This article is the second of our two-part guest series by Aaron Woo of Vanguard Legal. This article provides insight into legal agreements a buyer may require from the founder of a tech services company at the time of sale. This article is not legal advice. You can read the first part here.
Mergers and Acquisitions are a high-risk proposition for the acquiring company. There is uncertainty around the future with the strategic success, the cultural match, and the creation of joint GTM plans. But there is also an information disparity, with the seller having a far better understanding of the condition of the company than the buyer.
To mitigate their risk, one key item that the buyer will require for closing is the Seller's affirmation of certain assumptions regarding the condition of the Company, also known as "representations and warranties" within the "purchase agreement" upon which the Buyer’s determination of the purchase price is based on.
Below are some closing items and standard "reps and warranties" that are typically required in definitive closing documents.
Buyers will want to know about any defective products or services delivered to customers and the risk of any potential warranty claims. Through this analysis, the buyer will want to know the costs to repair, substitute, or replace any defects, and may set aside a warranty reserve apart from the purchase price (against which any warranty claims will be deducted).
The costs of honoring warranty obligations become more critical with a larger customer base or high-cost projects. The buyer may hold parts of the payment sum in escrow for managing warranty and other claims. Some sums can also be contingent on the future performance of the company. This is usually called Earn Out.
While the company is preparing for the sale, it is critical that none of the employees become aware of the potential sale prior to closing. Should any employee become aware of the sale, word can quickly spread to the entire workforce which can result in a mutiny. Not only can a mutiny cause operational delays to the business.
Key employees may also try to negotiate more lucrative, self-interested deals for themselves prior to closing; thus, defeating some of the economic assumptions of why the seller and buyer were doing the deal in the first place. If this happens, a portion of the purchase price may need to be allocated to address these employee demands resulting in less consideration paid to the owners of the company.
In addition, M&A deals would be considered Insider information and premature release of such information would be illegal for a public company.
Most companies will have employment agreements with key members of their management team, who are critical to the success of the business. In addition to addressing the base salary and benefits paid to the executive, many of these agreements will also grant the executive some form of equity in the company as an additional incentive to ensure the success of the business.
Oftentimes, such grants of equity will be tied to some vesting schedule, which can accelerate upon some exit event and/or termination of employment. It is important to examine these executive agreements to understand whether a buyer is able to retain these executives for a period after closing to help the company transition ownership. If not, the buyer will need to determine a price to retain the services and knowledge of these executives after closing.
As part of the pre-closing process, buyers will perform some level of “due diligence” to identify any “skeletons” (i.e. litigation, liabilities, liens, claims, etc.) that could burden the company. Afterward, the buyer normally drafts the definitive purchase agreement in which they stipulate certain key assumptions about the condition of the company under a Section titled "Representations and Warranties of the Company" upon which their proposed purchase price is based.
Because the Seller is in the position of knowledge, this now shifts the burden onto the Seller to identify any skeletons as exceptions to these Reps and Warranties. For bigger and older companies, a buyer may ask sellers to perform a state and federal lien and litigation search to identify any “skeletons” on public record and minimize any risk of uncertainty. Failure to disclose any skeletons could result in a reduction of the purchase price paid to the seller or trigger a post-closing indemnification obligation by the Seller.
Although this is not a contentious issue, Buyers will typically require the Seller to identify all of the Company’s insurance policies to understand its risk profile and any gaps in coverage. The seller, counsel and its insurance agent usually work to identify these policies and any actual or potential claims against these policies.
Any identified claims that exceed the policy limits will either need to be settled prior to closing or set aside in escrow post-closing to pay for any finally determined amounts. Occasionally, the purchase price may need to be adjusted to address any excess amounts of outstanding claims or to address the cost of retroactively covering any unknowns.
In these articles, we discussed M&A. Many tech services founders don’t like to think about a potential acquisition because they feel it distracts them from the job of building a great company. We would argue that creating a company that is acquirable is a prerequisite for creating a sustainable company. As such every tech services founder should understand how the legal process of M&A works.
We thank Aaron Woo of Vanguard Legal for sharing his insights and expertise. If you are a technology business, please feel free to reach out to him at woo@vanguardlegal.io. Once again, we have to clarify that this article does not constitute legal advice and that no attorney-client relationship is created.