Executing Smaller Deals and Negotiating Key Legal Provisions

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 episode, Anthony Krueger, Associate at Morrison & Foerster LLP, debunks this myth and discusses how to execute smaller deals and negotiate key legal provisions.

Executing Smaller Deals and Negotiating Key Legal Provisions

11 Dec
Anthony Krueger
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Executing Smaller Deals and Negotiating Key Legal Provisions

Executing Smaller Deals and Negotiating 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

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 episode, Anthony Krueger, Associate at Morrison & Foerster LLP, debunks this myth and discusses how to execute smaller deals and negotiate key legal provisions.

special guests

Anthony Krueger
Associate at Morrison & Foerster LLP

Hosted by

Kison Patel

Episode Transcript

Smaller deals vs bigger deals

Smaller deals are harder than bigger deals. If you think about it, with smaller deals, every dollar is more important. Each dollar is a bigger percentage of the deal. So if you have a hundred thousand dollars issue on a million-dollar deal, that's a big deal compared to a hundred thousand dollars issue on a billion-dollar deal.

And with that, you have a harder bid ask or harder negotiating lines when dealing with valuation. A lot of times with these medium size or smaller deals, maybe it's a family-owned or operated business, or a founder's first exit. And every dollar is super important to them, whether it be retirement or whether it be for their next venture. So they're going to be really hard on negotiating those values.

Buyers are doing the same thing. They know that with each deal comes potential claims so they need to get the best price they possibly can. With that, we ended up doing all of these crazy structures, to bridge the valuation gaps on the medium sized deals. It can get pretty interesting, pretty crazy.

Smaller deals are more emotional. It’s just more real to them. It's not one person in a 30-person business development team executing one of their 30 deals. This is their past 10 years, or maybe a make-or-break for an investor on their first acquisition into a rollup. So it does become way more emotional, way more real and important to that person in their personal lives.

Also they have smaller teams, so you have one founder or two founders that are doing all of the diligence. They're not just going and handing the ball off to their GC or their accounting team. They're answering every one of those questions that the buyer's asking and the buyer's actually having to go down and sit with them.

You run into deal fatigue more because of the smaller teams and there's also just a lot of teaching and education that needs to be done. When you go through a process, it's your first time. 

I just bought my first house recently, and I closed deals all day, every day. It happened for the past seven years and buying my first house was super stressful. So it puts you in that mindset of running your first transaction or selling your first company or similar things.

Complexities of smaller deals

As I mentioned previously, there's a couple of things. A lot of times, you'll have a buyer and a seller trying to bridge a valuation gap. There's a number of ways they can do that. One of the most common ways people do that is with earnouts. Another way people can do that is by mixing up the considerations.

So say the buyer doesn't want to shell out this much cash, but maybe they're willing to give you a promissory note in connection with that cash. Basically, they'll buy the business, give you some money up front, and then that business will presumably be generating some revenue for them. They'll use that revenue to pay off the promissory note later on. 

And then, sometimes you also see this in a lot of private equity firms too, they'll demand a rollover. So the seller sells their business, but 20% of their stake, they rollover into equity in the private equity firm. Then that adds a layer of complexity too. 

  • What kind of rights do I get with respect to my investment in that private equity firm? 
  • What's the valuation of that private equity firm? 

You run into all of these things versus larger deals. It's usually cash. Sometimes when we get into the big public deals, it's stock and cash, a little bit of split, but you don't run into earnouts, promissory notes, equity and cash. And I've seen all four of those things on one deal. It can get crazy quickly, but as the attorney, this is the deal that was struck and it's my job to help execute this deal and figure out how this all plays out.

You also run into points of complexities with respect to downside protection. Typically, nowadays we're seeing a lot of what's called rep and warranty insurance. And, I'm sure a lot of the listeners may be familiar with it. But just for the ones that aren't, rep and warranty insurance is an insurance policy that you get to prevent against downsides or claims that the buyer buys.

Now, with smaller deals, sometimes it can be too expensive to get that. Although we are seeing insurers go lower and lower, you'll end up going to a traditional indemnification provision. And so what this is, we take the insurer out of it. Me and you as the buyer and seller, let's hash out the risk. Let's hash it out, if you're a buyer, when can you bring a claim against me? What amounts am I required to pay you back for what? 

You have to negotiate all of that and figure out a way to do that. Indemnification provisions aren't particularly unique, but it is a whole other aspect that you wouldn't like that you have to negotiate and think through, and there is a lot of value there to be negotiated on the margins. That's one point. 

Also, with these types of deals, they'll typically always be on a cash-free debt-free basis with a working capital adjustment. And so many times when we're dealing with startups or small family-owned businesses that are being acquired, they're usually on a cash-based accounting system.

So they're recording their bills when they get the bill. They're recording their payroll when they pay the payroll. Now we're closing in the middle of the month. We have to figure out what our working capital is. So we have to take that whole cash-based accounting system and figure out accrual or negotiate for the buyer to accept a cash-based system. Or maybe we leave some cash in the bank, and so it adds another layer of complexity. 

Working capital and purchase price adjustments generally can get complex with these smaller deals too. There's just a lot more unique situations when you're dealing with smaller companies that are getting acquired, than when you're dealing with large companies, especially large public companies that have everything disclosed. The buyer knows exactly what they're getting into when they say they'll send the LOI. A lot of times on these private smaller deals, they send the LOI, and then let's go figure out what we're getting ourselves into and then having to renegotiate from there.

Other layers of complexities


What is an earn out? Typically, an earnout goes like this: I give you money up front, as the buyer. Depending on how the business that I buy does, we'll give you some more money later on, whether a year or two years, some period of time typically.

It sounds really good, and it can bridge the gap between a bid and an ask that are apart. “You think your company's worth 10 million, I think it's worth eight. Let's say, we'll give you eight now and in two years it performs like the way you think it's going to perform.” But then, you strike that LOI and how do we negotiate it?

We jokingly say it's an agreement to fight later, because these are inherently, subject to dispute. It's something that buyers and sellers should beware when entering into this type of structure and transaction.

There’s a caveat that there's no typical earnout. Every single earnout I've ever seen is unique. There's no standard language for an earnout. We have to do a lot of work on the back end to work with their clients to draft this stuff. But you'll see, a lot of times, earnout structured based off of revenue.

So what's the revenue over the next year or two years? Or sometimes, EBITDA. Other times, it'll be structured on KPIs. But how many units did your company sell? How many products did the company sell over a fixed period of time? And so forth.

Each metric is really a business decision. And I have to be careful here because I don't want to pigeonhole myself in future negotiations. But a lot of times, sellers want the top line because it's easier. Sellers want revenue. It's easier to figure out. It's easier to calculate. Buyers will want something lower, bottom line, EBITDA, net income.

  • Well, how much cash am I actually getting? 
  • How much free cash flow am I getting? 
  • Or how much of the products am I getting? 

But with that, every single line between top line and bottom line, there comes discretion and accountants and lawyers and folks can use that discretion to make the numbers better or worse. And really, you're trying to align the incentives between the buyer and the seller to be along with the business so that, for every additional dollar of revenue or dollar of EBITDA or sale, the buyer and the seller are both making money off of that, even after paying the earn out so that everybody's winning. That's really hard to figure out. 

It's hard to give a best practice because these are really case by case. But on  the legal terms, there are some things that you'll see getting fought over a lot and need to be cognizant of, because a lot of times, the business folks figure out the KPIs. They figure out what the trigger is, but they don't think about this other stuff.

One of the big things we fight about is operating covenants: who controls the business during the earnout period? The seller is going to be trying to have as much control as they possibly can, because they want to try and maximize the company's ability to have that earnout.

Sometimes the sellers don't stay around, so then they'll negotiate for negative covenants. You can't be bundling our products with your products separately or heavily discounting our products to sell more of your products, for example, or giving away all of our stuff for free in order to sell more buyer products. You'll see operating covenants along the lines of, you won't do anything in bad faith to hinder the company's ability to achieve the earn out. 

And then if the seller has a lot of leverage, they might even say you have the duty to try and maximize the earn out. And so we'll get in the weeds there, and really that exercise starts on each side of sitting down with the legal teams, the accounting teams, and the business teams early on and saying:

  • How can the other side screw this over if they wanted to?
  • What are the pitfalls? 
  • Maybe not even necessarily bad faith, but what are the pitfalls that they could run into that we see that could really hurt the potential for this earnout? 

And kind of going through the list. So, it’s like us, the accountants and the business folks all going through that and brainstorming and making a list of like 13 things. Like, these are the things we got to care about and the other side's doing the same thing. And then we get together and try and try and get as many things on our list and into the operating companies, and they do the same. So that's a big key legal provision that we see a lot.

The other thing you want to think about too is as the seller, specifically, this is more of coming from the sell side: 

  • What's the buyer's plan for the business post closing? 
  • Is this a roll up? 
  • Is this a company that's going to be securely acquiring a bunch of other companies, combining them, and then may either take the company public or sell it to a private equity shop?

In which case, I know I'm doing this deal with you and I trust you, but what happens if you go sell my business to someone else in a year, and we have a two-year earnout period and now they're running the business? 

And so, we'll often get into: should the earnout payments be accelerated? If so, do the earn outs have a cap? Oftentimes, they'll have a cap, but not always. And so you have to go through that. 

And then what happens if you don't pay? Are you paying interest? Are you paying penalties? Et cetera. And just thinking about that, what are typical earnout periods you see?

It really is all over the map. I see a lot of things like one-year, two-year, but I've seen five years. It can vary. 

But then, you also get into, how is that acceleration calculated? Is it the first year? Is it the whole thing? Et cetera. And you also have situations where, let’s say we have a two-year earn out. We didn't maximize our first year potential, but our second year crushed it. Can we go now that we overachieve our target in the second year? Can we go back and reclaim some of the money we left on the table in the first year? Because overall, when you have a multi-year or not, we hit all of our targets, but on a year-by-year basis, maybe the first two years were slow. So you can see the complexities.

Audit rights are when the buyer reports to me how the earn up is progressing. Especially in situations where the seller's not staying on or the seller's taking their money and they're off to Lake Como. As the buyer, I want you to tell me how the business is doing and how we are progressing towards the earnout. Then we'll fight over how often you need to be giving me reports.

  • What do those reports need to say in them? 
  • What happens if I get that report and the line items are just clearly wrong? 
  • What's the dispute mechanism?
  • What rights do I have to go and inspect the books of the company?

To see there's no way that we've only sold a hundred products. We were selling thousands of products a week before the sale or before the close. So we'll get into that as well. 

Typically, you'll see folks either demanding it quarterly or at the end of each earnout period. The buyer will basically give you a statement saying how much you're receiving as a result of how they did. But other sellers when they have more leverage though, they won't lead up to that. 

Sometimes depending on the buyer, maybe the buyer's public company is already doing quarterly reporting. So then you can maybe negotiate for that to have a separate quarterly report. Their accountants are already presumably doing it anyway. But if you have a private company that is only doing their financials annually, that might be a harder ask. 

Reps and warranties

Reps and warranties are representations and statements that you make about the quality of your business when you're selling it. It can range from anything. 

I have the authority to enter into this contract. 

I own the company that I'm selling. 

I've gotten all the required approvals. 

I have entered into these contracts listed on this schedule attached here too, and all of those contracts are good.

I don't have any disputes under them. 

I've paid them on time or I've been receiving payments on time for my customers. 

Here's all my employees. 

Here's all my employee benefits. 

All my employee benefits have been administered in accordance with law. 

I haven't broken any laws.

I'm not in breach of any laws currently.

And so, you're making statements about the quality of the business. It’s similar if you're buying a house, you say the foundation's good. I own the house, the roof's good, the plumbing's good. 

What happens is the seller will look at all those. We'll mark them up, so we'll go back and forth and red line. 

Is there a knowledge qualifier you haven't breached in any material laws to your knowledge? One's infringing on your IP. So we'll go back and forth and once we get those statements down, you sign up to those statements. And what happens after the deal closes if those turn out to not be true?

We see this a lot. We make a big announcement that we just sold this company. Big news, a lot of money. The ex disgruntled employee from two years ago is like, “What the heck? I thought I had stock options in that company?” or “I thought I had ownership in that company. I didn't get paid. Where's my money?” They may come running and say, this paper the CEO signs is promising me shares, and so we have to deal with that.

And the buyer who now owns the company, the legal entity, has moved over, exchanged hands. The buyer is now sitting on that liability, that claim, they have to deal with it because that ex disgruntled employee has a claim against the company.

A lot of times, what buyers and sellers will do is, they'll agree that to the extent that there's liabilities that happened as a result of the way I was operating the business before I sold it, that's mine. Anything after the company, afterwards is yours.

And of course it needs to be specific to the reps and the warranties that we agreed to. That's us negotiating the risk. And so that's what an indemnification clause is. If these statements that I made turn out to be not true, and you as the buyer suffer some damages or losses, or have to pay a fine as a result of these untrue statements, I will pay you back and I'll cover you. 

As you can imagine, it's similar to the earnouts, you can get pretty deep in the weeds on a bunch of different provisions. 

  • How do you make a claim? 
  • When do we decide? 
  • How do we agree?  

A lot of times, there is also recovery risk. You just sold your company for 10 million dollars, you're off in Lake Como. Now we're trying to find you and sue you. So what many times you'll see is the parties will agree to hold back a percentage of the deal proceeds, 10% to 20% typically. But it can be higher or lower than that depending on the deal. And they'll put that money either in an escrow, so they'll go to a bank and say, hold this money for us.

And that gives the seller some comfort that the cash is there, or the buyer will just hold on to it for you. And the nice thing for the buyer, especially right now and with interest rates, is they're collecting all the interest on that money.

And so then, what happens is the buyer makes a claim against the seller for that indemnification and they take it out of that hold back or that escrow. There's going to be some negotiating back and forth. You have to provide the seller information about your claim and they're going to review it similar to the audit rights and make sure that they agree with it. But that's typically how that indemnification process works.

This is where reps and warranties insurance would fit in as an alternative to the holdback. So instead of the indemnity, instead of the holdback or the escrow, we would agree that the buyer would go buy insurance from a third party to cover any breaches of the reps and warranties.

Obviously the seller will be getting the 20% up front. And we'll figure out the cost of the insurance policy, and if there's a problem, the buyer can go after the insurance policy. Not all buyers like to do the insurance policy for a bunch of different reasons, but we are seeing them and we advise them to do reps and warranties insurance all the time. But some people just don't like either. 

You usually have to do a lot of diligence, get your lawyers and your team to provide a fulsome diligence report. You have to do heavy accounting. So sometimes when you're dealing with these smaller deals, it can be really challenging for smaller founders or small family-owned businesses to go through that whole process, because it is daunting and it's a lot of time. 

And so some buyers might say, “Hey, listen, we're getting a really good deal here. We don't want to run this person through the ringer. We've priced it assuming this and we'll hold 20% back. And that 20% now is in our pockets and we're not even having to fight with the insurance policy over getting the claims. We're holding onto it and collecting the interest.

So, there's benefits and pros and cons on both sides to getting reps and warranty insurance, but as the deal gets smaller and smaller, it becomes less likely that reps and warranty insurance makes sense just from the out-of-pocket costs. 

In terms of how it impacts the actual purchase agreement, basically you're going to add a whole two or three extra pages at the back going over how indemnification claims are done, and what risks there are. 

There's a lot of things you're negotiating for. You're really almost negotiating like a separate insurance policy on top of the actual mechanics of us buying and selling the company. So for example, we'll have reps and warranty survival periods. 

How long do these reps and warranties survive before the buyer to bring a claim?

When can the seller really be scot free on the boat in Lake Como without having to worry about this? And so we'll see general reps and warranties, 12 to 18 months, 24 months, sometimes with fundamentals being around six years. 

Sometimes they'll link it to statute of limitations and it can vary depending on the deal and depending on the leverage that the parties have. So really, you're looking at how long the buyer can make a claim, which is tied to survival periods, and that will vary between fundamental and general reps.

Fundamental vs General Reps and Warranties

Fundamental reps are really the big things. Like, I own the company. The company is in existence. Taxes are typically in fundamental reps and other similar statements.

Your general reps are going to be things about your contracts, top customers. Sometimes, depending on where the value is in the company. So is this a heavy IP company? We can put IP in fundamental or general. And so you end up negotiating what is in that fundamental category and what is in the general category.

With that comes additional protections and limitations and with respect to that downside recovery mechanism. So oftentimes, general representations and warranties will have a cap, a maximum that the buyer can pull back from the seller with respect to breaches of those general statements. And often that's tied to how much money they're holding back the deal or how much money they put in the escrow. Not always, but most of the time, we'll only go after this money that's set aside with respect to all of the general stuff. 


As part of the reps and warranties process, you'll go through that. You'll look through the 10 pages, you'll go through with your lawyer, your accountants, you'll be like, “Oh, actually, where it says ‘we've always classified our employees and independent contractors correctly or under applicable law.’ We realized through due diligence that there were a couple independent contractors that we hired a few years ago that may have been misclassified.” 

In other words, they may have been under applicable law, classified as an employee. And so you'll go on the disclosure schedules and that rep will say “except as set forth on schedule Y or X or number, everyone was classified properly.”

So you go on the disclosure schedules and you'll say, “these three might not be classified correctly. So going back now, if those folks turn out to have been misclassified and the buyer suffered damages, there's an exception there to that rep. And so they don't get coverage unless we specifically talk about it and negotiate it within the contract.

That’s why those scheduled exceptions or disclosure schedules typically can be very important. And buyers and sellers need to look at them very carefully because it impacts the risk a lot. It can be painful because it is signing up to the dotted line of due diligence

But specific indemnities then get negotiated based on what known liabilities we think are out there. From there, it's like, okay, we have these three potentially misclassified folks. What is the order of magnitude? How much potential damages could be there? So then you work with us, you work with our employment experts to look at what does the law say? How much would we owe them?

We could potentially owe them overtime. We could potentially owe them for benefits and then fines, et cetera. And so you'll work with the specialist to figure out what that number is and then the parties will negotiate. Do we cap it at that number? Do we set aside? 

We basically make a separate new holdback escrow to capture those specific indemnities, those specific issues. And of course, the buyer's trying to make that specific indemnity as broad as possible. If I'm drafting the first draft, they’ll probably say well, you've had misclassification issues, you know that, so on a few employees, we should get it all covered. Because we don't know what else is out there and we know that, but we know that this is something that you've overlooked before. 

The seller's going to come back and say, no, the general reps exception to that only applies to these three folks, so you're covered under the general reps with respect to other people. That should be under the normal general reps, and the normal general reps have a lot of caps, limitations, things like that where the specific indemnities are usually outside of all of that. And so it's uncapped or capped at purchase price with no deductibles, limits, holdbacks, etc.

So, we'll negotiate that, fight about that, and that always gets interesting. But it's not dollars up front, but you're negotiating over like probabilities of dollars on the backend that a roll of the dice materializes and we see it often. So you are negotiating for value when you're dealing with that. Maybe you're not changing the top line purchase price dollar on the deal, but it is real dollars, or at least real probability for real dollars later on.

Disclosure schedules

Maybe we can circle back to what reps and warranties are. So reps and warranties often start off with “except to set forth,” and it typically is numbered in association with the number of reps. So except to set forth on section one of the disclosure schedule: Are companies in good standing in the state of its incorporation in all states where it needs to be? So you'll put together all of those schedules into what's called a disclosure schedule. 

Some of the reps, not only just have exceptions to the reps, but they will be like an affirmative statement. So the rep will say, “set forth on schedule three is all of my material contracts, including, but not limited to contracts that have consideration over 250,000, contracts where you've bought and sold a company.” You have to go in and list all of your contracts there. Same thing with employees, you typically have a rep that attaches schedule six is the employee census. 

You'll need to go and fill all that information out. So sometimes it's bolstering the reps and warranties or really getting the seller to sign on the dotted line with respect to the materials they gave you in due diligence. Other times it's, tell us all of the exceptions and you've got to go through it all and think about it and work with your team to try and cover your downside as much as possible. 

They are super painful because you start negotiating the reps and warranties on the first time you review the agreement and it doesn't get set in stone until the night you signed before, sometimes even the day you signed before.

And those reps and warranties are constantly being expanded and shrunk. Getting them right is a massive process or deal, but they do have significant implications on the back end of what kind of coverage. So if you're sloppy about them, it might be easier when you're actually trying to get the deal done, but it can be painful on the back end.

Oftentimes, reviewing is a pain. Oftentimes, when we’re working with sellers, we are working with the sellers to prepare them and put them together, and reviewing them is just as painful. But reviewing them is 10x easier than putting them together for sure.

Another good point on disclosure schedules generally, like a practice tip, is oftentimes, sellers reach out to us. They have an LOI at hand, and then it's like we have to go and clean up. Not only do we have to go and start preparing your disclosure schedules. When we do that, we find all the hair, and it's hair that we can clean up and that the buyer is going to demand us to clean up. But now we're doing it while we're trying to negotiate. 

There are obviously time sensitivities to that, and it's way easier to clean up issues. When you're not trying to negotiate a deal and under a time crunch and you have a little bit more free time, it can also hurt you and put you in a bad negotiating spot.

So a big tip to our sellers is, if you're thinking about selling or like you need to be selling in the next year or two, or that's where you’re looking to get out, reach out to an M&A lawyer, and get your accountants involved and loop them into that process to start thinking about and preparing and getting your house in order beforehand. 

Go and get your data room beforehand, get it together, get it cleaned up. And it's going to help not only simplify that whole disclosure schedule preparation process, but it's also going to allow you to clean up your issues without time crunch; without someone looking over your shoulder and potentially deducting purchase price later on, or making it a big issue that you're now negotiating with 10 different lawyers on a call or having to talk about “oh yeah, we found this a couple of years ago. We cleaned it up. It's done.”

Caps and Baskets 

These are limitations on the seller's indemnification obligations. Cap is kind of what we mentioned before. What's the maximum amount of money that I'm going to have to come out of pocket to you for these old claims? Because inherently, some of this stuff should have been priced in. You know you're getting into a little bit of this when you're buying the company and you've done due diligence as well. And so caps really are thresholds or maximums on how much I'm going to have to come out of pocket. 

So for general reps and warranties, we're often seeing those tied to the amount that's held back or put into escrow. For fundamentals, we typically see purchase price and then sometimes, you have kind of a quasi in between grouping. We call them an intermediate set of reps and warranties. 

For example, if you have a heavy IP company or heavy government contractor, we'll put government contracts reps or intellectual property reps into that middle bucket and they'll have like a 40% or 50% cap. So, where's the value in the business? It’s kind of like what we're thinking about when we're negotiating that. 

Baskets and deductibles are interesting. So this is like the deductible that you think about through car insurance, how much money can the buyer come after us for a thousand bucks just because like this? So this is like, no, the buyer has to pay some deductible or what's called a basket, or there has to be some minimum threshold before they can bring a claim. And so, this will be like maybe half a percent. So this will be like some sort of threshold.

A basket is what we usually call a tipping basket. And so that will mean, once you have enough losses to get to that tipping basket, you get dollar one. Let's just say the baskets 50,000 so the buyer now has incurred 50,000 in damages. They can bring a claim to you from dollar one. So they'll bring you a claim for 50,000 deductible, which is typically always smaller than the basket. It means that buyers only get what's above that deductible. So they have 50,000 in damages. There's a 25,000 deductible. They can bring a claim for 25,000 above the threshold.

When you’re defining the basket, you’re defining basically the minimum threshold, what’s the minimum amount of losses that the buyer has to suffer? What's the minimum pain the buyer has to suffer before they can come after you? And so, when you're negotiating that, you'll be negotiating not only what that threshold is, but whether or not that threshold is a deductible. Meaning completely out of pocket from the buyer, or is it a tipping basket, which is, once we get to that, then the basket tips over and we get all of it, the buyer can come after you from dollar one. 

There's certain limitations that sellers will ask for and buyers push back on non-exhaustive lists, duty to mitigate. So the buyer has to try and if the buyer has losses, the person comes up to them and says, we own this, try to negotiate it down or try to see what they can do with respect to the claim to reduce the claim to the extent reasonably possible.

There's also sometimes duties to go after insurance first. So even though you didn't get a rep and warranty insurance policy, this claim, this damage may have been covered by the company's general insurance policies that it had. And so, go after the insurance first, and then if to the extent you're not able to recover anything, or to the extent you weren't able to recover all of your damages, then you can come after the buyer.


I would say that would be a limitation or a covenant that the buyer would agree to. A carve-out from the limitation would be like fraud. So if the seller was fraudulent, then the cap doesn't apply, the basket doesn't apply. We can get all of our money back and you'll indemnify us for all of it. 

Fundamentals are typically a carve-out from limitations as well. So, typically the basket does not apply to breaches of fundamental reps. Did you own the company or not? And if I have suffered damages because you didn't own the company, I'm not dealing with the basket deductible. I'm going straight after you. Fundamentals will typically have, like we mentioned before, an upper threshold cap, but there will be carve-outs from some of those limitations.

Working capital adjustments

In terms of working capital adjustments, I don't know how in-depth we need to go into here. They are tricky and this is another one where you need to get your accountants involved early because we do see a lot of cash-based accounting companies agreeing to working capital adjustments. 

And as you can imagine, calculating accruals and calculating prepaids on a company that doesn't calculate those regularly is really difficult. It can be really painful, and it makes the whole process really hard to negotiate. And so, getting those advisors involved early can help you:

•negotiate your LOI so you don't have to deal with it.

•or get them ready and get them moving on figuring out:

  • what expenses we prepay 
  • What expenses we pay after we've received the service.
  • Are we paying our month on the first day of the month or on the last day of the month? 

And just going through that, figuring out what kind of unique line items on their balance sheet that they have. Do they have restricted cash? So they put cash in a separate account that is subject to a letter of credit or a big deposit on a lease. That's technically the company's cash, but there's conditions on it and it's not free to be moved. We run into a lot of that with the smaller to medium-sized deals. And so to the extent you can get ahead of it, it can be huge.

It is a quasi-legal accounting business exercise so we are working extremely closely. Like we'll be on three-way calls between business folks, the accountants and the legal team going over all of this, because we need to figure out what those unique items are and then how to be negotiating for it. 

And you see it sometimes in situations where you have maybe a general practitioner on the opposite side of you that has given the seller good advice. It helps form the company, it has been giving them general good corporate advice the whole time, but they're not M&A Deal lawyers, but the company trusts them. So they have them run their M&A process.

And then all of a sudden, we're sitting on the other side as the buyer’s counselor. We've got all this stuff to deal with and we need to negotiate it. And so when you're dealing with sophisticated folks, they'll get all of that and it will all be one way versus if you’re going, for example, up for restricted cash, if you're going up against maybe another sophisticated, big M&A lawyer, it's like, okay, we have all this restricted cash, it's supposed to be cash free, debt free.

In other words, we're supposed to get a dollar for dollar adjustment for every dollar of cash that we have on the books. Should we be getting a dollar for dollar adjustment on that? The seller's going to say, of course. And if you have an unsophisticated buyer's counsel, that makes sense to the dollar, but then the lease comes around and they take that deposit back. So now the buyer doesn't get the benefit of that cash. So they're left-holding the bag, if you will. 

What we would try and negotiate is let's put that money in a holdback. We'll give you the purchase price adjustment as a holdback. And then as soon as that lease is up and we get whatever money we get back, then we'll release it to you. So there's a lot of little things that we work in tandem with the accountants and the business folks to brainstorm and figure out where the middle ground is, or that can be really important. 

Another thing you see on working capital adjustments too is, especially with these companies where it's all over the place, you'll see people try and negotiate for thresholds or what they call collars. So if the working capital is between X and Y or there won't be an adjustment. So instead of just having a hard line in the sand, like a single dollar line in the sand, they'll negotiate a little bit more flexibility between the parties too. Because they just know that it's not going to be perfect.

And here's what our deal is, and so some folks, some buyers really like having collars and working in capital adjustments. Other buyers don't like it. They think we should get every dollar we're entitled to. It's interesting. And sellers are the same.

Deferred revenue

Deferred revenue is right when you get a prepayment or you get a payment upfront for a year's contract, and the contract's technically monthly, but they pay their annual fee upfront. And so, we're not recognizing that revenue. I'm not an accountant, so this is just how I understand the concept. We're not recognizing that revenue until we actually earn it, but we have the cash in the bank. 

And so, treat it as a liability on the balance sheet. Is that considered indebtedness? Really we just need to provide them services. What's the cost of providing those services? For things like software, it can be relatively low.

And so oftentimes, especially in software company deals where you have like these licensing arrangements, or there's a lot of deferred revenue, it gets heavily negotiated. Whether that's treated as indebtedness, whether it's treated as working capital, whether it's not taken into consideration at all. 

There's a lot of M&A accounting rules too about when that deferred revenue comes over, how much of it can actually be treated as a liability. But you have to think about it from the seller's perspective. Or at least the buyer's saying they're selling all this, they're getting the cash, they're taking the cash before, before the closing, and now we're stuck kind of servicing all of these contracts for post-closing contractual periods. That's one point that gets negotiated a lot in working capital adjustments.

Accrued bonuses and vacations

Accrued bonuses and vacations are other things that get negotiated a decent amount and that's one of those points where it's really hard if the seller isn't accruing those on their books, they just pay them. They're running a cash based system. They just pay them each month or they pay them when the person leaves. So you have to figure all of that out, which can be difficult, but doable. 

But, some folks try to get that working capital as just a line item on the balance sheet. Other investors, other buyers, they'll try to treat that as a transaction expense. So all of your accrued payroll, all of your accrued bonuses, you pay that out. Before the closing, that's on your dime. And then we'll take care of everything afterwards versus some buyers will throw it in with the working capital and will come out in the wash. 

But you can see the logic and the reasoning on both sides, but it goes back to what we said before. Is it nickel and diming or are we going to be a little bit more lax with that? And often, it will come into how much is it? How big is the deal? How much is it in the deal? And so you got to look at that as well. 

Get your accountants, get your lawyers involved early. That's the key bullet point coming out of this talk. 

Working capital adjustments are huge, and because of the smaller deals, they typically don't have large legal teams. I can't tell you how many of these medium-sized deals, like big companies, sometimes even 40 million, where we have a bookkeeper. We have a third party bookkeeper that helps us with our books in our account or taxes each year.

Getting those folks who are not used to dealing with the pressure and the intensity of an M&A transaction, and the real dollar for dollar adjustments to the amount, can make things extremely difficult. So by getting them in early, you can either get a specialized accounting team involved, which I would recommend on the legal side for sure. Like getting a specialized legal team, but you can maybe get a specialized accounting team. And just having everyone get together and work together, figure out what our issues are before we jump overboard here and start entering the market.

Advice to those doing small deals

Get your house in order. Start thinking about the process before you get the LOI in. It is really hard to do but it’s possible. And we see it, when it happens, which is unique, those deals go by so much smoother than when we just get LOI and we have all this stuff we need to clean up and we haven't told our accountant yet, we're trying to close in four weeks.

So get your house in order. Stay organized, get your information clean, get your data room set up, and have your business records orderly. Have your attorneys help you with that. And start to think about a process, especially if you don't have the best accounting records, you don't have a large accounting team, you don't have a legal team. Get those outside advisors working together ahead of time. And we see a lot of clients, they don't want to pay the expense, especially without a deal on the table, but it's like the old adage: An ounce of p

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