It would be great if there was some kind of M&A traffic signal that could indicate if a deal is a go or a no-go, but for now buyers and sellers have to be careful and prepare, according to experts.
Some of the biggest challenges to a successful M&A include the target company’s “overstatement of financial metrics,” according to Sean M. Aylward, vice chair of the Corporate and Securities Group at the West Orange-based law firm Chiesa Shahinian & Giantomasi.
“Sometimes, when the potential acquirer looks under the hood at the detailed financial statements, such as when conducting a quality of earnings analysis, they find that sales, net income or EBITDA [earnings before income taxes, depreciation and amortization] are overstated, for example, as a result of inappropriate add-backs to EBITDA,” he says. “Also, some companies do not adequately document their rights to any proprietary intellectual property, which can become an issue in the valuation of the target company.”
Another potential sticking point—which Aylward says is on the rise—involves concerns over potential out-of-state sales tax and/or corporate tax liability.
As more states seek to boost revenue, state taxing authorities are becoming more aggressive about claiming that out-of-state businesses have nexus, or sufficient physical presence, that makes them subject to local sales/use and income tax. Many states are also claiming that the company has a liability for uncollected sales tax and/or unpaid corporate tax.
“We recently represented a New Jersey-based business, with an enterprise value [an economic measure reflecting the market value of a business] of approximately $100 million, in an acquisition,” Aylward explains. “The buyer was concerned about potential liability for sales taxes on out-of-state transactions that our client believed were not in fact subject to sales tax.”
The deal was in danger until Aylward suggested creating an escrow account that could be used to reimburse the acquiring company if a subsequent sales tax audit went against the target company’s actions.
“To safeguard the interests of our client, we also negotiated provisions that gave our client the right to participate in—and approve any adjustments arising from—any audit or other compliance-related activities,” he adds.
Business owners looking for advice about acquiring a business are likely to hear a lot about the risks facing a buyer, from cooked books that can improperly inflate the valuation, to the challenges in integrating the two companies’ cultures, which can impede efficiency and increase operating costs. But sellers have to be careful too, according to John Vanarthos, a member of the management committee at Norris McLaughlin & Marcus P.A., a Bridgewater-based law firm.
“Some sellers see unrealistic dollar signs when they look to sell their business based upon what they hear about the high values that some buyers are willing to pay for businesses in their space,” he says. “By the time they reach a deal in principle with a buyer—usually expressed in the form of a LOI, or letter of intent—they realize that there are a number of factors that can effectively reduce the purchase price.”
For one thing, sellers learn that most buyers value a business based on the assumption that the business is debt free. “As such, any debt carried by the business will be deducted from the purchase price,” Vanarthos explains. “Buyers also have an expansive view as to what constitutes ‘debt,’ typically including items such as accrued bonuses, severance obligations and many other accrued liabilities.”
Vanarthos also points out that “although an LOI outlines the basic terms of the deal, it’s not a final document and is usually subject to ongoing due diligence that can turn up unexpected risks and potential liabilities that the buyer expects the seller to shoulder.”
Some sellers also think that business valuations are based exclusively on earnings. But buyers also expect to see a reliable balance sheet. “One common issue is the amount of working capital that the selling company may be required to have as of the closing date,” he cautions. “Working capital is generally defined as the difference between current assets and current liabilities—subject to certain modifications—as of the date of the closing. The wrinkle is that the amount of working capital as of closing is subject to verification by buyer, which typically takes place during a period of two to three months after the deal actually closes. Problems can arise because of disputes over issues like the collectability of accounts receivable or obsolescence of inventory, which can affect the level of working capital as of the deal closing date.”
If the target company falls short on its closing working capital, the seller may have to make up the difference, even after closing, he adds.
The legal ride doesn’t end there. “Even after exhaustive due diligence, most buyers will expect the seller to retain legal responsibility for unknown liabilities that arise from pre-closing operations, whether arising from products or services made or sold prior to closing, or from conduct of its personnel prior to closing, such as workplace discrimination or sexual harassment,” according to Vanarthos. “Even though lawsuits from these matters may not be filed until after closing—because they relate to events occurring prior to closing—most buyers will expect the seller to remain responsible for those lawsuits, even though the seller may have had no knowledge of those events when it sold the business.”
He says that one of the “key roles” the seller’s lawyer must fulfill in an M&A deal is to make sure that his client—the seller—is fully aware of these issues “and to negotiate certain limitations and exceptions to seller’s responsibility for these so-called unknown liabilities.”
Even after all those issues are considered, a planned M&A can still be threatened.
“We recently represented a company based in Europe that wanted to acquire a New Jersey-based flavoring and fragrance, or F&F, company for about $75 million,” Vanarthos says. “But often, European businesses are concerned about the volume of lawsuits in U.S.—they tend to be less litigious outside of this country—and the buyer wanted strong protection against liabilities.”
The buyer’s fears were stoked by the fact that a number of flavoring and fragrance companies in the U.S. had been sued over a particular food additive used in many products that was considered safe when treated properly but which could cause serious health risks if mistreated.
The New Jersey manufacturer balked at committing to any kind of indemnification, since “F&F is a seller’s market, and target companies typically command high valuations and have a lot of say over deal terms,” explains Vanarthos. So the transaction looked like it might crater.”
With his buyer-client ready to walk, Vanarthos’ team went the extra distance to help their client accurately measure the scope of the risks involved. “We did a 50-state analysis of every case that was out there, noting how the ingredient was used in those cases and the nature of the harm caused,” he details. “In each case, we tried to track the typical time period between the date the affected consumers bought the product until they first became symptomatic, as alleged in the each lawsuit. We then did the same analysis with regard to how and when the ingredient was used and sold by the target company. In that way we were able to give our client some sense of the remaining time period that the target company would likely remain vulnerable to lawsuits related to this ingredient.”
All of this information meant that Vanarthos’ team was able to help quantify the risks associated with potential lawsuits, which helped the buyer’s insurance carrier to price out a liability-risk policy. “The easy way out would have been to advise our client to kill the deal,” he says. “But that would not have been in the client’s best interest.”
After all, when an M&A works out right, everyone benefits.