March 15, 2018 | Sherrard Roe Voigt & Harbison Blog I Tracy A. Powell
As a transactional health care and corporate attorney, things seem to come in waves. There are times when I feel like my entire day or week is spent in regulatory analysis or structuring new ventures. At other times, I think all my clients are buying or selling something. Recently, I seem to have assisted my clients in a lot of sales of their businesses or medical practices.
In most cases, a business has been built over many years. The owner has invested time, sweat, and tears into dealing with all the things that are required to build a successful business. The owner may be enjoying a nice revenue stream and along comes a larger operator or a private equity or venture-backed enterprise looking to pay a multiple of earnings. Friendly gestures are exchanged, a mutual nondisclosure is executed, and some initial discussions ensue. Things look promising!
Given some 20/20 hindsight, here are some things that have caused heartaches down the road for clients in similar circumstances.
Most sellers usually sell once; buyers do this sort of thing all the time.
This is not intended to insult the intelligence of my selling clients. They are invariably good businesspeople who have built successful businesses and are not “babes in the woods” with no ability to protect themselves. However, experienced Buyers know how to keep sellers interested and committed before addressing potential deal breakers; they use jargon with which one-time sellers may not be familiar (e.g., “due diligence” “financing contingencies” “usual and customary reps and warranties”). Sometimes an apparently straightforward term can mean something very different to parties and lawyers with a lot of experience in buying and selling businesses. In short, don’t sign things (including “letters of intent” or “term sheets”) without understanding the basic terms or buzzwords, and certainly not without having your counsel and other advisors’ input (more on this later).
Buyers often use certain techniques that seem perfectly innocent and logical, yet they can have important and negative effects.
“Let us business folks work that out first, and then we will let the lawyers get involved later.” I have seen this technique employed on multiple occasions. Most folks think of themselves as honorable and more understanding of their own business than any lawyer or accountant. So, the Seller will engage in discussions with Buyer, and maybe even hammer out a term sheet or letter of intent (or “LOI”) that purports to be nonbinding. But, in some cases, the term sheet or LOI has binding and nonbinding provisions. In other cases, even if nonbinding, the LOI outlines what are intended to be basic business terms (e.g., purchase price target; asset sale vs. stock sale; post-closing employment and noncompetition provisions; etc.). Although such terms might be “nonbinding”, it is difficult to renegotiate them later, even if the Buyer later burdens the deal with many other items that negatively impact the Seller (that were not part of the LOI). As such, be careful in agreeing to anything, whether it appears to be a business or legal consideration, without consideration of how it impacts the entire transaction. Don’t keep your lawyer on the sidelines too long or at key times.
For what it is worth, the “let’s work this out as business people” strategy often crops up later in deals, even after the lawyers are fully involved. Again, I have seen this used strategically by Buyers (and even, while sometimes improper, by Buyers’ legal counsel) to isolate a Seller and to extract an advantage. You should have engaged a competent attorney to assist in the transaction; use them wisely and allow them to help.
“Let’s resolve purchase price (or some other items of importance) first; we can deal with the other details later.” This technique is used to allow agreement on an important item or items that may be seen as critical to even further discussions. Unfortunately, some of the more mundane details that are ignored might turn out to be very important down the road or even impact the entire sales proposition. This happens frequently when another document is to be provided at a later date. For example, a Seller agrees to take a portion of the purchase price in the form of equity in the Buyer. The terms of the equity are to be covered by a to-be-provided shareholders agreement or operating agreement. When that that document is finally offered for review, it provides severe restrictions on liquidation rights, etc. Don’t commit to any documents or key terms before you have the complete package and your best deal. An attorney will be able to assist you in deciding whether something can safely be left for later in the deal.
Earnouts (not usually seen in sales of medical practices, but productivity bonuses may be similar) rarely work out in a Seller’s favor. Yes, earnouts are often used to bridge the gap between what a Seller thinks its business is worth vs. what a Buyer does. But in my experience they rarely provide Sellers with the face value or maximum payout. The Buyer controls the transferred business on a post-closing basis. Also, keep in mind that if you have to fight over an earnout down the road, the Seller will have to pay for legal fees and expenses out of their sales proceeds; the Seller no longer has the revenue stream to support any legal fight. The Seller is already emotionally incentivized to settle as quickly as possible to avoid a huge legal battle with ensuing fees and expenses. Even with fee-shifting provisions, this remains a big item as those fee-shifting provisions generally do not force one party to pay the legal fees of the other party unless there is a judicial decision in favor of a party; with the cost of litigation and the likelihood that any dispute will be resolved via settlement, those fee-shifting provisions offer little relief. Avoid earnouts if at all possible, and if you do accept them, (i) negotiate hard to have control over certain items or to prevent the Buyer from doing things that influence the targeted items (or else place the attendant risk of doing those things on the Buyer), and (ii) set yourself up for a disappointment.
Often shares of stock or membership interests are issued in connection with the sale as part of the purchase price. This equity is usually subject to substantial restrictions and limitations that devalue it or prevent its liquidation freely. Sellers should demand that any equity issued be subject to a repurchase by Buyer at some future point and without any diminution in value than that given in the sales transaction.
Although I mention it indirectly above, I want to make it more explicit – I often see Sellers allowing themselves to get too far down the road, avoiding hard details until emotionally invested or “deal fatigued”, and then finding themselves unable or unwilling to walk away. This can also happen when Seller allows the Buyer to meet with its key employees or have a conversation with a key customer. Once the word is out that a sale is under consideration, it is hard to walk away and not suffer. Remember, the only good deal is one from which you can walk away.
Buyers teams often employ the “good cop, bad cop” approach. The initial contact or the lead negotiator is the good cop, always making efforts to be accommodating, but reserving that “our CFO” or “equity sponsor” has to approve. Often that approval process or a firm response to a request is delayed or strategically converted into a request for a concession. Beware of terms that have to be approved by someone else, and don’t consider a term set in stone until it has received that approval.
Keep in mind that legal fees and expenses after the closing come out of Seller’s proceeds, not the revenues of the business. Buyer has the business and its ongoing revenues to fund its legal expenses. Build this into your expected net proceeds, and make sure you set aside some of the proceeds to deal with post-closing legal, accounting, tax and other issues.
