LEGAL ADVICE

Study gives inside look at trends

in mergers and acquisitions
T
he purchase and sale of businesses obligations or to fund any buyer obliga-
are a key part of the U.S. economy tion for a working capital adjustment. The
and a common method by which median amount of holdbacks was about 10
business owners realize the value of their percent of transaction value. The amount
entrepreneurial efforts. Although every of the holdback is important but the
sale transaction is different, deals often indemnity terms that determine how and
contain similar legal structures and provi- how much of the holdback can be claimed
sions. by the buyer should be the primary focus
A helpful resource regarding current of the seller.
marketplace terms is prepared every
few years by the Mergers & Acquisitions Later claims of buyer or others
Committee of the American Bar Associa-
tion. The recently released 2009 Private Rochelle H. Klaskin Indemnification obligations of the seller
Target Mergers & Acquisitions Deal Points and Paul J. Karch can arise from several factors but in large
Study analyzes 106 publicly reported M&A are shareholders and members of Godfrey & part come from obligations related to
transactions that range from $25 million Kahn’s Corporate Practice Group. For more non-assumed liabilities by the buyer and
to $500 million. Even for business sales of information, Rochelle can be reached at 608- breaches of representations and war-
284-2607 or rklaskin@gklaw.com. Paul can be
less than $25 million, the study provides a reached at 608-284-2252 or pkarch@gklaw.com. ranties by the seller. For example, if the
useful benchmark of what terms and con- seller represents that all of its inventory
ditions in an acquisition agreement may is in good and saleable condition and it
be considered “market.” adequate amount of working capital at the turns out that 25 percent of the inven-
In any acquisition, there are generally closing but that the various elements of tory is obsolete, then the buyer will likely
four main parts to the definitive agree- working capital will vary from day to day have an indemnification claim against the
ment: a description of the purchase price in the normal operation of the business. seller. Sellers can limit their indemnifica-
and terms related to what is purchased; To account for those variations, and to tion obligations after the sale in two main
closing conditions; representations and remove any incentive of the seller to drain ways. First, the agreement can establish an
warranties of the seller regarding the tar- the working capital prior to closing, an overall indemnification cap; and second,
get’s business; and indemnification obliga- increasing majority of deals (79 percent in the buyer and seller can establish what is
tions of the seller after closing. While the 2009, up from 68 percent in 2006) include called a “basket.”
study analyzes many provisions and trends a post-closing purchase price adjustment An indemnification cap limits the
in acquisition agreements since 2004, we for variations in working capital and overall liability of the seller after the clos-
will highlight the provisions described in sometimes other assets or liabilities such ing, and 92 percent of the deals analyzed
the study that relate to: (1) adjustments as specified debt. included a cap. Of those transactions,
to the cash purchase price received by the Most of the time, an estimated working the cap equaled the transaction price
seller; and (2) what portion of the pur- capital number is calculated by the seller in 4 percent of the deals (down from 7
chase price is subject to claims made by and a payment based on that number is percent in 2006 and 14 percent in 2004),
the buyer or third parties. made at closing. Then, the buyer prepares and the transaction caps were less than
a post-closing balance sheet. After some the purchase price in 86 percent of the
Adjustments to cash sort of approval and dispute resolution transactions (as compared to 88 percent in
process, the closing balance sheet is con- 2006 and 74 percent in 2004). The mean
received at closing firmed, and the buyer or seller “trues up” cap was 21.72 percent and the median cap
the difference between the estimate and was 11.19 percent of the transaction value.
For the seller, the most important the final number. In some recent deals, we However, even when agreements include
term of any business sale is usually the have seen buyers and sellers differ on the caps, the agreement will also exclude some
purchase price, and the most important calculation of working capital. One good claims that are not subject to the cap,
part of the purchase price is usually the way to reduce the risk of differing inter- such as fraud and the breach of certain
cash received at the closing. Two common pretations is to have a sample calculation key covenants. Generally, caps will be a
terms of deals that directly affect the cash based on a prior balance sheet incorpo- smaller percentage when the purchase
received at or shortly after closing are rated into the agreement and adjustment price is larger. Given the buyers’ market in
post-closing purchase price adjustments process. 2008 and 2009, indemnification caps have
and holdback escrows. About 80 percent of deals include an trended upward.
Purchase price adjustments start with escrow or holdback from the cash paid at Another way to limit liability for the
the idea that the business will have an closing to back up the seller’s indemnity seller is to establish a “basket.” When a

 Capital Region Business Journal | March 2010

basket is established, a buyer may not percent included a First Dollar basket and 2 percent of the transaction value.
recover any losses under an indemnifica- 12 percent included a combination deduct- Every M&A transaction is unique, but
tion provision until the total losses exceed ible/First Dollar basket. These percentages there are common terms in those deals
a certain threshold. that are influenced by
This threshold is the market practices and
basket. The basket can In any acquisition, there are generally four main trends. Merger and
be either a “dollar-one” acquisition lawyers,
or “first-dollar” basket
or act as a deductible.
parts to the definitive agreement: a description investment bank-
ers, and others often
When the basket is argue in favor of or
a deductible basket, of the purchase price and terms related to what against particular
a seller only has to terms based on the
indemnify the buyer for
losses that exceed the
is purchased; closing conditions; representations “market” for those
terms. Deal experi-
threshold established
for the basket. In a and warranties of the seller regarding the target’s ence and understand-
ing the data in the
First Dollar basket, ABA Deal Points
once the losses exceed business; and indemnification obligations of the Study helps to assess
the threshold, the seller the reality of those
is responsible for the
losses that “filled up”
seller after closing. arguments. Common
understandings of
the basket as well as market terms can
those that exceeded bring efficiency and
the basket. Only 5 percent of deals did have remained generally the same for fairness to the process so that buyers and
NOT include a basket, while 47 percent of transaction since 2004. The value of the sellers may more easily reach their true
the deals included a deductible basket, 36 basket generally ranged from .5 percent to objective: closing the deal. n

Capital Region Business Journal | March 2010