2. Avoid Negotiating the Material Terms in an LOI. Other than with respect to
a no-shop provision (discussed above) and a Hart-Scott-Rodino filing (discussed below),
there are generally no significant benefits to the buyer in executing an LOI. Indeed, the
seller’s negotiating leverage is strongest prior to the execution of an LOI -- particularly if
the target is represented by an investment banker who has effectively created a
competitive selling environment (or the perception of same) -- and thus it is in the seller’s
interest (not the buyer’s) to negotiate the material terms of the deal in the LOI. The buyer
can avoid this trap in one of two ways: (i) by executing an exclusivity letter agreement
and skipping the negotiation of an LOI -- i.e., proceeding directly to the negotiation and
execution of a definitive acquisition agreement; or (ii) by executing an LOI that includes
a binding no-shop provision, but is otherwise non-binding (except perhaps with respect to
expense reimbursement and/or other “special” provisions) and is as non-specific/general
as possible (e.g., “this letter summarizes a proposal pursuant to which the Buyer would
acquire the Target”). Either approach gives the buyer not only strong negotiating
leverage, but also the time and flexibility to complete its due-diligence investigation prior
to agreeing to any material terms. Moreover, it will minimize the risk that the LOI will
be construed as a binding agreement between the parties -- the major reason why a buyer
should be circumspect with respect to the execution of an LOI -- leading to potential
damages if the transaction is not consummated. (Note: an LOI does serve a useful
purpose in deals greater than approximately $65 million -- i.e., it enables the parties to
make any required filing under the Hart-Scott-Rodino Antitrust Improvements Act of
1976.)
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and the significant deal risks in order to protect the buyer and to ensure that the buyer is
making an informed judgment with respect to price and terms. Deals often take on a life
of their own -- with emotions and egos involved -- and there is nothing more important
on the buy-side than a lawyer who is watching his client’s back.
6. Escrow a Portion of the Purchase Price. One step the buyer can take to
protect itself is to escrow a portion of the purchase price (e.g., 15-20%) for a period of
time post-closing (e.g., 18-24 months). Indeed, escrows are relatively common
(particularly where there are multiple sellers) because of the inherent unfairness of
requiring the buyer to sue the seller(s) to try to get some of its money back for a problem
or liability it never agreed to take on. Alternatively, the buyer can push for a hold-back
(i.e., a right to hold part of the purchase price) and/or a right of set-off in deals where part
of the purchase price has been deferred (e.g., where the buyer has issued a promissory
note to the seller as part of the purchase price); however, escrows are obviously more
amenable to sellers (i.e., less controversial) because the money is held by an independent
third party and the buyer does not have the unilateral right to withhold payment. A few
important points worth noting in connection with escrows: (1) the buyer should avoid
limiting its recourse solely to the escrow without any carve-outs unless it is completely
comfortable with the size of the escrow and has otherwise made an informed judgment
with respect to the significant deal risks and terms; (2) the old pooling-accounting
requirements of limiting escrows to 10% of the purchase price and one year in duration
are no longer applicable; and (3) where there are multiple sellers, the buyer should
require the sellers to appoint a representative who is authorized to make all decisions
relative to the escrow (as well as other substantive issues).
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motivation if it is unable to achieve its goals and thus is never entitled to an earn-out
payment. The bottom line is that earn-outs are very tricky from both a legal and business
perspective and should only be used as a last resort.
9. Don’t Give Away the “Basket”. One of the provisions sellers generally insist
on in the acquisition agreement is a “basket” to prevent the buyer from “nickel and
diming” the seller for any claims post-closing. The size of the basket varies from deal to
deal, but based on a recent study of the Committee on Negotiated Acquisitions of the
American Bar Association (of which I am a member), the norm is approximately .5% of
the purchase price. If the buyer agrees to a basket, there are a number of significant
issues that it must address, including the following: (i) it should push for a “first-dollar”
basket (sometime referred to as a “threshold”) as opposed to a “deductible” so that if its
damages exceed the basket, the seller would be responsible for all of the damages (i.e.,
beginning with the first dollar); (ii) the basket should only relate to breaches of
representation and warranties and not to covenants or specific indemnity provisions (this
is a common mistake); (iii) any materiality qualifiers in the representations and
warranties should be disregarded for purposes of the basket -- otherwise there would be a
so-called “double-materiality” problem (another common mistake); and (iv) there should
be appropriate carve-outs to the basket, the most common of which include capitalization,
due organization, due authority and ownership of shares.
10. Watch Out for Caps. One of the most important and hotly-negotiated issues
in any private-company acquisition is the cap (or ceiling) on the seller’s damages. Like
other material terms in the acquisition agreement, there is no right or wrong answer (or
“customary” or “market” amount): it all depends on the context of the transaction -- i.e.,
the bargaining power of the parties, the risk profile of the target, the purchase price, etc.
For example, in an auction context with 10 bidders expressing interest in a target, the cap
may end-up being 10% or less of the purchase price due to the competition. On the other
hand, if the target has a host of significant problems (and/or is financially troubled) and
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there is only one prospective buyer on the horizon, the cap may end-up being equal to the
purchase price (or there may be no cap). The lesson here, as discussed above, is that the
buyer must fully understand the target business and the significant deal risks in order to
make an informed judgment with respect to price and terms, including the cap. Indeed,
as discussed above with respect to the escrow being the sole remedy, if the cap is less
than 100% of the purchase price, the buyer should push hard to include certain carve-
outs, including the seller’s breach of (i) any covenants, (ii) specific indemnity provisions
(e.g., environmental, taxes, ongoing litigation, etc.) and/or (iii) certain representations
and warranties (akin to the carve-outs to the basket).
Scott Edward Walker is a former big-firm New York corporate lawyer, with 15+
years of sophisticated corporate-transactional and securities-law experience. Mr.
Walker is the founder and CEO of Walker Corporate Law Group, LLC, a boutique
corporate law firm specializing in the representation of entrepreneurs and their
companies, with offices in Beverly Hills and Washington, D.C. You can learn more about
Mr. Walker’s practice at www.walkercorporatelaw.com, and he can be reached at
swalker@walkercorporatelaw.com. Please note that the foregoing article has been
provided by Mr. Walker solely for informational purposes and does not constitute (and
should not be construed as) legal advice in any respect. Mr. Walker expressly disclaims
all liability in respect of any actions taken or not taken based on any contents of the
article. Copyright © 2009 Scott Edward Walker. All Rights Reserved.
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