Beware the Afterlife: Post Closing Obligations in Mergers and Acquisitions
At the closing of a merger or acquisition, after several months of identifying your partner, structuring the consolidation to minimize adverse tax consequences, negotiating the Letter of Intent, completing due diligence, finalizing transaction documents and planning the post-transaction integration, the parties sign definitive documents, exchange financial consideration, announce the deal publi...
At the closing of a merger or acquisition, after several months of identifying your partner, structuring the consolidation to minimize adverse tax consequences, negotiating the Letter of Intent, completing due diligence, finalizing transaction documents and planning the post-transaction integration, the parties sign definitive documents, exchange financial consideration, announce the deal publicly and celebrate the end of the process. But beware—the marriage has just begun! Despite all this hard work, not all transactions have a smooth and successful afterlife.
Issues arise after the closing and can be a source of conflict between buyer, seller and seller's shareholders. And it is these topics that often do not get sufficient attention during the merger process, but which dictate the future business arrangement between the parties.
Transaction Documents. While each transaction is unique, generally, the substantive documents include a purchase and sale (or merger) agreement, employment agreement with the seller's owners/principals and, if shares of the buyer are used as consideration, the shareholder agreement of buyer. Some or all of these documents usually include restrictive covenants regarding soliciting/servicing clients of buyer, hiring employees of buyer and/or safeguards for the buyer's confidential or proprietary information. In addition, some consideration may be payable over time pursuant to a promissory note or earnout—either in the purchase and sale/merger agreement or by incentive compensation under the employment agreement. Each document contains legal obligations for parties that survive the closing.
Purchase and Sale/Merger Agreement. This document is the primary "deal" document that governs buyer and seller. In addition to the obvious topics—such as what is being sold, what liabilities are being assumed by buyer or retained by seller, and the amount of purchase price—many of the other provisions can come back to haunt either party.
The substantive provisions of this agreement are the representations and warranties of the seller, and to a somewhat lesser degree, of the buyer. This is the heart and soul of the deal. The seller represents and warrants as to matters such as:
Corporate organization of seller.
Capitalization (ownership) of shares.
Seller authority to consummate the transaction.
Assurance that the seller's business has not suffered any material adverse changes over the period since its last financial statements prepared by independent accountants.
Assurance that there are no outstanding taxes due from seller, seller is in compliance with all applicable laws and that there are no threatened claims against seller, whether insured or uninsured.
Listing of all contracts as to which seller is a part.
Status of all leases for real estate, all accounts receivable and accounts payable, all personal property and assets, intellectual property, liens, indebtedness, liabilities, clients, employment arrangements, employee retirement and benefit plans.
Compliance with environmental laws and regulations, all insurance coverages, bank accounts and if a broker/investment banker is involved.
Wow! That's a mouthful. Making these representations and warranties requires the seller to fully research and disclose this information, most commonly in schedules attached to the agreement. Sellers often do not pay very close attention to several traps that must be disclosed. Does the seller own as many software licenses as are on the computers or has the seller violated the U.S. patent laws by networking the use of one license over several computers? Have projects in process been billed in an amount equal to the percentage of completion to date, or has the project been billed in an amount in excess of work to date? Has accrued vacation due employees been calculated? Are persons treated as independent contractors when they should be characterized as employees? Are all accounts receivable collectable or has an adequate reserve for noncollectability been established? Are financial statements fairly presented in accordance with generally accepted accounting principles consistently applied?
While buyers often make many fewer representations and warranties—typically addressing corporate organization, authority to enter into the transaction, financial statements, etc.—if shares of the buyer are being used for all or part of the purchase price, the buyer will have to make representations and warranties analogous in number and substance as to those of seller.
Why are these representations and warranties so troublesome? The answer is that the seller and its shareholders will have to personally indemnify the buyer for any losses arising from breaches (misstatements), while the buyer will indemnify the seller. Thus, a corporate obligation has become a personal obligation of the owners of seller, who must, as must the buyer, make sure these representations are complete and accurate.
So what can be done to mitigate this risk? The answer is that there are several strategies available. The first and foremost limiting factor is to attempt to limit the representations and warranties to "knowledge" or "actual notice." In addition, the parties often agree to a "basket," or deductible, so claims aggregating an amount which is small in comparison to the size of the deal will be overlooked. Owners of the seller frequently limit the exposure to an amount somewhat less than the total purchase price, so there is no case where the seller is actually worse off than before the transaction.
Another crucial agreement is the insuring for the acts of seller in delivering services prior to the consummation of the transaction. The arrangement for continuing professional liability insurance for past, completed projects of seller and ongoing projects assumed by buyer must be addressed and negotiated, so there is no "gap" in coverage.
If the transaction includes an earnout, or arrangement to compensate seller based on revenue and/or net income of the seller's operations after the closing, the seller must make sure it has operational control over the business. What if buyer does not support these operations? Will buyer charge seller's operations with a position of its overhead costs, thus reducing the chances of maximizing the earnout. Sellers often try to have the payments under the earnout based on a sliding, pro rata scale, and not an "all or nothing" arrangement, to increase the chances of some payment, and from the buyer's viewpoint, continue to incent the owners of seller.
Employment Agreement. Virtually all transactions include employment agreements with the owners/principals of seller, to assure both the buyer and seller that the transaction will be smooth and increase the chances of a successful deal. The parties must address the length of the term of the employment, salary and salary increases, incentive corporation, payment of expenses, and position/responsibility of duties. But the real issues are under what circumstances can the employee be terminated? The issue of termination without cause must be addressed: Can it occur? Is there severance? Are restrictive covenants waived? The most common source of contention is the definition of "cause": Is it objective (conviction of a felony, embezzlement, drug abuse), or is it subjective (failure to perform, failure to meet goals, failure to carry out directives of the board)? Owners of the seller want to assure the security of future employment while buyers want to make sure the former owner of seller will be productive going forward. Thus, both parties must understand the specific terms governing employment and their rights and obligations.
Shareholder Agreement. More and more, the owners of seller are becoming owners of buyer as the parties strive to integrate the operations of seller by having its former owners assume leadership roles going forward. The owners of seller should clearly understand the circumstances under which their stock is repurchased, how the stock is valued and over what period of time the stock is repurchased. Is the obligation to repurchase subordinated to bank financing? Do shareholders have to personally guarantee bank debt?
Restrictive Covenants. Perhaps the most sobering issue owners of a seller face is the realization that their future professional activities are now limited. Contained in one or more of the purchase and sale/merger agreement, the employment or shareholder agreement, restrictive covenants have lingering impact on the future of the former owners of seller. Typical restrictive covenants include total confidentiality of all proprietary and business information of buyer, agreement not to solicit clients of buyer, agreement not to provide services to clients of buyer, and/or agreement not to hire or solicit employees of buyer. The parties often negotiate the interests of the buyer, which paid for the business, and the owners of seller, who need to earn a living in their profession when no longer employed by buyer. Typical topics of discussion include the length of restrictions, whether the restrictions apply if the former owner of seller is terminated without cause and geographical and territorial applicability.
Unlike corporate transactions where one company buys another, the merger or acquisition of a professional services organization is more analogous to the creation of a new partnership between the principals of seller and the buyer and its owners going forward. However, it is incumbent upon the buyer, seller and seller's owners to each fully understand, prior to the transaction being completed, the legally binding responsibilities and obligations each owes to the other after the closing. It is the balancing of the interests of each party that is the art of the deal among architectural/engineering/environmental consulting firms and their principals. The more clarity and specificity that is brought to the process prior to closing, the better the chance that there will be no surprises, less conflict and a successful transaction.