Surprises are rarely good. There are many different emotions that come with the experience of surprise: fear, anxiety, and joy—to name a few. Deals can also cause the same emotions for a deal maker. Perhaps the booked pipeline was stronger than expected or new management, while unproven in historical results, has the ability to create margins unheard of for that industry—all of which would lead to joy and relief. However, not all surprises end happily—some can be alarming and stressful, and some may be so adverse that they completely kill the deal. In a deal, it is usually due diligence that reveals the good, the bad, and the ugly. The following are a few stories and some suggestions on how to avoid unpleasant surprises.
When Negotiating Key Terms, Sharing Is Caring.
Many key aspects of a deal are discussed by the parties early in the process before a draft letter of intent is circulated. To avoid the dangers of deal killers and last-minute changes that may jeopardize a deal, transaction structuring and other major considerations are best discussed with key advisors early in the process, ideally before a recommended detailed term sheet is drafted.
That said, drafting detailed purchase and sale/transaction agreements, which tend to be drafted throughout the due diligence process, typically addresses the finer points of a deal and defines critical terms of the transaction. To avoid unnecessary dispute over key deal terms, it’s best to share this document between parties continually (which should include financial, operations, human resources, and tax teams). In this case, sharing avoids the surprise of unfavorable terms and exorbitant legal fees.
What Could Go Wrong Combining Operations? A Lot.
In theory, combining companies sounds like a good idea, but that’s not always the case. Buyers are always looking for synergies from a contemplated transaction and have expectations to realize cost synergies by eliminating duplicative activities carried out by the seller. Synergies may also be realized by taking advantage of distribution channels or broadening the buyer’s product line.
However, more often than not, expected synergies from a transaction do not materialize as planned. In many cases, the failure to capture synergies results from the lack of proper integration planning and/or failure to conduct sufficient operational and commercial due diligence in the process. More successful integrations and achievement of synergies come when the analysis and plan is developed well before the deal closes. Deal makers are never excited to surprise the board or key stakeholders with news that they didn’t meet expected numbers that had been agreed upon when the deal was approved. If all went according to plan, the news would be quite different. In performing operational due diligence prior to closing, the deal maker can meet their objectives with the transaction and would be on course to realize identified synergies.
The Cross-border Surprise
The buyer may underestimate the actual impact of non-U.S. operations because most of a target’s footprint (or those most important to the buyer) may be in the U.S. As due diligence proceeds, an understanding of the nature and extent of non-U.S. operations and the historical relationship and role with the U.S. target company is critical.
The difficulties in performing due diligence outside the U.S. may become an obstacle to the timely progression of the due diligence process as well as the perceived cost/benefit due to the relative revenue or asset base size of the entities. Information may need translation, language barriers may lead to misinterpretation, time zones could make communication difficult, cultural differences may influence the speed and urgency of conducting due diligence, and the buyer may need a team on the ground in one or more countries. Managing this process could be a virtual nightmare for the buyer if all diligence requirements are not addressed early on. The challenges can be complicated if consideration is not made for tax diligence as well. In cross-border transactions, understanding the plan post-transaction as well as any additional tax liabilities can be a key matter in the deal if not the most critical.
Sell-side Due Diligence
The buyer’s and seller’s perspective of a sell-side report may not always align. The seller typically is under the impression that the report, put together on their behalf, should ease the buyer’s concerns and eliminate the need of performing their own diligence. Like buying a car, a buyer wouldn’t purchase it without taking it for a test drive first and understanding the specifics that are important them. The same is true in a deal, the buyer needs to be comfortable that the due diligence performed presents an objective view of the key findings.
While there is value in a sell-side report, not all reports are created equal, so understanding scope and depth of analysis is key. There could be issues with respect to timing, and information could be stale and require an update. The buyer may also have additional risk areas that they would like further diligence on. That said, a report may contain findings that are outside the scope of buyer due diligence that may prove to be helpful in evaluating the target company. For these reasons, a sell-side report should be read early in the due diligence process to ascertain relevance and provide insights as to the amount of work necessary to verify its assertions. Even though a sell-side report exists, it may not be legally reliable, and the buyer has a fiduciary responsibility to perform their own diligence. If the sell-side work is done thoroughly, and the report and databook are provided with the intent of full transparency, it should only require a top up confirmatory effort. The existence of a sell-side due diligence report does not eliminate the element of surprise because full transparency is often not provided depending on how the sale process is managed.
Typically seen in transactions involving a closely held target company, owners have informal profit-sharing or bonus arrangements for key employees to share in the profits of the company, and potentially in the gains in the event of its sale. Employees who have contributed substantial sweat equity in growing the company are viewed by sellers as phantom owners. Promises may have accumulated and may remain unpaid and/or deferred until a liquidity event. The amount and effect of these arrangements in a change of control can be significant and they need to be taken into consideration as part of the transaction and after the closing.
Further, undocumented or undisclosed profit-sharing and bonus arrangements may exist for a wider range of employees, which may have a significant impact in the year of the acquisition. How these amounts are measured and the timing for their payment need to be understood, as the employees may expect them after the contemplated acquisition. Without inquiring about these potentially invisible arrangements, an unexpected surprise and real cash flow impact and working capital impact may arise after the closing of the contemplated transaction.
These compensation arrangements are just two examples of an unwelcome surprise for the buyer. If employees own equity in the target company, careful consideration should be given to whether the employees should transition their equity or be cashed out. This also raises important questions around the overall retention strategy for key employees, the need to set aside funds for a retention compensation pool, and how and when these compensation costs will be paid.
Intercompany transactions can cause a sense of anxiety for deal makers. When the word ’intercompany’ is added to other words it can create trepidation for due diligence: intercompany transactions, intercompany agreements, intercompany pricing, intercompany loans, and the list goes on.
Intercompany transactions create their own set of unique challenges in carving-out a target. The business to be carved-out of the seller is often dependent on some intercompany functions performed by the selling enterprise. This creates many interrelated issues that need to be considered for the post-close acquired company, such as a transition services agreement with the selling entity, and an immediate and forward looking plan of integration with the acquiring enterprise.
Unravelling and understanding the nature and complexity of pre-close intercompany arrangements is an important and challenging task, even in situations where the target company is not being carved out. In the case of an acquisition of multiple entities, intercompany arrangements may require modification in connection with the contemplated transaction. A significant layer of complexity is added when related entities are in countries outside the U.S.
Asset or Equity Deals
Imagine a due diligence process that produces unpleasant findings. Someone suggests the transaction should be changed to an asset deal to provide additional insulation from some troublesome exposures identified. If the target is a corporation (not a flow-through entity for income tax purposes), an asset sale could be subject to double taxation—once at the corporate level and then again when proceeds are distributed to its owners. Thus, the assets would be sold at great additional cost, unless there were tax attributes available to shield the tax. As a result, an asset sale may not be practical due to tax consequences. Careful consideration should be made to the advantages and disadvantages of asset and equity transactions. Implications are very different for both the buyer and seller in each circumstance.