Executing Smaller Deals and Negotiating Key Legal Provisions

This conversation is with Anthony Krueger, associate at Morrison and Forrester, AKA Mofo. In this interview, we talk about executing smaller deals and negotiating key legal provisions. We cover the differences between smaller and larger deals, complexities of smaller deals, using earnouts, reps and warranties on smaller deals, and working capital adjustments. This episode is sponsored by the M and A Science Academy. The M and A Science Academy is the most robust M and A training resource for folks who value continuous learning and professional development in M and A. Our courses are packed with real world expertise, curated from the best M and A professionals across the globe. Whether you're a seasoned pro or just starting out, there's always something new to learn at the M and A Science Academy.

Kick off the new year by elevating.

Your skills and knowledge and make better deals in 2024. Enroll today@mascience.com academy. Again, that's mascience.com academy. Let's get to the conversation with Anthony.

I'm Kisan Patel and you're listening to.

M and A Science where we talk with deal professionals and learn valuable lessons from their experience. This podcast focuses on stories, strategies and what actually happened during M and A deals. Hello M and A scientists here at M and A Science. Our goal is to continuously expand our understanding of M and A and use that knowledge to create top notch training programs and resources. By visiting mascience.com, you'll find all the information you need to take your MA skills to the next level. Get started by signing up for a free weekly newsletter to stay up to date on our latest courses, upcoming events and expert interviews. Again, that's mascience.com I'm your host, Kisan Patel, CEO and founder of M and A Science. Joining me today is Anthony Krueger, associate at Morrison & Forester, aka Mofo. Mofo is an American multinational law firm with over 1000 lawyers who advise clients across a range of industries and practices including intellectual property, patent litigation, corporation, corporate M and A, business restructuring, and securities. Today we're going to talk about executing and negotiating key legal provisions in smaller deals. Anthony, how's it going?

Going great. Thanks for the intro. Happy to be here.

Did I do that intro right? I saw you chuckle a little bit.

Yeah, no, I thought it was good. I thought it was good. I always giggle a little bit at whenever someone says mofo. But we got the mofo.com email so we really leaned into it.

Awesome. I appreciate taking time and I'm excited to have this conversation. You're going to teach me how to Be an M and A attorney in an hour.

Gonna teach you to get as knowledgeable as possible without taking my job.

Fair enough. Before we kick off this conversation, I think we should get the legal disclaimers out of the way. This is all personal opinions, not any clear representation or legal advice that we're providing. By continuing listening to this podcast, you incur $500 of legal fees payable to M&A Science. Send a check. I'm just kidding. What else should we have in there?

This isn't legal advice or legal strategy. Contact your lawyer. When talking about what's typical and what's market. Every deal is different, every deal is unique. What's market and what's typical is constantly changing and people have different views about that. So what might be typical in all of the deals I've done might be completely atypical for your lawyer and what they've done. This is all just having a friendly conversation amongst friends.

With that, let's learn some M and A legalese.

Let's do it.

Can we kick off with a little bit about your background?

I'm an associate at MoFo. I have a finance degree. I've been practicing corporate law for almost seven years now. I started my career in dc, moved to Austin, Texas and last year joined MOFO as one of the founding attorneys to help launch their Austin office. So my practice is primarily M and A. But as you can imagine in Austin we do a lot of startup and what's called ECVC or emerging company venture capital type work as well. So we help companies form, raise money both on the investor side and sell side. But really where I spend most of my hours is in M and A. MOFO is a top tier law firm. We are representing your household technology companies and the biggest and biggest deals. But also given Austin's kind of emerging a young startup scene, we do a lot of medium sized to smaller deals as well. So really getting a large breadth in different transaction types, private companies, public companies. And so I really enjoy it. Every deal is different and I kind of love that about my job.

Let's break it down. Smaller deals versus bigger deals. Is it true that 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 dollar issue on a million dollar deal, like that's a big deal compared to $100,000 issue on a billion dollar deal. With that you have harder bid asks or harder negotiating lines. When dealing with valuation, it's 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. And so they're going to be really hard on negotiating those values. And buyers are doing the same thing. They know that with each deal comes potential claims and so they need to get the best price they possibly can. We end up doing all of these crazy structures to bridge the valuation gaps on the medium sized deals. It can get pretty interesting, pretty crazy.

We'll talk about some of those structures. Do you get a sense that these smaller deals are just more emotional? You mentioned the founder owners.

Absolutely. It's just more real to not a business development team, one person and then a 30 person business development team kind of 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. And also they have smaller teams. 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 and they're answering every one of those questions that buyers asking and the buyers 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. Your first time. I just bought my first house recently and I close deals all day, every day, have been 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.

Let's break it down. What are the complexities of smaller deals?

A lot of times you'll have a buyer and a seller trying to bridge evaluation gap. And so 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 with mixing up the consideration. 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. So basically they'll buy the business, give you some money up front, and then that business will presumably be generating some sort of revenue for them and they'll use that revenue to pay off the Promissory note later on you see this. A lot of private equity firms too is they'll demand a rollover. The seller sells their business, but 20% of their stake, they roll over into equity in the private equity firm. And so then that adds a layer of complexity. 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? And so you run into all of these things versus like larger deals, it's usually cash. Sometimes when we get 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. Yeah, you 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.

Okay, so we got the capital structure. What other points of complexities do we run into?

So 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. Rep and warranty insurance is insurance policy that you get to prevent against downside or claims that the buyer buys. With smaller deals, sometimes it can be too expensive to get that, although we are seeing insurers go lower and lower. But you'll end up going to a traditional indemnification provision. What this is if we take the insurer out of it, me and you as the buyer and seller, let's hash out the rest. If you're a buyer, when can you bring a claim against me? What amounts do I, am I required to pay you back for what? And so you have to negotiate all of that and figure out a way to do that. Now indemnification provisions aren't particularly unique, but it is a whole other aspect 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. With these types of deals they'll typically always be on a cash free, debt free basis with some sort of working capital adjustment. 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. They're recording their bills when they get the bill, they're recording their payroll when they pay the payroll. And so now we just were closing in the middle of the month, we have to figure out what's our working capital. 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. It adds another layer of complexity. Working capital and purchase price adjustments generally can get complex with these smaller deals too. There's just like 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 send the loi. A lot of times on these private smaller deals to send the loi and then let's go figure out we're getting ourselves into and then having to renegotiate from there.

We got three big areas. We got the earn out capital structure in general, we have reps and warranties and then we also have working capital adjustment. Yeah, let's take these apart and I'll.

Do my best to try and keep this in layman's terms as possible. I think a lot of times deal lawyers and people like myself have been doing it for a long time can get lost in the, in the mumbo jumbo. So stop me if you want me to double click on anything or talk about anything further. So earnouts, what is an earn out? So typically an earnout is I give you money upfront as the buyer. Depending on how the business that I buy does will give you some more money later on, whether year or two years, some period of time. Typically it sounds really good and it can bridge the gap, as we mentioned earlier, 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, okay, we'll give you eight now and two in two years if it performs like the way you think it's going to perform. But then you strike that loi and it's how do we negotiate it? And it also, it's an agree, we jokingly say it's an agreement to fight later because these are inherently subject to dispute. And so it's something kind of buyer beware, if you will, when you're entering into this type of structure or and also seller beware when you're entering into this type of transaction. Typically you'll see these earnouts. The caveat that there's no typical earn out. Every single earnout I've ever seen is unique. There's no kind of standard language for an earn out. We have to do a lot of work on the back end to work with our clients to to draft this stuff. But you'll see a lot of times earn out structured based off revenue. So what's the revenue over the next year or two or sometimes EBITDA. Other times it'll be structured on KPIs. How many units did the company sell? How many products did the company sell over a fixed period of time?

Is there any best practice with that or just from what you've seen that hey, this is probably what you shouldn't do and maybe lean more towards these metrics.

Each metric is, it really is a business decision. And I have to be careful here because I don't want to pigeonhole me myself in future negotiations. But a lot of times sellers want top line because it's easier. So sellers want revenue, it's easier to figure out, it's easier to calculate. Buyers will want something lower. Bottom line, EBITDA, net income. How much cash am I actually getting? How much free cash flow am I getting? How much of the products am I getting? But with that, every single line in between top line and the 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 case by case on the legal terms. There are some things that you'll see getting fought over a lot and to be cognizant of because a lot of times the business folks, they figure out the KPIs, they figure out what the trigger is, but they don't think about this other stuff. The one of the big things we fight about is operating covenants. Who controls the business during the earn out 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 earn out. And 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 earnout. And so we'll get in the weeds there. And really that exercise starts on each side 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. What are the pitfalls that they could run into that we see that could really hurt the potential for this earnout? And going through the list, 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 get as many things on our list into the operating covenants and they do the same. So that's a big key legal provision that we see a lot.

It sounds like it is quite a bit of variable depending on each person's concern. I like the way you framed it as essentially like that Charlie Munger inversion that are going to go wrong ahead of time.

Invert, always invert. Yeah. The other thing you want to think about too is this is more of from the sell side, what's the buyer's plan for the business post closing? Is this a roll up? In other words, is this a company that's going to be serially acquiring a bunch of other companies, combining them and then may either taking company public or selling to a private equity shop in which case okay, I know I'm doing this deal with you Kisan, I trust you but what happens if you go sell my business someone else in a year and we have a two year earnout period and now they're running the business so we'll often get into should the earn out payments be accelerated and if so, how much do the earnouts have a cap? Oftentimes they'll have a cap, but not always. So you have to go through that. And then what happens if you don't pay? Are you paying interest, penalties, et cetera? And just thinking about that, what are.

Typical earn out periods?

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

Cool. Now you can throw an option in, company gets acquired, we want to accelerate this earn out.

Yeah. And then also you get into, okay, how is that acceleration calculated? Is it the first year basically, or is it the whole thing, et cetera. Then you also have situations where, okay, so 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 like overachieved our target on 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 multi year earnouts, overall, we hit all of our targets, but on a year by year basis, maybe the first two years were slow. You can see the complexities that you can get.

This is why we have attorneys here for these specific edge cases we don't think about and the deal guys don't.

It can get really complicated. Yeah.

Audit rights.

Audit rights. Are you, as the buyer, you're reporting to me how the earn out is progressing, especially in situations where the seller's not staying on or the seller's taking their money, they're off to Lake Como. I want you to be telling me how the business is doing and how are we progressing towards the earn out? And so then we'll fight over how often do you need to be giving me reports? What are those reports need to say in them? What happens if I get that report? They're like, this can't be right. These line items are just clearly wrong. What's the dispute mechanism or 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 100 products. We were selling thousands of products a week before the close. We'll get into that as well. Typically you'll see folks either demanding it quarterly or at the end of, at the end of each earn out period, the buyer will basically give you a statement saying, here's how we did, here's how much you're receiving as a result of how we did. But other sellers, when they have more leverage, they want lead up to that. Depending on the buyer, maybe the buyer's public company is already doing kind of quarterlies, quarterly reporting. So then you can maybe negotiate for that to have a separate quarterly report. Their accountants are already presumably doing it anyways. If you have a private company that they're only doing their financials annually, that might be a harder ask.

Okay. Obviously there's some avenues to go validate numbers and make sure that things are the way they should be. I think that's like everything related to earnouts.

Earnouts are interesting to talk about because they are so specific to each deal, it's hard to get into super specifics because it's so different. The next thing that I'm looking at if I'm on this deal is the indemnification language and the indemnification provisions and the reps and warranties.

Yeah, I want to make sure I got my keywords here. So we have indemnification clauses. Yeah, reps and warranties. Reps and warranties is actually not specific. There's reps and warranties insurance.

Right.

You are going to write out your reps and warranties in the contract.

Yeah, that's exactly right. 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'm not under. I don't have any disputes under them. I paid them on time or I've been receiving payments on time from 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. So it really is. You're making statements about the quality business. 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 redline. Is there a knowledge qualifier? You haven't breached any material laws to your knowledge. No 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 it's what happens after the deal closes if those turn out to not be true. And so we see this a lot. We make a big announcement. We just sold this company. Big news, lot of money. The ex disgruntled employee from two years ago is, 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 come running and say, look at this paper the CEO signed. It's promising me shares. And so we have to deal with that. 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 there's liabilities that happened as a result of the way I was operating the business before I sold it, that's mine. Anything afterwards is yours. It needs to be specific to the reps and the warranties that we agree to. That's us negotiating the risk. And so that's what an indemnification clause is. It's if these statements that I made turn out to be not true, you as the buyer suffer some sort of damages or losses or have to pay a fine as a result of these untrue statements, I will pay you back. And so as you can imagine, it's similar with 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. 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, 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. That gives the seller some comfort that the cash is there. Or the buyer will just say, I'll hold onto it for you. The nice thing for the buyer, of course is, especially now with interest rates, is they're collecting all the interest on that, on that money. So then what happens is the buyer makes a claim against the seller for that indemnification and then they take it out of that hold back or that escrow. Of course 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 with 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 would fit in as an alternative to the holdback.

You mean reps and warranties insurance. 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 as a seller you're like great, I'm getting my 20% upfront 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 and do reps and warranties insurance all the time. But some people just, they don't like either. You usually have to, you do a lot of diligence, get your lawyers and your team to provide a fulsome diligence report. You have to do heavy accounting. Sometimes when you're dealing with these smaller deals, it can be really challenging for smaller founders to go through that whole process or a small family owned business to go through that whole process because it is daunting. It's a lot of time. And so some buyers might say, hey listen, we, we're getting, 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. There's benefits on both sides, pros and cons on both sides to getting reps and warranty insurance. 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 upfront.

How does it impact the actual purchase agreement? Would you change things and provisions in there?

Basically you're going to add a whole like two or three extra pages at the back, typically going over how indemnification claims are done, what risks there are. And so then there's a lot of things you're negotiating for. You're like 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 warranties survival periods. How long do these reps and warranties survive for the buyer to bring a claim? So when can the seller really be scot free on the boat in Lake Como without having to worry about this 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. It can vary depending on the deal and depending on the leverage that the parties have. So really you're looking at how long can the buyer make a claim which is tied to survival periods, and that will vary between fundamental and general reps. Are you familiar with fundamental or general? You want me to break that down?

Yeah, let's do that.

So fundamental are really the big things. I own the company, the company is in existence. Taxes are typically in fundamental reps and other similar kind of statements. Your general reps are going to be things about, here's my contracts, here's my top customers, depending on where the value is in the company. So is this a heavy IP company? We could 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. And with that comes additional protections and limitations. And with respect to that downside recovery mechanism. So oftentimes, general representations and warranties, there will be 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 deal or how much money they put into the escrow. Not always, but most of the time we'll only go after this money that's set aside with respect to all the general stuff. I liken this to when you're buying a house, if the seller told you, yep, the heater's good and the locks were just changed, I own the house. That's fundamental. The heater's good. Yeah, you can, you can go after the escrow for the heater, but if you didn't own the house, I get my whole money back. There is no cap or that we're capped at the purchase price of the deal.

Got it. So we have these two types of reps. Fundamentals, generals, indemnities. What are specific indemnities?

As part of the reps and warranties process, you'll go through that. You'll look through the 10 pages, you'll go through it with your lawyer, your accountants, you'll be like, oh, actually here where it says, we've always classified our employees and independent contractors correctly or under applicable law, we realize, going through due diligence, that there was a couple independent contractors that we hired a few years ago that may have been misclassified. In other words, they may have been should under applicable law, classified as an employee. And so you'll go on the disclosure schedules and you'll say in 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, we don't. These Three might not be classified correctly. So now, I guess going back, if those folks turn out to had 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. So that's why those schedule of 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 off of kind of what known liabilities we think are out there. And so then from there, okay, we have these three potentially misclassified folks. What's 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, okay, what does the law say? How much would we owe them? Oh, 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 the parties will negotiate. Do we cap it at that number? Do we set aside basically make a separate new holdback escrow to capture those specific indemnities of specific issues. And of course, the buyer's trying to make that specific indemnity as broad as possible. So they'll probably, if I'm drafting the first draft, it's. You've had misclassification issues, you know that on a few employees we should get it all covered because we don't know what else is out there. But we know that this is something that you've overlooked before and the seller's gonna come back like now, the exceptions only applies to 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. And so 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, et cetera. We'll negotiate that fight about that. That always gets interesting, why we pay the big bucks. It's not dollars upfront. You're negotiating over like probabilities of dollars on the back end that roll of a dice materialize. And we see it often 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.

What are disclosure schedules and why does everybody hate reviewing them?

Disclosure schedules. Maybe we can circle back to what reps and warranties are. So reps and warranties often have, they'll start off with except as set forth and it typically is numbered in association with the number of the rep. So except as set forth on Section 1 of the Disclosure schedule, companies in good standing and all in the, in the state of its incorporation, all states where it needs to be. And so you'll put together all of those schedules into what's called a disclosure schedule. And so 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 that where you've bought and sold a company. And so you have to go in and list all of your contracts there. Same thing with like employees. You typically have a rep that says attached as Schedule 6 is the employee census. You'll need to go and fill all that information out. 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 gotta go through it all and think about it and work with your team to try and cover your downside as much as possible. And so they are super painful because you start negotiating the reps and warranties on the very 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. So and those reps and warranties are constantly being expanded and shrunk and getting them right is a massive process ordeal. But they do have significant kind of implications on the back end of what kind of coverage. So if you're sloppy about them, it can be pain. It might be easier when you're actually getting, trying to get the deal done, but it can be painful on the back end.

Yeah, I didn't even think about putting them together. I just thought about reviewing them Was a pain in the ass.

Yeah, reviewing is a pain. Oftentimes when we're working with sellers, we are working with the sellers to prepare them and put them together. Yeah. And reviewing them is just as painful, but reviewing them is 10x easier than putting them together. Another good point on disclosure schedules generally is like a practice tip is oftentimes sellers reach out to us, they have an loi at hand, and then it's okay, we have to go and clean up. Not only do we have to go and like, okay, let's 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. Not only is there 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 of a free time, but also it can hurt you and put you on a bad negotiating spot. So big tip to our sellers is if you're thinking about selling or you know, like, I need to be selling in the next year or two or that's where I'm looking to get out, reach out to an M and 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 beforehand, get it together, get it clean 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 kind of purchase price later on or making it a big issue that you're now negotiating with 10 different lawyers on a call about or having to talk about versus oh yeah, we found this a couple years ago, we cleaned it up. It's done.

All about the prep.

Yeah.

How about caps?

Yeah, caps and baskets and deductibles and maybe we can talk a little bit about the carve outs from those. Really, these are like limitations on the seller's indemnification obligations. So 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. Inherently, some of this stuff should have been priced in or, 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. 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 like intermediate set of reps and warranties. For example, if you have a heavy IP company or heavy government contractor will put government contracts reps or intellectual property reps into that middle bucket and they'll have a 40 or 50% cap. Whereas the value in the business is what we're thinking about when we're negotiating that baskets and deductibles are interesting. So this is the deductible that you think about with your car insurance. Can the buyer come after us for 1000 bucks just because this. So this is like. No, the buyer has to pay some sort of deductible or called a basket, or there has to be some sort of minimum threshold before they can bring a claim. And so this will be like maybe a percent, half a percent, some sort of threshold. And 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 $1. So the buyer now has incurred, let's just say the basket's $50,000. Has incurred $50,000 in damages. They can bring a claim to you from $1. So they'll bring you a claim, $50,000. A deductible, which is typically always smaller than the basket, means that the buyer is only getting what's above that deductible. So they have $50,000 in damages. There's a $25,000 deductible. They can bring a claim for the $25,000 above the threshold.

Okay, so when you define your basket, you're defining how much more they can actually exceed.

Yeah. So you're defining basically 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? 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. The buyer can come after you from $1.

All right. Other limitations.

There's certain limitations that sellers will ask for and buyers push back on non exhaustive list 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, 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.

Is that the carve out from limitations?

I would say that would be like a limitation or a covenant that the buyer would agree to. A carve out from the limitation would be like fraud. 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. 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 going, 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. There will be carve outs from some of those limitations.

Okay, I think my brain has had enough around reps and warranties and indemnification I can handle. The other big pillar we had was around capital adjustments, working capital adjustments.

I don't know how in depth we need to go into here. They are tricky. This is another one where it's 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. Getting those advisors involved early can help you, number one, negotiate your loi, you don't have to deal with it. Or two, get them ready and get them moving on figuring out, okay, let's figure out what expenses we prepay. Let's figure out what expenses we pay after we've received the service. Right? 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 like 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, like 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.

Yeah, it sounds like there's a lot of little things that go into it. Getting the accountants in it sounds like earlier the better. Like even as you're taking this deal to market, having a good sense of what that's going to look like. What on the legal side, what are the key terms clauses you end up having to consider and negotiate.

It is a quasi legal accounting business exercise. So we are working extremely closely. Like we'll be on calls, three way calls between business folks, the accountants and the legal 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 where situations where you have maybe a general practitioner on the opposite side of you that has given maybe the seller good advice, helps form. The company has been giving them kind of general good corporate advice the whole time. But they're not M and A deal lawyers, but the company trusts them so they haven't run their M and A process. And so then all of a sudden we're sitting on the other side as the buyer's counselor. We're saying we have all this stuff to deal with and we need to negotiate it. 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 up, for example, restricted cash. If you're going up against maybe another sophisticated big ma lawyer, it's 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 unsophisticated buyers counseled, okay, that makes sense, it's a 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, they're left holding the bag, if you will. So what we would try and negotiate is let's put that money in A holdback. So we'll give you the purchase price adjustment as a holdback. And then as soon as that lease is up, whatever money we get back, then we'll release to you. So there's a lot of little things that we work in tandem with the accountants and the business folks that brainstorm and figure out where the middle ground is. That can be really important. Another thing you see on working capital adjustments too is especially worth these companies where it's all over the place is you'll see people try and negotiate for thresholds or what they call collars. So it's if the working capital is between X and Y, 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 dollars and working in capital adjustments. Other buyers don't like it. They think it's we should get every dollar we're entitled to. It's interesting. And sellers are the same way.

That's like some real differentiated business culture, right? Do we want to nickel and dime this out or somebody wanting to do that?

It is interesting kind of seeing the differences between folks. And you never know what decision is going to be made.

Can we talk about deferred revenue? Where does that fit in?

So deferred revenue is you get a payment upfront for a year's contract and the contract's technically monthly, but they pay their annual fee upfront. We're not recognizing that revenue. Of course, 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. It is a treated as a liability, maybe on the balance sheet. Is that considered indebtedness? Really, it's we just need to provide them services. So what's the cost of providing those services? And so for things like software, it can be relatively low. Oftentimes, especially in software company deals where you have like these licensing arrangements where there's a lot of deferred revenue there 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 and 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 like the buyer is saying they're selling all this, they're getting the cash, they're taking the cash 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.

Then you got this other piece with accrued bonuses and vacations.

Yeah. So accrued bonuses and vacations, that's another thing that gets. It gets 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 at when the person leaves. So you have to figure all of that out, which can be difficult but doable. Some folks, they try to get that as working capital, as 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 from before the closing, that's on your dime. And then we'll take care of everything afterwards. Versus some buyers say let's we'll throw it in with the working capital, we'll come out in the wash. You can see the logic and the reasoning on both sides. But it goes back to what we said before of 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 accountant and get your lawyer involved in this one.

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

It is a funny one because it's an overlooked item, especially if you're doing smaller deals or newer to do an M and A. You really don't think about capital working adjustments, which tend to be pretty significant depending on the business type especially.

And they're huge. And because 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 it's we have a bookkeeper, we have a third party bookkeeper that helps us with our books in our account, our taxes each year. Then getting those folks who are not used to dealing with the pressure and the intensity of an M and a transaction, the real kind of dollar for dollar adjustments to the amount. It can make things extremely difficult. So by getting them in early, you can either maybe 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 them everyone get together and work together. Okay, let's figure out what our issues is before we jump overboard here and start entering the market.

Got any other advice for people doing small deals?

Get your house in order. Start thinking about the process before you get the and hard thing to do.

I'm a deal guy at heart, and that's really hard to do.

It is really hard to do, but it's possible. And when it happens, which is unique, those deals go by so much smoother than when we just. Here's the loi. And it's. We have all this stuff we need to clean up. 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, have your business records orally and have your attorneys help you with that. If you know. And you sure need to think about a process, especially if you're. 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 together and working together ahead of time. We see a lot of clients like, they don't want to pay the expense, especially without a deal on the table. But it's kind of like the old adage, an ounce of prevention is worth a pound of pain and it does end up being more economical in the long run.

Great advice. Anthony, what's the craziest thing you've seen in M and A?

I've been in some crazy negotiations. I've definitely, I think crazy things to me are when we see, especially when we're representing the sellers, we see sellers walk and it's like, wow. Like, that's when you know that they have the actual negotiating leverage when they're willing to walk. Bringing it back full circle. Dealing with just good general attorneys, like good people, but that don't do M and A all the time. You end up fighting about, like, really weird stuff and negotiating over provisions that you've used the same language and 30 other deals and no one's ever marked it up. And you end up spending multiple hours and multiple revisions on this language because this person is just not used to this language. And it's new, so I feel like those are the craziest situations. Definitely when we see people actually walk and dealing with kind of lawyers, it's you might have a really good doctor that you go to all the time, but if you need an organ transplant, you probably go to a specialist in that situation. That or we run into the crazy situations.

Yeah, it's probably advantages you get over it too.

Yeah. Yeah, that's right.

Hey Anthony, this has been a great conversation. Thanks for taking the time. You're helping me become a better M and A scientist, as I always say, so I value that. Plus, I don't think I'm getting billed for this, so this is even better. But those of you who want to continue, they probably reach out to Anthony on LinkedIn, mention M& A Science. He'll hook you up with a discounted billable rate.

We'll do the best we can. Yeah.

M and A Science special. This has been great. Thank you so much for taking the time to do this and having this conversation.

Yeah, thank you so much. It was a pleasure.

Those of you still tuned in, till next time. Here's to the deal.

Foreign.

Thank you for taking the time to explore the world of M and A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M and A function or optimizing one that you've already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email Kisan K I S o n a science.com or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter. Again, that's mascience.com here's to the deal. Views and opinions expressed on M and A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or or affiliated with any individual. This podcast is purely educational and is not intended to serve as a basis for any investment or financial decisions.