As the Great Recession of 2008-2009 begins to abate, many corporate acquirers are noticing that the values of potential acquisition targets remain depressed. For an acquirer who believes that 2010 and 2011 will bring an economic recovery in the U.S. economy, the current values of target companies can appear very attractive. But while the rewards of a well-chosen and -executed acquisition in an environment like the current one can be very substantial, the risks of mergers and acquisitions (M&A) under these circumstances can also be considerable. Potential acquirers are well-advised to do all that they can to identify and mitigate the risks that are present in any particular M&A situation. While every situation is unique, this article will attempt to explore some of the more common risks and how an acquirer should address them, assuming that the target company is not subject to bankruptcy proceedings.
Deal Format
M&A transactions take one of three different types of format: an asset acquisition, a stock acquisition or a merger. In an asset acquisition, the acquirer buys all or substantially all of the assets of the target company, choosing the assets that it wishes to take and the liabilities that it chooses to assume. In a stock acquisition, the acquirer buys all of the outstanding stock of the target company from its shareholders. In a merger, the acquirer or a special purpose subsidiary merges with the target company, and the two companies become one under the alchemy of the corporate merger statute. In both a stock acquisition and a merger, the acquirer ends up with all of the assets and liabilities of the target company. Each format carries different tax consequences, but in general an acquirer obtains more favorable tax consequences from an asset acquisition. (A description of tax consequences is beyond the scope of this article.)
The acquisition of a troubled private (i.e. non-public) company typically is structured as an asset acquisition. Due to the amount and nature of the troubled company's liabilities, the acquirer will usually want to pick which assets and liabilities it takes and which it will leave behind in the shell of the target company. Often, significant liabilities of the target company will not be assumed by the acquirer, and the person to whom the liabilities are owed is left to pursue collection efforts against the shell of the target company that remains after the closing of the transaction.
Special Considerations in Arriving at Deal Terms
During good economic times, the purchase price of an acquisition is often driven by a discounted cash flow analysis of projected future earnings of the business. Another major determinant of purchase price is often the price or multiple of, for example, revenues, gross margin or earnings, at which other similar deals have been completed in the recent past. Unfortunately, these drivers often break down during times of significant economic dislocation like the present. Projections of future earnings are currently much more difficult to make and to realize than is normally the case, and deal-making activity in the recent past has been quite sparse and arguably driven by unusual factors, like the inability of some companies to raise funds for working capital or the need by owners to obtain immediate liquidity.
While an acquirer will certainly need to develop and rely on an earnings model to justify an acquisition and the price tag associated with it, prudence suggests that he should also be prepared to discuss other drivers of value with the potential target. For example, an acquirer may project very little in the way of earnings for a potential target over the next two or three years, but the seller may not be willing to consider the very low purchase price implied by a discounted cash flow analysis of those projected earnings. The seller may prefer to base the purchase price on the net values of its assets, the notional value of (for example) a key patent, or the cost of independently replicating its assets and business. A shrewd acquirer will anticipate and be prepared to discuss his offer in the context of these factors.
The sellers of a target company with shareholders other than the management group have certain fiduciary duties that they must fulfill in a sale of the company. Although these fiduciary duties are complex and vary between different situations, in essence they require the target company board to obtain the best price reasonably available for the shareholders. Often in the context of a troubled target company, the purchase price is low, and if the target company has a multi-tiered capital structure with preferred stock holders having priority over common stock holders, then the common stock holders may face a very small payout in the deal. At the same time, it is common for acquirers to engage key managers for a period of time after the closing occurs, and they may offer some of those key managers an employment agreement and an equity incentive. Sometimes these situations appear to shift a portion of the acquirer's purchase price away from shareholders and toward those key managers. This type of situation is fraught with fiduciary duty issues. Acquirers should be on their guard in such situations, as aggrieved shareholders may sue the board or key managers for breach of fiduciary duty, and attempt to assert a claim against the acquirer for aiding and abetting that breach of fiduciary duty. An acquirer may be held liable for aiding and abetting a breach of fiduciary duty by the target board if it knew or should have known that the target board was breaching its duty and participated in some sense in that breach.
Asset-Side Issues of Potential Concern
Often an asset deal will explicitly provide for the acquirer to take a substantial amount of the accounts receivable of the target company. These accounts receivable often represent a large part of the value that passes at closing. An acquirer should treat these accounts receivable with special care in a troubled situation. A distressed acquisition target may, for various reasons, fail to properly discount the collectability of its existing accounts receivable. Sometimes the target company has been under prolonged pressure from its bank and other creditors, and its balance sheet has become, shall we say, somewhat aspirational. In other cases, the persons owing the accounts receivable find that they have less incentive to pay the amounts owed at full value, if the target company is going away. The acquirer should carefully review the accounts receivable that it expects to take in the deal, to make sure that their value is accurately reflected in the deal terms.
Liability-Side Issues of Potential Concern
During the process of selecting which assets and liabilities of the target company the acquirer wishes to take in the deal, the acquirer may be tempted to leave dauntingly large accounts payables with the sellers. While there is nothing inherently wrong with structuring the deal in a way advantageous to the acquirer, and these choices are generally given effect legally, the acquirer should make sure that it understands who the creditors of these accounts payable are who will be left pursuing a dubious collection claim against the shell of the target company. Key suppliers, for example, may have no legal claim against the acquirer for the unsatisfied amounts that they are owed, but they may have some very practical - and potentially powerful - levers available to them to force the acquirer to pay them. They may be able to cut off supplies of key materials, goods or other inputs to the acquirer in an attempt to force the acquirer to come to terms with them.
An acquirer may face a similar problem with key customers of the target company. It is common for troubled companies to have increasingly dissatisfied customers, through cost-cutting measures and the other disruptions that troubled companies often undergo. These customers may have higher levels of complaints and economic claims against the troubled company. A shrewd acquirer will perform careful due diligence on key customers of the target company, to understand what level of business can be expected from them in the future, but also to understand what claims they might assert after the closing. Although such customers may not have a legal right to pursue a claim against the acquirer for the sellers' defective goods or services, they may nevertheless try to force the acquirer to satisfy their claims as the cost of continuing to do business with them.
After performing a conscientious due diligence review of the target company's business, an acquirer may believe that it has a fairly complete picture of the assets and liabilities that it is taking as part of the deal. However, experience has shown that, no matter how good and thorough the due diligence effort has been, there is always that chance that an odd or completely unexpected liability will surface in the future, perhaps long after the deal has closed. Experienced counsel can ensure that the purchase agreement is drafted in such a way that these unexpected liabilities remain the responsibility of the sellers, either in the first instance by denying any recourse by the holder of such a liability against the acquirer, or by providing a clear indemnification right to the acquirer against the sellers if the liability cannot be side-stepped.
A troubled target company will commonly have at least some bank debt which is secured by a security interest under the Uniform Commercial Code. Because it is distressed, it may have other liens filed against it, such as judgment liens and tax liens. Most of these liens will continue to attach to the assets of the target company, even after being sold to an acquirer in an asset purchase deal that avoids other liabilities, and even if the acquirer does not have actual knowledge of the lien. That is, after all, an important purpose of a lien: to force the debtor to address a debt by making its assets difficult to sell to a third party. For this reason, an essential part of the due diligence review of a potential target company consists of an official lien search regarding the company and its assets. Experienced counsel will know the various offices and courts which the search should cover, in order to provide reasonable comfort that all significant liens are identified and addressed. Where liens exist, counsel will be able to coordinate the release of the liens with the closing of the transaction.
If the parties choose to structure the deal as an asset purchase in which the acquirer only takes specified assets and only assumes specified liabilities, the courts will generally uphold their chosen terms, even in relation to third parties like creditors of the target company. However, behind this general rule lie a number of exceptions that depend on the circumstances of the deal. One of these exceptions is under the theory of "deemed merger," where the acquirer will be considered to have assumed all of the liabilities of the target company. One way in which a transaction can fall within the Deemed Merger Exception is if the sellers maintain a substantial continuity of ownership in the post-closing company. So if a smaller acquirer acquires a larger target company, and if the purchase price paid to the sellers consists of a large percentage of the stock of the acquirer, then there may be enough continuity of ownership to consider the transaction a deemed merger.
A deemed merger may also be found where the parties to the transaction in their press releases and deal announcements to customers and other third parties describe the deal as a merger. By so doing, third parties are encouraged to think that the acquirer will be assuming all of the liabilities of the target company. While it may be tempting to the businesspeople managing the acquirer to put across a reassuring message to key third parties like customers and vendors, such a message must be carefully framed to avoid misleading those third parties about the format of the transaction. Experienced counsel should be involved in crafting such press releases and other communications, to avoid this potential pitfall.
Some states' laws require a seller in an asset acquisition to publish and send to creditors an official notice of the sale of its assets in bulk. While most states have repealed these bulk sales laws, they present a serious issue where they remain in effect. Experienced counsel will be able to identify whether a transaction is affected by bulk sales laws and to help comply where necessary.
Indemnities
Acquisition agreements almost always contain provisions allowing the acquirer to make a claim against the sellers if the contractual representations and warranties that the sellers have given to the acquirer turn out to be untrue, or if a creditor of the target company whose liability was not assumed by the acquirer attempts to impose liability on the acquirer. These provisions are known as indemnities, and typically a great deal of attention and negotiation is devoted to defining and limiting their scope. One of the key issues in these negotiations is often what the sellers' maximum exposure for indemnity claims should be.
In the context of a troubled target company, the acquirer may as part of its overall effort to mitigate the risks of the transaction, propose a very high maximum of the sellers' exposure, to ensure that it will not be without recourse if a large claim should be presented. However, if the sellers perceive the purchase price to be low in relation to what they consider the fair value of their company, then they may resist having a large exposure to indemnity claims. Also, if the purchase price is low and the seller is in a difficult financial situation, much of the sale proceeds may go toward satisfying creditors. Pursuing an indemnity claim may involve a great deal of credit risk; there may not be any significant assets remaining to pursue. As a result, the negotiating issues around the indemnities may prove even more difficult and contentious in the context of a troubled target company. There are no easy solutions to these indemnity issues, but experienced counsel can suggest ways in which the relevant risks are allocated among the parties in a way that corresponds to their knowledge of the underlying facts and their tolerance for liability risk.
Purchasing a distressed business has substantial potential upside. That upside can be secured by comprehensive due diligence relating to exactly what assets are being purchased and what assets are being left behind, and by careful attention to provisions aimed at reducing an acquirer's risk over time. Experienced counsel can help.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
Once a company becomes subject to bankruptcy proceedings, the ground rules for M&A activity change in very important ways. The discussion in this article does not cover bankruptcy-related issues.
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