Category / Negotiation

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Keeping Company Sale Proceeds: Indemnification-Related Provisions

The indemnification-related provisions are the most important outside of the purchase price itself in a company sale transaction. This post outlines indemnification-related issues when negotiating a company sale.

In the vast majority of sales of privately held emerging companies, the indemnification-related provisions are the most important outside of the purchase price itself—these provisions often determine whether the seller may hold on to the amount paid by the buyer.  I say “indemnification-related” as it is typically not the indemnification provisions themselves that are most important.  Rather, it is the provisions that define and limit the rights to indemnification, determine how damages are calculated, and state when the rights can be exercised.

For example, the upper limit of the amount of indemnification damages that a seller is responsible for in the event that there is an indemnification claim (commonly referred to as the “cap”), is often more important to the seller than the indemnification language itself, which can be written fairly broadly.

While the indemnification-related provisions are important, they are relatively complex and interrelated.  A negotiating “win” in one area for a seller, such as a low cap on the amount of indemnification damages available to a purchaser, can be negated by a negotiating “loss” in another area, such as broad exclusions from the cap.  Because of how these provisions are interrelated, we usually review and negotiate them in their entirety.

Here is an outline of indemnification-related issues that are often negotiated in a company-sale transaction:

  • Survival of representations and duration to make indemnification claims
    • Duration of survival of “fundamental” representations
    • Duration of survival of other representations
    • Time period to make indemnification claims
    • Exclusions from any of the above
  • Sandbagging
    • Anti-sandbagging provisions
    • Pro-sandbagging provisions
    • Silent
    • Nonreliance provisions
  • Indemnification as the exclusive remedy
    • Covering all transaction-related documents
    • Exceptions to the exclusive remedy
  • Cap
    • Amount
    • Exclusions
  • Basket
    • Amount
    • Exclusions
    • Deductible or first dollar
  • Materiality Scrape
    • None
    • Single
      • Breach
      • Damages
    • Double
  • Indemnification damage reduction
    • Tax benefits to buyer
    • Items covered by insurance
    • Buyer obligation to mitigate losses

As indemnification and related provisions are complex and sometimes difficult to understand, they are frequently glossed over by those who do not have the background (or patience) to take the time to understand them.  These provisions, however, can have a significant impact on the financial end result of the sale transaction.  Having a comprehensive negotiating strategy when negotiating indemnification-related provisions is often crucial to a successful sale transaction.

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Company Sale Structure Considerations

In this AlphaTakes video, Matt Storms discusses the common considerations that drive the decision on how to structure a company sale transaction.

Here are the key takeaways from this video:

  1. The most common considerations that affect the transaction structure for the sale of a privately held emerging company are taxes, assignment of contracts, seller shareholder approval, transfer of licenses and permits, ability to exclude certain assets or liabilities, and simplicity.
  2. Which factors are important are often deal specific.
  3. While no transaction structure is right for all deals, an asset sale transaction is used most frequently in privately held emerging company sales.
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Software Deals Using the Customer’s Form

Ever try to license software or provide SaaS to a Fortune 500 company or some other high profile company? Did they insist on working from “their paper”? You know enough not to simply hope for the best and sign whatever contract they put in front of you, but you also don’t want to delay further a months-long sales effort over the paperwork. What do you do?

The Customer’s Form Contract

You want the deal, so you tell them to send you the draft. BigCo sends you its contract. It’s a long, complex document that rivals the King James Bible. You send it to your lawyer, who spends an hour or two reviewing it. The lawyer comes back with a list of concerns that go something like this:

  • The intellectual property terms don’t apply to the deal you’re trying to close. You simply want to provide access to your SaaS platform, and the contract has your company assigning over all of its IP – effectively preventing you from offering a SaaS platform to your other customers.
  • The security terms are totally overbearing. You’ll only receive publicly available, anonymized information, but the contract has your company submitting to monthly penetration tests, annual SOC 2 Type 2 audits across all five principles, and background checks on all your employees by a third party of your customer’s choosing.
  • The renewal and termination provisions give your customer a right to terminate at any time, for any reason, with a pro-rata refund.

You then call your counterpart at BigCo and negotiate the renewal and termination provisions, while your lawyer rewrites the intellectual property and security terms. You’ve now spent your own relationship capital negotiating a key term, you’ve spent money on legal expenses, and the revisions haven’t even been sent to your customer’s attorney yet. Worse still, you’re beginning to wonder why they sent over a contract that requires this much hassle.

Here’s the problem: When they told you they wanted to work from their paper, you felt like you were in no position to negotiate. You spent a long time to get the deal to that point, and the economics were finally set. Your counterpart may have even said, “Our legal can be a pain. I don’t like having to deal with them, but it’s how we do things at BigCo.”

A Better Way Forward

Assuming you are even willing to work from their form, consider an alternative. Imagine instead that you told your counterpart at BigCo, “Certain legal items are really important to us. They are X, Y and Z. If we can work from a contract with those included, I’m confident the lawyers can hammer out the rest and we can quickly get this deal done.”

So what are X, Y, and Z? Here’s a sample of issues that are critical in many software deals:

  • Intellectual Property – Are you assigning your software (literally giving the code and full ownership to your customer), licensing it and reserving ownership rights to yourself, providing user access to a SaaS platform, or something else?
  • Data – If you’re providing a SaaS platform, who is responsible for the content of the data uploaded into it? Who owns it? What can (and can’t) you and your customer do with it?
  • Termination – Under what circumstances can your customer terminate the agreement?

Obviously that’s not an exhaustive list, and critical issues vary from deal to deal and company to company. Ideally, you already know your X, Y and Z.

When you communicate key legal concerns the moment you are willing to concede on using their paper, you send some important signals to BigCo:

  • You’re willing to work with them if they’re willing to work with you.
  • You know that the legal terms matter, and you know which issues are especially critical for your deal.
  • You want to learn quickly whether they will insist on dealbreaker terms.
  • You will expedite the process to get the deal done.

If your counterpart at BigCo also wants to get the deal done soon, your message will reach BigCo’s legal department. And if BigCo’s legal department takes cues from your counterpart, you’re much more likely to receive an agreement that actually applies to your deal. This saves everyone time and money in the long run.

But suppose your counterpart doesn’t want to close quickly or doesn’t relay your message, or suppose the legal team doesn’t take cues from your counterpart. Suppose the contract you receive from BigCo’s legal department isn’t any better. Are you really any worse off than if you had not tried this approach?

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AlphaTakes – Structures for a Company Sale Transaction

In this AlphaTakes video, Matt Storms discusses the most common types of deal structures for a company sale transaction.

In this AlphaTakes video, Matt Storms discusses the most common types of deal structures for a company sale transaction.

Here are the key takeaways from this video:

  1. There are a variety of ways to structure a company sale transaction.
  2. The most common types of deal structures are an asset sale, stock sale, and merger.
  3. The most common types of merger structures are a direct merger, a forward triangular merger, and a reverse triangular merger.
  4. Making a sale transaction tax free is often complex.

 

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A Company Sale NDA is Different

A common misperception is that all Confidential Disclosure and Nondisclosure Agreements (NDAs) are virtually the same. This article describes some ways that company sale NDAs can be different.

A common misperception is that all Confidential Disclosure and Nondisclosure Agreements (NDAs) are virtually the same. In other words, many people think that it doesn’t matter whether an NDA is for a vendor, customer, employee, strategic, or potential sale transaction—a standard NDA should be sufficient. The truth is, they are and should be different. This is especially true in the company sale context.
Here are some ways that company sale NDAs can be different:

(1) Definition of confidential information

The description of what constitutes confidential information in typical NDAs does not include a number of things that a seller often wants kept confidential in the sale context—most notably, the fact that the seller is considering selling the business or that the buyer and the seller are interested in a sale transaction.

(2) Permitted use of confidential information

A general use restriction seen in “standard” NDAs is often insufficient as a limitation on use of confidential information shared in the company sale context. Moreover, if the buyer is in private equity or is another type of financial sponsor, a limitation on using the confidential information only in connection with the consideration of a potential acquisition of the seller may not be adequate. It often does not limit the disclosure of confidential information to other potential buyers as part of a “clubbing” deal, which sometimes is counter to the seller’s desire to create competition among suitors.

(3) Who the buyer can share the information with

Many NDAs typically restrict disclosure of information by the recipient to those within the recipient’s organization who “need to know” for the stated purpose. Often, in the company sale context, buyers need to also share that information with financing sources, investment bankers, transaction consultants, lawyers, and others.

(4) Non-solicitation of seller’s employees and customers

While it is uncommon to see restrictions on solicitation of a party’s employees and customers in the typical NDA, it is more common to see the matter covered in a company sale NDA as those relationships are more vulnerable in the sale context, especially if the employees and customers know that the seller is interested in selling.

(5) Antitrust requirements

If the buyer is a competitor, provisions and processes should be included that address antitrust concerns.

(6) Seller point person

It is somewhat common to see an individual within the seller’s organization designated as a point person for whom the buyer must work through to obtain confidential information. The intentional procedural bottleneck is designed to ensure that relevant people within the seller’s organization are appropriately briefed, that certain people within the seller’s organization are not contacted by the buyer, and to some extent, keep track of the confidential information that is disclosed.

(7) Seller’s form of NDA

A common issue in many commercial transactions is whose form NDA should be used. In the company sale context, however, use of the seller’s form of NDA is the norm. Also, it is more common to see the NDA in the form of a letter, countersigned by the potential buyer, rather than the standard form of two-party agreement.

Because of some of the unique issues that arise in company sale transactions, sellers should craft the form of NDA they use with those unique issues in mind and not rely on forms or templates used in other contexts.

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Letter of Intent Deal Terms for a Company Sale

In most deals, a seller in a company sale process has the most leverage at the LOI stage of negotiations. It’s typically a good idea for a seller to get tentative agreement at the LOI stage on key terms that inevitably have to be negotiated. This article summarizes some of the common key terms to include in an LOI.

Following the nondisclosure agreement, the letter of intent (LOI) is typically the first step in formalizing the company sale process when a company auction process is not involved.  The LOI stage is usually an exciting time for the seller—the seller is full of optimism, there is no deal fatigue, and the new relationship with the buyer has not yet been tested by heated discussions.

The LOI can accomplish a lot.  At a fundamental level, it establishes whether there really is a deal on key issues.  Often times, first time entrepreneurs and those who have not been through a company sale process are willing to proceed with a lengthy “no shop” or “no talk” exclusivity requirement, based only on a non-binding agreement on price.  While purchase price is obviously an important term, it by no means is the only important term.

In most deals, a seller in a company sale process has the most leverage at the LOI stage of negotiations.  The seller has not invested a lot in the deal and it’s the easiest point at which to just say “no” to a request of a buyer.  Rarely, however, do terms get better for the seller after the LOI stage.  On the flip side, buyers will typically take aggressive positions after the diligence process or on the initial draft of the purchase agreement.  They know sellers have committed a lot to the deal and at some point in the process, become committed to making the deal happen for a variety of reasons.  Often, a seller is willing to concede more at a later stage than what the seller would have been willing to do earlier.  As a result, it’s typically a good idea for a seller to get tentative agreement at the LOI stage on key terms that inevitably have to be negotiated.

From a seller’s perspective, here are some of the areas worthy of consideration of including in the LOI:

  • Deal structure, especially if the seller is looking for capital gains treatment
  • Items that affect net proceeds at closing
    • Escrow holdback amount and time period for the escrow, or a statement that there will be no escrow
    • Working capital adjustment amount or a statement that there will be none
    • Earn-out (if any) or a statement that the listed purchase price does not include one
  • Duration of the survival period of seller’s representations and warranties
  • Basket and cap for post-closing liabilities
  • Indemnification cap exclusions
  • Employment requirements of key individuals or at least which individuals or types of individuals the buyer intends to retain, post deal (e.g., 80% of software engineers)
  • Targeted closing date

Buyers will often resist some of the provisions under the guise that, “we don’t know enough information at this point, so we prefer to agree upon those terms after the diligence process.”  The same thing though could be said of the purchase price.  The reason to negotiate the points earlier is that it places the burden on the buyer to change them later.  Once a term is in the LOI, the parties usually tend to feel sort of a “moral” obligation to adhere to those terms.  Buyers frequently need a major diligence finding to justify a modification to a term contained in the LOI, even though those terms are usually nonbinding.

Including more deal points in the LOI also helps to limit surprises later that may surface, such as, “we always require sellers to have no indemnification cap for breaches of representations related to intellectual property.”  Moreover, without touching on the key deal points at an early stage, it’s hard to determine whether the parties have a basic meeting of the minds, even with the assumption that there will be no material surprises in the diligence process.

As with most other things, deciding on the appropriate amount of detail in the LOI is a balance.  On the one hand, it requires including enough detail to help ensure that there really is likely a deal, while also, from the seller’s perspective, taking advantage of the leverage that a seller typically has at the LOI stage.  On the other hand, the seller should not put too much pressure on the buyer at the formative stages in adding too much detail and unnecessarily elongating the time period of the LOI stage.  Striking the right balance is the first step in a successful sale process.

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Closing the Software Deal – Part 2

Closing software deals with less legal hassle demands more than just a good agreement – it requires a well-informed and well-equipped sales team. If your company offers SaaS or licenses software to other businesses, consider these additional tips to close deals quickly and at a lower legal cost.

Build a Legal FAQ

Your team should know most of what’s in its agreement and why it’s there. Customer stakeholders who are not attorneys are quite likely to ask your sales team questions that are both ‘legal’ and important to the deal, long before an attorney is involved. Getting the answers right demonstrates your company’s experience, preparation, and ability to ensure customer success, all while speeding the deal to close. Getting the answers wrong – or not knowing the answers – simply decreases the likelihood of closing the deal or increases customer acquisition cost for no good reason.

A few examples of questions for which most sales teams should know the answers, particularly in SaaS deals:

  • What are the details of your SLA? Do you offer credits or refunds? If so, how are they calculated? What’s been your uptime historically? When do you schedule routine maintenance? Are you using third party hosting providers? If so, who?
  • Do you use data uploaded by your customers into the platform for any reason other than providing your service? If so, what are you using and why are you using it?
  • Are customers able to download their data from your platform? If so, how quickly can it be done? In what formats? Where are you storing that data?

You may even find it helpful to develop a ‘legal’ FAQ written by your attorney with guidance from your sales leaders. Sales leaders can ensure the FAQ includes answers to the legal-related questions they commonly field in the trenches, while your attorney can ensure the answers reflect what’s in your agreement. When new questions come up on a recurring basis, your attorney can also update your agreement where appropriate.

Create a Decision Tree & Fallbacks

Assuming you’ve closed enough software deals to know what is and is not negotiable in your agreement, how can you be more efficient? When you’re part of a small startup, virtually everything filters up. But, as your company grows, that cannot continue when the number of deals grows as well. What types of matters need to be on your plate – and what types of matters can you leave to the head of sales? Are you leveraging what you negotiated in prior deals?

They say the most important question in law is, “Who decides?” That’s absolutely true when closing a software or SaaS deal. If certain issues are commonly negotiated and you concluded they are minor, then consider whether it’s more efficient for your company to leave those issues to someone else. If other issues are more significant, then make clear who does and does not have the power to negotiate those items.

When you leave certain issues to someone else, provide alternative provisions that you and your attorney wrote and approved. You can even create an alternative version of your contract with footnotes for each of those alternatives.

Train the Team

Obviously, these solutions will not matter if your team does not know how to use them. But by this point, you may be asking yourself whether they have the time for what amounts to legal training. After all, they are busy trying to close deals, and they want to stay focused on the big picture.

If you’re convinced that some basic tools and process can help your company close software or SaaS deals with less legal hassle, put those tools to good use. Build an FAQ and iterate on it. Document a decision tree. Provide written alternatives. Critically, take the time to train your staff on how to use them. An hour of legal training and negotiating during employee onboarding or annual meetings can prevent more expensive back and forth months later. At the very least, the materials become simple resources your reps can leverage if they don’t remember the details.