Buying and Selling When the Going Gets Tougher: Should the m&a environment sour, dealmakers still can complete major transactions by using the right tools.

In the expanding economy of the last eight years, stock became a very popular acquisition currency, and debt financing for those who preferred cash was readily available. The onset of the Asian financial crisis had little impact on deal volume in 1997. The mergers and acquisitions climate changed, however, after the extent of the Russian economic crisis became apparent in August 1998. Emerging markets as a whole began to look shaky and investors abruptly shied away from risk. Banks tightened their global credit standards, the high-yield bond market floundered, and the stock market became volatile. In the resulting uncertain market, those who did not have cash found it difficult to obtain and those who planned on giving or receiving stock discovered that its value could soar or plunge between signing and closing. By many measures, last year’s uncertain market was brief and now is over. By early October 1998, mergers and acquisitions began to bounce back. The year ended with the announcement of several megamergers and acquisitions and a significant overall increase in deal volume over the preceding year. Nevertheless, many of the factors contributing to last year’s uncertain market remain. An uncertain market could return at any time. This article proposes strategies for would-be buyers and sellers to cope with and succeed in the next uncertain market. An uncertain market does not mean that acquisitions should be avoided or abandoned. Rather, buyers and sellers should reevaluate and possibly modify the strategies that served them well in the past few years in order to more successfully buy and sell in an uncertain market. There are many valid business reasons for completing strategic acquisitions in an uncertain market. Sellers may need cash to offset losses in other businesses or foreign markets and may be willing to part at reasonable prices with assets that they were unwilling to sell only a few years ago at inflated prices. For their part, cash-rich buyers may identify new opportunities to vertically integrate or to expand into related fields or new markets. However, like international acquisitions in countries experiencing economic turmoil, domestic acquisitions in a climate of economic uncertainty face special challenges that can derail even those transactions that make the most strategic and economic sense if the participants are unprepared to confront them. Stock prices, interest rates, and exchange rates may be volatile, debt financing may be difficult or impossible to secure, potential purchasers and even sellers may be skittish, but some acquisitions, especially smaller strategic acquisitions, could and should go forward. The following are some suggestions for the successful completion of acquisitions, first from the seller’s perspective and then from the buyer’s perspective. Strategies for Sellers Many of the most important strategies for sellers relate to early phases of a potential acquisition before there is really a deal. But in an uncertain market, these early phases can be key; sellers must take full advantage of the time before a purchase contract is negotiated and executed in order to plan and prepare for the potential sale. Preparing to Sell The first step is to “know thyself,” which includes understanding the business or assets to be sold, the reasons for selling them, and the approximate terms and conditions necessary to make a sale worthwhile. This is particularly important in a volatile market, when market noise and fluctuating valuations can easily distract the seller from the fundamental requirements for a beneficial sale. Conduct an early examination of the business or assets to be sold in order to identify and begin to clean up any title issues, resolve any disputes, and understand any problems that might delay or impede a sale. In an uncertain market, a potential buyer almost certainly will try to leverage such issues to gain monetary or other advantages. Early detection of troublesome issues and efforts to address them can speed up the sale process and perhaps even avoid an otherwise negative impact on the sale price. Fielding Bids The next step is to select a buyer carefully, and perhaps an alternate buyer as well, each of whom seems likely to close the deal even in the face of market uncertainty. Expect preliminary offers to have short fuses and possibly be revised downward. In an uncertain market, many acquirers will buy only at what they perceive to be bargain prices. The seller should determine how badly it wants to sell and what the lowest price is at which the sale makes economic and/or strategic sense. If the buyer’s bargain bid is below the seller’s comfort level, the sale should be called off. It is better to withdraw assets from sale early on than to have them tainted by a failed acquisition. Consider an auction and try to include more potential buyers than usual in each round of bidding, knowing that in an uncertain market many may drop out for reasons that have nothing to do with the value of the target business or the potential buyers’ desire to own it. Include bidders with capital from different sources (e.g., both public and private bidders). Try to keep an alternate buyer or two available in case negotiations with the buyer of choice are unsuccessful. Enter into confidentiality agreements with all potential buyers. Understand that in an uncertain market, many potential buyers may turn out to be only window-shoppers. Ensure that your confidential material will be properly returned or destroyed if the potential purchaser is not interested or does not have the money to complete the deal. Consider adding a clause to the confidentiality agreement that restricts the buyer from announcing the transaction without the seller’s consent. It is designed to prevent the buyer from making the potential acquisition public before crucial terms are agreed to or revealing it at a time that could be disruptive to the target. Perform due diligence on potential buyers. Chart the stock performance of the public companies against appropriate indices and examine relevant measures to determine their financial health. Remember that in an uncertain market the ability of the buyer to pay and to close the transaction is at least as important as the bid price. In addition, look for news announcements of key events or other acquisitions that the potential buyer may consider important in order to determine whether the transaction could be delayed or dropped in case of a shortage of money or other key resources. Understand, too, that many potential buyers located outside of the U.S., particularly those based in countries that recently devalued their currencies, will find U.S. acquisitions to be expensive and may not be serious bidders. Selecting a Buyer When selecting the winning bidder, look for a buyer with the ability to pay in cash and a reputation for completing deals. But do not rule out stock as an acquisition currency. Understand that highly leveraged deals may not close in a tight credit environment. An ideal potential buyer will not need external debt financing at all or will need only a small amount of outside financing to get the deal done. Be especially wary of a bid requiring a “financing-out” clause in the purchase contract which will allow the buyer to scuttle the deal if it can’t obtain financing. “Financing-out” clauses leave the seller uncertain as to whether the transaction will close until the scheduled closing date. They also provide the buyer with a way out of the acquisition that may not trigger liquidated damages or other compensation for the seller’s costs and efforts. In an uncertain market, a slightly lower bid with no “financing-out” demand from a bidder with a proven ability to pay will likely be preferable to a somewhat higher bid with such a demand from a bidder with a spotty track record for completing deals. Consider requesting that potential buyers submit comments on a draft purchase agreement with their final bids. This strategy should force major differences into the open at an early stage, and help to distinguish similar bids. Risk allocation is an especially important factor in an uncertain market, and a heavy markup of standard representations and warranties may indicate unwillingness on the part of a buyer to assume a normal level of business risk. Such a markup may also indicate the buyer’s willingness to accept the seller’s terms with respect to liabilities, employees, and indemnification, among other matters. The seller should ensure that it agrees on the key points before deciding to negotiate with only one buyer. Structuring the Sale Structuring the sale is an important step that is best begun early and, to minimize additional uncertainty, completed before in-depth negotiations on the purchase agreement take place. Tax issues and other key drivers that could impact the transaction’s structure should be thoroughly explored and resolved early. One distinct advantage of determining the structure before engaging in detailed discussions with the buyer is that structure is less likely to be included in give-and-take negotiations. Instead, the buyer likely will accept the structure as a condition of the sale or have to justify why a different structure would benefit both parties. In an uncertain market, agreeing on the structure of the transaction early is critical because a clash over structure will not serve as an excuse for the buyer to walk away. Once the seller and potential buyer have agreed on essential terms (as for example, in a letter of intent), the sale process should be expedited to give the buyer less room to drop out. However, this stage must be managed deftly. Bear in mind that pushing a potential buyer too hard to quickly sign a contract with no “outs” may backfire and drive that buyer away, especially in an uncertain market where other attractive targets may be available. An effective way to shorten the process is by being prepared having title policies and environmental and engineering surveys up to date, diligence materials assembled and ready for review, personnel prepared for questions, and a contract drafted at the earliest opportunity rather than by aggressively hounding a hesitant bidder. Negotiating the Purchase Agreement The next step is to negotiate the purchase agreement. In negotiating the agreement, the seller should be particularly aware of risk allocation in the context of both a successful acquisition and a failed or aborted one. In doing so, it will be better prepared to progress toward completing the acquisition in an uncertain market. When negotiating the purchase agreement, include a liquidated damages clause and consider requiring a deposit at signing that can be applied toward the purchase price at closing. In addition to compensating the seller for time and money expended if the sale is aborted, the deposit will deter the buyer from terminating the agreement prior to closing without adequate justification. Ensure that the clause sufficiently binds the buyer. For example, after the high-yield debt market evaporated, some banks reportedly relied on material adverse change (so-called MAC) clauses in their financing commitments to refuse to honor them. The commitments were made with the understanding that the bank debt would be refinanced by issuing high-yield debt securities which had become extremely difficult. A bank failure to honor an existing commitment should not, by itself, trigger a termination in which the buyer escapes liquidated damages. At the very least, the buyer should be required to make reasonable efforts to find alternate financing. Make sure that any indemnification provision is limited in time (one to two years is standard in many contexts) and is preferably subject to a basket and cap to limit post-transaction uncertainty. The basket will help ensure that the seller need only indemnify the buyer for serious breaches of representations and warranties, and the cap is designed to prevent the seller’s liability from exceeding a certain level, which is rarely greater than that of the total purchase price. Provide for a preliminary dispute resolution mechanism that is not as formal or as expensive as litigation or arbitration. In many transactions, a committee of two high-level executives, each of whom is trusted and respected by both parties, is entrusted with resolving minor disputes so full-scale dispute resolution can be avoided. A transaction in an uncertain market is likely to involve surprises that neither side foresaw or took into account. An informal dispute resolution mechanism can prevent such surprises from derailing the transaction prior to closing or resulting in litigation after closing. This is especially important in asset transactions involving significant real estate, where a disputed right to close, for example, could cloud the title of the assets, and effectively prevent them from being sold to another buyer until the dispute is resolved. Strategies for Buyers Potential buyers also face risks in deciding to purchase businesses or assets in an uncertain market. Just as preparation is key for potential sellers, potential buyers must become discriminating shoppers before heading for their check books. Potential buyers also must prepare for and accomplish timely post-closing integration in order to secure the benefit of their bargains. Preparing to Buy The first step is to adequately prepare for the purchase, which includes devoting a substantial amount of time to the buyer’s financial and strategic goals, as well as the options for attaining them. To begin with, the buyer should evaluate different financing sources before incurring significant transaction costs to determine whether adequate financing is available and, if so, what options are most cost-efficient. Understand that cash may be more attractive to the seller than shares of stock that are wildly fluctuating in price. Cash also may be preferable to a purchaser that will be exposed to additional stock market risk between signing and closing. On the other hand, if debt financing will be required in order for the acquirer to pay cash, it should know that debt financing may be difficult, in some cases impossible, to obtain on reasonable terms. In such cases, partial or total equity financing may be the best alternative. Due Diligence Perform due diligence as soon as possible and as carefully as possible with adequate personnel. Proper diligence is critical in helping screen out problem transactions and providing negotiating leverage in a climate of market uncertainty. Tailor the diligence to the target’s industry and direct the investigatory team toward industry-specific issues that they might not otherwise focus on. Be on the alert for possible culture clashes, fraud, potential litigation, understated liabilities, environmental problems, Year 2000 compliance, technological incompatibility or obsolescence, noncompliance with the Americans With Disabilities Act (ADA), and poor reputation or product quality. Any of those issues could reduce the expected financial benefits of an acquisition and some might make it altogether unwise. The buyer should determine why the seller wants to sell and understand seller time constraints so it can use them to its advantage. Remember that in performing diligence on a private company, certain helpful secondary materials, such as SEC reports, are not available, so the buyer’s team must ensure that it not only delves into the primary material but also organizes and evaluates additional important raw data. Understand that until the purchase agreement is signed and possibly for a short period thereafter if the agreement contains a diligence out the buyer can and should ask for a price reduction if serious problems surface in the course of due diligence. The buyer should be prepared to resist the seller’s attempt to speed the process beyond the bidder’s comfort level. For instance, a buyer should not let a seller rush it and demand negotiation of a definitive purchase agreement before diligence is completed. However, the wise buyer knows that it may be competing against other bidders who have a more streamlined approval process. Monitor the evolution of the transaction to determine whether, when, and why to accelerate the pace. Making an Offer The buyer’s next step is to make an offer for the target business or assets, taking into account what it is willing to pay, the structure of the bid process, and any current or expected uncertainties in the m&a and capital markets. The acquirer should offer to purchase only if it understands the industry and if the acquisition fits well with what the company does best. Acquisitions for diversification purposes often fail in the best of market situations and may be tricky to accomplish in an uncertain market. It is essential to understand what is being acquired and how it should be paid for. Bid only for assets that fit with the company’s key strategies at attractive prices. In an auction, reevaluate the bid periodically until it becomes final. Obtain all available information possible about the seller and competing bidders, as well as their respective motivations. Is the seller motivated to sell at a low price, for example, to offset losses incurred in other markets? Is there likely to be stiff competition for the business? Consider revising the bid up or down if new information or circumstances, such as diligence results or increased market uncertainty, indicate that the bid should be modified. Above all, don’t get drawn into a bidding war at the extremes of quality trophy assets at the highest level or assets that won’t be crown jewels at the lowest. In either case, the bidder likely will pay too much for the assets. Expect valuation difficulties and seek different internal and external opinions on an acceptable range within which the transaction is attractive and the accompanying terms are satisfactory. In a volatile market, it may be difficult to pin down not only what the assets are worth but what price should be paid for them. Incorporate expected synergies into the valuation model, but be realistic about them. Negotiating the Purchase Agreement Negotiation of the purchase agreement is very important. In addition to price, a potential buyer should focus on issues that could have the most impact and lasting consequences and ensure that it can modify or abandon the deal if circumstances warrant. Focus on key provisions such as representations and warranties, post-closing covenants, and indemnification. Before going into the negotiations, know which types of risk you are willing to accept and which types of risk you wish to avoid. If stock is the acquisition currency and the seller receives a stake in the combined company, allocate market risk so that some risk is assumed by the seller. A fixed exchange ratio is often employed in a “merger of equals,” and in an uncertain market the buyer will want a ceiling on the value of shares issued just as the seller will want to establish a value floor. Another approach to managing risk is a fixed-value approach, which may be preferred by sellers but which may leave the buyer exposed to the risk of having to issue additional shares as the result of a decline in its stock price. Accordingly, many structures combine the fixed-value approach with a collar that establishes minimum and maximum exchange ratios. A final market risk management strategy, which is less frequently employed than caps, collars, and floors, is negotiating a “walk-away” right. It allows the buyer to abandon the transaction if the value of its stock is above an agreed-upon price that in turn is substantially higher than its market price when the purchase agreement was negotiated. The walk-away right likely will not appeal to sellers because it adds uncertainty as to whether the transaction will close. Consider requesting a “no-shop clause” to avoid wasting unnecessary time and money. In an uncertain market, a seller may attempt to negotiate with more than one buyer at a time. At the very least, the buyer should be reimbursed for diligence and other out-of-pocket expenses if the seller signs a deal with another buyer. Negotiate a holdback, escrow account, or guarantee if there is concern about the seller’s financial condition after the transaction closes and doubt about its ability to indemnify the buyer and make other post-closing payments. The ability to recover from the seller is particularly crucial in an uncertain market. The buyer must make sure it indeed can walk away if necessary. In negotiating the liquidated damages provision, the amount that the two parties agree to should be money that, under the worst foreseeable market conditions and other circumstances, the buyer can leave on the table. The buyer should negotiate exceptions when a potential failure to close might not be under its control. An example might be a refusal by the acquirer’s banks to honor their financing commitments. Integrating the New Business The final step is post-closing integration. Despite the importance of post-closing integration, it is an area in which many buyers fall short. In an uncertain market, the stakes for a successful integration rise markedly, and it is particularly important to achieve the synergies expected to result from the acquisition. Dedicate key personnel to the task of post-closing integration. Provide them with incentives and empower them to realize the synergies that in-house strategists and outside advisers predicted the deal would achieve. Succeeding in Turbulent Times In an uncertain market, highly leveraged mergers and acquisitions may virtually disappear. However, well-planned, strategically motivated business acquisitions could and should still be negotiated and consummated. It may, for example, be possible to acquire assets from sellers based overseas who need money because they are facing losses at home but under normal circumstances may not have made the properties available at reasonable prices. Likewise, the tightening of credit standards may require some companies in need of cash to deleverage by divesting businesses and streamlining their operations. Likely buyers would be low-debt companies that gain the opportunity to vertically integrate, acquire customers, enter new markets, or acquire new technologies. However, even participants in these strategically grounded transactions must exercise care to ensure that the strategies that they typically employ to negotiate and consummate transactions are reexamined and, if necessary, revised to conform to the vagaries of the marketplace. The result should be a reallocation of assets that results in stronger and more focused companies that are ready for the next strategic opportunity.