys, John Schreiner and Jeff Petersen, who discuss several legal issues that arise in most M&A transactions – one taking the seller’s perspective while the other providing the buyer’s perspective. This episode will help you see several important issues from both sides of the table so you’re better prepared for your own M&A transaction.
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Buyers And Sellers: The Two Sides Of M&A Transactions With John Schreiner And Jeff Petersen
Law professors constantly ask students to be prepared to argue either side of the law when discussing a legal issue. That way, you can learn the law from all angles, seeing to every corner of an argument. In this episode, we’re going to try something new. We are being joined by two expert attorneys, John Schreiner and Jeff Petersen, who will be discussing several legal issues that arise in most M&A transactions. One of them will be taking the seller’s perspective while the other will be providing the buyer’s perspective. The M&A Unplugged Community could benefit from seeing several important issues from both sides of the table so you better prepare for your own M&A transaction.
John is with Perkins Coie and focuses his practice on providing counsel to closely-held established and emerging companies for their daily business needs. He also represents private and public companies in mergers and acquisitions, divestitures, private equity financings, corporate governance, commercial contracting, and general business matters. Jeff focuses his private practice on transactional matters including corporate formation, venture capital, private placement transactions, mergers and acquisitions, and general corporate advisement. Jeff serves clients across the country and maintains offices in California and Illinois. John and Jeff, welcome to the show.
Thank you. It’s good to be here.
Thank you, Domenic.
This is the first time I’ve done something like this, so we’ll be feeling our way through. Before we get into it, could you provide a little bit more about your background so the M&A Unplugged Community get to know you a little better? Jeff, why don’t you start us off?
I’ve been a corporate attorney for years and was a partner with K&L Gates in Chicago. John and I were colleagues there. Several years ago, I decided to open up my own practice. I have since that time represented midsize and small companies in a host of merger and acquisition transactions as well as a private placement of securities.
John, how about yourself?
After leaving K&L Gates and parting ways with Jeff, I joined Perkins Coie, an international law firm with a real strong presence up and down the coast and here in Chicago. In my practice, I like getting to know and understand my client’s business needs so that when I’m offering advice, in addition to giving them the legal resources or legal answer that they’re looking for, I can also give them a practical one or business answer to help them evaluate and mitigate risk and not get in the way of the business needs of the company or the client.
Jeff, you had brought this concept to me of, “How about if we do a point-counterpoint?” It took me back for a second and then I started to think about it. I thought, “That’s a great idea,” because often, as intermediaries, we’re in a situation where either we represent the seller or the buyer and there’s a sticky issue that comes up. As you guys know, doing M&A transactions, there are many sticky issues. I always find that my team and I are having to educate our clients so they understand the other side because in many of these cases, what’s good for you is bad for the other party. It’s important for us to have that dialogue. It is great that you have history and been colleagues for a long time, but you can take either side of an issue. Why don’t we start with indemnity? What’s the definition of indemnity? Why is it important? We can then go into the seller perspective and the buyer perspective.
With a typical purchase agreement to purchase the assets or stock of a company, you’re going to have representations and warranties that are made about the company. The seller is going to tell me that they own the company, that they don’t have any issues with their employees or their customers. There’s no litigation. They’ll show me their financial statements and let me know that those are true and accurate and prepared in accordance with GAAP, a variety of other reps and warranties. If any of those are wrong, either intentionally or unintentionally, the buyer would have a post-closing claim for breach of contract.When a company comes together prepared at the letter of intent stage, that helps to grease the skids for the deal in general. Click To Tweet
It will typically include an indemnification scheme within the purchase agreement. The indemnity scheme lays out the limitations on what a buyer is able to recover. The indemnification scheme also has the mechanics for how a buyer would make a claim for both direct damages and third-party claims that come against the buyer. Finally, it will identify the scope of recoverable damages. This is negotiated, what is the exposure of a seller after closing and how is a buyer able to be made as close to whole as possible if the company they’re buying isn’t the company they thought they were buying?
The premise is that the seller has to warrant that and they’re passing along materially accurate information to the buyer. If not, the buyer’s got the right to go back after him. Jeff, why don’t we start on your side? You’re going to represent the seller’s perspective. In the seller’s perspective, what’s your counsel that you’re providing here? There are many nuances to reps and warranties and indemnities, but at a high level, where are you advising a sell-side client?
This is the area that I always get a seller’s attention. What I tell them is, these are the provisions or parts of the contract where you might have to give your money back or at least a portion of it. That always captures attention. What I tell them is on the reps and warranties, they’re generally standard, but you need to go through them closely. We need to make sure that they’re not overreaching on the part of the buyer then we try to put in limitations in the indemnity like a cap. A lot of times, what you’ll say is the buyer can get indemnified but only up to a certain amount of the purchase price, say 10% of the purchase price, and there are certain exemptions to that that we can get into.
If it’s outright fraud, if it’s something fundamental like you don’t own assets, which you say that you’re selling to the buyer, those are exceptions to the cap. In general, you can get a cap of 10% to 20% on the purchase price and you can also get a limitation period, which is a 1 to 2-year period after the sale. The buyer then can come back to you if there’s an indemnified claim. If it goes beyond that period, what you generally say is you’ve owned the company. It’s past a point where you should be able to come back to the buyer and say forward some money back over again. There are exceptions there for things like fraud or some fundamental representations as well.
Jeff, in a situation where you represent the sell-side client and you’ve done the initial draft of the asset purchase agreement or stock purchase agreement, where are you typically starting? Where are your starting points on caps and time limits? We won’t get too detailed in the baskets and things like that, but at the highest level where’s your starting point?
With the lawyerly caveat, every situation is different. In general, I would start at a 10% cap with a one-year survival period. Even if I’m drafting the agreement, I want to be fair and balanced because I think it doesn’t help anybody to be too extreme. It adds time and expense to both sides. I will put in exceptions there for things like fraud. If it’s a fraud, there should be no cap. If you didn’t own the assets, there should be no cap. I think what John will say as the buy-side attorney is he’ll want to see things in there in the fundamental representation. That’s uncapped things like taxes and maybe employee benefits and intellectual property claims.
He brought up a new term, fundamental, but let me kick it over to John a little bit to get his reactions to your starting point around 10% in one year. John, generally, how are you advising buyers through that process?
I take a similar approach to that. I want to focus on the most important issues for my clients so that we can get to a deal sooner than later. Time can kill deals. A lot of times, you may have a rollover or post-closing employment and you need to maintain a good relationship with the seller. Depending on the counsel on the other side, I would typically try to start with a 15% to 20% cap on what I call operational representations and warranties. I am talking about no litigation, no issues with employees or customers, and then go to an enterprise value cap for more fundamental like you own the company and you’ve paid your taxes. Depending on the industry that the company is in intellectual properties, it is particularly important.
If there’s a risk of environmental issues, I’ll tend to have an extended rep where I’ll have a higher than the 15%, 20%, but not quite as high as the entire purchase price. That said, I have one client that’s been doing a number of acquisitions across the United States. Their target companies tend to be represented by less sophisticated counsel. Oftentimes, they’ll be using the lawyer that they’ve used for the last ten years to help them with everything but has never done an M&A deal. In that case, I’m starting without any limitations on my indemnification. Believe it or not, probably 7 times out of 10, we get away with that.
To Jeff’s point, while that’s an aggressive move, it leaves my client with all the leverage if there’s an issue after closing, but we still do quite a bit of due diligence. We work closely with those sellers to make sure that we do fare it out ahead of time any potential issues because we do not want to come into a situation, buy a company and figure out that there’s something wrong with it and have to deal with litigation or the threat of litigation to get made whole. We’d much rather identify that issue ahead of time and either elect not to do the deal, adjust the purchase price, or otherwise correct the issue.
It’s interesting you brought up a situation where you had an inexperienced attorney on the other side and you were able to push the limits and the cap. Sometimes, we experience the opposite. If there’s somebody that doesn’t do a lot of M&A transactions or none at all, they’re an impediment to the process because they don’t have enough knowledge and they dig their heels in on issues that they shouldn’t be digging their heels in. It effectively can kill a deal or cause the other party to have to bend in ways they shouldn’t have been because they didn’t have an experienced advisor on the other side.
I had a deal a couple of years ago, we were buying a forklift company. The family lawyer who was the trust and estates lawyer dug his heels and we had a series of company representations and warranties and the indemnifications were made by the selling stockholders, we’re doing a stock deal. He didn’t think that the stockholders should have to indemnify for a breach of the company reps. He couldn’t quite understand that after closing, we own the company and if the company was indemnifying for breach of its reps, we’d be paying ourselves with our own money.
It took quite a while and I ultimately relied on ABA model stock purchase agreement with commentary to educate him. Generally, I’d rather have a good lawyer on the other side. The agreement’s going to wind up much more in the middle of the road. If in diligence and negotiations, the parties are doing things right, you’re going to have a good deal and hopefully not going to have an indemnification claim afterward. Getting that deal done is more important so if it were up to me, I’d have Jeff on the other side of the deal rather than someone who doesn’t do this for a living.
It’s such a good point for the M&A Unplugged Community. Having an experienced attorney that has done a number of M&A transactions and different types of transactions is important. At the end of the day, it will save you money. Believe me, because I’ve seen the other side of it and I’m sure Jeff and John have as well. John, you bring up diligence, which is an important component of indemnity and reps and warranties. What role does the quality of the diligence information play in your starting point on indemnities and in a negotiation?
If we’re both conducting full due diligence and some clients opt not to do as deep of a dive in due diligence, they’re looking to get a deal done quickly. They’re looking to save on expenses, but assuming that we’ve done a deep dive and assuming that we see what we want to see. We see good corporate records. There are standard terms and conditions in their contracts that are reasonable. It gives us a lot more comfort that’s not something that’s been overlooked. Most of the time, when you have a post-closing claim, it’s not because somebody was hiding the ball, it’s because they didn’t realize it or they didn’t know what they were doing wrong.
If we see a company that is in good shape, we’re generally going to be more reasonable on our indemnification because we don’t have as big of concerns. Similarly, if the company has a reputable counsel, we get a little bit more comfortable. The brand of your counsel is important because we know that you’ve been getting good advice. A lot of times, when I have a client that’s getting ready to sell before the sale process even kicks off, we’ll start doing diligence ourselves on that client to make sure that if there are any obvious issues, that we can correct those ahead of time before prospective buyers come in and have a look. Get your house in order in advance of a sale process. I imagine you help out with that quite a bit too, Domenic. We work with advisors who do that quite often.
We try to get our clients to pull together diligence early and often. As a matter of fact, as soon as we engage, we start to build out a data room and we continue to do that throughout the process. We encourage the clients to do that. Jeff, I’m sure you’ve been in a situation where you’ve got a buyer counsel who’s trying to push the limits on caps and time limits because they were uncomfortable with diligence yet. Your position might be, “We were open kimono. We gave you the opportunity to come in and look at everything.” What’s your pushback when you’ve got a buyer counsel that’s trying to push the limits because they’re hiding behind diligence?
One thing is there’s a lot of market data out there as to what market and what our standard terms. We use those and we rely on our work too. It’s especially helpful when we have an advisor like you on the seller side because that’s a party who can almost serve as a mediator sometimes and talk through the attorneys to the business people as to what is the market standard. I was sharing with John that I had a deal and buyer’s counsel, big firm, but they were adamant that indemnity wasn’t going to be the sole and exclusive remedy. That’s an important point for business owners to know is you want the indemnity except in cases of fraud. Generally, that’s going to be your sole remedy, so if there’s a problem post-deal, everybody’s going to look to the indemnity provisions as to how does this play out? What are our limitations? Buyer’s counsel wouldn’t accept that and say, “We’re not going to have an exclusive remedy,” and we wound up loading up with data giving about 6 or 7 different studies showing that that’s in about 99% of the deals that are going to be your sole remedy and that finally got them to give on that point.The parties should be working together towards thinking about integration and transition. Click To Tweet
Has either of you or both of you been exposed to rep and warranty insurance? I am interested in getting your opinion on that. I interviewed Matt Somma of ABD not too long ago and they’re a rep and warranty insurance broker. It seems that insurance has been popping up more. It allows the seller to walk away with 100% and it gives the buyer a lot of comforts, not around fraud and things like that. Where do you think that plays a role? Do you like to see that? Do you want to see rep and warranty insurance? I am interested to get your opinion.
I’ll leave this one-off. As a buyer, oftentimes, I will start a bid with the concept that we will include rep and warranty insurance. It’s becoming prevalent in certain spaces such that if as a buyer you don’t offer a rep and warranty insurance, you’re at a disadvantage. The PE funds tend to be doing this in middle-market and upper middle-market deals. The strategics are a little slower to catch on. I’m certainly advising my clients to do that and say, “You’re at a competitive disadvantage if you’re bidding against a private equity fund.” They’re coming in with rep and warranty and insurance telling seller a few things. You’ve got a specific and low post-closing potential liability. You’re going to be able to walk away with that money and buy that boat, get that second house and go to the beach and not have to worry about it. It’s becoming more prevalent. Certainly, it is a lot more affordable than it was when it originally rolled out. I’m starting to see it even in lower middle market deals where it can make economic sense to bring that to the table.
I understand the premiums have come down. I don’t know what’s going to happen here post-COVID environment because there’s a brave new world. Pre-COVID, it seemed like the premiums were coming down and making it much more affordable for a lower middle market transaction to consider rep and warranty insurance. Jeff, what’s your perspective on this?
I echo what John says. On the seller side, you love to see that the buyer is going to have it in place. I’ve had buyers get that insurance when the seller hasn’t. If it’s something that’s within the buyer budget, we think there’s any potential for an issue. It helps everybody sleep better at night.
Jeff, in situations where you know what market is, you’ve got a reasonable attorney on the other side, but you’ve got a client that’s being completely unreasonable. I find oftentimes there’s a motivation factor that plays here when people dig their heels in on things that they shouldn’t be digging their heels in and they’re not taking the wise counsel of their attorneys who has done lots of these transactions. What is your approach with your clients when they’re digging their heels in and they shouldn’t be?
In a situation like that, that’s where I think some tough love is called for. I have been in that position before. What I tell my client is I would never come in and try to run your business because you’d be out of business within a week. Based on my experience having done these deals hundreds of times, you’re on the wrong side of this one. It’s counterproductive. Even as your advocate and someone who’s fighting for you, I’m here to say that this is one that’s unreasonable and it’s not something that the buyer should be expected to give on. Sometimes it takes them to break down those walls, but in general, good business owners have been through the wars before and you can get them to understand after some time.
John, how about you? Do you have a magical thing that you use with your clients that helps move the needle?
If I’m on the buy side, I’ll often put on my law professor hat and use the Socratic Method and ask them questions to get to the right answer. If they’re intransigent on a certain rep or limit, I’ll have them walk through with me and I’ll say, “What are the unlikely scenarios where we’re going to see a breach here? What keeps you up at night? What are you worried about here?” As they walk through that and articulate their concerns, oftentimes, we feel that we can solve for that either by narrowing the rep to a specific concern or helping the client to land at the conclusion that this company isn’t ever going to have this issue. We’re willing to trade and take the risk here, which we’ve identified to be minimal in exchange for lessening our risk somewhere else, where it’s probably more realistic to occur.
This has been enlightening. I love the back and forth, the practical approach to what could be a sticky issue. Jeff, let me punt it over to you some last comments on indemnities or anything related to it that you think are important to mention.
I guess my overall comment on it would be to echo this at the start of the business owner. This is most likely the biggest transaction you’re ever going to undertake and the indemnity is the key provision where your $10 million deal could become an $8 million deal. It bears all the careful attention that your business does and to John’s point, it helps to drill down the due diligence, helps to ask questions, helps to have a good advisor like you, Domenic, upfront, quite honestly. That can put them in the best position before the letter of intent is done. When a company comes together prepared at the letter of intent stage, that helps grease the skids for the deal in general. That’s why I always try to get all the indemnity terms outlined in the letter of intent so we’re not fighting about it when we’re drafting the definitive agreement. I think fronting everything and putting it on the table and getting it solidified upfront is the best thing a seller can do.
I’m glad that you brought that up, Jeff. I couldn’t agree more. We always advocate our clients in working with our attorneys that we get everything on our table possible. You can’t get everything in it, but as much as you can because it makes for a smoother transaction later on and you’re not fighting when the parties should be working together towards thinking about integration and transition. It is not a time to be fighting and the more you do upfront, the better. That’s great advice. John, how about you?
I’m frustrated as a buyer counsel when I’ve got Jeff doing that to me because at the LOI stage, that’s still the courtship. If there are potential other bidders out there, I’m trying to play somewhat nice and in the indemnities, probably the most important provision in the purchase agreement. Here I am, getting back into a corner when we’re still trying to get them to let us in the door. Additionally, I may not be far enough along in my due diligence to be comfortable with my indemnity. It’s pushing me into doing what market is generally for deals of this size in this industry. It is good for a seller’s counsel when they do that. I agree when I’m representing a seller that’s important to do.
One point coming out that’s maybe a little unique is in this post-COVID world, how do you disclose against and how do you exclude or protect yourself for issues that are attributable to what’s happening in the economy or the ability of a company to continue with shelter and place orders or other restrictions? One thing that we’re trying to focus on is having narrow specific disclosures rather than saying, “Our supply lines have been impacted by COVID, generally.” We are trying to limit those disclosures, but still recognize that this company for better or worse is not the same company that it was before.
Jeff had sounded like John was ready to do some battle there. I should’ve stopped and let that happen. John, you bring up a good point on the other side. I don’t want to overstep here, but I think what you said, if there hasn’t been enough due diligence done, it’s hard to lock into indemnity. Is that a solid pre-qualifier not maybe 100%?
That’s fair and it’s tough to jump up a cap or something because the diligence shows that the company has been sloppy. What it oftentimes pushes us towards is a buyer is a specific indemnity. We’re carving out a series of potential claims that wind up then being completely on cap, rather than subject to a slightly higher cap.
Jeff and John, this has been a great conversation and I enjoyed talking to both of you and getting both perspectives. I know the M&A Unplugged Community is going to get a ton out of this. I am hoping buyers and sellers can get an appreciation for the other side. It’s important to understand that you have to bend, but you have to understand that you know these issues from both sides. In closing here, Jeff and John, I’d love for you to leave your contact information with the M&A Unplugged Community. How can they get in touch with you if they wanted to reach out? Jeff, why don’t you start us off?
The best way to reach us is through our Chicago office number, which is (312) 583-7488 and the name is Jeff Petersen. Thanks, Domenic.
My direct dial is (312) 324-8475 or feel free to email me at [email protected]. Thank you.
I want to thank Jeff and John for taking the time to share some important information about indemnities. We were going to try to get to a couple of other issues. What we’ll do is to invite Jeff and John back to cover some other important topics to get the sell-side and the buy-side perspective. If you would like to learn more about the process of acquiring or selling a business, please visit our website at SunAcquisitions.com or feel free to reach out to me at [email protected]. I look forward to seeing you again on the next episode of the show. Until then, please remember that scaling, acquiring, or selling a business takes time, preparation, and proper knowledge.
- Jeff Petersen
- Perkins Coie
- Matt Somma – Previous episode
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About John Schreiner
About Jeff Petersen
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