Acquisition agreements are the most important legally binding documents in the acquisition process, but their role is frequently misunderstood. They structure the deal and allocate liabilities and responsibilities among buyers and sellers.
The commercial terms of an acquisition agreement are usually developed out of those anticipated in a non-binding Letter of Intent (LOI) agreed to by the buyer and seller earlier in the deal process. LOIs and other deal steps leading up to the acquisition agreement are detailed in Part 3 of this series. Terms originally developed for the LOI may subsequently be adjusted as a result of due diligence activities and by negotiations leading up to the execution of the acquisition agreement.
Acquisitions are described here from the buyer’s perspective. Acquisitions provide opportunities for buyers to create synergies with their own organization and to increase the operating margins of the acquired entity by implementing an acquisition plus globalization (A+G) business model, introduced in the Part 1 of this series.
Outcomes of acquisitions often hinge on how investment banks are used for deal management, as outlined in the Part 2. Outcomes can also be influenced by the potential for conflicts of interest by attorneys and accountants, particularly those representing sellers. This subject is addressed in this installment.
Liabilities from acquisitions can be recognized, limited and allocated in an acquisition agreement. The most important aspect of an agreement is the price or the price formula. Liabilities and prices will be addressed in a future article in this series.
We begin here by examining what acquisition agreements do and then describe their contents. We look at the mechanics of agreements and the role of representations and warranties in these documents.
What Does an Acquisition Agreement Do?
Signing an acquisition agreement represents a promise to transact a deal if certain terms and conditions are satisfied. Closing usually occurs later, when the agreement’s conditions are met, additional contracts are executed, and consideration (payment) is exchanged to cause the deal to take effect.
An acquisition agreement may sometimes be called a purchase agreement or a merger agreement, although not all acquisitions result in mergers. Depending on how a deal is structured, it may be known as a stock purchase agreement.
The agreement structures the deal, sets out the terms of an acquisition, and specifies the conditions that need to be fulfilled in order for the deal to close. It determines the purchase price and how payments are to be made. It contains the seller’s representations and warranties about the condition of the business and its assets and liabilities. The buyer represents that it has the necessary authorizations and financial resources to complete the transaction.
Representations Need to Be Investigated
Representations are factual statements, whereas warranties are promises made to ensure that representations are true. The list of representation statements is cataloged in a disclosure schedule. These statements may include representations on tax liabilities, the status of litigation, and the assets to be included in the sale and their condition.
A complicating factor in reviewing representations for buying Indian call centers is the common practice of owners to lease key pieces of equipment, such as predictive dialers and call center software. Complications can be exacerbated by the difficulty of obtaining accurate representations regarding the payment status of lease invoices or, in some cases, whether assets are under lease.
In the U.S., falsifying representations can lead to significant legal penalties, including possible incarceration. Nonetheless, buyers of U.S. firms need to have an accountant participate in due diligence of a seller’s operations before representations are prepared in an acquisition agreement. This is intended to prevent post-acquisition surprises involving hidden liabilities and losses, and to contribute to a fair price being set. Overseas buyers can have their own accountants participate in this process, but they really need to engage an accountant with substantial due diligence experience in the U.S.
In acquiring an American outsourcing firm, key representations and warranties that buyers need to focus on are those pertaining to the business relationships between the outsourcing firm and its clients. A common issue that I see in South Asian firms buying U.S. call centers and business process outsourcing (BPO) facilities is whether the seller’s outsourcing programs are locked into the seller’s U.S. facility or can be moved to more competitive locations.
Buyers of U.S. call centers and BPO facilities need to expect that outsourcing programs may be locked into the incumbent facility and should plan their post-acquisition strategies accordingly. Strategies for addressing facility lock-ins will be addressed in an upcoming article in this series. Now we turn to the mechanics of acquisition agreements.
The Mechanics of Acquisition Agreements
A signed acquisition agreement binds the parties to complete the transaction within a set period and specifies the obligations of the buyer and seller. The agreement can trigger damages if one party delays or fails to meet certain obligations. Here a delay by a buyer reconsidering its strategy and the potential synergies and benefits of an acquisition can spoil a deal and lead to break-up fees.
Acquisition agreements specify the other documents that need to be in place for closings to occur. Audited financial statements are chief among these, because the actual price to be paid may be determined by recent revenue data and other financial information contained in those statements. Additional documents needed for closing can include title insurance and real estate transfer documents, lease transfers, and documents associated with any government approvals that may be required.
The buyer may seek non-compete and non-circumvention agreements from the principal owners of the entity being sold. These promises are meant to prevent sellers from setting up or joining up with a competing enterprise and luring customers away from the business that is being sold. The standard period ranges from one to three years, with three years being the most common.
I used to use five years for non-compete and non-circumvention agreements, but have since moved to three years — and occasionally to two — because I believe that a five-year period is unreasonable and unfair. Given that the rate of change in outsourcing is increasing, three years is an incredibly long time to be outside the field. In negotiating acquisition agreements, there could be an inverse correlation between sale prices and the lifespan of non-compete agreements.
An allocation statement is often included as part of the acquisition agreement, wherein the parties agree on how the sales price will be allocated among different assets or categories of assets. The allocation statement can impact the tax liabilities of both the buyer and seller. For example, if the seller has previously assigned a net book value of US$30,000 to a vehicle that is allocated a price of $50,000 in the allocation statement, then the seller may be liable for long-term capital gains taxes on $20,000 from income received when the vehicle is sold for more than its book value.
The resale value of telecommunications and call center equipment declines quickly. The major source of value of a North American outsourcing company is rarely found in its hard assets, but rather with its conceptual or blue sky assets such as customer loyalty and goodwill.
The interests and objectives of buyers and sellers may differ in putting together an allocation statement, leading to disagreements that slow the agreement process. Determining whether or how incumbent managers will be utilized following the acquisition can also slow agreements, since sellers will often insist on post-acquisition employment agreements being executed in tandem with the acquisition agreement itself. Buyers may want wide latitude to remove incumbent managers, particularly those that are members of the sellers’ families.
I like to build cushions into timelines for non-U.S. buyers, in recognition of the fact that signings, closings and currency-control permissions often take longer than expected. Additional delays that exceed those cushions are one of my biggest fears.
Attorneys and Accountants
Buyers are almost always better served by having the acquisition agreement drafted by their own attorney, with input from their investment bank’s acquisition advisor. The alternative is to have the seller draft the agreement and then spend time going back and forth attempting to have the agreement revised to the buyer’s satisfaction. Exceptions are found in some seller auctions and bankruptcy sales. Exceptions are also found when managers from the firm or business unit being sold are also participating in the acquisition as buyers, which is referred to as a management buyout or MBO.
Buyers using an investment bank should have their acquisition advisor from that organization present to manage both the signing and closing events. An investment bank should be able to refer both the buyer and seller to specialized deal attorneys. In a relatively simple mid-market deal for a firm selling for between $4 million and $20 million, each side may spend between $15,000 and $50,000 on legal fees to draft and close on an acquisition agreement.
A buyer may spend between $15,000 to $50,000 on accounting fees for due diligence activities in order to execute an acquisition agreement for a relatively simple mid-market deal. The buyer’s expenses for accounting fees will be less than the amount they spend on attorney fees. For the seller, accounting fees will exceed the range presented above because the seller needs to produce audited financial statements.
The attorneys that represent each side need to be specialists in acquisition deals and should be screened to ensure that they do not have conflicts of interest. The use of a seller’s general counsel can harm a deal because this attorney stands to lose a major client if the deal goes through. They may consequently try to spoil or delay a deal that does not substantially benefit them personally.
Accountants can also present conflict of interest issues, particularly on the seller side. A seller’s accountant who stands to lose a major client if a deal is completed may confuse their personal financial interests with those of the seller.
In years past, I used to be able to ignore conflict-of-interest issues regarding accountants and lawyers. Now, if it appears as though one side is hamstrung by these issues, I would recommend passing on a deal. Buyers, in particular, need to be ready to jettison an acquisition target that is not represented by an experienced independent deal attorney or a target whose owners have not resolved conflict-of-interest issues with their accountants. There are other fish in the pond.
Anthony Mitchell , an E-Commerce Times columnist, has beeninvolved with the Indian IT industry since 1987, specializing through InternationalStaff.net in offshore process migration, call center program management, turnkey software development and help desk management.