Executing Smaller Deals and Negotiating Key Legal Provisions
Dec 11, 2023
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Anthony Krueger, Associate at Morrison & Foerster LLP M&A debunks the misconception that smaller deals are easier to execute. Topics covered include executing earnouts, reps and warranties insurance for smaller deals, and working capital adjustments. The podcast also explores important legal provisions in M&A and the significance of involving accountants and lawyers early in the process.
Smaller deals are harder to negotiate due to the higher value placed on each dollar and the emotional attachment of sellers.
Negotiating smaller deals involves complexities such as bridging valuation gaps, negotiating reps and warranties, and handling working capital adjustments.
Earnouts are crucial in smaller deals to bridge the valuation gap, and negotiating earnouts requires careful considerations of control, limitations, and performance calculations.
Deep dives
Negotiating Smaller Deals vs Larger Deals
Smaller deals are often harder to negotiate than larger deals due to the higher value placed on each dollar. In smaller deals, every dollar is a larger percentage of the overall deal, making negotiations more complex. Additionally, smaller deals tend to involve family-owned or operated businesses or founders' first exits, leading to higher emotional attachment and more intense negotiations. Buyers and sellers in smaller deals are focused on maximizing their positions, leading to unique deal structures like earnouts and rollovers. Overall, smaller deals require careful attention to valuation, negotiation lines, and bridging the gap between buyer and seller expectations.
Complexities of Smaller Deals
Smaller deals come with their own set of complexities that can make negotiations challenging. One complexity is bridging the valuation gap between buyer and seller, often requiring the use of earnouts or mixing up consideration. Another complexity is the negotiation of reps and warranties, especially in areas like operating covenants and liabilities. Working capital adjustments are another challenge, particularly when dealing with cash-based accounting systems, considerations for deferred revenue, and accrued bonuses and vacations. These complexities require close collaboration between legal teams, accountants, and business representatives to navigate and negotiate effectively.
Earnouts: Bridging Valuation Gaps
Earnouts play a crucial role in smaller deals to bridge the valuation gap between buyer and seller. With earnouts, the buyer pays an upfront amount and commits to providing additional payments based on the performance of the acquired business over a specific period. Earnouts are commonly structured based on revenue, EBITDA, or specific key performance indicators (KPIs). Negotiating earnouts involves considerations such as control over the business during the earnout period, limitations on claims, and calculations of payments based on performance. Earnouts are case-specific and require careful attention to ensure alignment of incentives for both buyer and seller.
Reps and Warranties: Quality and Liability
Reps and warranties involve the seller making statements about the quality of their business when selling it. These statements cover various aspects, including ownership, contracts, compliance with laws, and financial performance. Negotiating reps and warranties requires agreements on limitations, such as caps on indemnification obligations, survival periods, and exceptions for fundamental representations. Specific indemnities address known liabilities and require detailed analysis of potential risks and appropriate coverage. Disclosure schedules are essential in highlighting exceptions and providing comprehensive information. Negotiations also involve considerations like fraud carveouts, duty to mitigate, and insurance coverage for breaches of reps and warranties.
Working Capital Adjustments: Accounting and Negotiations
Working capital adjustments are a significant factor in smaller deals and involve accounting complexities and negotiations. These adjustments determine the net working capital transferred with the deal and impact the purchase price. Challenges arise when dealing with cash-based accounting systems, deferred revenue, accrued bonuses, and vacation liabilities. Negotiating working capital adjustments requires collaboration between legal teams and accountants to ensure fairness and accurate valuation. Considerations like baskets, deductibles, thresholds, and treatment of specific items like deferred revenue and accrued liabilities need careful attention. Early involvement of accounting and legal experts helps streamline the process and minimize potential issues.
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 of the M&A Science Podcast, Anthony Krueger, Associate at Morrison & Foerster LLP, debunks this myth and discusses how to execute smaller deals and negotiate key legal provisions.
You will learn:
•The complexities of smaller deals
•Executing earnouts
•Reps and warranties insurance for smaller deals
•Working capital adjustments and its effect on smaller deals
This episode is sponsored by the M&A Science Academy. If you’re looking to improve your in-house training, we have corporate training plans provided. Give your team members access to the best-in-class courses, templates, and networking opportunities in the industry. It’s also a great way to show your support for M&A Science. If you’re interested in learning more about individual or team plans, visit this page.
Episode Bookmarks
00:00 Intro
04:36 Smaller deals vs bigger deals
06:35 Complexities of smaller deals
06:52 Other layers of complexities
10:10 Earnouts
18:03 Reps and warranties
24:08 Fundamental vs General Reps and Warranties
25:35 Indemnities
28:40 Disclosure schedules
32:34 Caps and Baskets
35:52 Carve-out
36:44 Working capital adjustments
40:47 Deferred revenue
42:01 Accrued bonuses and vacations
44:12 Advice to those doing small deals
45:12 Craziest thing in M&A
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