Recently, I’ve been involved in a few ‘problematic’ deals involving the purchase of the shares of a corporation (i.e., not asset deals). The problems have been serious, and mainly avoidable, I would like to think anyhow. I live in hope.
The operative reason for some of these issues is simply inexperience on the part of the parties and some of their advisers, as I do lots of quite small deals, meaning from $50K to $1.0M. I would like to offer you a point form listing of the most common problems and my suggestions for avoiding same:
1. Establish the “Value” for the Corporation: it is absolutely essential that the buyer establish what value he puts on the corporation to be bought: not the price to be paid, but his subjective value, based on a number of financial and non-financial factors. In the big deals, invariably, the value is premised upon the last audited financial statements, with particular emphasis on certain items: revenue, margin, EBITA, cash flow, ratios, etc. The due diligence then focuses on the integrity of those numbers, and closing is conditional upon the corporation meeting or exceeding those results in the period from those last audited financial statements to closing or just before closing. Simple.
Problem is, small deals involve small corporations that rarely have audited financials, and I see a lot of surprisingly aggressive small business accounting, there’s some scary stuff out there. The buyer must make a decision early on whether or not to believe and rely upon the seller’s financials. If not, the buyer needs to get reliable financials or partial financials done, to form a baseline for value, and based on value, to set a price.
The idea is that the buyer will pay $500,000, for example, if the corporation shows EBITA of not less than $125,000 – so the value is 4 times EBITA, to justify the price to be paid of $500K.
There are lots of variations, including a fixed maximum price like our example, or a formula that allows for a price of more or less than the target price. Unless the deal is a disguised asset deal, where the buyer is buying a non-active shell just to get certain key assets (real estate, machinery or distribution rights), the concept is the same: buyer must determine the value for the Corporation against which the price will be confirmed, adjusted or closing will not occur.
Often both buyer and seller are in a big rush to close the deal and move on with real work – haste makes waste of course, but this is another article sometime – but the result is that there is not enough time to do interim financial statements to cover the period from the last financials (however unreliable) to closing. So, at closing the buyer is taking a big risk that the old financials are garbage.
The well-established solution to bridge that uncertainty has been the earn-out provision or set-off against the seller take-back financing. The earn-out is a bluff: if your corporation can really make those numbers, I’ll pay you the full price; if it can’t, I pay less in a post-closing payment. Or, provision is made for a set-off of the promissory note given by the buyer to the seller for part of the price, and if financial results aren’t met, part or all of the note is forgiven or reduced.
A short time ago, I didn’t like earn-outs or set-offs, but lately, I’ve become a believer. Fact is, small business owners are getting much more aggressive (i.e., sleazy) advice these days, and more and more games are being played in the financials. This goes on and will continue to go on because we’re not dealing with audited financials – though an audit is no guarantee of results, past, present or future.
Another solution: buy assets!
2. Do a Good LOI: I’ve done a two-page LOI (letter of intent) to buy the largest bank in Canada, can’t tell you which one, but my recent experience has taught me that it pays to have a pretty detailed LOI – especially on price, price payment, security for vendor take-backs, critical conditions to closing for buyer, list of key assets expected to be there at closing (even if a share deal) and confidentiality. Even if the LOI is expressed to be non-binding, the discussions necessary to create an agreeable LOI will flush out many things: the good faith of seller, or not; potential problems, the style and competence of your team members and seller’s team, and timing.
3. DDR is everything! And I really meant that literally. I see a lot more fraud and skullduggery, much of it initiated and supported by my legal and accounting colleagues, than ever before, all rationalized in their minds as good, aggressive business techniques. So, it’s caveat emptor all right, and no question is out of bounds. The legal documents will give you some assurance, some comfort, but the best comfort is what you can verify independently with your own eyes – public office searches (litigation, corporate, PPSA, and others less accessible, like WSIB, GST, PST and income tax), review of files, questions to owner and staff, random checks, financial review of numbers and common, industry ratios and practices – turn the business inside out, it’s your best chance, ever.
Once you close the deal, all you have is a lawsuit, or maybe a holdback, but the holdback might not be large enough to absorb the problem – e.g., a $1 million tax issue or a Human Rights complaint of a former employee/concubine of the owner.
If you’re a seller, then alert your team to the need to give the buyer full access and cooperation. I tell buyers to regard non-cooperation as a red flag, a hint that the seller has skeletons in the closet. Moreover, be sure to keep the due diligence process moving along, as it can bog down in emails and letters back and forth for weeks, and some people just don’t know how to resolve things or cure problems. No due diligence of a small business should take more than a month – if it does, there’s problems somewhere.
4. Talk Big Issues Out in Person: You know, I hate meetings. Yet, I’m starting to think that deals can die on the vine in the course of emails and phone calls. Misunderstandings from cryptic or misworded emails can linger, even worsen. Phone calls with some but not all the players can prolong discussion and polarize views. I don’t suggest holding regular or frequent meetings – but meetings when a few important issues arise, before each side digs in or looks for ‘traders’ to raise.
5. Lawyers for Legal, Accountants for Financial and Tax: If I had a nickel for every time I heard an accountant say, “Well, I’m not a lawyer, but I think…”, I’d have a whole lot of nickels. Fact is, the corporation’s accountant is usually closer to the client, more trusted, more familiar, for a bunch of reasons. But, fact is, accountants give lousy legal advice in my experience. What they should say is, “Well, I’m not a lawyer, but if I were you, I’d call your lawyer on that point…”
6. Sellers Should Use Agents: Where the seller has never done a deal, he or she is wise to hire a broker/agent to help them through it. I guarantee that the seller will thereby save legal and accounting fees, and get a better price, more than paying for their fee. Another fact is that the closest adviser to the seller, the accountant, may or may not be very experienced or savvy in doing deals, whereas a broker does dozens of deals a year, getting broad and deep experience.
7. Get the Team Onside: Another unsaid factor is that sometimes the old company lawyer or accountant really don’t want the deal to happen for the seller, and will surreptitiously sabotage the deal to keep the client in their practice. Inside employees can do that too, more than you would think. Be alert to it. The agent can help in this respect, being your eyes and ears, and team cheerleader.
Sometimes too much secrecy and too late disclosure of the deal creates resentment, and gives rise to cooperation issues. I think owners are a bit too paranoid about telling key people and perhaps a bit unrealistic about the likelihood of leaks. When someone carrying a huge lawyers’ box comes into the office and is shuttled into the boardroom with no introductions to staff or small talk, trust me, everyone in the office knows about it and they come to the obvious answer – which could be wrong!
I advise the buyer to get the core team onside fairly early, build some loyalty with good comradery and maybe even some incentives ($$$’s) for closing on time.
8. Last but FOREMOST: I’ve been astounded in the last few years of share deals where the owner of the corporation to be purchased, and the corporation’s accountant, don’t seem to understand that after the closing of the share deal, the owner(s) can’t then declare dividends and proceed to physically pay out cash monies from the corporation back account! It’s really simple: the former owner has no legal capacity to declare dividends and pay out monies after the deal. And, you can’t legally backdate it either. That’s fraud, and is almost always a direct, major breach of the operative share purchase agreement.
Similarly, you can’t repay a shareholder loan to the owner after closing, for the same reasons. Practically, the former owner won’t have the cheque book after closing, and the new owner will have changed the signing authorities at the bank. If the bank documents are not so changed, then shame on the new owner, it is negligent.
Note that I say this in either case of dividends and shareholder loans, even if the share purchase agreement and/or the reps and warranties or covenants specify that such dividend is to be paid, or that shareholder loan is to be repaid. Sure, you can sue on a clear promise to allow such payments – but I guarantee you that in 99% of business purchase deals, the new owner/buyer finds something negative after closing, and will hold back any amounts otherwise due to the former owner to compensate for the problem.
The foolproof solution is so obvious, and is invariably followed by competent deal parties without debate: get the money physically and fully out before or at Closing!!!
Well friends, I think those are the main trouble areas I’ve encountered lately in share deals. The irony is that it is the least experienced, least knowledgeable parties that refuse to follow prudent advice on these matters, thinking they can create and enforce all sorts of ersatz variations to conventional practices, and instead of course, they end up in the hands of litigators and our judicial system seeking justice. What more can I do?