Structure Matters in Making Deals

October 4, 2004

By MICHAEL CARTER

Jim Jones, chief executive officer of Exite Co., just finished a meeting with a New York Stock Exchange (NYSE) company that agreed to acquire Exite for the asking price. He was leaving for a two-week vacation with peace of mind, and gave his attorney the following instructions, "I did the hard work, now you clean up the loose ends."

Two weeks later, the deal died and he learned a hard lesson, that structure, terms and conditions are as important as price. His attorney laid out following four categories of "deal-breaker" problems.

1. Structure

Although every seller wants 100 percent of the purchase price in cash at the closing, very few business owners are so lucky. Consideration can take the form of cash, notes, stock of the buyer and earn-outs. Each one needs to be considered carefully. Cash is cash with no issues, as long as cash means cash at closing.

Notes. The collectibility of the notes is determined by the creditworthiness of the acquirer. Jim Jones' note was not from the NYSE parent company, but from one of its largest subsidiaries. Unfortunately, the operating subsidiaries financial statements revealed a highly leveraged company with some serious litigation. Clearly, the subsidiary's creditworthiness was different from that of the Fortune 500 company. Once a seller is satisfied with creditworthiness, the value the note depends upon other factors, including term of the note, amortization (schedule of payments), collateral, interest rate and default provisions. Bottom line, the seller becomes a lender to the buyer and needs to carefully understand the value the notes.

Stock. Sometimes sellers accept the buyer's stock in lieu of cash. In this case, Jim Jones was thrilled to receive a New York Stock Exchange stock that had appreciated over the years and was considered a solid investment. The stock was highly liquid and the market was deep enough to sell Jim's $5 million of stock quite easily. However, when the buyer required a lock-up for 180 days, he had a very different opinion. Stock prices may fluctuate dramatically in a short period, sometimes related to the company's prospects, as well as external events (terrorism, war, Middle East turmoil, presidential elections, a financial markets crisis, rising interest rates), thereby introducing a meaningful level of risk. Receiving stock of a privately held company raises even greater issues, which will not be covered here given the numerous complexities involved with privately held stock.

Earn-outs. Earn-outs are future payments that may be paid to the seller if the buying company reaches some mutually agreed upon targets. Financial targets are often used, such as sales, gross margin, or operating earnings. Earn-outs are often used to bridge differences between the bid and ask in a transaction. Although we have seen companies make more on the earnout than on the up front cash, there are many pitfalls to earnouts. Here are only a few:

How to measure earnout targets. Earnings are more problematic than revenues. As we all know from the movie industry, profits can mean different things to different people.
What happens when the selling business is combined with another business unit of the buyer?
How much control of the business will the seller have during the earn-out period?
Can the seller and key employees be terminated during the earn-out period? What happens if fired with cause? Without cause?
Will the buyer change strategies that reduce the likelihood of making the earn-out?
Will the buyer have the cash to pay the earn-out?

2. Indemnification

It is common for the seller to indemnify the buyer up to the purchase price for representations and warranties that the seller is making on the condition of his company. Such indemnification covers ownership of assets, taxes, accuracy of the financial statements, litigation, employee matters, compliance with law, contracts and intellectual property.

Jim's attorney asked that the reps and warranties include the clause "to the best of my knowledge," which was declined. It's difficult to prove the seller knew that a particular representation was wrong. Today, buyers seem more set on representations that exclude that hedge.

3. Contingencies

No doubt, contingent liabilities are the toughest issues when selling to a public company. There are business risks that smaller privately held companies take on regularly, but are viewed very differently from the eyes of a deep pocketed buyer.

These buyers don't mind paying a premium for a business, but do not want to take on a contingency that is unlimited. Serious contingent liabilities give buyers heartache and usually end up with the seller depositing part of the purchase price in escrow, tougher indemnification language, reduction in the purchase price or no deal at all. They typically include environmental, litigation, taxes, human resource or other legal issues.

4. Real estate

Exite owned its premises and, as part of the transaction, the seller agreed to a lease. However, Jim didn't mean a two-year lease. Owning a building may be a blessing or a curse. It truly depends upon the situation. Jim's plant is in the middle of Iowa and would be difficult to sell if vacated by the buyer. Jim anticipated a seven-year lease and rental income of $200,000 per year. This income was a key consideration to Jim, as he knew how difficult it would be finding a quality tenant. In this case, the buyer wanted the flexibility of terminating the lease on 60 days notice and the option to extend the lease for several years, which further depresses its value.

Obviously, there are many issues related to structure, but as we have learned over many years, structure is critically important. It receives very little attention by entrepreneurs and more often than not is the reason transactions collapse.

Michael Carter is a managing director of Carter Morse & Mathias, an investment banking firm based in Southport, Conn., specializing in raising capital, mergers and acquisitions, and valuations.