M&A Buyer Protection Provisions in Private M&A Purchase Agreements Beyond Indemnification for Breaches of Representations and WarrantiesPurchase Price Adjustments, Contingent Payments, Accounts Receivable Repurchase, Inventory Audit, Retained Liabilities

Today’s faculty features:

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

The audio portion of the conference may be accessed via the telephone or by using your computer's

speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 1.

THURSDAY, NOVEMBER 21, 2019

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

Danielle Asaad, Partner, Squire Patton Boggs, Cleveland and New York

John J. McDonald, Managing Partner, Tremont Street Partners, Greenwich, Conn.

Tips for Optimal Quality

Sound Quality

If you are listening via your computer speakers, please note that the quality

of your sound will vary depending on the speed and quality of your internet

connection.

If the sound quality is not satisfactory, you may listen via the phone: dial

1-877-447-0294 and enter your Conference ID and PIN when prompted.

Otherwise, please send us a chat or e-mail sound@straffordpub.com immediately

so we can address the problem.

If you dialed in and have any difficulties during the call, press *0 for assistance.

Viewing Quality

To maximize your screen, press the ‘Full Screen’ symbol located on the bottom

right of the slides. To exit full screen, press the Esc button.

FOR LIVE EVENT ONLY

Continuing Education Credits

In order for us to process your continuing education credit, you must confirm your

participation in this webinar by completing and submitting the Attendance

Affirmation/Evaluation after the webinar.

A link to the Attendance Affirmation/Evaluation will be in the thank you email

that you will receive immediately following the program.

For additional information about continuing education, call us at 1-800-926-7926

ext. 2.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please

complete the following steps:

• Click on the link to the PDF of the slides for today’s program, which is located

to the right of the slides, just above the Q&A box.

• The PDF will open a separate tab/window. Print the slides by clicking on the

printer icon.

FOR LIVE EVENT ONLY

5

SUPPLEMENTAL BUYER PROTECTIONS

IN M&A PURCHASE AGREEMENTS:

Purchase Price Adjustments, Earnouts, Escrows, A/R and Inventory

Provisions, Asset Purchase Transactions, Set-Off Rights,

Specific Performance and Fraud Claims

John McDonald

Managing Partner

Tremont Street Partners

John.McDonald@TremontStreetPartners.com

Danielle Asaad

Partner

Squire Patton Boggs

Danielle.Asaad@ SquirePB.com

6

WHY BUYERS SHOULD NOT RELY SOLELY ON AN INDEMNITY FROM THE SELLER OR RWI POLICY

• In a perfect world, every M&A transaction would be an unqualified success. However, the reality is that M&A transactions sometimes do not work out as planned.

• For buyers of private companies, the indemnification process can be a crucial way to recoup losses resulting from misrepresentations or omissions made by sellers in connection with the transaction, but often sellers insist on numerous limitations.

• Supplemental Buyer Protections:

→ Purchase price adjustments.

→ Earnouts and other contingent consideration.

→ Escrows, holdbacks and other security.

→ Specific provisions for accounts receivable.

→ Specific provisions for asset deals.

→ Setoff rights.

→ Specific performance and claims for fraud.

7

PURCHASE PRICE ADJUSTMENTS: PURPOSE

• Provide Value Protection:

→ Generally, purchase price adjustments are designed to reconcile the performance of the target company between signing and closing based on financial information.

→ A purchase price adjustment should ensure that the buyer will get a business at closing with a balance sheet consistent with what the buyer believes it is paying for, and that there are no surprises resulting from the way the business is operated through closing.

• Not an Earn-Out/Milestone Payment:

→ Purchase price adjustments are used when parties agree on the value of the target company and need a mechanism to ensure that the agreed value is delivered at closing.

→ By contrast, earn-outs are used when parties have differing views on the value of the target company (or both parties are uncertain) and they agree to rely on the future performance of the target company to measure the purchase price to some extent.

• Purchase price adjustments can be “one-way” (downward adjustment only) or “two-way” (either downward or upward adjustment).

8

PURCHASE PRICE ADJUSTMENTS: MECHANICS

• Working capital is the most common purchase price adjustment component.

→ Working capital is equal to current assets (e.g., accounts receivable and inventory) minus current liabilities (e.g., debts due within one year or less).

• Other financial components sometimes used (typically in addition to working capital) include cash, indebtedness and transaction expenses.

• Purchase price adjustments can be on “dollar-for-dollar” basis or subject to a collar.

• Two kinds of adjustments: one-part adjustment v. two-part adjustment.

→ For adjustments made at closing, the seller often prepares the financial statements and the calculation of the adjustment.

→ For adjustments made after closing, in most cases, the buyer prepares the financial statements and calculation of the adjustment (typically 60 to 90 days after closing).

• Accounting Principles: GAAP v. principles set out on a schedule.

9

PURCHASE PRICE ADJUSTMENTS: DISPUTES

• Common Causes of Disputes related to Purchase Price Adjustments:

→ Not properly defining the financial components of the purchase price adjustment.

→ Not consistently and properly calculating the target amount and the actual closing amount.

→ Not taking into consideration seasonal or other fluctuations relevant for the target company.

→ Not clearly articulating the relevant accounting principles and adjustment mechanics.

→ Not taking into consideration the interplay between the purchase price adjustment and the indemnification provisions.

• Dispute Resolution: Disputes are typically resolved by an independent accountant.

→ Scope of the independent accountant’s review.

→ Allocation of the independent accountant’s fees among the parties.

10

EARNOUTS AND OTHER CONTINGENT CONSIDERATION – PART 1

• In addition to cash, contingent and deferred consideration, such as earnouts, buyer stock, seller paper – makes up a substantial amount of total consideration in M&A transactions.

• Earnouts – seller receives additional purchase consideration if the target company meets specified financial performance goals after closing.

• Buyer stock – seller receives shares of stock of the buyer.

• Seller paper – seller receives subordinated promissory notes from the buyer entity under which they receive payments in installments over time, with interest.

• Non-cash transaction consideration can be forfeited by sellers to satisfy their indemnification obligations to the buyer.

• Buyer indemnifiable losses can come from:

→ Third party claims – these are preferably satisfied in cash (rather than non-cash transaction consideration) because the buyer often has to come out of pocket to the third party to satisfy the claim in cash.

→ Buyer-discovered issues with the target company – these can be satisfied more readily with non-cash transaction consideration, since they typically go to diminished value of the target company to the buyer, rather than a need to satisfy a claim made by a third party.

11

EARNOUTS AND OTHER CONTINGENT CONSIDERATION – PART 2

• A key issue is valuing non-cash transaction consideration for purposes of satisfying buyer indemnification claims.

→ Buyer may be hesitant to accept forfeiture of earnout payments to satisfy a current indemnification claim if the underlying performance criteria haven’t yet been satisfied and therefore the seller may not ultimately be entitled to the earnout payment.

→ Buyer stock can be valued at then-current FMV, original issuance value or the better or worse of the two. Typically will want to legend stock certificates to reflect the indemnification obligation and otherwise restrict transfer during the indemnity period.

→ Seller paper can be readily cancelled or reduced, but be cognizant of cancellation of indebtedness income issues.

• If there are multiple forms of non-cash transaction consideration, typically need to determine which will be forfeited first to satisfy buyer indemnification claims.

→ Buyers will typically want to either have their choice of which form of transaction consideration to cancel (in any combination) or sequence them in order of most liquid/soonest/most certain payment to least liquid/most deferred/most contingent.

→ Sellers will sometimes turn buyer’s arguments about the potential value of earnoutsagainst them in negotiations about sequencing.

12

ESCROWS, HOLDBACKS AND OTHER FORMS OF SECURITY

• Most M&A deals have some form of escrow to back up the seller’s post-closing adjustment obligations and/or indemnification obligation to the buyer.

→ Typically, 10-15% of the purchase price is placed into an escrow account with a third party bank unaffiliated with either party for 12-18 months after closing.

→ Escrow periods are a negotiated item, but are typically tied to completion of the first audit and filing of the first consolidated income tax returns of the buyer including the target company.

→ With the rise of Rep & Warranty Insurance, escrows in some M&A deals have either been reduced to very small amounts or eliminated entirely, with claims on the policy substituting for recourse against the seller.

• Typically only in very small deals where escrow fees are a consideration, the buyer simply holds back some of the purchase price to satisfy indemnification claims and pays it to the seller after an agreed-upon time post-closing that corresponds to the typical escrow period.

→ This idea often quickly morphs into seller paper, since the seller wants some form of security and structure.

• Sometimes, sellers post letters of credit to satisfy indemnification obligations. Negotiating the language for draws on the letter of credit can get complicated due to bank requirements.

13

ACCOUNTS RECEIVABLE ADJUSTMENT PROVISIONS

• For some target companies, typically smaller ones or those growing rapidly, A/R can make up a large part of its overall value, putting stress on the collectability of those A/R, as the buyer would suffer substantial loss if the target company’s A/R aren’t collected.

• This is particularly the case if there are a few very large A/R, there are substantially aged A/R, and/or there isn’t much history of A/R collections for the buyer to evaluate.

• As a result, parties sometimes negotiate forced repurchase provisions in which the buyer can “put” any target company A/R that are not collected within a defined period (usually 90-180 days) back to the seller at stated value, less any reserves for uncollectible accounts applied to them. Buyer usually has to use reasonable efforts, consistent with past practice, to collect A/R.

• The flip side is sellers sometimes negotiate provisions in which A/R written off as uncollectible by the buyer in the NWC adjustment process are assigned to the seller, as the seller has effectively “paid” for them through a downward NWC adjustment.

• Need to be cognizant of the interplay of A/R-specific provisions, NWC adjustments (since A/R are a component of current assets included in NWC) and reps & warranties concerning A/R to avoid double or triple counting.

• Risk to the buyer is that the seller damages target company customer relationships through aggressive collections efforts with respect to A/R assigned back to it.

14

INVENTORY ADJUSTMENT PROVISIONS

• For manufacturing and distribution companies, inventories of raw materials, work-in-process and finished products can make up a large part of their overall value, putting stress on the carrying value and salability of those inventories.

• The concern is that target company inventories include obsolete, damaged or otherwise unsaleable products or materials.

• In these transactions, a physical inventory audit and evaluation of the target company’s inventories typically occurs pre-closing or during a short post-closing period (60-90 days), sometimes using an outside industry expert appraiser.

• If the inventory process occurs post-closing, a portion of the purchase consideration is set aside and paid to the seller upon completion of the inventory audit and evaluation.

• Sometimes, there is a dispute resolution mechanism process like in post-closing purchase price adjustments involving competing industry expert appraisers.

• Any inventory written off as unsaleable is typically assigned to the seller, as the seller has effectively “paid” for that inventory through the downward purchase price adjustment.

• Need to be cognizant of the interplay of inventory-specific provisions, purchase price adjustments (since inventories are a component of current assets included in working capital) and reps & warranties concerning inventories to avoid double or triple counting.

15

ASSET PURCHASE TRANSACTIONS

• In M&A transactions structured as asset purchases, rather than stock acquisitions or mergers, seller indemnification of buyer for “excluded liabilities” provides an additional avenue for buyer protection, in addition to indemnification for breaches of reps & warranties.

• Typically, a “line in the sand” is drawn at closing and any liabilities relating to pre-closing operation of the target company, or relating to excluded assets not acquired by the buyer in the transaction, are “excluded liabilities” that are the seller’s responsibility.

• Indemnification for “excluded liabilities” is often not subject to any indemnification deductible or threshold, based on the premise that they’re entirely the seller’s responsibility, and “excluded liabilities” are sometimes also excluded from the indemnification cap, although less often. Sometimes there is a higher cap for “excluded liabilities” than rep & warranty claims.

• There are sometimes also longer or unlimited indemnification periods for “excluded liabilities”, as contrasted with the typical 12-18 months after closing for rep & warranty claims.

• This can create an arbitrage opportunity where buyers are motivated to characterize issues as “excluded liabilities” rather than rep & warranty breaches.

• “Wrong pocket” provisions are typically included providing for payments between the buyer and the seller if one party receives payments or other consideration relating to pre- or post-closing operations of the target company and therefore belonging to the other party.

16

SET-OFF RIGHTS

• If the buyer has an obligation to make a future payment to the seller in the form of:

→ Promissory note or deferred payment,

→ Contingent payment or earnout, or

→ Payment under a transition services agreement or supply agreement,

then the buyer should consider including a contractual right allowing it to set-off amounts otherwise owed from the seller under an indemnity or other post-closing obligations against any future payment.

• Things to consider:

→ When can the buyer invoke its set-off right.

→ Mechanics for exercising set-off rights.

→ Default by the buyer.

→ Dispute resolution.

17

SPECIFIC PERFORMANCE

• If it is important for the buyer that the seller be enjoined from taking certain actions, rather than simply being liable for monetary damages, then the buyer should ensure that the purchase agreement has an equitable remedies (or specific performance) provision.

• Entitlement to equitable relief – “Seek”

→ Breach of the agreement would cause irreparable harm to the non-breaching party.

→ Monetary damages would be insufficient to compensate the non-breaching party for its losses and there is no adequate legal remedy.

• Waiver of requirement to post a security.

• No requirement to prove damages.

• The breaching party will not contest an order of equitable relief.

• Interaction with other remedies in the purchase agreement.

18

FRAUD CLAIMS

• Courts place a high value on the sanctity of the contract, especially when it is the result of a negotiation process involving two sophisticated parties represented by counsel, which is usually the case in M&A transactions. As a result, it is very difficult to prove fraud claims.

• In addition, fraud claims entail litigation in which the buyer will be required to incur significant legal expenses, potentially over a period of years, before obtaining compensation from the sellers for its losses.

• However, in situations in which the buyer has very substantial losses due to intentional seller misrepresentations, a fraud claim may be a way in which the buyer can try to obtain compensation for those losses.

• Buyers asserting post-closing fraud claims typically rely on three theories:

→ Sellers made affirmative statements (written or verbal) that were intended to induce the buyer to close the transaction.

→ Sellers who were familiar with the company’s operations and were involved in the sale process became aware of an event that made a representation in the purchase agreement false, but the sellers did not disclose this to the buyer.

→ Sellers took affirmative steps to hide information from the buyer.

19

FRAUD CLAIMS: ELEMENTS UNDER DELAWARE LAW

• Under Delaware law, a buyer has to prove the following:

→ The seller falsely represented or omitted facts that the seller had a duty to disclose;

→ the seller knew or believed that the representation was false or made the representation with a reckless indifference to the truth;

→ the seller intended to induce the buyer to act or refrain from acting;

→ the buyer acted in justifiable reliance on the representation; and

→ the buyer was injured by its reliance.

Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1032, 1050 (Del. Ch. 2006).

20

FRAUD CLAIMS: LIMITATIONS

• Sellers typically insist on the following limitations:

→ Sellers define within the purchase agreement the universe of information that forms the basis of the sellers’ transaction with the buyer.

→ Sellers include an exclusive remedy framework in the purchase agreement so as to place limits on the total damages that a buyer can recover in any dispute, even if for a fraud claim.

→ Sellers try to “compartmentalize” which sell-side party is making each particular representation – i.e., to attribute to the target company (and perhaps to certain insider-owners) representations concerning the target company’s financial and business information while attributing very limited representations to the target company’s owners.

• If a buyer makes a claim of fraud based on misrepresentations made by the seller in documents provided before the purchase agreement was entered into, these claims are sometimes referred to as “extra-contractual” fraud claims.

21

FRAUD CLAIMS: RECENT DELAWARE CASELAW

• ChyronHego Corporation, et al., v. Cliff Wight and CFX Holdings, Inc., C.A. No. 2017-0548-SG (Del. Ch. July 31, 2018).

→ The Delaware Court of Chancery dismissed the buyers-plaintiffs’ claim for extra-contractual fraud on the basis that the purchase agreement contained an effective anti-reliance clause that precluded such claim, but the Court allowed the buyers’ claim for fraud related to the express representations and warranties in the purchase agreement.

• Sparton Corporation v. Joseph F. O’Neil et al., Civil Action No. 12403-VCMR (Del. Ch. August 9, 2017).

→ The Delaware Court of Chancery dismissed the plaintiff-buyer’s claim that it suffered $1.8 million in damages as a result of the defendants-sellers’ misrepresentation of the target company’s working capital. The buyer argued that the sellers’ alleged extra-contractual misrepresentations warranted judicial intervention despite the express anti-reliance and exclusive remedy provisions in the merger agreement. But the Court emphasized that the anti-reliance provision in the merger agreement had excluded any representations made by the sellers during the pre-merger negotiations.

22

QUESTIONS?

John McDonald

Managing Partner

Tremont Street Partners

(203) 708-7255

John.McDonald@

TremontStreetPartners.com

Danielle Asaad

Partner

Squire Patton Boggs LLP

(216) 479-8655

Danielle.Asaad@

SquirePB.com