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M&A comes in varying sizes. However, there’s a common misconception that smaller deals are easier to execute than larger ones. The truth is, that smaller deals come with their own unique set of challenges that could possibly make them even harder to do. In this article, Anthony Krueger, Associate at Morrison & Foerster LLP, debunks this myth and discusses how to execute smaller deals and negotiate key legal provisions.
“There’s more unique situations when you’re acquiring smaller companies. Large companies have everything disclosed and the buyer knows exactly what they’re getting into.” – Anthony Krueger
Challenges of Smaller Deals
According to Anthony, while smaller deals might seem straightforward at the outset, smaller deals are actually harder to do because of several reasons:
1. Valuation Gaps
In smaller deals, every dollar negotiated is a bigger percentage of the entire purchase price. This makes negotiations extremely difficult, especially when small to medium-sized sellers are looking for the best price for their company. This often leads to intricate structures being employed to bridge gaps.
2. Emotional Founders
Smaller deals often involve founders or family businesses making their first exit. The sellers have an emotional attachment to the business and the employees which can make negotiations more difficult.
3. Unsophisticated Sellers
On smaller deals, most sellers are unsophisticated and inexperienced. They don’t have extensive teams that will handle the sale process. This often leads to buyers educating the seller on the M&A process, and the seller experiencing deal fatigue, which could hurt the business.
4. Can’t Afford Reps and Warranties
Representation and Warranties insurance can get very expensive and impractical on smaller deals. So instead, buyers and sellers agree on indemnification provisions, taking out the insurer in the process and negotiating every possible protection for both parties.
- Working Capital Adjustments
Many smaller businesses operate on a cash-based accounting system. Converting this to an accrual system, or getting the buyer to accept a cash-based approach during a deal, can be complex. These adjustments and negotiations around the purchase price can be intricate in smaller transactions.
Bridging Valuation Gaps
Because of the difficulties bridging the valuation gap between the buyer and the seller, they often use special deal structures to satisfy both parties. Here are some of the most common ones:
1. Earnouts - Smaller deals often employ earnouts to address valuation challenges, especially when the target company lacks a consistent track record. The buyer pays upfront and promises to pay additional cash if the business performs the way the seller hoped it would, in a certain period of time. This agreement can cause a lot of challenges, from success criteria to business control during the earn out period.
2. Promissory Note - Another way to bridge valuation gaps is the issuance of a promissory note. In this scenario, the buyer pays a certain amount up front, and the remaining balance is to be paid using the revenue of the acquired business.
3. Rollover Equity - Commonly used by PE firms, rollover equity is when a portion of the selling price is converted into the PR firm's equity. This adds another layer of complexity as the seller will want to know the rights included in the investment and the valuation of the PE firm at that particular moment.
Indemnification Provisions
Since reps and warranties insurance are too expensive for smaller deals, both parties must negotiate representations and warranties on their own. This is extremely challenging and could add two to three more pages to the overall purchase agreement. Here are some of the most common things negotiated during this phase:
1. Survival Period - It will dictate how long these reps and warranties survive and the buyer can bring a claim to any breach of representation. This typically ranges from 12 to 24 months, depending on whether they are fundamental or general reps and warranties.
2. Fundamental vs General Reps and Warranties
During negotiations, both parties must also negotiate which declarations will classify under fundamental or general reps and warranties. Fundamental reps are the bigger issues in the business, while the general reps are the smaller ones. This is extremely crucial, as fundamental reps allow the buyer to claim the entire purchase price, while the general reps are limited to a certain cap.
3. Indemnities
Because there are no reps and warranty insurance, talking about specific indemnities in the contract is crucial for the buyer’s protection. Buyers must now review the disclosure schedules to check for risks before signing the contract.
4. Caps and Baskets
When negotiating for indemnities, there must be an agreed cap and baskets. The cap sets the maximum amount a seller may owe for specific claims. The basket, on the other hand, sets the minimum amount of losses that the buyer has to suffer before they can claim damages. There are two types of baskets.
1. Tipping basket - allows the buyer to claim every dollar suffered, once they reach the minimum amount.
2. Deductible basket - allows the buyer to claim every dollar suffered beyond the minimum threshold.
Advice for Doing Small Deals
Anthony believes that it’s vital to prepare ahead for a smooth transaction. Before receiving the LOI, ensure everything is in place and organized. Maintain orderly business records, set up the data room, and consult with attorneys.
If you lack strong accounting or legal teams, collaborate with external advisors early. Though some might hesitate due to initial costs without a confirmed deal, early preparation can save significant complications and expenses later on. Remember, early prevention can mitigate larger issues down the line.