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A Great Defense is a Strong Offense

Sep 7, 2022 | Cascade Conversations

Join Raj Kothari, Managing Director – Cascade Partners and Peter Roth, Partner – Varnum Attorneys at Law as they discuss how to help work through challenges and issues with companies to minimize the impact on a potential merger and acquisition (M&A) transaction. Surprises can kill a deal – find out how financial and legal professionals work together to prevent that from happening in this Cascade Conversations episode.

 

Video Transcript:

00:00:00:11

Speaker 1

Welcome to Cascade Conversations. Join the team at Cascade Partners and their network of trusted advisers as they work to demystify details, terminology and strategies in the world of acquisitions, divestitures and financings.

 

00:00:16:27

Speaker 2

I’m Raj, Kothari managing director here at Cascade Partners. And joining me today is Peter Roth, a partner at Varnum, a law firm based in Grand Rapids, but with offices throughout Michigan. Pete, today we thought let’s talk a little bit about, you know, we use the term, hey, a great, great defense is a strong offense and wanted to get a sense of how you work through challenges and issues with companies to really minimize impact on a potential M&A transaction.

 

00:00:45:16

Speaker 3

Great. Thanks, Raj. It’s an excellent topic. You know, we often say surprises kill deals. And so, you know, the first thing I would say is we try to identify things upfront. You know, it’s very rare we run into an issue that we can’t solve in some way. We can’t get through and get the deal done except when it comes up and we’re not prepared for it.

 

00:01:07:10

Speaker 3

It comes up at the end you know, then buyers get spooked and problems, you know, erode deal value.

 

00:01:13:12

Speaker 2

Yeah. And that leverage changes, right. In terms of your ability to work through a problem upfront as opposed to at the end when you’re down to that single buyer and they’re trying to figure out how to how to recapture some of that purchase price.

 

00:01:25:28

Speaker 3

Right. If we know about it upfront, first of all, we might be able to fix it usually we can fix it. If we can’t fix it, we get it out on the table. And when you’re taking the business out and marketing it, you’ve got five people that are trying to put their best foot forward to buy the business and you just put in the same like there’s this environmental issue and here’s it’s a known issue.

 

00:01:43:09

Speaker 3

It’s not that big an issue. Here’s how we’re going to deal with it. You know, we can manage through it. On the other hand, if you’re down, like you said, to one party at the end, they, you know, they find it. They’re going to their environmental lawyer is going to say, oh, it’s a $10 million problem. And then they’re going to have the leverage to, you know, whack the deal value.

 

00:01:58:11

Speaker 2

Yeah, we’re we’ve that’s the strategy we’ve often taken is, hey, let’s get it out there upfront. Let’s either fix it right before we go to market or lay it out there. So it’s defined in the confidential information memorandum. It’s part of the management presentation, and it’s all part of the components when they’re putting value together because often if when we run the process competitively, right, many buyers will overlook those operational issues and just say, oh, it’s part of a deal.

 

00:02:26:11

Speaker 2

We’ll deal with it and it and it protects to protect potentially later on.

 

00:02:30:12

Speaker 3

Yeah, absolutely. And there’s two ways to look at any problem, right? There’s the worst-case scenario which guys like me will immediately jump to because we’re lawyers. And then there’s the likely outcome, you know, so if you think about somebody that maybe hasn’t filed a tax return in the state where maybe arguably should have, you know, the accountants can say, well, you know, there’s no statute of limitations.

 

00:02:47:29

Speaker 3

Actually, you never filed returns. It never started. So you can look back 30 years and here’s your worst case scenario and it becomes a big number versus what’s likely to happen much smaller. And maybe we do an offer, a compromise with the state and actually try to solve the problem proactively so we can propose those sort of solutions.

 

00:03:04:13

Speaker 2

Well, and as lawyers write well, we’re looking at a lot of the business issues and environmental and things like that. Often, you know, corporate hygiene, the solid corporate books and records are overlooked. How do you guys approach and think about that in the beginning of a transaction?

 

00:03:21:18

Speaker 3

We approach it, Raj, by trying to do a full sort of diligence like we were the buyer so we’ll set up the data room with the bankers, get everything set up in there, and then we’ll go through it and we’ll look for gaps. So if there’s a contract and there’s a missing signature or maybe the document signed in the Second Amendment sign, but the First Amendment’s not signed, we’ll identify that and then we’ll fill that gap and fix it.

 

00:03:44:07

Speaker 3

So basically we’re looking for things that the buyer will find and have questions about and then trying to fix that so that the questions answered before they ever ask.

 

00:03:52:14

Speaker 2

And that becomes really important, right? In terms of making sure, hey, you can find those minute books. You can you can make sure the contracts, not just the commercial terms, but those business terms like rights of assignment and consequences of a transaction. That’s a lot of what we found, you know, has been really helpful that you guys have been able to pull out because our clients are typically thinking about the commercial terms.

 

00:04:16:00

Speaker 2

Sure. But you and I and we’ve got to think about, well, what’s the impact of a transaction? And I think that insight that that you and your team have been able to provide on transaction has been really has been really valuable, critical to make sure we’re identifying issues.

 

00:04:30:05

Speaker 3

No, thank you. And that that’s a good point. I mean, because different issues are going to come into play when you’re just running your business day to day versus when you’re doing a transaction. You mentioned assignment clauses. That’s probably the easiest example, right? If you contract might be perfect from a commercial standpoint, but if it says you cannot assign this contract to a buyer, well then we have an issue when we’re trying to move the assets and maybe it says we can’t assign, but maybe it allows a change in control which isn’t technically an assignment.

 

00:04:56:04

Speaker 3

So there’s a structuring way we can get around that issue if we can’t get the consent. That’s an example of something we can address. Similar issue that we’ve run into is some exclusivity type provisions. You know, we run into contracts that say you can only sell this product in this market exclusively. Maybe that’s fine for the business being sold, but if that clause covers affiliates now, it binds the buyer and the buyer’s going to worry about that same sort of non-compete or exclusivity clause.

 

00:05:22:22

Speaker 3

So it’s things like that that you might not think about day to day that when you’re working through a deal, you do need to worry about.

 

00:05:28:09

Speaker 2

Well, we are, you know, again, directly to the point of, hey, what’s a what’s a good defense, that strong offense understanding those assignment rights and those consent rights make a big difference in the transaction and how we negotiate upfront. Either, A, how we’re going to structure the dock the deal, we got to do it this way or getting the buyers to kind of accept or go over, hey, there’s a consent.

 

00:05:50:29

Speaker 2

We’re not going for that consent. The buyer has got to take that risk. But by defining that, by knowing it upfront and then defining it upfront, we maximize the positioning for for our collective client as we’re going to the marketplace yeah.

 

00:06:04:06

Speaker 3

I think that’s a really good point. Where you guys have been great is, you know, when you go out and you’ve got the five people that are all trying to put their best foot forward and you say in your process letter, you know, tell us all of the conditions, tell us all the things that you’re going to require to get to a close.

 

00:06:16:29

Speaker 3

And we can put those consents right out there and say, OK, if buyer one saying we need to get ten different third parties to consent buyer two is only saying we’ll need two of the ten. You know, you know.

 

00:06:27:18

Speaker 2

You’ve got that likelihood of closed.

 

00:06:29:08

Speaker 3

Right? Deal certainty.

 

00:06:30:12

Speaker 2

Right? Absolutely. So, you know, one of the things that we’ve started using a lot more is representation and warranty insurance and really is a way to kind of put up a picket fence around all of those things that we don’t know. And it really give sellers some level of certainty, but it also gives buyers a level of certainty.

 

00:06:50:23

Speaker 2

Can you talk about how you’ve used or how you think about rep and warranty insurance in that in that perspective?

 

00:06:56:27

Speaker 3

Yeah, maybe we should define rep and warn insurance in case you and I use this. We we just say RWA, right? So I mean, so historically what’s happened is a seller is going to make representations and warranties in the contract promises about the business. I haven’t violated the law I don’t have any breaches of contract, I don’t have any labor issues, those sort of things.

 

00:07:17:00

Speaker 3

And then there’s indemnity to backstop that. So if one of those representations is inaccurate, the the buyer can say, hey, I was harmed by that and the seller, you need to give me some of the money back. So gives buyer remedy sellers don’t like giving money back though, so it’s not ideal what’s developed is a product called rep and warranty insurance, as you know, where instead of the seller having to stand behind those reps and warranties, an insurance company does which is really handy, as you said, for both buyers and sellers.

 

00:07:44:06

Speaker 3

The nice thing for sellers is they don’t have to risk giving any right back. It’s a clean deal. I put the money in my pocket.

 

00:07:49:23

Speaker 2

They know the certainty of what their exposure is.

 

00:07:52:02

Speaker 3

I sleep at night. I don’t have to get a million bucks back. On the other hand, the buyer still got recourse. If there’s one of those things that they’re relying on, one of the representations is in True Untrue, they go and they get the insurance company to pay them back. It has changed diligence, though. You know, some of these things we’ve been talking about in that insurance companies are now underwriting this and they’re not going to just do that with no due diligence.

 

00:08:15:29

Speaker 3

And so it requires, you know, they require a buyer to do pretty exhaustive diligence, have a diligence written diligence report. You have to have an underwriting call with the insurer and all their advisors. So, you know, when we’re on the sell side, having that all prepackaged and ready to go, you know, if we know a buyer is going to insure the deal, which most of them are now, you want to have that stuff ready so they can get the insurance underwriting well.

 

00:08:40:19

Speaker 2

And really, it also helps with the negotiation because as representing the seller, right, we’re willing to take more robust representation and warranties to give the buyer more confidence because in the end of the day, if there’s an issue, we’ve got a small deductible that we’re part of. And the rest, there’s really a claim they got to go to the insurance company and the buyer’s.

 

00:09:02:12

Speaker 3

Loading the.

 

00:09:02:22

Speaker 2

Risk, right? Removing that risk profile. And I found that the buyers like it because they they’re they take all the emotion out of raising an indemnity claim. Right. Because if I’m going to my partner or the selling shareholder is often the Bahamas, it’s a little harder conversation than going to insurance companies. But then I find our ability to give on the language tends to make people a lot happier about the dynamics.

 

00:09:27:13

Speaker 2

And, you know, sellers are you know, instead of putting six, seven, 8% in escrow, they’re now got a half a percent chance that they’re exposed. And and we find that a great way to get get sellers comfortable and again protect or create a good offense around those things that you just can’t you just can’t predict.

 

00:09:46:24

Speaker 3

You know, one of the things we’ve been seeing I’d be interested in what you see range of deals that are some are insurable and some are we’ve seen some deals recently, especially as the market’s been more busy, where insurance companies are being a little more cautious and if you can’t get a deal underwritten by the insurance company, it really puts a pressure.

 

00:10:04:20

Speaker 3

Yeah, actually. What do you see in that?

 

00:10:06:03

Speaker 2

Yeah, we definitely saw it late last year as as the market very tightened up. But what were what were the way we’re finding the distinction is, is the buyer sophisticated enough to be able to put a real diligence package together that the underwriters are going to look at? And so one of the things that we’re doing is assessing or prepping them for, hey, can they get through that diligence process to do that?

 

00:10:30:28

Speaker 2

And then depending on the reasons they break down, we’ve actually been able to push some of that liability back to the buyer basically saying you’ve had the information, you’re right, it’s your issue you committed and we’re not taking the additional exposure. Knock on wood, we’ve been lucky we take a very proactive approach. We actually go and identify rep representation and warranty insurance at the beginning of the process when we’re talking to the seller and just before we go to market.

 

00:10:59:24

Speaker 2

So as part of what we’re presenting to buyers is not just the deal and the documentation, but we’re actually saying, hey, we already have quotes or underwriters have already looked at this and said they’re willing to underwrite this deal subject to due diligence and that pricing and that element allows us to be more insistent that rep and warranty insurances is in play.

 

00:11:22:06

Speaker 2

So we’ve been lucky. We haven’t had one that hasn’t been that has not been able to get underway, and that makes a huge difference in the process.

 

00:11:30:17

Speaker 3

Yeah. And going back to your sell side clients, it allows them to really offload that risk sleep at night. I’m not going to have to give my money back.

 

00:11:36:24

Speaker 2

Well, I’m we use it, right? And we use that together on a deal last year on the buy side, where we use that as a tactical advantage in our negotiation with the seller to say, Hey, we’ll do this, will lower your risk and give our client a little bit more confidence that right if and when we have a representation of warranty claim that the process is a little less emotional and cleaner as we go through that.

 

00:12:02:12

Speaker 2

So we’ve you know, we’ve both and I mean that case for both used on that one together to help us.

 

00:12:07:01

Speaker 3

And it’s a huge differentiator. I mean, if you’re a you know, somebody is looking to be a winner in an auction on the buy side and you say, I need the seller to ask or $10 million and then somebody else says I need them to ask or $500,000, you know, that’s going to swing, you know, how how a seller looks.

 

00:12:22:23

Speaker 3

The two buyers.

 

00:12:24:04

Speaker 2

You mentioned at the beginning of our conversation about environmental and environmental is one of those big ugly ones that can get get particularly messy. I know when we’ve worked through environmental issues, you know, we’ve been very thoughtful about making sure that the buyer understands regulatory elements around environmental issues, particularly here in Michigan, but in other municipalities in other states where the rules are very different because what we found is many buyers kind of get a negative reaction without understanding the facts.

 

00:12:55:10

Speaker 2

How have you guys kind of driven that same type of process or thought about kind of addressing environmental problems upfront?

 

00:13:02:05

Speaker 3

Sure. I think a lot of times, you know, if we’re running a process for a seller, we’ll get a phase one. If there’s not a current phase one will get the environmental test. And, you know, maybe you have to pay ten or $15,000 to get that phase one. But if you get to phase one and it’s clean, you can say to a buyer, at least in Michigan, if you’ve got a clean phase one, you have what’s called the innocent purchaser defense.

 

00:13:22:29

Speaker 3

So even if something shows up later you’re not on the hook for it because you did your diligence. You have that clean phase one, and we found that to be important in educating. You know, not only you run that and you find a problem, OK, then you can.

 

00:13:34:29

Speaker 2

Educate the seller.

 

00:13:35:27

Speaker 3

You get the seller and you got to fix it or deal with it. But if it’s clean, which a lot of times it is, then you can educate, you know, your buyer that that is not an issue we’ve specifically found that if international buyers, international buyers get really freaked out by U.S. litigation and U.S. environmental lies. And so if we can walk them in their advisers through, here’s the reports we have and here’s why you don’t have any real meaningful exposure, it makes things go much.

 

00:14:01:10

Speaker 2

Well, we find that phase one also helpful to scope the problem, because if we’re doing it upfront, we know the scale, the scope of the problem, or at least we have a perspective as opposed if the other side does it and they come back and say, oh, my gosh, you know, you got a $10 billion problem and you’ve done the work and said, No, no, this is a $50,000, you at least have the basis to argue for something in the middle.

 

00:14:24:01

Speaker 2

And no, do we take care of it upfront and make this a non-issue, or do we let it sit and that the buyer is educated and knows that that’s the case?

 

00:14:31:22

Speaker 3

Well, it circles back to what we were talking about earlier, about getting things on the table early. When you have competitive tension, when the leverage is on our side, on the sell side, if we’ve got a problem, we think it’s $100,000 problem. They’re going to turn it into $1,000,000 problem. You know, we put it up on the table when we’ve got options, get somebody locked in and it’s only 100,000, no problem.

 

00:14:49:07

Speaker 3

And yeah, maybe we have to put $100,000 in escrow but we avoid dealing with it later and having it be a much bigger problem.

 

00:14:55:18

Speaker 2

And I think that’s the core, right? I mean, at the end of the day, what we’ve talked about today is, hey, how you use a good offense to protect against defense. And that work starts up front both with the lawyers, your investment bankers, your accountants and the other advisors to make sure you really know where all the skeletons are and you pull them out.

 

00:15:14:06

Speaker 2

So you’re not getting they’re not being found at the end of the deal. When you’ve lost all your leverage, you’re down to that single buyer.

 

00:15:20:26

Speaker 3

Yeah. That leverage shifts a huge thing for what we’re talking about and a lot of other things. The leverage, I tell people that leverage starts especially especially if we got bankers running a good process like you guys, it starts with the seller and just it shifts all the way through the deal until the buyers have all the leverage at the end.

 

00:15:37:00

Speaker 3

And, you know, if you’re the seller, you want to fight a fight here, not here. And vice versa. So.

 

00:15:42:24

Speaker 2

Well, fantastic. Peter, thanks for spending this time with us and sharing your insights on how we can be proactive in managing a deal process. Well, thank.

 

00:15:50:13

Speaker 3

You, Raj. Appreciate it.