Protecting Buyers in M&A Transactions: Thinking Beyond Indemnification and Escrows
This article is republished with permission from South Carolina Lawyer, the official magazine of the South Carolina Bar. A full copy of the article is included below.
In an acquisition involving the purchase and sale of a business, seller’s indemnification obligations are usually the most heavily negotiated provisions in the purchase agreement, and for good reason. Most purchase agreements provide that indemnification is the buyer’s exclusive remedy for seller’s breach of representations, warranties, and covenants, and for excluded liabilities.
Buyers sometimes negotiate carve-outs from the exclusive remedy provision, such as fraud and intentional misconduct by seller. Those carve-outs, however, are typically very limited. Consequently, the scope of seller’s indemnification obligations is critically important.
The most common way in which a buyer secures seller’s indemnification obligations is by placing a portion of the purchase price in escrow at closing. The escrowed funds are available to the buyer to satisfy seller’s indemnification obligations.
The American Bar Association, M&A advisory firms, and other organizations publish deal studies that summarize deal terms for a selected set of M&A transactions. Practitioners often use those studies to argue that certain indemnification and escrow terms – such as time limitations, minimum claim amounts, thresholds, and caps - are “market.” Unless the acquisition has some unique aspects, many sellers strongly resist terms proposed by buyers that are outside of the “market” terms reflected in recent deal studies. This creates challenges for buyers seeking to obtain customized indemnification protection against deal-specific risk.
Indemnification and escrows are the primary means by which buyers protect themselves against post-closing acquisition risk. Indemnification provisions, however, are becoming more standardized. Consequently, it is increasingly important that buyer’s counsel encourage the buyer to explore additional protections outside of indemnification and escrows.
It is easier for sellers to evaluate buyer proposals that are narrowly tailored to address specific business risk. In addition, most sellers are naturally more receptive to buyer proposals outside of the context of indemnification. Consequently, buyers increase their odds of success when they propose protections against deal-specific risk outside of the context of indemnification.
This article will explore buyer protections that are often overlooked in M&A transactions. For simplicity, the article assumes that the acquisition is structured as an asset purchase, that the selling entity is a private company, and that a selling entity or other selling parties continue in existence after closing.
Negotiate an Accounts Receivable Repurchase Obligation
In many acquisitions, accounts receivable constitute a significant portion of the assets of the acquired business. Buyers often view the collectability of aged accounts receivable with more skepticism than sellers. In those situations, buyers can propose an accounts receivable repurchase obligation. An accounts receivable repurchase obligation gives the buyer an option to sell, and requires the seller to repurchase, some or all accounts receivable that remain uncollected after a certain date following the closing.
Sellers can rely on collection history and familiarity with their customers to evaluate collection risk. Sometimes sellers are confident that accounts receivable will be collected. In those cases, a repurchase obligation can reduce the buyer’s collection risk without placing a significant burden on the seller.
The buyer and seller can easily customize a repurchase obligation. A repurchase obligation can apply to all purchased receivables or to a subset of purchased receivables, such as receivables owed by particular customers. The buyer and seller can select the date on which the buyer’s option becomes exercisable and the length of the exercise period. The buyer and seller can choose different exercise dates and exercise periods for different receivables.
Buyer’s counsel should be careful to draft buyer’s option to sell accounts receivable as an option, rather than as an obligation. The buyer can expect that seller will aggressively pursue collection of repurchased receivables. The buyer may choose not to sell receivables to the seller when the buyer will continue to do business with the account debtors. The buyer may decide to keep the receivables to retain control over the business relationship.
Most acquisitions include a working capital adjustment. The purchase price is increased or decreased after closing to reflect the difference between the working capital of the acquired business that the buyer used as a basis for calculating the purchase price and the actual working capital of the acquired business on the closing date.
Typically, accounts receivable are included in the working capital adjustment. If the buyer negotiates an accounts receivable repurchase obligation, the working capital adjustment should take into account the repurchase obligation.
Seller’s repurchase obligation usually takes the form of a covenant in the purchase agreement. If the purchase agreement provides that indemnification is the exclusive remedy for seller’s breach of covenants, the repurchase obligation should be excluded from the exclusive remedy provision. Otherwise, if the seller breaches the repurchase obligation, the buyer’s remedy will be limited to indemnification. Furthermore, the buyer’s remedy often will be subject to minimum claim amounts, threshold amounts, and other indemnification limitations.
Conduct an Inventory Audit
Sometimes inventory constitutes a significant portion of the assets of the acquired business. Inventory control systems and procedures vary significantly from one business to another. The buyer may be concerned that seller’s inventory counts are not accurate or that the seller values inventory differently than the buyer. The buyer can reduce those risks by negotiating the right to conduct a physical inventory audit before the closing, either jointly with the seller or under seller’s supervision.
The seller may resist a pre-closing inventory audit because the audit will disrupt seller’s business operations. Also, if the seller has not announced the sale to seller’s employees, the audit will likely raise questions.
The buyer should offer to conduct the audit at a time that will cause the least disruption to seller’s operations – typically over a weekend – and on a date that is as close to the closing date as practicable. Under those circumstances, the seller will often agree to a pre-closing audit.
The buyer should also emphasize to the seller that conducting a pre-closing audit can benefit the seller. The audit gives the seller the opportunity to resolve inventory issues at a time when the buyer is still somewhat deferential to seller’s business methods.
Typically, inventory is included in the working capital adjustment. When the buyer conducts a pre-closing inventory audit, the inventory value determined in the audit should be used as the inventory value in the working capital adjustment.
Alternatively, if the purchase agreement is simultaneously signed and closed, the buyer and seller may choose to increase or decrease the purchase price at closing to take into account the change in inventory value. If the buyer and seller make a purchase price adjustment at closing, inventory should be excluded from the post-closing working capital adjustment.
Obtain a Tax Compliance Certificate
When negotiating indemnification provisions, buyers often pay particular attention to sellers’ indemnification obligations for tax liabilities of the acquired business. In South Carolina, a buyer can reduce its exposure to state tax liabilities of the acquired business by requiring that the seller deliver a tax compliance certificate from the South Carolina Department of Revenue at the closing.
Section 12-54-124 of the South Carolina Code provides that when a majority of the assets of a business are transferred, any taxes generated by the business that were due on or before the date of the transfer constitute a lien against the assets in the hands of the buyer until the taxes are paid. A lien does not arise, however, if the buyer receives a certificate of compliance from the South Carolina Department of Revenue stating that all tax returns have been filed and all taxes generated by the business have been paid. A certificate of compliance is valid if obtained no more than thirty days before the closing.
If the buyer is not acquiring a majority of the assets of the business, the buyer should require that the seller deliver a “Transferor Affidavit” at the closing. The South Carolina Department of Revenue advised in Revenue Rule #04-2 that when a buyer acquires less than a majority of the assets of a business and the buyer obtains a Transferor Affidavit from the seller, the Department will not place a lien against the assets in the hands of the buyer.
In the Transferor Affidavit, the seller certifies that the seller is transferring less than a majority of seller’s business assets, based on fair market value. A form Transferor Affidavit is available from the South Carolina Department of Revenue. A Transferor Affidavit is valid for thirty days from the date on which it is signed.
Utilize Buyer’s Post-Closing Payment Obligations
Buyer gains an upper hand by structuring an acquisition so that the buyer will make payments to the seller after the closing. This commonly occurs when the buyer pays part of the purchase price in promissory notes or earnouts. The notes represent deferred payment obligations. Earnouts are contingent amounts that the buyer agrees to pay to the seller if the acquired business meets specific performance targets after the closing.
The buyer and seller also may enter into commercial agreements at the closing that require the buyer to make payments to the seller. Those agreements can include supply agreements, purchase agreements, transition services agreements, technology support agreements, lease agreements, license agreements, consulting agreements, and/or employment agreements.
Whether the buyer and seller enter into these arrangements should be driven primarily by business considerations. The existence of obligations by the buyer to make post-closing payments, however, creates the opportunity for the buyer to negotiate additional buyer protections.
Earnouts, by themselves, are a form of buyer protection because the buyer pays the seller only if the business exceeds specific expectations after closing. In addition, when an acquisition includes earnouts or other post-closing buyer payments, buyer can negotiate setoff rights.
Setoff rights are a powerful tool to induce seller’s compliance with its obligations after the closing. Setoff rights are most commonly negotiated with two components: (1) notes and earnouts, and (2) seller’s indemnification obligations. Indemnification is an obligation that may be owed by the seller to the buyer. Setoff occurs when the buyer reduces the amount the buyer pays to the seller under notes or earnouts by the amount of an indemnity payment that the buyer has a right to receive from the seller.
Setoff rights, however, can be more creative. The buyer should consider other setoff mechanisms if the seller strongly objects to the scope of the proposed setoff rights or if notes and earnouts are not included in the acquisition structure.
First, the buyer should consider negotiating setoff rights with respect to payment obligations other than notes and earnouts, such as payment obligations under commercial agreements. Many buyers overlook the possibility of negotiating setoff rights when an acquisition does not include notes or earnouts.
Second, the buyer should consider negotiating setoff rights against seller obligations other than indemnification. Buyers should take advantage of the opportunity to use setoff rights to protect against deal-specific risk.
For example, it may be important to the buyer that the seller complies with a certain covenant in the purchase agreement, such as a noncompetition restriction. Or, the buyer may be concerned about liability relating to a defined business issue - such as a litigation matter, an environmental condition, or an employee situation. The buyer can negotiate setoff rights tied directly to the seller’s breach of a specific covenant or to a potential liability. For example, the seller may agree to be responsible for, and defend against, a particular litigation matter that may arise after closing. The buyer can negotiate setoff rights that provide that if the buyer incurs costs or suffers damages as a result of that litigation matter, the buyer has the right to reduce the amount the buyer pays to the seller under notes or earnouts by the amount of those costs and damages.
In some cases, setoff rights linked to a covenant or liability provide broader protection – although against more specific risk – than setoff rights more generally linked to seller’s indemnification obligations. Setoff rights that are linked to indemnification are subject to the minimum claim amounts, thresholds, caps, and other limitations set forth in the indemnification provisions. Setoff rights that are linked to a covenant or liability, when carefully drafted, are not subject to those limitations.
Even if the buyer does not negotiate express setoff rights, the buyer may have common law setoff rights. Moreover, even without express or common law setoff rights, as a practical matter, the buyer can always threaten to withhold payments. Consequently, the buyer has significantly greater leverage to resolve post-closing disputes with the seller when the buyer structures an acquisition to include post-closing payment obligations.
Use Cross-Default Provisions
Cross-default provisions are another powerful tool to induce seller’s compliance with its obligations after the closing.
If the buyer and seller enter into commercial agreements at the closing, one or more of those agreements can include cross-default provisions to the purchase agreement. The cross-default provisions give the buyer the right to terminate the commercial arrangement if the seller fails to comply with specified obligations under the purchase agreement.
Like setoff rights, cross-default provisions can be tailored to address deal-specific risk. The buyer’s termination rights can be triggered by seller’s failure to comply with one or more specific obligations in the purchase agreement.
For example, it may be critical to the buyer that the seller complies with post-closing noncompetition restrictions set forth in the purchase agreement. The buyer and seller may enter into a supply agreement at the closing. Pursuant to the supply agreement, the buyer will supply a specialized product to the seller after the closing. The buyer can include a provision in the supply agreement that gives the buyer the right to terminate the supply agreement if the seller breaches its non-competition restrictions.
Cross-default provisions are most valuable to the buyer when included in a seller-favorable agreement. In that situation, the seller is motivated to avoid behavior that gives the buyer – or arguably gives the buyer - the right to terminate the agreement.
Prior to the closing, when the buyer and seller are fully occupied negotiating a multitude of acquisition documents, cross-default provisions in other agreements may not draw significant attention from the seller. Those cross-default provisions, however, can be valuable to the buyer after the closing.
Obtain Representation and Warranty Insurance
When a buyer is concerned that a purchase agreement does not adequately protect the buyer against a significant business risk, the buyer should consider obtaining a Representation and Warranty insurance policy. When Representation and Warranty insurance was first introduced in the 1990s, it was generally viewed as conferring limited benefit at a high cost. Representation and Warranty insurance, however, has become more cost effective and is being used more frequently.
A Representation and Warranty policy provides protection for unintentional breaches of seller’s representations and warranties. The buyer and seller can use a policy to cover a deal obstacle - often environmental representations - or to provide “blanket” coverage for all representations. Coverage does not extend to seller’s covenants in the purchase agreement.
Representation and Warranty policies are used most frequently to extend the protection provided by seller’s indemnification obligations. Coverage can, for example, provide limits above the indemnification cap and/or provide benefits beyond the expiration of indemnification periods.
Representation and Warranty policies are highly customized. The insurer reviews the purchase agreement, and the purchase agreement is incorporated into the policy. Cost is determined on a case-by-case basis.
Although Representation and Warranty policies are still not cost effective in most situations, a Representation and Warranty policy may be a viable solution when an acquisition presents a unique risk.
Robust due diligence is the best way to protect a buyer from acquisition risk. In addition, indemnification obligations will always be important. Buyer’s counsel should be careful, however, not to overlook other means of protecting the buyer against acquisition risk. After closing, those additional protections increase the odds that the acquired business will achieve success.