Ticking Time Bombs for Unwary Buyers: Failure to unearth lurking problems could touch off surprise disruptions post-closing.

When the M&A process seems to be going smoothly as a deal moves toward closing, that may be the very time to start looking for problems. A large number of transactions these days run into late-stage problems that require intense negotiation to resolve or, even worse, pose the threat of coming back to haunt the two parties after closing by landing them in court or before an arbitrator. Litigation and other bad outcomes can afflict deals of all sizes. “You’re going to see the same headaches whether the deal size is $10 million, $200 million, or larger,” says Glen Tucker, a Partner at Greenberg Dauber Epstein & Tucker, a Newark, N.J.-based law firm specializing in M&A. In an effort to highlight what can cause this kind of agita, Mergers & Acquisitions talked to practitioners to garner best practices about what might be called “post-due-diligence due diligence.” We’ve tried to concentrate on things that even experienced bankers, intermediaries, and attorneys can miss. Generally, the problems aren’t new issues – e.g., pensions, employment, earn-outs, non-compete agreements, intellectual property – but they often come in new guises. We’ve included information about what can go wrong as the deal is heading for the finish line, as well as things that can occur post-closing. Alan Gelband, founder of Alan Gelband Co., says there are only so many things that a dealmaker can control. But one of the most important things he can do is to make sure he knows whom he’s dealing with whenever possible. “I’ve been working with some of the same buyout firms for 15 years or more so I have a strong relationship with these buyers,” he asserts. If a dealmaker is working with an individual or a group for the first time, Gelband recommends that he check to see whether there’s a history of the counter party suing its advisers or other participants in previous deals. One reason for this scrutiny, according to Gordon Locke, an attorney based in New Rochelle, N.Y., who often represents intermediaries, is that “there’s no doubt that a high proportion of buyers have ulterior motives.” He adds that deal advisers must take care to classify the sensitivity of the information of the target. “You have to keep your trade secrets away from buyers, otherwise you run the risk of losing the deal and finding yourself in a weakened strategic position.” Before getting into specifics, let’s acknowledge that some observers say that to even talk about late-stage due diligence issues as a separate category doesn’t make sense. “A competent dealmaker would have caught nearly all of these problems and cleaned them up before the deal was close to the finish line,” Locke says. Probably so, but deal participants should read on because it’s a shame what can go wrong late in some transactions. Workforce issues In otherwise healthy deals, people issues can be a real Achilles’ heel. As such, employee problems are among the hidden time bombs that can disrupt a deal before or after closing. Problems with the target’s multi-employer pension plan can have serious consequences for both the buyer and seller. Tucker notes that liabilities associated with underfunded multi-employer pension plans can be especially troublesome. If a business has union employees, the seller may have been making all the contributions it was obliged to make to the union pension fund. Then it sells the business and the last thing it expects is a notice that the plan is underfunded and it has to pay its proportional share of the deficit. “This is a double-edged sword that can hurt both the buyer and the seller,” Tucker says, because liability can apply to both parties. He adds that the law is stacked against the parties if the union comes after the company to pay the amount of the underfunded liability. Bankruptcy, either corporate or personal, may be no help. “The trustee’s lawyer will go after both parties and will attack any other companies they may own.” One obvious solution to multi-employer pension plan underfunding isn’t a walk in the park either, Tucker says. “You can try to talk to the actuary of the plan while you’re doing your due diligence, but it’s a delicate thing because you can easily end up letting word out about the transaction.” he says. Another tack is to get the seller to indemnify the buyer and hold it harmless for any damages resulting from a shortfall in the fund. Tucker adds that if the deal involves a strategic buyer that already has a relationship with the union, it can be easier to secure this type of indemnification. “A strategic buyer may feel it’s going to face the same problems in its other operations,” Tucker says. A second kind of workforce problem can arise if the target has a defined benefit pension plan. If the plan is underfunded when the company changes hands, it can expose the new owner to problems. For example, if the buyer terminates the plan after taking control of the company, it can incur liabilities to the Pension Benefit Guaranty Corp., a federal agency that insures pension plans. Tucker notes that the costs of settling these kinds of pension issues can wipe out the entire selling price. He recommends that if the deal is being done as an asset sale for cash, the buyer can offload the liability, but if it’s an acquisition of stock, which may be necessary for tax and other reasons, the buyer will have fewer options. Another employee issue that dealmakers must consider is how to provide incentives for senior management to keep workers on board. The most common technique involves using bonuses and incentive agreements. This is especially important in cases where the buyer is not going to run the business himself, or the target will be folded into a larger operation. In both these cases, the loss of senior managers can drain value from the deal. Tucker also warns buyers to be certain that non-compete agreements are in place for senior managers who are exiting, although retaining them could be a better option. The new owner can risk waking up and finding a new competitor down the block who knows everything about the business. “You don’t want to hand such excessive leverage to key employees, so it’s worth it to structure things so they’re happy and they stay in place,” he says. Another way employee retention issues can sabotage a deal applies to the treatment of rank-and-file workers. Federal law, the Worker Adjustment and Retraining Notification (WARN) Act, mandates that most large-scale layoffs must be announced as much as 60 days in advance. “Anybody doing an M&A deal must be aware of the huge impact of violations of layoff notification rules,” Tucker says. Employee benefits, especially how the buyer will handle the transition from the seller’s health care plan to the successor plan, can be a tough problem. “The status of benefit plans is often the first issue that people ask about when the deal is announced,” says Peter Coffey, a Partner at the Chicago office of Michael Best & Friedrich. He advises that the quicker you lay those plans side by side and make adjustments for their future shape, the fewer problems that the transition is likely to cause. Another tip for handling people issues that goes along with Tucker’s warning to identify potential union pension fund liabilities is to examine any existing union contracts. “You have to ask for copies of union contracts because for all the buyer knows, the contract will be up for renegotiation next year,” Locke states. This could greatly change the financial metrics of the transaction, he adds. Problems with earn-outs Of all of the post-closing snags, the earn-out may be the most problematic. The earn-out is designed to pay a seller additional compensation for an increase in the future value of the assets, especially if there’s some disagreement on the basic purchase price. For the buyer, it’s a tool against overpaying for value not yet realized at the time of the sale. The inherent problem with earn-outs, as well as other post-closing provisions such as non-compete agreements and non-solicitation pacts, is that they attempt to define what hasn’t yet happened, dealmakers note. Larry Glasgow, a Partner at Dallas-based Gardere Wynne Sewell, says that even the most excellent drafting won’t eliminate confusion and potential clash over earn-outs. He says that this is the case even when there’s no pressure to get the deal done. If the provisions are being negotiated at the eleventh hour, i.e., a last-minute step to settle up, dealmakers may find all sorts of surprises. “Often the parties don’t have a clear understanding of certain accounting items that go into the calculation of the earn-out,” he cites as one point of contention. Glasgow says he directs his due diligence team members to be on the lookout for what he calls “deal fatigue.” He says that may result in a tendency to not pay as much attention to critical post-closing as is paid to representations and warranties and other contractual aspects of the deal. Glasgow recommends that dealmakers write the earn-out specifications so that the calculations will be based on the historic accounting methods of the seller. He says that this can prevent the buyer from trying to stack the earn-out its favor by applying a different set of accounting standards if the seller is the client. Tax and environmental considerations While there are many ways of paying insufficient attention to the tax considerations of the deal that can cause late-stage problems, Peter Coffey warns dealmakers to be careful to check if the sale they are working on represents the second time the company has changed hands in a relatively few years. “If your sale is the second change in control, it may decrease the tax flexibility in the transaction,” he advises. It’s hard to believe that dealmakers might overlook the obvious liabilities in environmental issues, but M&A pros say that it happens. “You have sellers who have never studied their property and they don’t want to spend $12,000 to do it now,” Tucker says. But the deal leader has to tell everyone to make sure environmental issues are on everyone’s radar screen. The acquirer must examine environmental issues because if they surface after the deal closes and there aren’t adequate contractual safeguards in place, there often is no way to shift or cap liability, Tucker adds. Intellectual property matters Dealmakers need to identify the intellectual property (IP) assets that will be transferred in a deal. “For new-economy companies, like technology or biotechnology, you don’t have a lot of other hard assets,” says Constance Sugiyama, a Partner at Gowling Lafleur Henderson in Toronto. She warns that if the seller doesn’t have a team capable of doing IP due diligence, that can be a recipe for disaster. She suggests that principals make sure that the key developers of the target’s core products are “locked up” with incentives that will ensure that they don’t leave. Sugiyama also says it’s important to be able to trace the lineage of patents and other forms of IP that the company will rely on going forward. In many cases, she notes, due diligence requires a team of professionals in a number of disciplines in order to effectively analyze the target’s IP. “I can’t tell you how good a company’s molecules are, but we have attorneys here with Ph.D.’s in biochemistry who can,” she says. A related field that dealmakers must monitor is information technology (IT) licenses. If the target licenses software from a third party, it behooves the buyer to ensure that access to this technology is ensured. “You have to think through how the deal structure might imperil the continuous supply of software,” says Dennis White, a Partner in the Boston office of McDermott Will & Emery. A problem that pops up frequently, he adds, is the change-of-control provision in software contracts, which can include a huge fee to reestablish access to the product or system. Customer retention issues Customer defection is always a concern when businesses change hands. “A seller may say, This is my customer list, and they’re all stable,'” says Mark Kuehn of Gibbons, Del Deo, Dolan, Griffinger & Vecchione, Newark, N.J. But he says that deal attorneys should make sure that the contract is tight enough so that if customers defect, the buyer has recourse to seek compensation from the seller. Another deal attorney notes that customer retention can be critical to the deal since what you’re buying in many deals is cash flow, and if significant customers bolt, that cuts into the cash stream. Avoiding Late-Stage Deal Headaches “All clients withhold information,” Locke asserts, not necessarily because of dishonesty, but often because they don’t know what’s important. One trick of the trade that Coffey likes to use is to pose the following question to clients who are sellers: “I ask them to put themselves in the shoes of the operational executive on the buyer’s side who’s going to run the company or unit 30 days after closing. I ask them to tell me what information they would be interested in knowing about the business a month from now.” Coffey also suggests that dealmakers think through whatever experiences they’ve had themselves or have read about that can apply to the industry in question. “If it’s a food services deal, you want to think about food integrity issues and check to see how the company looks to the regulatory agencies,” he advises. T. Patrick Hurley, Managing Director of MidMarket Capital Advisors in Philadelphia, says that a problem he often sees is too much optimism on the buyer’s side. He says this can lead them to accept some assumptions that don’t seem viable in retrospect. Other dealmakers point to the desire of some negotiators, especially private equity groups, to close deals quickly as a source of late-stage and post-closing problems. “I’ve found that people who aren’t strategic buyers underestimate the cost of the solution to some problems that appear during the process,” Coffey says. Special problems can plague a deal when a target is part of a joint venture or is being sold by a larger company. For example, when an acquirer buys a division of a diversified company, the agreement sometimes includes a provision for the former parent to continue supplying services, such as information technology support, for a transition period after closing. This can cause problems if the divested unit’s needs suddenly become a low priority for the parent. Private equity firms can be particularly vulnerable in this type of situation because they may not be able to source such functions elsewhere, deal experts say. Communication is key Above all, dealmakers should keep in mind that a smooth deal process could be disrupted by poor communication among members of the team. “You have to make sure that the deal team is communicating with the guys who are doing the drafting,” Glasgow says. The risk is that if the seller doesn’t raise an issue with the buyer and the relevant information was scattered somewhere among team members, it becomes hard to raise it in the late stages of negotiations. Coffey notes that the earlier he can get the deal teams talking to each other the better. The problems that the teams can’t work out between themselves should be referred to the banker or attorney who is overseeing their work. When the teams do discover something unexpected that could disrupt the deal process, Coffey says he uses what he calls a “24-hour rule.” “If I become aware of an additional due diligence item, I like to give the team 24 hours to scope it out and try to devise a solution,” he says. After that time period, he says he’ll take the information to the counter party because to wait any longer might cause them to think information is being willfully withheld. Coffey adds that it’s a good idea to prepare a solution that can accompany communication of any bad news to the party on the other side of the table. Tucker offers cautionary advice that late-stage deal snags happen with such frequency that wise dealmakers keep on the watch for them. “In 75% of deals, something flares up late in the game. That’s why I always keep the closing binders handy,” he says. Copyright 2005 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com