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Launch Series Ep.5: Legal Diligence and Structuring with Scott Alderman and Alex Temel - Ep.187

Think Like an Owner

CHAPTER

Legal Aspects of a Search Acquisition

The speakers provide an overview of the legal process of acquiring a business, including key components such as the indication of intent and letter of intent. They discuss the amount of legal diligence that should be done before signing a letter of intent and highlight the importance of business and technology diligence. They also discuss the process following the drafting of a letter of intent, including conducting legal due diligence and reviewing contracts.

00:00
Speaker 3
Yeah, this was a great episode and we'll dive in and then two more episodes in the series to go, which will be a ton of fun. But absolutely, if we haven't listened to the first four episodes, they do a great job of kind of setting the stage for this one. But anyway, we'll get into the legal episode here. Well, thank you both for coming on the fifth episode in the launch series. This one focused on deal structuring and a lot of the legal aspects of a search acquisition. Goals for the episode are going to be walking through the legal process of acquiring a business, some key levers that dry the economic outcome of that acquisition. And then maybe some pitfalls or areas to avoid within a deal process. But Scott, perhaps a good way to start would be just getting an overview and a feel for the initial part leading up to the L.A.I. and then maybe key components of the L.A.I. and then we'll jump over to Alex and go back and
Speaker 2
forth. That sounds great. And Alex, thanks for having us. I'm super excited to be a part of this next chapter of the launch series, which I've really enjoyed to date. And so maybe just to describe the overall arc of the legal process and how that interweaves with the commercial side of a transaction. Initially, an entrepreneur connects with a business owner. And if there is some sense of a mutual fit and intent, there's an exchange of information over time where the entrepreneur is evaluating how attractive the business is and what he or she would pay for it while the business owner is ascertaining, is this someone that I would want to sell my business to? Sometimes along the way, the entrepreneur may provide a document that's often called an indication of intent or I.O.I. That's a very high level non-binding indication of how the entrepreneur would value the business and what the key terms of a deal might be. And that's just a very early forcing function to determine if the two parties are in the same ballpark on a few key terms like valuation. But at some point, the entrepreneur determines that it's time to make an offer for the business to the business owner in the form of an L.O.I. or letter of intent. And this is where the first significant legal lift can happen. And the L.O.I. defines the critical terms that the buyer and seller agree to and provides a framework that will be used to inform the purchase agreement, which we'll talk about in a bit. And if an L.O.I. is signed, there's a series of due diligence work streams that occur in parallel prior to drafting the purchase agreement, which is the ultimate governing binding agreement for the sale. A place of start might be what are the typical key components of an L.O.I. Those would include, you know, what are you buying? I mean, typically we're buying all of the assets of a company, but it could be a stock purchase or often certain assets might be carved out of transactions such as real estate or, you know, if the owner owns an airplane through the business, things like that. Second, what is the price or consideration that's being paid? The biggest component is usually upfront cash, but it could also be a promise to pay a portion of the purchase price in the future through a seller note and or an earn out tied to the future performance of the business. The L.O.I. typically states that when you're buying the company, it will come with a typical amount of working capital in the business on day one. The intent there is to make sure you are, you know, you're acquiring a normally operating business that isn't going to have a liquidity crisis, you know, on day two. And then usually there's a notion of some kind of escrow account that some of the purchase price that's held back to mitigate certain risks. And we'll talk about more about that as we go
Speaker 1
forward. One of the critical pieces of creating the first draft of the L.O.I. is to take a step back and look at this goes to Scott's first point about what are you buying and figuring out whether it's assets, equity, and or the type of business and are you buying the whole thing or part of the business. In most deals, you're buying 100% of the business and you have to make an assessment of whether it's assets or equity. Ideally, we always want to purchase assets so that we can identify which liabilities we're taking and which ones we leave behind. But in a lot of targets that are already set up as corporations, sometimes you have to buy the equity or the stock of that business. So that's often a front end discussion with the seller, but recognize that we would prefer to lead with an asset deal than an equity deal, both for liabilities and for tax purposes. But that's not always feasible and realistic. So if you end up buying the stock of a company, it just leads you down a different path than if you buy the assets in business.
Speaker 3
How much diligence should be done prior to drafting and signing an
Speaker 1
L.O.I.? So from a legal perspective, generally very little, what we often do is might have a half hour conversation with the seller and their counsel if they're available. Often they have a necessarily higher counsel. I found it very helpful to have a half hour conversation at the front end to identify that we'd like to buy assets. Is it feasible? Does it trigger any third party consent, et cetera, et cetera? That you want to limit that because that can be even done generically in the term sheet or the L.O.I. and the L.O.I. will set forth those six parameters that Scott went through to define whether we have a deal or not. And if you can't get agreement on the high level six items, some of the minutiae and details below it become less relevant. A lot of it is a decision by the entrepreneur and the searcher as to how much certainty you want and requires depending on the deal dynamics. If you have a non-competitive process where you're not competing just to get to exclusivity, I like to see people try and get as much information as they can up front. But often the deal dynamics are such that you're going to punt some of the more difficult, challenging things like exact structure until later on into the process. So ideally you would have a good amount of information in order to decide what type of structure, assets, equity, et cetera, et cetera. But if the deal dynamics don't allow it, my advice is get the term sheet signed up. We can figure that out afterwards.
Speaker 3
That makes sense. And maybe as a foundation for discussing pre-L.O.I. purchase agreement and onward, I think it might be helpful to set up what is the timeline for when each of these things happen. So you mentioned relatively little legal work is done at the L.O.I. stage. When would that change? When does legal come in? How long does it generally take with and without debt? And then maybe some other things that might affect timeline. But just broadly giving up, give me a high level overview for the legal timeline. I think it would be a helpful place to start.
Speaker 1
Yep, absolutely. So let me start with the broader timeline. I'm typically saying four to five months in terms of from a transaction meeting a seller that's ready to sell to a potential closing. If you think about that five month timeline, there is typically a full month and a half or two of what I would call business-type diligence, making sure that on the technology side and on the investor side that there's overall support for that. Let me pause for a moment Scott. Where do you see the right or the sweet spot of the amount of time that the searcher should spend on that business slash tech diligence as a general matter to get indications of interest from the investors?
Speaker 2
Yeah, well, I think it's really situation specific. But ideally, the searcher has met several times with the seller. Here she's had a chance to review say three years of financial statements. If there's a technology element to the company, maybe some initial discussions with a technical expert who's participating in the process. And really, another thing that's really important is just really getting to know the seller and understanding the seller's expectations and what their lifestyle wishes are post acquisition. Maybe what their spouse's lifestyle wishes are. And some of those softer elements can be just as important as the commercial elements.
Speaker 1
Yeah, one of the big critical pieces in terms of that timeline, Alex, really relates to is it a broker deal or not? Sellers that have hired brokers tend to prepackage a lot of the front end work. So they're more organized and it condenses what I'll call the pre legal period. Sellers that are cold called and have not really spent the last year and a half or year working with a banker about the concept of selling their company. There's often a lot of dialogue and discussion preparation that comes in before I get involved. But let's take a situation where LOI is signed and there is 90 days of exclusivity. Okay, you will find exclusivity periods between 60 and 120 days with 90 tending to be the more common period. What I advise folks is that if you have a non-leverate deal, so if there is not debt, I need five weeks from start to finish to get you to a closing. So do not start the true legal process until five weeks before. And within that five week period, I can get done all of the M&A work. I can get all of the equity work done relating to the investor funding portion of the transaction. And pre that five week starting the clock, you want to start your QV and you want your QV to be timed essentially that at that five week mark, your QV provider can give you a thumbs up on the deal. Your QV will not be done, but they'll give you that preliminary response. It says, there are no huge issues or no red flags and you have presented those additional findings to your lead investor or lead investors. And they have shown overall support for the transaction. That's really when you start the legal clock. If there is leverage, you need at least six or seven weeks. That's the critical distinction because lenders, even though they will tell you they can do it in four weeks, they never get a deal done in four weeks. It's really six weeks from start to finish. From the time a term sheet is signed. So it's somewhere between that four and six week mark, depending on the nature of the deal. But you really want before you start the legal clock, your preliminary QV, your preliminary tech diligence, if there's critical tech, and you want to know your lead investor or investors are supportive of the deal. That's kind of to me when you start the time clock. Now, prior to that, we will send out a due diligence request list, because what happens in every transaction is to sellers get antsy. They want to know that the lawyers are working. So we have all a due diligence request list that we will prepare in Taylor for the target business that gives the seller a couple of weeks to prepare, create the data room, collect that information. And then at that five or six week mark, we are ready to start full more towards the closing process.
Speaker 3
Any pitfalls within that initial pre-LMI diligence period or drafting the LMI to avoid and look out for?
Speaker 1
From my perspective, the most critical things to identify at that stage are on the legal side, whether you have the right structure and third party consensus or regulatory approvals. If you have a deal that is regulated and you need a third party to provide an approval, I've had transactions where the buyer and seller think they can close it four weeks. And it turns out we have a six month regulatory approval process that upsets everybody. So to me, in that first week, seller and their counsel need to identify third party consensus to get the deal done and identify whether structurally there's an issue. So for instance, if you have 100 owners of the business and you have to flip it to a merger, that's going to add time to the process. So at that very front end, you want to identify as your different calling them pitfalls, things that will slow down the process, because that will just be a shock to everybody.
Speaker 2
I would just add, Alex mentioned investor support and really throughout this process, even prior to signing an LOI, but certainly in that period between an LOI and starting work on the purchase agreement, you want to be bringing along your investors and making sure that you have adequate support to fund your acquisition at the end of the day. That's a process and you may not have 100% enthusiastic support on day one. And it's not unusual that not all of your investors participate for whatever reason, and you may need to bring in an outside investor or two to fill an equity gap. But you just want to make sure that you aren't investing all this time and hard due diligence costs without having that critical massive support behind you.
Speaker 1
It is typical, and I see regularly three to four investors in your group not participating in the acquisition. And it's often the smaller ones, but sometimes it's one of the larger ones, and then it's a function of the balancing act of when do you bring in the gap investor once the right time, once the wrong time speak to your lead investors about who might want to do super pro rather, because there's a preemptive rights notice period that tends to happen a few weeks later. And what I tell everybody is the preemptive rights process, which is the formal one when you notify your investors and they get the investors have the opportunity to opt out of the deal. When you send those out as an entrepreneur or a searcher, you should pretty much know with 95% certainty what the answers from the individual investors are going to be at that point in time. That is not a surprise document. So I encourage everybody to have regular conversations with their investors. And the pitfalls that I see are the entrepreneurs that believe that if they wait longer to engage, the investors will become somehow more favorably inclined for the deal. I've actually found the opposite. It's the constant engagement, constant update without being annoying, but giving material facts and the Q of E results, etc. etc. is a critical part of that engagement with the investor.
Speaker 3
So the L.O.I. being a precursor to the purchase agreement, what needs to happen after the L.O.I. is drafted before you start drafting the purchase agreement? What happens next?
Speaker 1
Yeah, there is always tension between the process of drafting the purchase agreement and the signing of the L.O.I. The seller tends to believe that once the L.O.I. is signed, that a purchase agreement should be produced in a matter of days thereafter. And on the buy side, we always have to have a discussion about the dynamics of the deal and what is the ideal period of time between the L.O.I. signing and the purchase agreement in a perfect world where there are no deal dynamics driving the timeline specifically. On the legal side, we would have an opportunity to do a few weeks of due diligence of reviewing the company, reviewing their contracts, understanding the employment arrangements, and the other specifics of the deal so that we could factor them into the drafting of the purchase agreement. There will be components in the purchase agreement that are not covered by the L.O.I. And if we rush into drafting a purchase agreement, we end up with a more generic document that has footnotes that is subject to diligence and subject to other things. So you can produce the document that is not as fruitful and productive on the document. So in an ideal world, I would have two full weeks of legal due diligence to review documents, have discussions with the entrepreneur about what positions you want to take in the document, and then also if there are difficult issues, have an opportunity to speak with the lead investors about those difficult issues and then produce the document. So ideally, it would be two to three weeks. And again, think about it from a five to six week period. I never get that ideal situation, unfortunately, because it's always that the seller wants something sooner. So you go in the middle. So basically, we take 10 days from the time the L.O.I. sign to produce an initial draft of the purchase agreement. That's the general timeline. That will be a 85% good document, 15% with blanks or to come and things to be decided in the process. But that's enough to send it over to the seller, have them have concrete things to work with. But we backfill all the items of lack of knowledge that we didn't have because I'm not getting the due diligence.
Speaker 3
You mentioned about trying to reduce risk and delays ahead of using legal. Given that legal is going to be one of your larger, if not the largest, cost. What are some helpful ways to reduce risk and ensure a smoother legal process once that begins?
Speaker 1
This is again, is it yield dynamics and point of tension between honestly, always entrepreneur and lawyer? All of the searches I work with have four mellow eyes that I give them. That is a three-page document that goes through the nine critical things that will be negotiated, whether it be price, working capital, demification, escrows. Each time most of the entrepreneurs see that, they have a pause and say, boy, I'd really love to send over a two-page document. Not a four-page or three and a half-page document. It's fine to send a two-page document or just hands off five of the nine items or four of the eight items. But recognize that those will have to be negotiated at some point. My guidance, and I know there's within the industry, different people have different approaches to this, is that your time and the entrepreneur's time and the investor's time is their most valuable asset. So I like to know up front whether there's going to be a meeting of the minds between buyer and seller, and have found very few deals where people have punted hard issues to the back end and hoping that they work out. And I hate to see entrepreneurs use six weeks of their 18-month period on a transaction that's not going to happen because they don't address things at the yellow I see. So the best way to decrease that uncertainty is I think the uncertainty comes into two forms. One is meeting of the mind between buyer and seller, and the second one is do you have investor support? And the sooner you, and the more effort you put in the front end of the transaction to address those two issues, leads you to a greater success at the back end.
Speaker 2
Yeah, and I would just add, I think searchers sometimes get different advice from different investors on how soon should you try to get a company under LOI? I mean, on one extreme, there's the idea that just get it under LOI and under exclusivity as soon as possible, and we'll figure out everything after that. And I think to Alex's point, that introduces a lot of risk. And the more time you can spend getting to know the company and getting to know the business owner, and the more detail you can include in that LOI, the greater the chances that there isn't going to be a really unpleasant surprise post LOI.
Speaker 1
Yeah, I think the other piece is for the entrepreneur to have a conversation with their legal advisor, and be very open eyes about the terms that you might agree to in an LOI. Often I see things agreed to in an LOI like earnouts or put call rights, different things related to the acquisition or the rollover components of it, that ultimately the investors say no to, and they're not going to agree to. So you want to get that out upfront. If the deal is such that it requires an earnout, have a conversation with your lead investor or investors so that you can go through the dynamics of why this is a good idea of this transaction, because in 90% of them, it's a terrible idea. But in this one, it may require it, maybe necessary, but have it upfront because I have seen investors walk away simply because there's too much complexity that potentially could have been avoided without a hard to hard conversation at the front end.
Speaker 3
It might be helpful to go over a couple of those types of conversations. What points or structure elements often lead to those hard conversations the most, and which ones are helpful to bring up closer to the start of the process versus leaving towards the end?
Speaker 2
Well, one of them that Alex mentioned was earnouts. And sometimes an earnout structure can be necessary and really helpful to, for example, bridge a small gap in valuation expectations. And maybe there's an opportunity to base a fraction of the purchase price on the next 12 months of financial performance, tying it to revenue, target, or an EBITDA target. I think where we're often presented with structures that don't make a lot of sense is when a large percentage of the consideration is in the form of an earnout and or the measurement stick of the earnout spans quite a long time, like multiple years. And in those situations, the chance of the searcher and the the the seller getting sideways over time is much higher because the searcher is going to want to operate the business as he or she sees fit. And over time, if that's inconsistent with the business owner or the seller earning his or her earnout, they're going to take an issue with that.
Speaker 1
A couple of other key points that I see come into play, the rollover in the terms of the rollover. And whether the seller is simply selling the business and moving on to the next phase of their life, or are they going to retain a percentage? If they're going to retain a small percentage, they five five percent versus if they're going to retain 30 percent, that can become a very real issue. And the rights that they have, because as most of you know, the base of the equity documentation here is a majority rule. And there are no special people in the cap table. So the question becomes, should a rollover holder who might own 25 percent have extra rights relative to the other investor? So that's often a point that you want to have upfront that their dollar will be treated like every other person's dollar and they will not have special rights. Maybe they have a board seat depending on the amount of the position, but even that often is up for debate, whether it's a perpetual board seat, or they get for the first year or two years. Next items, if there is a seller note and seller financing, the terms of that instrument become very controversial at times. So you might have some very basic parameters in terms of interest rates. And I've seen certainly in the last year, seller notes and the rates on those notes have become more of an issue than they were before, because it used to be, you know, if you go back three years ago and you said they could get eight percent paper, they thought they were getting a great instrument. Now, eight percent paper doesn't look so good. It's creeping up to 10 and 12 percent. So you and the term of that relative to if there is deaf financing, sometimes the seller note sellers think, oh, I'll have it out saying for two years, but you have a senior facility for five years and you have to work through that balance. Next big issue is the role of the seller. What will they be doing on a go forward basis? And again, the entrepreneur needs to think about from two perspectives. What's realistic in terms of do you need them to, if it's a generational business, do you need them to be there to support you in the next phase? Then equally as important as what is their expectation and what do they want to do? Because I have seen deals fall apart, not over monetary issues, but the person is selling the business and they really want to be a steward for better for worse for the next 18, 24 months. And the entrepreneur says, no, no, we're going to now run it. You know, figuring out if there's a meeting of the minds there is really important. We've talked about the earnout. Maybe the last item is the treatment of with all health purchase price adjustments, whether it's working capital or debt. If it's a software business or deferred revenue. Those can be in certain deals, massive relative percentages. You know, I've seen transactions where the deal price is $11 million, but there's $3 million different revenue number. And you have to figure out whether that's treated as debt and costs to get sold. So in most cases, interestingly, it's hard to say there's a specific roadmap of these are the six items. But when a deal is in front of you, it's not hard with your advisors and your lead investors to identify what those critical five or six points are. And then you just have to make strategic decisions on each of them.
Speaker 2
Just add to that. You know, I think it is very typical that the seller is a stakeholder in the go forward business through through one of the means that outs described. We may have a equity rollover. Maybe there's a seller note has some kind of role in the company, maybe a landlord. And one thing, you know, we have just learned that is
Speaker 3
while
Speaker 2
everyone goes in with the best of expectations, it doesn't always the relationship between the entrepreneur and the seller doesn't always work out. And so when you look at all those elements that allow the seller to be a stakeholder in the go forward business, you know, magnitude is important. I think you want the seller to be incented to support the go forward business. But if they have too much at stake and the relationship sours, you want to be able to just go your separate ways without too much distraction. And that can be hard to do if the seller is, you know, say the largest stakeholder in the go forward business.

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