How to Buy a US Outsourcing Firm, Part 5: Indemnifications

In buying a U.S. company, liabilities do not cease once a seller has completed a deal. The allocation of liabilities is usually determined in the acquisition agreement. Acquisition agreements are described in the previous article in this series. Here we examine the role of indemnifications in acquisition agreements.

The role of indemnifications in mergers and acquisitions has become highly developed, scrutinized and refined by investment bankers (as described in the second article in this series) and other deal managers intent on controlling risks and providing a high degree of predictability for buyers of U.S. businesses.

Indemnifications make the acquisition process safer for buyers, especially buyers who are not accustomed to making acquisitions of U.S. businesses or for whom every acquisition represents a major strategic transaction. Buyers from outside of the U.S., such as the Indian call center owners who I work with and who are using acquisitions to quickly expand in U.S. outsourcing markets (as described in the first article in this series), need to know how to use indemnifications so that they do not overpay.

Quantifying Liabilities

The significance of indemnifications in acquisition agreements increases when the liabilities of the entity being sold cannot accurately be determined or may only appear later, after an acquisition agreement has been signed. Buyers (usually through their deal managers) conduct due diligence to verify the condition of an acquisition target before signing an acquisition agreement. However, due diligence efforts may be incomplete, limited by a lack or relevant or timely information, or may not anticipate liabilities such as litigation that appear following an agreement’s signing.

In most acquisitions, the buyer will require the seller to indemnify the buyer by defending the business from certain types of claims and to reimburse or otherwise protect the buyer for discrete categories of liabilities, as specified in an acquisition agreement. There are two types of liabilities:

  1. Liabilities that are disclosed by the seller; and
  2. Liabilities that are not disclosed.

Acquisition agreements should contain provisions for both types of liabilities. An acquisition agreement may define some types of undisclosed liabilities as breaches of the agreement — tax liabilities, for example — and then make provisions for how breaches will be handled.

Remedies available in the courts for breaches may not be enough for buyers because these remedies do not allow buyers to fully recover all costs incurred from a breach. These costs can include attorney fees and out-of-pocket expenses incurred by buyers. Court-applied remedies may not extend to the length of time that buyers need to recover their losses. Provisions for adequate remedies for buyers therefore need to be set out in acquisition agreements, along with indemnifications for liabilities that do not represent breaches of those agreements.

The extent of indemnification offered to the buyer commonly affects the sale price. Ideally, most sellers would like a sale to be made on an as-is basis. However, if costly liabilities appear after an as-is sale, then the buyer is likely to have overpaid. Buyers will therefore seek to drive prices down for acquisitions with substantial or significant-but-unquantified liabilities. Except in a distressed sale, buyers generally prefer to have all liabilities paid for by the seller if those liabilities were incurred prior to closing a deal.

Sellers can push for higher prices if they are willing to extend protection (i.e. indemnify the buyer) for liabilities incurred before sellers relinquished control of the business. Higher prices can also be sought if buyers can be satisfied that due diligence activities have adequately quantified liabilities and that liabilities are sufficiently controlled.

Inversely, businesses being sold with the potential to saddle buyers with significant liabilities are expected to have their prices discounted. Sometimes liability exposures do not appear until well into the deal process, after other deal steps have been completed.

For example, in conducting due diligence in West Virginia of a horse stable complex attached to a commercial horse racing track, everything initially appeared to support earlier valuations made by parties involved in financing the asset purchase. However, in examining old maps and aerial photos of the site, I realized that the steep hill overlooking the stables had not existed forty years earlier. Although it appeared as just a big muddy hill, it was actually a huge, unstabilized pile of untreated horse manure that had been co-disposed with hypodermic needles and other veterinary waste. The cost of remediating the site would have drastically reduced the value of the property.

Two Phases of Due Diligence

Due diligence activities are generally conducted in two phases. Initial due diligence focuses on the commercial aspects of the target business such as revenues, cash flows, client base, operating margins and other performance metrics. On the basis of that initial due diligence, a buyer may offer the seller a non-binding letter of intent (LOI) that sets out the proposed terms of a deal, including a price formula.

If the seller accepts the LOI, then due diligence is renewed. As described in the third article in this series, which details the stages typically followed in mergers and acquisitions of U.S. outsourcing companies, post-LOI due diligence concentrates on liabilities.

A pitfall that buyers can make in due diligence is to attempt to go over every single aspect of the entity being purchased. A better strategy is for a buyer’s representatives to prioritize what they are looking for and to concentrate on the top priorities first and foremost.

If buyers intend to retain the brands of the entities being purchased, then they should look closely at the strength of those brands. If they are buying software products to be integrated into buyers’ products, then due diligence should focus on how the software products were built and how they function. In buying a business process outsourcing (BPO) or call center company or brokerage, a priority would be the strength of the client base and whether there are any lingering liabilities from outsourcing projects handled by the seller.

A pitfall of concern for buyers from outside the U.S. is for due diligence efforts to be concentrated on aspects of a business that buyers understand. This can lead to the neglect of issues such as intellectual property, regulatory compliance, and long-tail environmental liabilities that would commonly receive considerable attention from U.S. buyers. Intellectual property and environmental liabilities will be covered in an upcoming article, along with liability allocation options.

Post-LOI due diligence can be frenetic and intense, with buyers’ representatives requesting information that may not initially be available to sellers. Sellers have an interest in cooperating with these requests in order to allow the deal to go through and for the price to not be discounted because of unresolved liability issues.

Sellers may feel that buyers’ requests for information are unreasonable and excessive. Even when sellers cooperate to the best of their abilities with buyers’ due diligence activities, sellers may believe that the buyers’ representatives are going overboard in their due diligence efforts.

“You cannot find something that doesn’t exist,” sellers may declare. Buyers can retort: “absence of evidence is not evidence of absence.”

Anthony Mitchell , an E-Commerce Times columnist, has beeninvolved with the Indian IT industry since 1987, specializing through in offshore process migration, call center program management, turnkey software development and help desk management.

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