Tag / merger

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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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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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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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Preparing for Due Diligence for the Sale of a Company

There are steps that you can take in advance to prepare for due diligence in connection with the sale of your company. The documents and information that will be of greatest interest to an acquiror depend on the reasons the acquiror wants to buy your company. Establishing good record-keeping habits early or at least well in advance of a transaction will help keep momentum as you work toward the closing, reduce the chances that any skeletons in the closet will become bargaining chips for the acquirer, and preserve some of your sanity.

Executives who have not led a sale or merger of a company before are often caught off-guard by how much work goes into due diligence. For many who are successful, the building of the business crescendos and culminates in a sale. The term sheet is signed, you smell the money, and perhaps even book your post-closing vacation, but you may not realize that you’ve just signed up to run a muddy obstacle course race while also running your business. Your next several weeks, maybe months, will be consumed by responding to page after page of information and document requests from your potential acquirer. You will be questioned about all aspects of the business. Because you want to keep the pending transaction under the radar and limit the impact on your business if the deal does not go through, you assemble the smallest employee team possible to help you with the transaction. You may find yourself requesting files and summaries from various employees in the guise of another business need, copying after hours, and arranging off-site meetings with the acquiror.

To preserve some of your sanity during an M&A transaction, there are steps that you can take in advance to prepare for due diligence.   Continue reading →