Structuring Acquisitions of Family-Owned Businesses: Valuation,...

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Presenting a live 90-minute webinar with interactive Q&A

Structuring Acquisitions of Family-Owned

Businesses: Valuation, Due Diligence, Deal

Structure, Operational Transition and More

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, JUNE 23, 2016

Eva Davis, Co-Chair, Private Equity, Winston & Strawn LLP, Los Angeles

Lawrence M. Kern, Partner, Winston & Strawn LLP, Chicago

Nishen Radia, Managing Partner, FocalPoint Partners LLC, Los Angeles

Margaret Shanley, Principal, Transactional Advisory Services Practice Leader,

CohnReznick LLP, Los Angeles

Rachel Ingwer, Associate, Winston & Strawn LLP, New York

© 2016 Winston & Strawn LLP

Recent Trends and Legal Developments You

Should Consider in 2016: Part I –

Mergers & Acquisitions

April 6, 2016


Today’s Speakers

Oscar David Partner

+1 (312) 558-5745

[email protected]

2

Robert Rawn Partner

+1 (212) 294-6721

[email protected]

Richard Falek Partner

+1 (212) 294-3314

[email protected]

Jim Junewicz Partner

CHI: +1 (312) 558-5257

NY: +1 (212) 294-6700

[email protected]


Agenda

• Overview of 2015/1st Q 2016 Deal Activity

• Rising Trend of Antitrust Enforcement in M&A Deals

• Current Issues in Earn-Outs

• Update on Increased Use of Rep & Warranty Insurance

• Fraud Issues in Mergers

• Rise of Aiding and Abetting Liability for Financial Advisers

• Investor Activism Update

• Decline of Disclosure Only Settlements – Trulia and Other Cases

3


Overview of 2015/1st Q 2016 Deal Activity


Overview of Deal Activity in 2015¹

• Worldwide M&A activity breaks all-time record

• Major catalyst is record number of mega-deals in excess of $10B

• Global deal value totaled $4.7tn, up 42% from 2014

• Global deal frequency stable, with approx. 42,300 M&A transactions

• Q4 2015 largest fiscal quarter on record with $1.6tn in announced

deals globally

• 50% increase in value from Q3 2015

¹ Thomson Reuters, Mergers & Acquisitions Review: Full Year 2015.

5


Overview of Deal Activity in 2015 (continued)

• Increase in cross-border M&A activity¹

• $1.6tn in total value announced in cross-border M&A², accounting for 1/3 of

total M&A volume and a 27% increase over 2014 levels¹

• Large increase in deal multiples²

• Median for revenue: 1.7x (more than 20% over 2014)

• Median for net income: 23.7x

• Median for EBITDA: 11.2x

• Median for free cash flow: 33.1x (more than 20% over 2014)

• M&A Trends in the U.S.¹

• Increase of 64.3% in value over 2014 levels for announced M&A deals

involving U.S. targets

• $2.3tn in M&A activity for U.S. targets driven by 9,962 announced deals

¹ Thomson Reuters, Mergers & Acquisitions Review: Full Year 2015.

² Bloomberg, Global M&A Market Review (Financial Rankings) 2015.

6


Overview of Deal Activity in 2015* (continued)

7

• Top U.S. Industries for M&A in 2015

* Thomson Reuters, Mergers & Acquisitions Review: Full Year 2015.


Overview of Deal Activity in 2015 (continued)

• Surge of mega-deals in excess of $10B¹

• 67 deals valued at over $10B were announced, totaling $1.86tn

• Numerous key deals:

• SABMiller-AB InBev Acquisition: $117B

• Royal Dutch Shell-BG Group Merger: $82B

• Charter Communications-Time Warner Cable Acquisition (Announced and Pending): $80B

• Trends in U.S. Market in 2015²:

• Abundance of Liquidity (Investment & Non-Investment Grade)

• Generally Stable Stock Market

• Active IPO Market

• Increase in Spinoffs

• Increase in Strategic Acquisitions

• High Activist Activity

• High Public Valuations

¹ A Record Year for M&A Mega Deals, Financial Times, December 22, 2015.

² Citi, Looking Back at 2015 and Ahead to the Future, February 19, 2016.

8


Overview of Deal Activity – Q1 2016

• Volume Decrease During Q1¹:

• Global M&A volume of $701.5B, down 25% from Q1 2015

• 9,250 M&A deals announced worldwide, down 10% from Q1 2015

• Value of announced global M&A deals down 56% from Q4 2015²

• 73% of global M&A volume in cash deals¹

• Global cross-border M&A activity totaled $304.6B in transaction

volume²

• Driven in part by outbound M&A activity from Chinese acquirors, totaling

$86.6B in M&A transaction volume

• M&A Trends in the U.S. (through Q1 2016)¹:

• U.S.-targeted M&A volume of $248.2B, down 40% from Q1 2015

• 2,206 U.S.-targeted M&A transactions announced, down approximately

17% from Q1 2015

¹ Dealogic, Global M&A Review: First Quarter 2016.

² Thomson Reuters, 1Q 2016 Global M&A Financial Advisory Review.

9


Overview of Deal Activity – Q1 2016 (continued)

10

• Top U.S. Industries for M&A in Q1 2016¹:

¹ Thomson Reuters, 1Q 2016 Global M&A Financial Advisory Review.


Marketplace Conditions/Outlook for 2016*

• Expected Deal Drivers:

• CEO and U.S. Consumer Confidence Remain Relatively High

• Interest Rates Remain Low

• Large Amount of Financial Sponsor Dry Powder

• Headwinds:

• Volatility in High Yield Markets

• Steep Drop in Commodity Prices

• Highly Challenging IPO Market

• Concerns Regarding China’s Economy

• Stock Market Correction

• Election Year Uncertainty

* Citi, Looking Back at 2015 and Ahead to the Future, February 19, 2016.

11


Rising Trend of Antitrust Enforcement in

M&A Deals


Antitrust Enforcement Worldwide 2015

• Approximately $70 billion in transactions were blocked or abandoned

in significant jurisdictions worldwide (including US, EU and China).

• Number of transactions challenged in court in both US and EU

increased dramatically.

• As number of multinational transactions increase, so does

coordination between different agencies.

13


Antitrust Enforcement U.S. 2015

• Numerous high profile U.S. cases filed in 2015, e.g.:

• Sysco/US Foods (blocked)

• GE/Electrolux (abandoned)

• Ardagh/St. Gobain (settled)

• Staples/Office Depot (ongoing)

• Agencies falling back on traditional analysis, particularly market

definition and arguing for narrowly described markets or channels

(e.g., “large business customers” in Staples/Office Depot)

• Only litigation loss was in Steris/Synergy which was a unique

“potential competition” argument which was disproved by facts of

case.

14


Vigorous Enforcement Likely Continues

• U.S. trends:

• FTC and DOJ bulked up on litigation talent

• Agencies more aggressive in rejecting settlements (e.g., rejection of

offer to transfer contracts to Essendant in Staples/Office Depot)

• Recent bankruptcy of Hagen (bought divested Safeway/Albertsons

stores) likely to cause greater scrutiny of divestiture packages

• Numerous current E.U. investigations including Halliburton/Baker

Hughes, GE/Alstom, Mondelez, DEMB, Fedex/TNT, Telia/Tele

Danmark.

• More and more jurisdictions worldwide implementing filing regimes

and/or analyzing transactions more closely

• Chinese merger clearance typically “long pole” when seeking multi-

jurisdictional clearance.

15


How to Attack

• Just being sued often a loss for parties because of time, expense,

uncertainty may cause business deterioration (particularly for target).

• Even if parties willing have time and resources to fight, litigation

always uncertain.

• “Business-like” as opposed to “legal” approach.

• Know the “market” – gather as much information as possible on

amounts and types of fees and caps in other deals much like

review of EBITDA or other multiples.

• Study logistics of other transactions, particularly time from

signing to clearance(s)

• Build protections for contingencies into underlying agreement --

e.g., break-up fees, ticking fees, divestiture requirements/caps,

end dates/extensions.

16


Current Issues in Earn-Outs


Valuation Gap in Mid-Market M&A

• A few thoughts on the valuation gap in Mid-Market M&A

• Mergermarket Group’s North American Mid-Market newsletter.

• Roundtable report focuses on how buyers and sellers can close valuation

gaps in 2016

• http://mergermarketgroup.com/wp-content/uploads/2016/03/Firmex-Mid-

market-Newsletter-Q1-2016_Final-LR.pdf

18

http://mergermarketgroup.com/wp-content/uploads/2016/03/Firmex-Mid-market-Newsletter-Q1-2016_Final-LR.pdf






















Recent Developments in Delaware Law

re Earn-Out Provisions

• “[A]n earn-out provision often

converts today’s

disagreement over price into

tomorrow’s litigation over the

outcome.”

• Vice Chancellor Laster,

Airborne Health, Inc. v. Squid

Soap, LP

19


What is an Earn-Out?

• Consideration in an M&A transaction payable to a seller which is

contingent upon the future performance of the target business and/or

based on the achievement of certain milestones.

• Generally structured as payments contingent on satisfying certain

milestones, for example:

• Financial Targets

• EBITDA

• Revenue

• Net Income

• Non-Financial Targets

• Regulatory Approval

• Increase in New Customers

20


Why Earn-Outs?

21

Source of Price Uncertainty

Undeveloped Product

New Market Financial Info

Unreliable Limited Historical

Operations Uncertain

Future Recent

Restructuring

Small Companies


Why Earn-Outs? (continued)

• Provide a level of acquisition price protection

• Deferment on cash necessary for closing

22


What is Market: ABA 2015 Private Target Deal

Study*

23

Includes Earn-Out

25%

No Earn-Out 75%

2012 Deals Includes

Earn-Out 38%

No Earn-Out 62%

2010 Deals

*Private Target Mergers & Acquisitions Deal Points Study (Including Transactions Completed in 2014): Study of publicly

available acquisition agreements for transactions completed through 2014 that involved private targets being acquired by

public companies.

2014 Deals Includes

Earn-

Out

26%

No Earn-

Out

74%


What is Market: ABA 2015 Private Target Deal

Study (continued)

24

Other 39%

Not Determi-

nable 10%

Revenue 19%

Earnings/ EBIDTA

39%

Combo 3%

Earn-Out Metrics

2014 Deals Includes

Earn-Out

26%

No Earn-

Out

74%


Houlihan Lokey 2015 Purchase Agreement Study*

25

*Houlihan Lokey Purchase Agreement Study for Transactions Completed in 2014 and Prior Years: Summarizes middle-

market change-of-control transactions in which Houlihan Lokey served as the financial advisor to either the buyer or the

seller. Study includes public and private transactions.

0%

5%

10%

15%

20%

25%

2010 2011 2012 2013 2014

Earn-Out Included

0%

5%

10%

15%

20%

25%

2010 2011 2012 2013 2014

Earn-Out as Median % of Purchase Price


Earn-Outs: The Nuts & Bolts

26


Earn-Outs: The Nuts & Bolts (continued)

• Agree on the targets

• Measure the targets

• Length of earn-out period

• Seller & buyer contractual

protections

27

http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=dy8ggIMdMqXnFM&tbnid=VoxbmnsAoy_UOM:&ved=0CAUQjRw&url=http://now-marketing-group.com/is-it-time-to-just-say-no/&ei=5VOBUpiiOKnlyQHYtIDYBA&psig=AFQjCNHBHS_KIaVvZPdKSGYNfZafJJhsdA&ust=1384293695235370


Earn-Out Target Examples

28

Financial Targets

EBIDTA

Revenue

Net Income

Net Equity

Earnings Per Share

Non-Financial Targets

Regulatory Approval

Minimum # of New Customers

Product Development Milestones

Number of Products Sold

Launch of a New Product


The Nuts & Bolts: Agree on the Targets

• Financial or non-financial

(or a combination)

• Targets must be:

• Objective and measurable

• Plainly defined

• Consistent with the character of the

target company

• Performance Metrics are tailored to

specific business in question—

creative approaches

• Customer retention

• Growth of customer backlog

29

http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=r-TDZm6GfeN-5M&tbnid=JvpKWyS6AFNJSM:&ved=0CAUQjRw&url=http://fineartamerica.com/featured/football-at-goal-line-on-football-field-elevated-view-thomas-northcut.html&ei=bFWBUpXxCsPmyQHvi4DoBA&psig=AFQjCNFEv-AP3qUlKqUpxq41BYDl31eLEg&ust=1384293993089427


2012 SRS Life Sciences M&A Study:

Earn-out Targets/Metrics*

30


The Nuts & Bolts: Measure the Targets

• Most earn-out disputes are a result of seller thinking buyer

manipulated measurement of target’s performance or disagreement

over calculations

• Heavily litigated type of earn-out dispute: disputes over post-closing

accounting methodologies

• Earn-out provision does not clearly define how earn-out thresholds are to

be calculated.

• Earn-out provision does not account for treatment of certain expenses and

revenues.

31


Practice Pointers: Measure the Targets

• Avoid these disputes through a detailed measurement plan of how

earn-outs are to be calculated

• Clearly identify accounting principles to be followed and how they are to be

applied

• Specify how specific expenses and revenues would impact the calculation

to the extent possible

• Identify the dispute resolution process

• In interpreting such provisions, Delaware courts will adhere to the

agreement’s plain language even if the outcome is “unfair” or results

in a windfall.

• Courts are highly unlikely to entertain an implied covenant of good

faith and fair dealing claim absent specific language

32


The Nuts & Bolts: Length of Earn-Out Period

• Periods range from about one to four years, depending on the target

chosen. Majority of targets end after three years.

33


ABA 2013 Private Target Deal Study: Earn-Out

Period

34

Not determinable

48 months

36 months

>24 to <36 months

24 months

>12 to <24 months

12 months

<12 months

Period of Earn-Out Subset: Deals with Earn-Outs*

6%

32%

0%

18%

3%

9%

12%

21%

*Percentages total 101% due to rounding.


The Nuts & Bolts: Seller & Buyer Protection

• Sellers seek protective covenants, i.e.

• Require target business to operate in the ordinary course of business

• Restrictions on disposing a portion of the target business

• Run business to maximize earn-out

• Good faith and fair dealing

• Information rights

• Additional protection if change in management (e.g., liquidated damages or

acceleration of payments)

• Note the potentially perverse earn-out incentives

35


ABA 2015 Private Target Deal Study: Covenants

36

Included 3%

(18% in deals in 2012)


Not Included

76%

Covenant to Run Business Consistent with Past Practice

Indeterminable

13% Included

0% (6% in deals

in 2012) (8% in deals

in 2010)

Not Included

90%

Covenant to Run Business to Maximize Earn-Out

Indeterminable

10%

Buyer’s Covenants as to Acquired Business

Subset: Deals with Earn-Outs


ABA 2013 Private Target Deal Study: Covenants

37

Included 18%



Not Included

76%

Covenant to Run Business Consistent with Past Practice

Indeterminable

6% Included 6%

(8% in deals in 2010) (10% in deals in

2008)

Not Included

88%

Covenant to Run Business to Maximize Earn-Out

Indeterminable

6%

Buyer’s Covenants as to Acquired Business

Subset: Deals with Earn-Outs



(continued)

• Heavily litigated type of earn-out dispute: Post-closing business

operations disputes

• Alleged operation of acquired business in manner aimed at minimizing

earn-out.

• Alleged failure to adequately invest in acquired business.

• Alleged failure to pursue opportunities that would have increased earn-out.

38



(continued)

• Lazard Technology Partners, LLC, v. Qinetiq North America

Operations LLC, April 23, 2015, Strine, L., 2015 WL 1880153

• Buyer agreed to pay $40 million up front and additional $40 million if

certain revenue targets achieved

• Earn-out provision provided that buyer was prohibited from “tak[ing]

any action to divert or defer [revenue] with the intent of reducing or

limiting the Earn-Out Payment.”

• Revenue target was not met, and seller sued alleging that buyer

violated implied covenant of good faith and fair dealing by failing to

take actions (such as signing of a reseller agreement) that would have

resulted in in an earn-out payment

.

39



(continued)

Lazard Technology Partners, LLC, v. Qinetiq North America Operations

LLC, (cont.)

• The Court of Chancery ruled that the covenant of good faith was

inapplicable because there was no “gap to be filled” in the merger

agreement, and that, even if there had been, it would be filled with an

implied term that also turned on the buyer’s intent, not with an implied

term that turned on some objective standard.

• Key factor: Negotiating history indicated that seller had attempted to

negotiate for a range of additional buyer affirmative post-closing

obligations, which buyer rejected. The only protection was an noted

on previous slide.

40



(continued)

Lazard Technology Partners, LLC, v. Qinetiq North America Operations

LLC, (cont.)

• The Delaware Supreme Court affirmed the lower court’s decision “that

the merger agreement meant what it said, which is that in order for

the buyer to breach the earn-out provision, it had to have acted with

the ‘intent of reducing or limiting the Earn-out Payment’ [and] that the

seller had not proven that any business decision of the buyer was

motivated [at least in part] by a desire to avoid an earn-out payment

• The Delaware Supreme Court also rejected the seller’s argument that

it could rely on the implied covenant of good faith and fair dealing to

avoid the burden to prove that the buyer intentionally violated the

earn-out provision.

41


Disputes Over Post-Closing Business Operations

Practice Pointers:

• Parties should steer clear of “aspirational” statements regarding the

post-closing conduct of the business and instead draft earn-out

provisions with specific guideposts

• “exclusively and actively” promote products of sold business

• act in “good faith” during earn-out period

• not “impede” ability of selling stockholders to achieve the earn-out

payments.

• Generally Delaware courts have enforced an agreement’s “plain

language” and have not been willing unlikely to come to the aid of a

sophisticated party that could have, but failed to, negotiate specific

contractual protections

42



(continued)

• Security for future earn-out

payments

• Security interest: Require

buyer to grant security

interest in target company

• Escrow: Require buyer to

put potential earn-out

payments in escrow

43

http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=c739lCZ_WQzwWM&tbnid=LifXzfqnNwY1SM:&ved=0CAUQjRw&url=http://icpurple.org/special-interests/money-bag-2/&ei=AFmBUqykFamEyAHFiYGABA&psig=AFQjCNEOKJn_fJhcirYzKcIqSmt-KPSHiw&ust=1384294972774625


Final Thoughts on Earn-Outs

• Recognize potential conflicting incentives

• Must agree on straightforward metrics to extent possible to avoid

future litigation and control perverse incentives

• Be specific re milestones, measuring methods

• Define clear set of responsibilities/contractual protections

• Difficult to enforce what is left unsaid

• To summarize, parties should be precise when defining the scope of

their respective obligations with respect to earn-out provisions. A

court will not imply a duty on the part of the buyer to maximize the

earn-out.

44


CLE CODE

72114


Update on Increased Use of Rep &

Warranty Insurance

©2016 Winston & Strawn LLP

• Market Trends*

• Product has matured since its introduction in 1998

• More competitive pricing

• More efficient process

• Growing acceptance by legal and investment banking community

• Statistics from a key US insurer (2013 vs. 2015) – Submissions up 235% (500+ in 2013 vs. 1700+ in 2015)

– Policies issued up 250%

– Premiums written up 300%

• Insurers are paying claims

• Encouraging even greater use

• Available in almost all industries (except for health care)

• Active insurers: AIG, AWAC, Ambridge, Beazley, Concord, Hartford,

Chubb/ACE, QBE, Maplepoint, Montpelier

*Statistics provided by Lockton’s Private Equity and Corporate Acquisitions Practice

Rep & Warranty Insurance – Current Trends


• Clean exit

• No concerns about significant indemnity claims

• Immediate dispersal of all sale proceeds

Advantages for Sellers


• Extend survival periods and caps beyond "market“

– Enables Buyers to design own indemnity package

• Supplemental protection to seller-friendly cap

• Protects key relationships, especially when sellers stay on as

management

• Ease collection concerns, especially when sellers are numerous

• Improved credit quality (AAA-rated insurance company vs. individual

seller)

• Can distinguish bid in an auction

Advantages for Buyers


Costs may be relatively insignificant when compared to deal value

• Typical premium is 3% - 4% of amount insured

– $30,000 to $40,000 per million

– Minimum premium may range from $150,000 to $250,000 (translates to a

minimum insured amount of about $3,750,000)

• Typical coverage amount is 10% of deal value

• Negotiated between Buyer and Seller

• Party paying the premium not necessarily the insured

• Both parties typically benefit, so premiums may be split

• In addition to premium, insurance carrier may charge an

underwriting fee to cover due diligence and other legal costs

(range of $25,000 to $45,000)

Either Seller or Buyer May Purchase


• Seller-side policies:

– Seller-side policies can "back stop" indemnification provisions

negotiated between buyer and seller

• For example, sellers can insure significant escrow amounts in

exchange for higher purchase prices

– Seller-side policies can mitigate effects of joint and several

liability across numerous sellers

• Buyer-side policies:

– Insurance policy "stands in shoes" of seller for purposes of

indemnity claims

– Buyer-side policies far more prevalent (over 90%)

Seller-side vs. Buyer-side


• Premiums: 3% to 4% of coverage amount.

• Coverage Amount: Commonly 10% of deal size.

• Retention:

– Underwriters want sellers to bear some risk to create incentive

for sellers to negotiate reps

– Underwriters usually ask for 1.5% to 2%

– Possible to obtain policies with no seller retention but pricing and

other terms may be worse

• Policy Period:

– Seller-side: Mirrors the survival terms in the acquisition

agreement—six-year maximum.

– Buyer-side: Up to six-year term is available.

Key Terms


Common Exclusions and Conditions

• Common Policy Exclusions

– “Actual knowledge” of breach

– Fraud of insured

– Fines and penalties (uninsurable by law)

– Asbestos

– Environmental (varies by industry/target/

carrier)

– Underfunded pension liabilities

– Medicare/Medicaid exclusions

– Purchase price or working capital

adjustments

– Specific reserves on financial statements

– Forward-looking statements

– Consequential and “valuation” damages

(e.g., multiple of EBITDA) previously

excluded but now can be covered

• Common Policy

Conditions

– Defense expenses included

as covered cost/within

definition of loss

– Subrogation against seller

limited to fraud

– Policy assignable with

consent

– Buyer’s knowledge limited to

deal team members


• Carefully consider and negotiate your insurance policy just as you

would negotiate an indemnification provision in a purchase

agreement

• Beware of succumbing to insurer's "form"

• Indemnification provisions in purchase agreement have to be

negotiated side-by-side with insurance policy

– Consider those areas that are likely to be excluded from the policy

– Negotiate earlier in the process for greater indemnification of such excluded items

– Can also seek alternative risk transfer vehicle (tax, environmental, other

contingent liability policy).

• “Actual Knowledge” Exclusion

– R&W policies exclude matters of which the buyer has "actual knowledge" (akin to

an "anti-sandbagging" provision in a purchase agreement).

– If buyer’s due diligence has uncovered a matter that would constitute a breach of

the reps and warranties and the seller has not disclosed it, we recommend

addressing the issue with the seller prior to signing (either via purchase price

reduction, specific indemnity or other method).

Key Takeaways


• In a competitive auction, sellers should consider signaling from the

outset that they intend to provide only limited indemnification,

effectively incenting the buyers – early in the process – to purchase a

R&W policy or, in the absence of one, be aware that other bidders

may be doing so.

• While private equity funds are purchasing these policies more

frequently (as buyers to better position bids and as sellers to provide

for more certainty on the return on investment), strategic buyers are

now more actively considering these policies.

• While R&W policies can be bound in a matter of days, an insured will

be in a better position to negotiate the terms of a policy more

favorable to the insured if it provides the underwriter with more time

(preferably 2-3 weeks or more)

Key Takeaways (continued)


• While the insured under a R&W policy has the backing of a AAA

rated credit, the insurance company will expect proof of breach and

loss, and to the extent that their interpretation of the amount of loss

differs from the insured’s, there may be some negotiation as to the

quantum of loss actually paid.

• Negotiation process is becoming more efficient

• There are many benefits but one must consider costs/challenges.

Key Takeaways (continued)


Fraud Issues in Mergers:

FdG Logistics LLC v. A&R Logistics

Holdings, Inc.


Background

• Action arises out of a transaction involving acquisition of trucking

company A&R Logistics Holdings, Inc. (the “Company”) by a

subsidiary of private equity buyer Mason Wells (“Buyer”).

• FdG Logistics LLC (“FdG”) held approximately 63% of the Company’s

stock and the Company’s founder, James Bedeker, held

approximately 19% of the Company’s stock.

• On December 18, 2012, Buyer and the Company entered into the

merger agreement (“Agreement”).

• FdG and Bedeker were also parties to the Agreement and FdG acted

as the selling shareholders’ representative.

58


The Alleged Fraud

• Buyer asserted that numerous “illegal and improper” activities took place and

that these were concealed from Buyer during Buyer’s due diligence

investigation of the Company, including:

• Concealing violations of environmental laws relating to wastewater discharge;

• Concealing over $2 million in necessary repair costs to facilities; and

• Manipulating truck drivers’ logs and falsifying truck maintenance costs.

• Buyer made four claims against the selling shareholders:

• One claim for indemnification for alleged inaccuracies in and breaches of a number

of representations and warranties;

• Claims for common law fraud and fraud under the Delaware Securities Act based in

part on documents provided to Buyer during due diligence; and

• One claim for rescission based on Buyer’s unilateral mistake.

• The selling shareholders moved to dismiss the common law fraud claim,

arguing that Buyer was incapable of demonstrating it relied on any extra-

contractual representations in any of the diligence materials.

• The selling shareholders also moved to dismiss the state statutory fraud and

rescission claims.

59


The Agreement: Disclaimer & Integration Clauses

• Disclaimer:

• Section 5.27 of the Agreement contained the following representation by the Company:

• “Except as expressly set forth in this Article 5, the Company makes no representation or

warranty, expressed or implied, at law or in equity and any such other representations or

warranties are hereby expressly disclaimed including any implied representation or warranty

as to condition, merchantability, suitability or fitness for a particular purpose. Notwithstanding

anything to the contrary, (A) the Company shall not be deemed to make to Buyer any

representation or warranty other than as expressly made by the Company in this agreement

and (B) the Company makes no representation or warranty to Buyer with respect to (i) any

projections, estimates or budgets heretofore delivered to or made available to Buyer or its

counsel, accountants or advisors of future revenues, expenses or expenditures or future

financial results of operations of the Company unless also expressly included in the

representations and warranties contained in this Article 5, or (ii) except as expressly covered

by a representation and warranty contained in this Article 5, any other information nor

documents (financial or otherwise) made available to Buyer or its counsel, accountants or

advisors with respect to the Company.”

• Integration Clause:

• Section 10.7 of the Agreement contained the following standard integration clause:

• “This Agreement, the Transaction Documents and the documents referred to herein and

therein contain the entire agreement between the Parties and supersede any prior

understandings, agreements or representations by or between the Parties, written or oral,

which may have related to the subject matter hereof in any way.”

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Legal Analysis: Fraud Under Common Law

• The court applied the standard in Abry Partners V, L.P. v. F&W

Acquisitions LLC:

• The court noted that representations and warranties without an affirmative

statement by Buyer disclaiming reliance on the extra-contractual

statements are inadequate to operate as a disclaimer of potential fraud

claims.

• The court also found that a standard integration clause that does not state

a party’s non-reliance on statements outside of the four corners of the

agreement at issue is ineffective to disclaim such non-reliance.

• Sections 5.27 and 10.7 of the Agreement thus lacked any statement of

what Buyer was relying on at the time it entered into the Agreement or of

Buyer’s non-reliance on any representations or warranties made outside of

the Agreement.

61


Legal Analysis: Fraud Under Common Law

(continued)

• Under Abry, Buyer’s allegations would only be barred if Buyer had

clearly disclaimed reliance on the fraudulent, extra-contractual

statements.

• The Company needed two things:

• To include a disclaimer in Article 5 that established Buyer’s reliance on only that

information provided, represented and warranted by the Company in the

Agreement; and

• To include a clear expression by Buyer disclaiming its reliance on any extra-

contractual statements.

• Thus, because Buyer never defined what information it relied on in

executing the Agreement and never effectively disclaimed reliance on

other materials, the court held that Buyer’s fraud claim must not be

dismissed.

62


Legal Analysis: Delaware Securities Act and

Rescission Claims

• The selling shareholders argued that the merger lacked any nexus to

Delaware to trigger the application of the Delaware Securities Act (the

state securities or “blue sky” law).

• The court agreed, finding that:

• The legislative intent of the Act was to prevent intrastate securities fraud, not

interstate securities fraud.

• There is a presumption that a state law is “not intended to apply outside the

territorial jurisdiction of the State in which it is enacted.”

• The mere fact that an entity is incorporated in Delaware does not create a nexus

to the state that evokes the policy rationale of intrastate fraud prevention.

• Thus, since the merger did not take place in Delaware, the proxy solicitation did

not occur in Delaware and the negotiations did not take place in Delaware, the

court held that the Act would not be triggered.

• The court also tossed Buyer’s rescission claims.

• Remedy was held to be impractical three years after the deal closed.

63


Practical Impact of the Court’s Decision

• Non-reliance clauses are ineffective if they are not drafted as an

affirmative statement made by the buyer.

• Standard disclaimers of representations by sellers and standard

integration clauses alone will not suffice to prevent fraud claims by

buyers based on representations made outside of the relevant

transaction agreement.

• No “magic words” are needed in effective non-reliance provisions but

must be from the point of view of the right party.

64


Rise of Aiding and Abetting Liability for

Financial Advisers

66

"Aiding and abetting" liability of financial advisors

• Major development under Delaware law

• Concept well-known in criminal law

• Now being applied to investment bankers in M&A transactions:

• Breach of fiduciary duty owed by target board to shareholders

• Plus knowing participation by advisor in the breach

• Can result in the liability of the banker to the shareholders

• Can result in significant monetary liability for financial advisors…

• Rural/Metro imposed liability of $75.8 million on RBC

• Barclay's paid $23.7 million in Del Monte

• …even in cases where the target board escapes liability because Section 102(b)(7)

charter provisions

• Leaves bankers with primary monetary liability to shareholders

• Has become frequent allegation; in 12 months ended September 2015, 14 cases brought against

bankers for giving tainted M&A advice

• Defendants have included the "Who's Who" of Wall Street

67

Theory of the Cases

• Cases basically provide that boards of directors breach their fiduciary

duties of "care" when negotiating with bidder unaware of significant

relationships between their advisors and the bidder.

• Plaintiffs argue that, because the boards are relying on the advice of bankers

with conflicts, the boards themselves become conflicted unless they know

about the conflict and take it into account when assessing the bankers'

advice.

• Courts have suggested that boards have duty to know of "conflicts" and

that their advisers "aid and abet" their breach by not telling the boards of

their "conflicts"

68

Actions giving rise to claims of aiding and abetting

• Failure of advisor to disclose prior or existing banking relationships between

advisor and bidder (Dole Foods; PLX)

• Advisor assisting bidder with financing for bid, especially without prior board

approval (Del Monte)

• Advisor "pitching" bidders before being hired by target, especially as to deal

under consideration (Zale)

• Participation by bankers with connections to bidder on committee approving

fairness opinion to target (PLX)

• Efforts by advisor to role as advisor to target board to "leverage" relationship

with bidder to win other deals (Rural/Metro)

• Note that these cases involved allegations courts felt were potentially

meritorious, not findings of liability

69

Takeaways

• Target boards should ask advisors about relationships with prospective bidders

early in process

• Advisors should report possible issues to target boards as early in process as

possible

• Timing is key

• Waiting until right before delivering fairness opinion can be problematic

• Other factors include:

• Who identified conflict and when?

• Whether – and when – second "cleansing" advisor retained

• Extent to which board understood how conflict might affect process

• How extensively was deal "shopped" before signing?

• Appearances can have exaggerated consequences

• Jocular emails often surface and create problems for bankers and boards

• Courts' analysis can readily be extended to their legal counsel


Investor Activism Update



• 2015 Shareholder Activist Campaigns Launched—highest number on record

• 2015: 507

• 2014: 292

• 2012: 396 (prior all time high)

• 3.6% increase 2014 to 2015

• 28% increase 2012 (prior all time high) to 2015

• 2015 High Market Cap of Targeted Companies

• 15 Mega Cap deals v. 9 in 2014 (in excess of $25 billion market cap)

• GE

• Chevron

• American International Group

• Mondelez International

• Qualcomm

• Dow Chemical

• GM

Source: Thomson Reuters

71



Global Campaign Status 2015

Settled 42.9%

Dissident Victory 24.8%

Withdrawn 14.9%

Management Victory 13.7%

Dissident Partial Victory 3.7%

Global Campaign Demands 2015

Seek Alternatives 44.9%

Board Rep 26.3%

Board Control 6.9%

Force Sale Spinoff Strategic Direction Oppose Sale/Say on Pay

Source: Thomson Reuters



Proxy Contests

• In 2015, 105 proxy contests

• Only includes fights where dissident filed proxy materials or provided public notice of an intent

to solicit proxies

• Including companies where changes or agreements were reached prior to any public filings,

127 campaigns resulted in at least one board seat for the activist

• Of 197 proxy fights in 2014 and 2015, only 32% resulted in a shareholder vote

• ISS and Glass Lewis support activists in most campaigns by supporting some or all

of a dissident’s nominees

73

Source: SharkRepellent.net



• Assets Under Management ($bn)

• 2015: $121.9

• 2013: $ 93.1

• 2011: $ 50.9

• 2009: $ 36.2

• Returns Delivered by Activist Investors

• 2007 through June 2014: +300% v. +38% for S&P 500

• June 2014 through February 2016: (38%) v. (2%)

• Significant underperformance since June 2014

Source: Citibank, Bloomberg

74



• Leads to Question: Has Shareholder Activism Peaked? • From Q2 to Q3 2015 – $7.8bn outflow of funds from Activist funds to investors

• 7 years prior to Q3 2015, activist funds saw steady increases of assets under

management

• “Shorting Shareholder Activism,” Bloomberg Article, January 13, 2016

• Shareholder activism as an investment strategy "absolutely has peaked and I would

short the class completely," – Rob Kindler, Global Head of M&A, Morgan Stanley

• More difficult to find unique targets

• Significant declines in investor returns

• However this question is ultimately answered, activist investors are here to

stay and will remain a significant force in the marketplace

Source: Citibank, Bloomberg

75



• Increased Financial Ability – Noted above

• Increased Sophistication

• More nuanced approach to activism not focused solely on short-term gains

• Investment periods can run three years or longer

• Support from Traditional Equity Investors

• Traditional investors view activists as bringing value to investors

• 76% of institutional investors viewed shareholder activism as positive in a 2014

survey

• Increase in Media Attention

• Activists have successfully used the media as a tool to effect change

• Larger Companies More Vulnerable

• Larger companies have become more exposed as a result of governance initiatives

such as elimination of classified boards and shareholder rights plans

• Note list of large companies noted above

76


Shareholder Activist Target Analysis

What could make a target attractive – i.e. what catches an

activist's attention?

• Operational Issues

• Reduced earnings, lowered/missed forecasts leading to reduced stock price

• Underperformance when compared to peers

• Balance Sheet Characteristics

• Significant excess cash

• Strong balance sheet with opportunity for additional leverage

• Perceived unlocked value

• Announcement of Fundamental Transaction

• Potentially unfavorable deal economics

• Failure to run robust deal process

• Other available fundamental transaction alternatives

77


Shareholder Activist Target Analysis

What could make a target attractive – i.e. what catches an

activist's attention? (cont.)

• Legal/Governance

• Significant government investigations/potential scandals or management’s

questionable legal judgment

• Disclosure issues

• Accounting issues

• Significant litigation not tied to fundamental business characteristics

• Shareholder Relations

• Lack of strong relationships with shareholder base

• Lack of consistent shareholder engagement

78


Investor Activist Objectives

• Focus on strategic initiatives as a way to increase stock price and liquidity

• Merger with competitor

• Sale of company

• Spin-offs

• Divestitures of underperforming assets or non-core operations

• Stock buybacks

• Increased cash dividend or extraordinary one-time dividend (usually involves

increased leverage)

• Management changes or other operational changes

• Proxy contests

• Stop pending or proposed strategic transaction

• Governance changes (i.e. elimination or reduction of structural defenses

and/or increase in shareholder rights)

79


Investor Activist Strategies/Tactics

• Not all activist campaigns are hostile – could lead to constructive dialogue to

benefit all shareholders

• Objectives vary across different activist campaigns – public v. private

strategies

• Proxy Contests

• Board Seats

• Settlement Agreements

80


Investor Activism: Company Preparation and

Action Items

• Stock watch programs

• Program to monitor trading patterns in company shares

• Monitor ownership reports filed with the SEC

• Generally watch activists that play in industry or sector

• Monitor early warning signs

• Be on the lookout for small gestures – letters to management, attendance on an

earnings call, etc.

• These can serve as warning signs in advance of an SEC filing that will garner more

attention

81



Action Items (cont.)

• Shareholder outreach and communications plan

• Ongoing communications with significant shareholders to tell the company’s story

• Always articulate the value proposition

• Provide feedback from shareholders and built relationships in the event an activist

emerges

• Develop a plan to reach out to smaller investors and the analyst community

• Be aware of Regulation FD compliance

• Company responses to activists can be won with the success of a communications

and investor relations plan

• Clear and Consistent Communications Strategy

82



Action Items (cont.)

• Board of Directors and Senior Management

• As a matter of ordinary practice Board should regularly review business

opportunities/challenges

• Continued focus on value enhancement strategies

• Focus on relationship between governance, executive compensation and activism

• Continued focus on board composition

• Regular update on communications with shareholders and related issues raised by

shareholders

• Address shareholder demands for information and transparency

• Have a response strategy and team in place in the event an activist comes

calling

• Above all the Board of Directors and Senior Management should consistently

focus on shareholder value creation

83


Decline of Disclosure Only Settlements –

Trulia and Other Cases

85

• Until September 2015, the following situation prevailed in virtually every M&A

transaction involving a public company:

• Merger agreement signed

• Litigation attacking deal commenced almost immediately thereunder

• Settlement reached in which:

• Companies involved agreed to often immaterial additional disclosures

• Agreed to pay plaintiff's lawyers fairly modest fee (e.g., $500,000) given stakes involved

• Companies, boards of directors and advisors received "global release" from all claims, whether

known or not, which could have precluded investigation or real wrongdoing

• Delaware court approved the settlement; court approval required under Delaware rules

• Generally agreed to be a win for bidder, target board of directors, advisers and plaintiff's

lawyer

• In short, for all parties except shareholders

• For $500,000 fee, all deal participants received blanket global release of all claims, known and

unknown

Sudden Decline of "Disclosure Only" Settlements

86

Sudden Decline of "Disclosure Only" Settlements

• Beginning in September 2015, some judges in Delaware began to

question whether these settlements worked for the shareholders of the

acquired company

• In exchange of additional disclosure that was often mundane, obvious

and immaterial…

• …shareholders gave up right to sue bidder, target companies and

advisors for any claim, even if material and unknown

• Inquiry into what might have happened was stopped

• Payment of modest attorneys' fees were cynically viewed as a form of

"deal tax"

87

Key Case: Riverbed Technology

• Decided September 17, 2015

• Vice Chancellor Glasscock approved "disclosure only" settlement but

expressed concern about practice

• Rejected the plaintiffs' counsel's fee request of $500,000, saying the

benefits of the settlement were "too modest" to justify such an award

• Reduced fee to $300,000

88

Key Case: In re Trulia

• Decided January 22, 2016

• Zillow agreed to acquire Trulia in July 2014

• Four cases filed

• Parties settled for making of additional disclosures and a global release

• Court noted minimal discovery prior to settlement

• Court found that none of four supplemental disclosures "were even

material or even helpful to Trulia's shareholders"

• Rejected the settlement, noting that what the shareholders "got" in the

form of supplemental disclosures didn't match what they "gave up" of the

release

89

• In 2014, lawsuits brought in 94.9% of completed takeovers

• And in 2015, in 87.7% of completed takeovers

• But, dropped to only 21.4% in fourth quarter of 2015

• Checked with our first class Delaware litigation group

• Fair to say developments may reduce Delaware cases

• Plaintiffs may try to avoid Delaware by bringing cases in other states,

where company is headquartered

• But other states often follow Delaware

• Investors may now have incentive to urge companies to adopt a forum

selection bylaw to increase chance that litigation will occur in Delaware

• Settlements based on plainly material disclosures should still be

approved

World may be changing…

90

CLE CODE

72114


Questions?

Oscar David Partner

+1 (312) 558-5745

[email protected]

91

Robert Rawn Partner

+1 (212) 294-6721

[email protected]

Richard Falek Partner

+1 (212) 294-3314

[email protected]

Jim Junewicz Partner

CHI: +1 (312) 558-5257

NY: +1 (212) 294-6700

[email protected]


Thank You

Attorney advertising materials – © 2015 Winston & Strawn LLP

By Eva Davis, Chair, West Coast Private Equity, Winston & Strawn LLP C. James Levin, Chair, Los Angeles M&A, Winston & Strawn LLP

Today’s M&A market is fueled by readily available acquisition financing on favorable terms, the largest “overhang” of private equity dry powder in US history, and excess cash on the balance sheets of US strategics. With these conditions, sellers of businesses currently are enjoying a very healthy and long-running “sellers’ market” with frequent auctions, multiple offers and high valuations. What can a buyer do to distinguish its bid in an auction to become the winning bidder? This second installment of our two-part article provides insights on the middle market private company M&A process (for sales of target companies with under $1.0 billion of enterprise value) and recommendations of how a buyer can improve results in an auction, including tips for a financial buyer (private equity fund) and a strategic buyer (operating company).

The first installment – “Maximizing Results in an Auction: A Map to Sell-Side Success” -- focused on the recommended steps a seller should take to obtain the best deal terms, including the highest possible price. That article can be found here [link or name/tie back to earlier article.]

For Buyers, Price Can Be (But Isn’t Always) The Most Important Term

While price may be all that matters for some sellers, there are other important deal terms that a savvy buyer can offer to position itself to be the winning bidder. Buyers should follow these eight (8) recommended steps from the outset of any auction process and through deal consummation in order to distinguish itself from the pack.

1. Put Yourself in a Position to Move Quickly.A buyer’s full M&A team should be on board from the outset, including internal deal professionals at the fund or company and any required external experts in areas such

as accounting, legal, environmental, insurance, consumer product/customer research, real estate, human resources, etc. The deal team should have access to any marketing materials regarding the transaction, the due diligence dataroom and any other available target or industry reports. Early access by the full buy-side team puts any bidder in a position to move quickly should it need to do so. Spending out-of-pocket money on external advisors also demonstrates to the seller that a bidder is serious. Front loading the due diligence process further signals to the seller that a bidder can do the deal on the proposed deal terms because that bidder is fully informed with all intelligence to provide its best offer, thereby giving the seller the confidence to select that bidder as a buyer with less risk that it will later demand a purchase price reduction when further information is learned. In the current sellers’ market, the failure of a buyer to incur costs early (both time and out-of-pocket) and in a material way can be fatal.

2. Seek the Right Information in Courteous Manner.

Not all sellers take the steps outlined in our first installment to fully inform all bidders of all diligence information related to the target. As a result, many bidders provide follow-on (and often multiple follow-on) due diligence requests in writing and through management due diligence meetings and conference calls. In a multi-bidder process, these follow-on requests can be extremely taxing on any seller, particularly those with lean teams or who have never been through a sell-side process, and, for some sellers, can appear to be nit-picking and overreaching. Some or all of the management team that is providing the due diligence responses to each bidder may be the same (or substantially the same) management team that will end up working for the buyer after the deal. Whether conscious or not, a bidder who is not “easy to work with” may not get the full information it is seeking, may get it in a piece-meal fashion or may get it late in the process. In a competitive process where buyer timing and responsiveness can be critical, “making nice” with the seller and management can go a long way.

Bidding Wars: How To Position Your Fund or Your Company to Win the Deal

© 2015 Winston & Strawn LLP 2

3. Meet Deadlines Early and Often.Meeting and exceeding seller-imposed timelines can be critical. Throughout an auction process, a bidder needs to position itself as serious and credible, and can do so in a meaningful way if it meets or surpasses seller’s timing requirements. At a minimum, lagging behind can mean that a potential buyer doesn’t get the full information it needs to prepare a well-informed bid and, at worse, can cause a seller to drop it from a multi-bidder process. Exceeding deadlines, such as turning in an early bid with full pricing and deal terms, can provide a bidder with the opportunity to provide a “pre-emptive” offer (essentially a “take-it-or-leave it” offer that expires before the bid deadline). “Pre-emptive” offers have been the trademark of certain private equity funds to position the fund to be the winning bidder before other bidders even submit their bids. Strategic buyers have also begun to pursue this same strategy with some success.

4. Minimize Closing Conditions. In a competitive process, a seller will pursue all avenues to guarantee that the buyer it selects as the winning bidder will close the deal quickly and on the offered terms. A bidder who positions itself to provide deal certainty and speed will have a leg-up in any process. For example, a bidder who is willing to make a required Hart-Scott-Rodino filing “early” (essentially off of a letter of intent rather than a later signed deal) and pay for the entirety of the filing fee can gain an advantage. In addition, a buyer who is willing to forgo all required third party consents or be the party solely responsible for obtaining such consents (e.g,, under supplier or customer contracts or from landlords), can also differentiate its bid. Further, a bidder who assumes meaningful deal risk between signing and closing, for example, by providing weakened or no “Material Adverse Change” closing conditions can also distinguish itself (e.g., the buyer assumes the risk of material changes in all or certain aspects of the target’s business, including changes in industry or changes in laws, or allows seller to update disclosure schedules between signing and with little to no consequence). Even strategic buyers in the same industry have been more willing to agree to “come hell or high water” clauses in antitrust area (where they would be forced to divest any asset that creates an antitrust issue). Many of these seller-favorable deal terms that historically were offered by private equity fund buyers seeking to distinguish their bids and demonstrate with certainty the

ability to close quickly are now being offered with more frequency by strategic buyers, and are being offered by buyers only after the completion of a fulsome due diligence process that allows the buyer to minimize the closing conditions with greater confidence.

Not surprisingly, in the current sellers’ market, financing contingencies are virtually unseen. Historically, many strategic buyers who could access cash on their balance sheets or draw on available lines of credit had an advantage over private equity buyers who relied on third party debt financing to pay a portion, and sometimes a meaningful portion, of the purchase price and who accordingly included debt financing contingencies in the definitive deal documents. More recently due to market conditions, many private equity funds have positioned themselves to provide the full cash purchase price for a target business without needing to access new third party debt – essentially, the full purchase price can be sourced directly from its fund limited partners, from pre-existing lines of credit maintained by the fund or through reliable equity co-investors. The private equity fund may then choose to refinance that purchase price with debt at a later date following the deal closing. Those private equity funds whose fund partnership documents limit their ability to draw the full purchase price from their limited partners (for example, because the full equity investment in the target at closing exceeds the maximum amount that can be funded for a single portfolio company investment) will customarily structure a transaction with a concurrent signing of the definitive deal documents and closing of the transaction to minimize the risk that a failed debt financing will derail the deal – or alternatively, will simply take on the financing risk entirely given the current favorable debt financing markets.

5. Consider European-Style “Locked Box” Approach with No Purchase Price Adjustment.

Sellers like certainty of proceeds. In Europe, especially the United Kingdom, deals are often done with a fixed cash purchase price with no post-closing purchase price adjustments. Typically, in US deals, the buyer buys the target on a “cash-free, debt-free” basis with an agreed-upon level of working capital and with sellers’ transactions expenses having been paid fully by seller. As such, the agreed-to purchase price in a US purchase agreement is generally subject to upward and downward adjustments


post-closing based on the actual levels of working capital, cash, debt and unpaid sellers’ transaction expenses at closing. In the UK and more recently in a minority of US transactions, there is an increasing prevalence by sellers (particularly private equity or private equity-backed sellers) to use what is known as a “locked box” purchase price approach. Under this approach, an equity price will be calculated using a recent set of accounts and balance sheet date in respect of which the buyer will have no ability to adjust after closing. The buyer will then rely on contractual protection to ensure that “leakage” from the “locked box” (basically no material cash or assets “out” and no material liabilities “in”) between the referenced balance sheet date and closing date. Absent the purchase agreement prescribing a different remedy, if such leakage takes place, then the buyer would have a right of claim against the sellers for breach of contract. Just as certainty of closing can be an important deal term to offer a seller, a buyer who is willing to offer a fixed cash price deal with no post-closing purchase price adjustments may be viewed more favorably by a seller in a competitive process.

6. Reduce Indemnification Obligations and Escrows; Obtain Representation and Warranty Insurance.

With or without the knowledge of seller, a buyer can choose to strategically use representation and warranty insurance (RWI) in order to distinguish its bid in a competitive auction. RWI protects the buyer, as the insured, from unanticipated and unknown losses that arise subsequent to the closing of an M&A transaction from breaches of a seller’s representations and warranties in the definitive purchase agreement. With the comfort that RWI insurance can be secured to mitigate the risk of seller’s breaches of representations and warranties for agreed-upon time periods, coverage amounts, retention amounts (deductibles) and other negotiated terms, the buyer is then well positioned to seek indemnification from a seller only on extremely limited terms (e.g., modest survival periods, liability caps and escrow amounts). The buyer also has the added benefit of obtaining deal protection from a more financially viable entity (a AAA rated insurance carrier).

Initially used as a strategic buy-side tool by private equity funds, more strategic buyers are currently utilizing RWI to provide the best deal terms to a seller. When used, the retention amount under the RWI for

breaches of representations (during the survival period for those same representations under the purchase and sale contract) is often the sum of the indemnification deductible and indemnification cap provided by the seller for those representations. For example, if the operational representations survive 15 months and a seller’s indemnification deductible is 0.75% of purchase price and seller’s indemnification obligation for breaches of those representations is capped at 3% of the purchase price, a buyer will often only seek insurance coverage for losses in excess of 3.75% of the purchase price during that 15-month period and potentially reducing that retention amount following the 15-month period when the buyer no longer has indemnification protection from the seller. Using this same example, the buyer may be willing to reduce the escrow to 3.75% of purchase price, and some buyers are willing to go even lower than this escrow amount (typically, so long as RWI will cover exposure in excess of the low escrow amount).

7. Advance Attractive Management Rollover Investment Terms and Incentive Plans.

Private equity funds have long provided the opportunity for founders and other existing owners of a target business to maintain a portion of their investment in the target after the private equity fund’s initial purchase of the business. This “rollover investment” allows some or all of the sellers to enjoy a “second bite at the apple” (hopefully at an even higher valuation) when the private equity fund exits its investment in the target in the future. Many private equity funds are increasingly allowing this “rollover” investment to be on the exact same economics as the fund (so that incentives of all post-deal owners are aligned completely, including dollars paid per share on an exit). Moreover, in order to entice management (who may not also be a seller of the business) to “back” a particular private equity fund (including providing easy access to information during the sales process, readily available responses to diligence requests, and sit-downs to go over future strategy and business plans) , many financial sponsors will offer attractive management equity incentive terms (agreed in advance prior to closing) that allow management to share in the upside of the business at the time of the private equity fund’s future exit from that business. As these “goodies” are offered to founders, sellers and management with more frequency and earlier in the process, some strategic buyers have become


more flexible in putting together management incentive packages (cash or equity) for key sell-side deal team members who will continue on with the business in order for the strategic buyer to remain competitive in the auction process (or at least maintain the active attention of the sell-side management team in that process).

8. Offer Meaningful Intangibles.Target businesses are run by people and sold by people, so the “soft stuff” that a buyer provides throughout the sales process can matter. Management should be “wooed” and treated with respect. Senior management from the buyer should meet in person with the sellers and its management; cell phones, computers and hand-held devices should be turned off during meetings; the buyers should learn the key players at the seller and target and match-up personalities with the buy-side team. The buyer should demonstrate that it “gets it” – so, the most senior team members at the buyer who understand the target’s business, industry and associated risks should be actively involved in the process and provide significant “face time” to the sellers and target management. The buyer should offer in-house operational expertise that lines up with the target’s business and industry and should identify a convincing go forward business strategy that stands out -- this may, for example, include attractive planned acquisition or expansion strategy. A private equity fund or strategic buyer may have opportunities unique to it that it can offer – for example, synergistic opportunities to partner with a portfolio company or limited partner at a private equity fund or customers, suppliers, licensors or research and development professionals at a strategic buyer. Finally, many sellers are also concerned with their long-term reputation and legacy – a buyer that can demonstrate a track record of success with acquired businesses may have a further leg-up in the process.

Conclusion

In today’s M&A market, fierce competition among potential buyers to successfully land a good target company is the new normal. Whether as a private equity fund or a strategic acquirer, bidders must search for ways to stand out from the crowd. And, while price may be all that matters to a seller, often other terms or bidders’ actions can affect the outcome of a competitive process. Bidders who get their team up to speed early and are prompt and targeted in tracking down the information needed to prepare their bid with confidence, will position themselves to meet, or even accelerate, the seller-imposed timelines that drive the process. Only if a bidder has demonstrated to the seller that it has done the necessary up front diligence work to be well advanced towards a definitive transaction will that bidder be able to submit a convincing pre-emptive offer.

In their efforts to offer attractive terms, bidders increasingly are acting early in the process to line-up RWI to better position their bid through improved indemnification and holdback terms. Sellers value certainty, and often judge a bid on the minimum proceeds that the bid delivers. A bid that the seller knows will yield not less than 97-98% of the total price looks attractive when compared to a slightly higher bid that leaves 5% - 10% of the proceeds at risk for later claims. RWI bidders get the benefit of minimum proceeds certainty. This same holds true for the bidder willing to minimize or eliminate post-closing purchase price adjustments.

Bidders who are looking for a leg up on competitors also never forget that each seller arrives at a deal with its own imperatives. In some cases, that may be a desire to stay meaningfully invested or involved, or to “take care of” a valued management team. In others, it may be an ability to manage key customer relationships, or to continue a legacy. In each case, senior team members need to communicate to the seller that the seller’s concerns are understood and are properly addressed.

Whether any of these suggestions will trump a higher price is almost always unknowable. But, without them, price is your only hope—and how much greener is your money than the next guy’s?


About Winston & Strawn

Winston & Strawn’s private equity practice is one of the broadest and most active national middle-market practices in the U.S., providing strategic advice and legal counsel to middle-market private equity funds, hedge funds, family offices, real estate funds, alternative asset managers, portfolio companies, and institutional investors.

Authors

Eva DavisPartner, Winston & Strawn LLP+1 (213) [email protected]

Eva Davis is a Partner and the Chair of West Coast Private Equity at Winston & Strawn. For over 20 years, Ms. Davis has counseled clients in M&A transactions, debt and equity financing transactions, and distressed sales and investments.

James LevinPartner, Winston & Strawn LLP+1 (213) [email protected]

James Levin is a Partner in the Los Angeles office of Winston & Strawn. His practice focuses on M&A, securities offerings, and other corporate transactions. He also advises boards of directors on corporate governance matters.

Attorney advertising materials – © 2015 Winston & Strawn LLP

By Eva Davis, Chair, West Coast Private Equity, Winston & Strawn LLP C. James Levin, Chair, Los Angeles M&A, Winston & Strawn LLP

Today’s M&A market is fueled by readily available acquisition financing on favorable terms, the largest “overhang” of private equity dry powder in US history, and excess cash on the balance sheets of US strategics. With these conditions, how can a seller of a business maximize the target’s value and enhance certainty to a quick closing in an auction process? What can a buyer do to distinguish its bid in that process to become the winning bidder? This two-part article will provide insights on the middle market private company M&A process (for sales of target companies with under $1.0 billion of enterprise value) and provide recommendations of how to improve results in an auction. This first installment focuses on the seller. The second installment will address the recommended steps for a buyer, including tips for a financial buyer (private equity fund) and a strategic buyer (operating company).

For Sellers, Preparation and Credibility Are Key

While sellers of businesses are currently enjoying a very healthy and long-running “sellers’ market” with frequent auctions, multiple offers and high valuations, a seller must do the work necessary to obtain the best deal terms, including the highest possible price. Detailed and thorough preparation with consistent, credible information is key. Sellers should follow these seven (7) recommended steps before any potential buyer is brought into the process (and should continue to support those steps by providing reliable and supportable information throughout the process).

Select the Right Investment Bank.Despite (or perhaps because of) the break-up of a number of the larger investment banks or investment banking arms at the larger commercial banks, the number of “middle

market” investment banks and single shingle brokers is as numerous as ever before. With a multitude of sell-side bankers from which to choose, many of whom have similar websites and pitch materials, how does a seller select the right investment bank to guide it through a sales process?

A sales process is a team effort, and the seller should interview the full investment banking team to understand each person’s role and what he or she delivers. Through those interviews, the seller should develop a clear understanding of each team member’s experience, his or her knowledge of the client’s business and industry, the key metrics that will determine the target’s valuation, the likely challenges in the sales process that the investment banking team foresees based on the client’s business or industry, a range of the valuation of the business and the underlying assumptions that support that valuation, and a commitment from all team members that they will be devoting substantial time on the sales process from start to finish. The seller should ask whom the bankers would recommend as potential buyers and why. The seller should also speak directly with the investment banking team’s past sell-side clients to understand the prior clients’ experience with the investment banking team, including “soft” items like fit, style, how the process was run, civility, ethics, whether time schedules and other commitments were met, whether the clients’ valuation aspirations were equaled or exceeded in a consummated deal and the general “feel” of the overall process. Matching up the seller’s expectations and the investment bank’s commitment to the sales process from the start is paramount.

1. Conduct Sell Side Due Diligence.Any buyer will likely highly scrutinize the target company’s business through a full-scale due diligence process. The seller should expect that all “warts” of the business will appear as a buyer completes its diligence. The seller can better anticipate, prepare for and position the target business if it has conducted its own due diligence on the target company in advance. Whether or not the target company has audited financial statements, an independent

Maximizing Results in an Auction:A Map to Sell-Side Success


advisor with technical financial and accounting background (that is not the target’s current audit or accounting firm) should conduct a thorough financial and accounting review of the target company for at least a full year (preferably two years) together with the most recent interim period, including an analysis of revenue recognition, inventory costing, customer concentration, unrecorded accruals, and non-GAAP measures such as EBITDA (earnings before interest, taxes, depreciation and amortization) and the preparation of a quality of earnings analysis.

Armed with its own due diligence information, a seller should be well aware of any potential issues with the target’s business before any buyer blind sides the seller with unexpected problems uncovered by the buyer. A seller who highlights the target’s issues in advance (whether financial or otherwise) with a ready response for the resolution or mitigation of those difficulties will better position itself to maintain seller-favorable deal terms, including price. Buyers whose expectations are dashed through the diligence process, particularly with respect to financial aspects of the target’s business, will almost always seek a purchase price reduction or, even worse, will walk away from the deal entirely.

2. Provide Sell-Side Due Diligence Results.Providing sell-side due diligence results from independent third parties to potential buyers early in the sales process, including items such as EBITDA and quality of earnings analysis, best positions the seller to receive the most competitive bids in an auction. Fully informed with this information, buyers will be more confident in submitting their “best and highest” offers in an orchestrated sales process, resulting in an increased likelihood that the seller will in fact obtain the best price for the target’s business.

Additional due diligence reports that a seller should consider providing cover areas such as legal due diligence and litigation assessment, environmental due diligence (including so-called “phase I” or “phase II” reports), information technology reports, customer satisfaction or consumer product reports, insurance claims reports (and related outcomes and coverage), labor reports (including expected transaction bonus and severance costs), and real estate lease reports (with monthly run rates, termination dates and key provisions under existing leases). Providing these reports in advance also has

the added advantage of speeding up the overall sales process since each buyer will essentially be conducting “confirmatory” due diligence, rather than beginning “from scratch.”

Finally, some buyers (particularly financial buyers) are less likely to engage in a full auction process because they believe competitive auctions with multiple bidders can be costly to the private equity fund buyer who must engage its own due diligence experts at its own cost and are less likely to result in a winning bid for the fund given a potentially high number of bidders. However, if the financial buyer is able to reduce its deal costs in the process considerably (which sell-side due diligence allows it to do), then the fund may be more willing to participate in the process, increasing the seller’s likelihood for maximizing a higher price.

3. Provide a Fulsome and Well Organized Dataroom.

In addition to providing sell-side due diligence reports, the seller should provide a fulsome and well-organized online dataroom that all bidders can easily access prior to the delivery of “final bids,” thereby allowing all bidders a level playing field from which to submit their bids and providing them with increased confidence at the time of final bidding. The dataroom should include not just the sell-side due diligence reports, but all “back up” information that was collected in preparing those reports. Other customary areas provided in the online dataroom include, organizational documents, operating agreements, stockholder agreements and all documents relating to the company’s ownership and capitalization; monthly, quarterly and annual financial statements and projections; the current year’s budget; letters from outside auditors and law firms; complaints (and related documents) from filed or threatened litigation; customer and supplier contracts and purchase orders; real estate leases and mortgages; patents, trademarks and copyright summaries and filings; debt, financing and security agreements and filings; any material agreements related to the business; research and product development reports; and documents that present any actual or threatened issues relating to the foregoing.


4. Meet all Projections During the Sales Process.

A seller will almost always prepare its own projections as part of the sales process – typically covering at least the next full year and often for monthly or quarterly periods during that year. Since the sales process may take several months, meeting those projections throughout that process is of critical importance. Just like a seller must be prepared to provide buyers with accurate and reliable historical sell-side due diligence information, the seller can only maintain its credibility with potential buyers if it meets or exceeds its own projections during the sales process. Failure to do so can be costly – likely resulting in a downward purchase price adjustment or a failed deal. On the flip side, exceeding projections can also provide a seller with an opportunity to seek an increase in any bid – particularly if this occurs before (or at the end of) any “exclusivity” period with a buyer when a seller has the opportunity and leverage to threaten to go shop the deal to others.

5. Keep All Buyers on a Short Timeline, including Limited or No Exclusivity.

Due to the high cost of a sales process to a potential buyer (both out-of pocket expenses and lost opportunity costs), most buyers will seek some form of “exclusivity” period during which the seller is prohibited from speaking with, providing information to or responding to inquiries from any other potential bidders. During this period, the buyer negotiates the definitive transaction documents with the seller and finalizes any due diligence that is not already complete. Once exclusivity has been provided to a potential buyer, the seller loses significant leverage in its negotiations with the buyer since it can no longer effectively threaten to change the price or other material deal terms or to seek offers from other bidders to improve the seller’s negotiating position. Well-prepared sellers (with detailed and available sell-side due diligence and a fully stocked data room early in the process) will be better positioned to offer exclusivity late in the process and for only a short period (from a few days to up to a week or so). If the target business is a “hot asset” with multiple bidders and high valuations, the seller may be able to avoid any exclusivity period at all with the buyer before definitive deal documents are executed. If exclusivity must be offered earlier in the process or for more than a couple of weeks, a seller should negotiate an exclusivity timetable

where due diligence and document negotiation milestones must be met and deal pricing and other material terms (typically those included in a term sheet) must be re-confirmed every week or two in order for exclusivity to continue.

6. Force Representation and Warranty Insurance on the Buyer.

With more frequency, sellers are strategically forcing representation and warranty insurance (RWI) on buyers in order to obtain the best bids from each buyer in an auction. Similar to “stapled financing” offered in leveraged buyouts, a seller pre-negotiates the terms of the RWI with an insurance provider. If ultimately purchased by a buyer, the pre-negotiated RWI provides funds to the buyer to cover the seller’s breaches of representations and warranties for agreed-upon time periods, coverage amounts, deductibles (or retention) and other negotiated terms. With the pre-negotiated policy, a seller signals to the buyer that the buyer must offer the best purchase price and terms to the seller given the limited scope of indemnification seller is willing to provide but knowing that RWI is available to the buyer and to all the other bidders (should any bidder choose to purchase the coverage). Through this process, the seller is able to maximize its dollars on exit and minimize any dollars it may have to return to buyer (through an escrow or indemnification) following exit.

When RWI is used as a strategic tool, the retention amount under the RWI for breaches of representations (during the survival period for those same representations under the purchase and sale contract) is often the sum of the indemnification deductible and indemnification cap provided by the seller for those representations. For example, if the operational representations survive 15 months and a seller’s indemnification deductible is 0.75% of purchase price and seller’s indemnification obligation for breaches of those representations is capped at 3% of the purchase price, a buyer will often only seek insurance coverage for losses in excess of 3.75% of the purchase price during that 15-month period and potentially reducing that retention amount following the 15-month period when the buyer no longer has indemnification protection from the seller.


In a competitive auction with a “hot asset,” sellers in the current market have been able to force some very favorable indemnification terms on buyers, including an indemnification deductible of 0.75% of enterprise value (not historically unusual), an indemnification cap for as low as 0.75% enterprise value (historically unusual) and an escrow matching the indemnification cap for as low as 0.75% of enterprise value (historically unusual) since buyers in the current market are typically able to obtain a buy-side RWI with 1.5% retention (i.e., the 0.75% enterprise value indemnification deductible plus the 0.75% enterprise value indemnification cap and escrow).

Conclusion

Even in the current seller-favorable M&A market, two themes pervade our Map to Sell-Side Success: Preparation and Credibility. No auction process can succeed in maximizing price if the buyers doubt the knowledge or credibility of the seller and management. Maintaining prospective buyers’ confidence requires a seller to project a candid understanding of the business and its challenges and opportunities. This requires preparation and forthright honesty. Without these, data becomes suspect; projections receive greater “haircuts”; diligence is protracted; and, a buyer’s attention wanders toward other opportunities. These key seller items outlined above will more than pay for themselves through increased purchase price, improved certainty to closing and accelerated speed to closing.

About Winston & Strawn

Winston & Strawn’s private equity practice is one of the broadest and most active national middle-market practices in the U.S., providing strategic advice and legal counsel to middle-market private equity funds, hedge funds, family offices, real estate funds, alternative asset managers, portfolio companies, and institutional investors.

Authors

Eva DavisPartnerWinston & Strawn LLP

Eva Davis is a Partner and the Chair of West Coast Private Equity at Winston & Strawn. For over 20 years, Ms. Davis has counseled clients in M&A transactions, debt and equity financing transactions, and distressed sales and investments.

James LevinPartnerWinston & Strawn LLP

James Levin is a Partner in the Los Angeles office of Winston & Strawn. His practice focuses on M&A, securities offerings, and other corporate transactions. He also advises boards of directors on corporate governance matters.

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