“Ask the Attorney” – Acquiring a Company (Part II)

by Scott Edward Walker on May 5th, 2010


This post is part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs).  As the VentureBeat Editor notes on the site: “Ask the Attorney is a new VentureBeat feature allowing start-up owners to get answers to their legal questions.”  Below is a longer, more-comprehensive version than I posted on the VentureBeat site.


My co-founder and I are friggin crushing it.  We launched our company about two years ago, and we now have an opportunity to buy a couple of struggling companies in our space.  We have lawyers we work with, but I was wondering if you could just give me a heads-up on some of the legal issues we should be thinking about.  Thanks!


Last week I discussed the following significant issues: (i) executing an exclusivity agreement; (ii) avoiding negotiating the material terms in an LOI; (iii) doing adequate due diligence; (iv) buying assets, not equity; and (v) protecting against a fraudulent conveyance claim.  Below are five more issues to think about.

1.  Escrow a Portion of the Purchase Price.  An important step you can take is to escrow a portion of the purchase price (e.g., 15%) for a period of time post-closing (e.g., 18 months).  Indeed, escrows are relatively common (particularly where there are multiple sellers) because of the inherent unfairness of requiring the buyer to sue the seller(s) to try to get some of its money back for a problem or liability it never agreed to take on.

Alternatively, you, as the buyer, can push for a hold-back (i.e., a right to hold part of the purchase price) and/or a right of set-off in deals where part of the purchase price has been deferred (e.g., where the buyer has issued a promissory note to the seller as part of the purchase price); however, escrows are obviously more amenable to sellers because the money is held by an independent third party and the buyer does not have the unilateral right to withhold payment.

2.  Use Earn-Outs Only As a Last Resort.  Earn-outs (i.e., post-closing contingency payments) are often touted by unsophisticated investment bankers and counsel as an effective way to bridge the gap between what the buyer is willing to pay for a business and the seller’s asking price.  The reality, however, is that earn-outs often lead to major disputes and business problems post-closing and should, accordingly, be avoided if at all possible.

On the legal side, a number of critical issues must be negotiated, including (i) the metric (e.g., revenue, EBITDA, profit, etc.) and milestones, (ii) measurement/accounting issues, (iii) exclusions/carve-outs (e.g., allocation of administrative or general overhead expenses, intercompany transactions and charges, etc.), (iv) the duration of the earn-out period, (v) the effect of acquisitions or dispositions relating to the acquired business and (vi) most significantly, post-closing operational control issues.  The amount of time and energy that is required to address adequately the foregoing issues can be extraordinary (often leading to pages and pages of provisions), and there will still be gaps because it is virtually impossible to anticipate every post-closing contingency.

On the business side, earnouts usually create significant impediments to the integration process and conflicting interests between the buyer and the target post-closing — e.g., if the metric is revenue growth, the target may sign-up a number of new customer contracts that may not be profitable or in the best long-term interest of the business; if the metric is profit or EBITDA, the target may cut back on capital expenditures or other expenses (such as marketing or advertising) — particularly as the end of the earn-out period approaches.  Moreover, target management may lose its motivation if it is unable to achieve its goals and thus is never entitled to an earn-out payment.  The bottom line is that earn-outs are very tricky from both a legal and business perspective and should only be used as a last resort.

3.  Don’t Give Away the “Basket”.  One of the provisions sellers generally insist on in the acquisition agreement is a “basket” to prevent the buyer from “nickel and diming” the seller for any claims post-closing.  The size of the basket varies from deal to deal, but based on a recent study of the Committee on Negotiated Acquisitions of the American Bar Association (of which I am a member), the norm is approximately .5% of the purchase price.

If you agree to a basket, there are a number of significant issues that you must address, including the following: (i) push for a “first-dollar” basket (sometime referred to as a “threshold”) as opposed to a “deductible” so that if its damages exceed the basket, the seller would be responsible for all of the damages (i.e., beginning with the first dollar); (ii) the basket should only relate to breaches of representation and warranties and not to covenants or specific indemnity provisions (this is a common mistake); (iii) any materiality qualifiers in the representations and warranties should be disregarded for purposes of the basket — otherwise there would be a so-called “double-materiality” problem (another common mistake); and (iv) there should be appropriate carve-outs to the basket, the most common of which include capitalization, due organization, due authority and ownership of shares.

4.  Include a Carefully-Drafted “MAC”.  From the buy-side, one of the most important representations and warranties of the seller (and closing condition if there is a signing and a subsequent closing) is that the business has not suffered a material adverse change (“MAC”) over a certain period of time pre-signing/closing.  Lawyers have a field day wordsmithing the definition of MAC — arguing over such issues as (i) the applicable period, (ii) whether “prospects” should be included, (iii) whether the target and its subsidiaries should be “taken as a whole” and (iv) of course, the exceptions.

The bottom line, however, is that most MAC definitions are extremely ambiguous, and there is little case law to provide any guidance as to what constitutes a MAC.  Moreover, the leading Delaware case, IBP, Inc. v. Tyson Foods, Inc., suggests that the standard as to what constitutes a MAC is quite high — “measured in years, rather than months.”  Accordingly, the buyer must be careful about relying on a MAC to terminate an acquisition agreement (or otherwise to sue the seller for breach of the MAC rep) unless the definition includes specific objective criteria — e.g., a specific dollar decrease in EBITDA or sales, etc.  (Note: as a downsize protective measure, an expense reimbursement provision should be coupled with the MAC and other closing conditions.)

5.  Watch Out for “Caps”.  One of the most important and hotly-negotiated issues in any private company acquisition is the cap (or ceiling) on the seller’s damages.  Like other material terms in the acquisition agreement, there is no right or wrong answer (or “customary” or “market” amount): it all depends on the context of the transaction — i.e., the bargaining power of the parties, the risk profile of the target, the purchase price, etc.

For example, in an auction context with numerous bidders expressing interest in a target, the cap may end-up being 10% or less of the purchase price due to the competition; on the other hand, if the target has a host of significant problems (and/or is financially troubled) and there is only one prospective buyer on the horizon, the cap may end-up being equal to the purchase price (or there may be no cap).

The lesson here — and the key takeaway of this post — is that you, as the buyer, must fully understand the businesses that you are buying and the significant deal risks in order to make an informed judgment with respect to price and terms, including the cap.  Indeed, if the cap is less than 100% of the purchase price, you should generally push hard to include certain carve-outs.


I hope the foregoing is helpful.  Indeed, as I noted last week, acquiring another company is tricky and raises a host of significant issues that need to be buttoned-down.  If you have any questions, please shoot them to me in the comments section of this post or via email at .  Many thanks, Scott

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