The Journal of Corporate Accounting & Finance11

These are difficulttimes for M&Aplanners. As oth-

ers have noted,because of the uncer-tain economy, theycan’t afford to pay too much foran acquisition, or take other mis-steps. Critics also observe thatthe often-quoted rationale forM&A deals—increased “syner-gy”—hasn’t panned out formany high-profile companies.Today’s CEOs are afraid ofbecoming the victim of anotherfailed deal.

The effective structuring ofan M&A deal in this newdemanding era starts first withthe advisory team for the partiesunderstanding the key issues andthe challenges that may stand inthe way of the closing of thetransaction as well as the keyfactors motivating the transac-tion. The motivation for the dealto happen and the underlyinggoals and objectives for thetransaction on a post-closingbasis will often affect the struc-ture of the transaction, pricingand valuation issues, and theability to obtain necessary third-party or governmental approvals.For 2003 and beyond, dealsneed to make genuine sense to

really get done or nobody willwant to finance them or play arole in facilitating a bad deal.

As financial professionalsand advisors to buyers and sell-ers, you know that nobody everplans to enter into a bad deal orsign a poorly structured agree-ment in advance. Many well-intending entrepreneurs andbusiness executives have enteredinto mergers and acquisitionsthat they later regret because theclassic mistakes such as a lackof adequate planning, lawyersand other advisors who did notunderstand the underlying goalsof the transaction, poorly execut-ed due diligence, misrepresenta-tions by one or more key partiesto the deal, overly aggressivetimetable to closing, a failure toreally look at possible post-closing integration problems or,worst of all, that the synergiesthat were intended to beachieved are illusory. Everyonesays that they want synergywhen doing a deal but few takethe time to develop a transac-

tional team, a jointmission statement ofthe objectives of thedeal or solve post-clos-ing operating or finan-cial problems on a

timely basis.Effective M&A agreements

in 2003 and beyond must be theresult of clear communication,leadership coordination, thor-ough due diligence (Garbage In,Garbage Out), and communica-tion among the professionaladvisory team, for example—disclosures in footnotes to finan-cial statements drive special duediligence requests.

STRUCTURING THE DEAL

There are virtually an infi-nite number of ways in which acorporate merger or acquisitionmay be structured. There areprobably as many potential dealstructures as there are qualifiedand creative transactionallawyers, accountants, and invest-ment bankers. The goal is not tocreate the most complex, butrather to create a structure thatfairly reflects the goals andobjectives of the buyer and sell-er. Naturally, not all of theobjectives of each party will be

In today's uncertain M&A environment, it is moreimportant than ever to avoid legal problems. Theauthor shows how to do it. © 2003 Wiley Periodicals, Inc.

Andrew J. Sherman

Today’s Shaky M&A Environment: How to Avoid Legal Problems

featu

reartic

le

19© 2003 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.10132

met each time—there willalmost always be a degree ofnegotiation and compromise.Virtually all structures, even themost complex, are at their rootsbasically either mergers oracquisitions, including the pur-chase or consolidation of eitherstock or assets. The creativityoften comes in structuring thedeal to achieve a particular taxor strategic result or to accom-modate a multi-step or multi-party transaction.

As mentioned elsewhere inthis issue, today’s M&A plan-ners have to deal with severalkey issues, including the formof payment (for example, cash,notes, or securities);whether the purchaseprice is tied to somethingelse; and whether pay-ments will be done ininstallments. And ofcourse, as always, thereare tax considerations, andthe question of how tohandle post-deal risks.

• Will the buyer beacquiring stock orassets of the target?

• In what form will the consid-eration from the buyer to theseller be made (e.g., cash,notes, securities, etc.)?

• Will the purchase price befixed, contingent, or payableover time on an installmentbasis?

• What are the tax conse-quences of the proposedstructure for the acquisition?

• How will post-closing risksand liabilities be allocatedbetween the parties?

ONE STEP VS. STAGEDTRANSACTIONS

Another key issue regardingthe structure of the deal and theterms of the acquisition agree-

ment for 2002 and beyond iswhether the entire transactionwill be completed in one “fellswoop” or whether it will occurover a series of steps. Duringthese times of uncertainty, theparties may want to get to knoweach other better before consid-ering a full-blown merger orthere may be some contingenciesaffecting the value of the compa-ny that are driving the buyer, oreven the seller, to want to slowthings down and consider a pre-liminary transaction as the firststep. The parties may wish toconsider a joint venture or strate-gic alliance as a precursor trans-action, as described below. One

example might be a teamingarrangement by and among twogovernment contractors prior toa merger or acquisition.

For example, from thebuyer’s perspective, there may becertain governmental approvalsneeded that affect the seller’svaluation, such as the approvalof the Food and Drug Adminis-tration (FDA) for a new line ofpharmaceutical or medicaldevices. These approvals may betwo years away (or longer) and ifnot obtained, would significantlyaffect the value of the seller’sbusiness. In such a case, thebuyer may want to consider analternative and more preliminaryinitial structure, such as a strate-gic alliance or a technologylicensing agreement. There may

even be certain shares exchangedto allow cross-ownership or thebuyer may want to purchase aminority interest in the sellerwith an option to purchase thebalance within six months afterobtaining FDA approval.

Even the seller may havecertain reservations about thebuyer or want to see certaincontingencies met before itcommits to selling 100 percentof its business. The buyer maybe waiting for some key third-party approval or event to takeplace, before the seller is reluc-tant to commit, such as thebuyer being in the process offiling for approval of an initial

public offering (IPO) of itssecurities. If these securi-ties are to serve as part ofthe seller’s compensation,then it may be wise to waitto ensure that there will bea secondary market (andhence liquidity) for theshares before moving for-ward. In such cases, theparties would enter into aletter of intent but therewould typically be a clause

that allows the seller to walkaway from the deal if the offer-ing is unsuccessful.

DEBUNKING THE MYTHS OFTHE STRUCTURE OF THEACQUISITION AGREEMENT

Once the due diligence hasbeen completed, valuations andappraisals conducted, terms andprice initially negotiated andfinancing arranged, the acquisi-tion team must work carefullywith legal counsel to structureand begin the preparation of thedefinitive legal documentationthat will memorialize the transac-tion. The drafting and negotiationof these documents will usuallyfocus on the past history of theseller, the present condition of the

20 The Journal of Corporate Accounting & Finance

© 2003 Wiley Periodicals, Inc.

Another key issue regarding thestructure of the deal and the termsof the acquisition agreement for 2002and beyond is whether the entiretransaction will be completed in one“fell swoop” or whether it will occurover a series of steps.

business, and a description of therules of the game for the future.They also describe the nature andscope of the seller’s representa-tions and warranties, the terms ofthe seller’s indemnification of thebuyer, the conditions precedent toclosing of the transaction, theresponsibilities of the parties dur-ing the time period between exe-cution of the purchase agreementand actual closing, the terms andstructure of payment, the scope ofpost-closing covenants of compe-tition, the deferred or contingentcompensation components, andany predetermined remedies forbreach of the contract.

Exhibit 1 is designed to be adiagnostic tool to ensure that allparties to the transaction under-stand the Acquisition Agreementand to ensure that the three (3)key categories of issues, namely,Consideration, Mechanics, andAllocation of Risk, have beenaddressed and that the definitivedocuments are reflective of the

business points reached betweenthe parties. Virtually all keyissues in the Agreement fall intoone of these three categories.

OTHER KEY ISSUES INPREPARING AND NEGOTIATINGTHE ACQUISITION AGREEMENTIN 2002 AND BEYOND

Allocation of Risk: As dis-cussed earlier in this article, theheart and soul of the AcquisitionAgreement is, in many ways,merely a tool for allocating risk.The buyer will want to hold theseller accountable for any post-closing claim or liability thatarose relating to a set of facts thatoccurred while the seller ownedthe company or that has occurredas a result of a misrepresentationor material omission by the seller.The seller, on the other hand,wants to bring as much finality tothe transaction as possible toallow some degree of sleep atnight. When both parties are rep-

resented by skilled negotiators, amiddle ground is reached both ingeneral as well as on specificissues of actual or potential liabil-ity. The buyer’s counsel will wantto draft changes, covenants, repre-sentations, and warranties that arestrong and absolute and the sell-er’s counsel will seek to insertphrases like “...except insignifi-cant defaults or losses which havenot, or are not likely to, at anytime before or after the closing,result in a material loss or liabilityto or against the buyer...” leavingsome wiggle room for insignifi-cant or non-material claims. Thebattleground will be the indemni-fication provisions and any excep-tions, carve-outs, or baskets thatare created to dilute these provi-sions. The weapons will be thebuzzwords referenced below.

Scope of the Assets: The typ-ical buyer will want to specify avirtual laundry list of categoriesof assets to be purchased but theclassic seller will want to modify

January/February 2003 21


Key M&A IssuesConsideration Mechanics Allocation of Risk• Structure • Conditions to Closing • Representations and Warranties• Scope of Purchase • Timetable (R&Ws) 2-Way Street • Price • Covenants (Including Covenants (Due Diligence Driven)• How/When Paid Not to Compete) • Indemnification• Deferred Consideration/ • Third-Party and Regulatory • Holdbacks and Baskets

Security Approvals • If Seller Is Taking Buyer’s Stock• Earn-Outs and Contingent • Schedules (Exceptions/ or Notes, then R&W’s Are a

Payments Substantiation) 2-Way Street• Other Ongoing Financial • Opinions • Collars

Relationships Between Buyer • Dispute Resolution • R&W Insurance & Seller • Methods for Dealing with

• Employment/Consultant SurprisesAgreements

• Post-Closing Adjustments

Exhibit 1

the list by using words like“exclusively” or “primarily.” Theseller may want to exclude all ormost of the cash-on-hand fromthe schedule of assets to betransferred. In some cases, theseller may want to license someof the technology rights in lieuof an outright sale or, at the veryleast, obtain a license of whathas been sold.

Security for the Seller’s Take-back Note: When the seller istaking back a note from the buyerfor all or part of the considera-tion, the issue of security for thenote is always a problem. Natu-rally, the seller will want non-contingent personal and corporateguaranties from the buyer andanyone else that it can manage toget. The buyer will be reluctant tooffer such broad security. Several“creative” compromises havebeen reached between the parties,including partial or limited guar-anties, the acceleration of thenote based on post-closing per-formance, the right to repurchasethe assets in the event of adefault, the issuance of warrantsor preferred stock in the event ofdefault, commercial-lender-likecovenants to prevent the buyerfrom getting into a positionwhere they are unable to pay thenote (such as dividend restric-tions, limitations on excessivesalaries, etc.), or contingent con-sulting agreements in the event ofa default.

Who Is on the Line for theFinancial Statements: The finan-cial statements provided by theseller to the buyer in connectionwith the due diligence and priorto closing are often a hotly con-tested item. The timing andscope of the financial statementsas well as the standard to whichthey will be held is at issue. Thebuyer and its team may prefer a“hot-off-the-press” and recentlycompleted audited set of finan-



Key Strategic QuestionsCorporate executives as well as M&A advisors need to consider the fol-lowing key strategic questions in planning for their next transaction orformulating their acquisition strategy:1. What lessons can we learn from the meltdown and significantly

reduced post-closing valuations of the companies that were veryacquisitive in 1998–2001? Is the GE/Tyco model of buying and runningmultidisciplinary business with common management and accountingsystems dead? How can conglomerates built via acquisition everachieve scale and full value? What can we learn from the deals done byCisco, Lucent, and many others? Can the mega-mergers such as AOL-Time Warner ever be successful from a shareholder value perspective?

2. What new due diligence, deal structuring, and negotiation tech-niques and practices have and will emerge in a post-Enron environ-ment? How will the new rules and regulations, such as the Sar-banes–Oxley Act affect the way that deals get done? Will these new“rules of the game” throw too much cold water on the environment?

3. How will global events and fears affect the level cross-border trans-actional activity? Will everyone decide to focus on their own back-yard? Or are those just the growing pains of globalization as wemove towards a truly interdependent world?

4. What does post-closing synergy really mean anymore? What wentwrong? Why have so many deals failed to achieve post-closing inte-gration and economics of scale objectives? Will shareholders trusttheir leaders and recommended deals?

5. What new responsibilities and risks do we all assume by advisingcompanies in connection with M&A transactions? Do the risks ofbeing held liable for failed deals justify the professional fees earnedin a given transaction? If not, how can we change our economicrelationships with our clients? Or do we get out of the game?

6. Where are the industry sectors or regions of the country that remainstrong and are likely to remain strong in late 2002, 2003, and beyond?How long will the defense and homeland security sectors remain hot?What about computer technology and telecomm? Biotech?

7. Are your advisory teams prepared to deal with the fact that intellectualproperty and intangible assets (e.g., brands, relationships, know-how,databases, patents, teams, etc.) make up the lion’s shares of theassets/value being purchased? Does the team have the skills andexperience to recognize these assets, make sure they have been prop-erly protected, and identify their full potential on a post-closing basis?

8. What can we learn from all of the roll-up transactions that havefailed? Many have not achieved their stated objectives or expectedsynergies and others are completely out of business—why? Is thismodel dead or just broken? If broken, how do we fix it?

Exhibit 2

cials from a Big 5 accountingfirm and the seller will want toserve up a “best-efforts” unau-dited and uncertified guessti-mate. Most deals wind up some-where in between, with verbiagesuch as “of a nature customarilyreflected” and “prepared in sub-stantial accordance with GAAP”and “fairly present the financialcondition” being banteredaround. The scope of the liabili-ties included on the statementsand who will bear responsibilityfor unknown or undisclosed lia-bilities will also be negotiated inthe context of the financial state-ments overall discussion.

The Existence and Scope ofthe Non-Compete: It is only nat-ural for the buyer to expect thatthe seller will agree to stay outof the business being sold forsome reasonable amount oftime. Depending on the seller’sstage of life and post-closingplans, which may include actualretirement, the parties are likelyto argue over the scope, dura-tion, and geographic focus ofthe covenant against non-com-petition. The more difficultissues often arise when a con-glomerate is spinning-off a par-ticular division or line of busi-ness and the remaining divisionswill continue to operate in simi-lar or parallel industries to thebusiness being sold to the buyer.The allocation of the purchaseprice to a non-compete covenantraises certain tax issues thatmust be analyzed and thesecovenants may have only limit-ed enforceability under applica-ble state laws if their scope orduration is deemed unreason-able or excessive. To furtherhelp you cover all the bases,Exhibit 2 lists some key strate-gic questions for M&A plan-ning. Exhibit 3 shows someimportant legal “buzzwords” towatch out for in agreements.

FOCUSING ON QUALITY

In sum, the next few yearswill be very challenging formerger and acquisition profes-sionals—the focus will be onquality deals, not on quantity ofdeals. Transactions will need tomeet all of the parties’ strategiccriteria and sellers will need topresent strong arguments to sup-port their valuation. Buyers willinsist on a clean set of financialsand a track record of good cor-porate governance practices as acondition to closing. The buyers

who have large cash reservesand access to credit lines at lowinterest rates are likely to contin-ue to be acquisitive but on amuch more selective and strate-gic basis. Competition amonglaw firms, accountants, andinvestment bankers to providesupport to this smaller basket ofdeals will be much more intense.This pace is likely to continueuntil the U.S. and global econo-my stabilize, the situation withIraq is resolved, and a few moresignificant victories in the waragainst terrorism are won.

January/February 2003 23


Playing with Legal BuzzwordsAny veteran transactional lawyer knows that there are certain key“buzzwords” that can be inserted into sections of the Purchase Agree-ment that will detract or enhance or even shift liability by and among thebuyer and seller. Depending on which side of the fence you are on, lookout for words or phrases like:

1. “materially,”2. “to the best of our knowledge,”3. “could possibly,”4. “without any independent investigation,”5. “except for...,”6. “subject to...,”7. “reasonably believes...,”8. “ordinary course of business,”9. “to which we are aware...,”10. “would not have a material adverse affect on...,”11. “primarily relating to...,”12. “substantially all...,”13. “might” (instead of “would”),14. “exclusively,”15. “other than claims which may be less than $____,”16. “have received no written notice of...,”17. “have used our best efforts (or commercially reasonable efforts)

to...,” or 18. even merely “endeavor to...”

as tools for negotiation and as phrases.

Exhibit 3



Andrew J. Sherman is a capital partner in the Washington, D.C. office of McDermott, Will & Emery, aninternational law firm with nearly 1,000 attorneys worldwide. Mr. Sherman is a recognized internationalauthority on the legal and strategic aspects of business growth. Mr. Sherman is an adjunct professor in theMasters of Business Administration (MBA) program at the University of Maryland and Georgetown Univer-sity where he teaches courses on business growth, capital formation, and entrepreneurship. Mr. Shermanhas been general counsel to YEO since 1987. Mr. Sherman is the author of 11 books on the legal andstrategic aspects of business growth and capital formation. His most recently published books include TheComplete Guide to Running and Growing a Business (Random House, 1997), Mergers and Acquisitions: AStrategic and Financial Guide for Buyers and Sellers (AMACOM, 1998), Parting Company (Kiplinger’s,1999), Raising Capital (Kiplinger’s, 2000), and Fast Track Business Growth (Kiplinger’s, 2002).

The Journal of Corporate Accounting & Finance11

Documents

Transcript of The Journal of Corporate Accounting & Finance11