By: Aaron Ghais
Are you in the process of buying a company that’s been struggling with financial problems? If so, then I’ve got some news for you: there are a number of critical things you need to know about how this is going to be very different from buying a financially healthy company.
I recently helped one of my clients buy a financially troubled company and was reminded of the perils associated with dealing with a Seller who is very short on money. Having been through this process a number of times, I’ve seen the pattern of challenges that present themselves in this type of acquisition over and over again. Permit me to share some insights with you.
As is typically the case in deals like this, the good news in my recent deal was that the purchase price was great for my client because the Seller’s business had been in a tailspin for a couple of years. They were desperate to sell and we had some negotiating leverage that arose from the fact that the Seller had to complete the deal quickly or risk slipping into bankruptcy.
Most of the good news, unfortunately, ended there. Let’s get into a handful of the more challenging aspects of my client’s deal that present themselves often in acquisitions of financially troubled companies.
1. Unmotivated Lawyers.
Let’s put this bluntly: if the Seller is short on money, it’s unlikely it will be able to pay its lawyers in full, which means the Seller’s lawyers will be looking to do as little work as possible and are more likely to bring their C-game rather than their A-game. What does this mean for you as the Buyer? It means your lawyers are going to have to do more work and your fees are going to be higher as a result.
To take a couple of examples from my recent deal: we had to do more than our fair share of the document drafting; and we had to take an inordinate amount of time to understand the Seller’s complicated debt structure. Given the potential risks to my client, we just couldn’t depend on the Seller’s lawyers to read the almost 1,200 pages of promissory notes in order to tell us what they said and how to structure our deal to address the rights and remedies held by the noteholders.
2. Worried Lenders.
Distressed sellers often have a long list of worried lenders waiting anxiously with their hands out to collect their share of the sale proceeds. That was certainly the case in my deal, where the Seller had several dozen lenders holding convertible promissory notes previously given to them in exchange for their loans to the Seller.
The promissory notes gave the lenders certain consent, participation, and similar rights that had to be digested and addressed in our deal structure so as to minimize the risk of post-closing claims against my client, the Buyer. Things were made more complicated by the participation of some of the larger lenders in our negotiation of the merger agreement, turning our deal quickly into a cumbersome and at times contentious multi-party negotiation.
3. Skeleton Staff.
Normally, the Seller’s management team will be around and motivated to respond to due diligence questions, prepare disclosure schedules, assist with transition matters, and work with the Seller’s lawyers to help move the sales process to closing.
In my recent deal, believe it or not, we were left to deal solely with a mid-level employee who had some book-keeping experience but little more in the way of management expertise or knowledge of the Seller. Why? Because the Seller couldn’t afford to pay its management team any longer, so the entire team of people who really knew the Seller’s business was long gone.
Where did this leave us on the buy-side? Well, put briefly, it left us in the dark! And I’m pretty sure Seller’s legal counsel felt the same way more than once. This put an extra burden on us to look under every rock during the due diligence process and to push hard, even harder than normal, to try to get my client some post-closing protections against unanticipated or previously undiscovered liabilities and claims. That point leads nicely to my last point.
4. Weak Post-Closing Protection.
Normally in private company deals, the Buyer has the ability to seek indemnification for post-closing claims relating to breach of contract and for liabilities that arose prior to closing and on the Seller’s watch. (See my posts HERE and HERE.) That’s also true when buying a financially distressed company. As mentioned in my introduction above, however, buying a financially distressed company is different in a number of ways and this is one example. Think about it: the Seller is all out of money, it has lenders who will likely gobble up all (or most) of the sales proceeds, and it still has to pay its legal and financial advisors for assisting it during the sale. How will Seller have any money left to satisfy your post-closing indemnification claims?
This was certainly a concern in my recent deal. So what did we do? The answer: all we could. We negotiated the right to escrow a portion (okay, an uncomfortably small portion!) of the purchase price that the Buyer could draw against as reimbursement for any losses; and we reserved the right to offset earnout payments that would have otherwise gone to the Seller’s shareholders, as a way to further reimburse the Buyer (if necessary) for any additional losses.
The rub on the offset right, though, is that we had no way to know for sure whether the Seller’s business would even generate any earnout payments against which Buyer could reimburse itself. So putting that all altogether, the bottom line is that we had far less protection than we would have liked, or that we would have received from a financially healthy Seller.
Does any of this make you concerned about buying a financially distressed company? It should. And I haven’t even covered all the potential pitfalls, like successor liability and fraudulent conveyance issues.
But hopefully you’ve taken away at least two things from this: first, that in exchange for a low purchase price, you’re going to have to incur some risks and do some work to try to minimize those risks; and, second, that you’re going to need a very good lawyer to help you navigate the process and protect you. Are you comfortable with those risks? Have you protected yourself as much as possible? And are you sure you’re getting adequate legal counsel?
If you’d like to discuss any of this, please don’t hesitate to contact me.
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