Join Raj Kothari, Managing Director at Cascade Partners, and Peter Roth, Partner at 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:

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.


Raj Kothari – Cascade Founder and Managing Director:
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 we’d talk a little bit about, you know, we use the term, “Hey, a 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.


Peter Roth – Partner at Varnum Attorneys at Law:
Great! Thanks, Raj. It’s an excellent topic. You know, we often say, “Surprises kill deals.” And so, 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 or it comes up at the end, then buyers get spooked and problems erode deal value.


Raj Kothari: 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 recapture some of that purchase price.


Peter Roth: 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 sim Like, “There’s this environmental issue, and here it’s a known issue, 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 to one party at the end and they find it, they’re going to their environmental lawyer and they’re going to say, “Oh, it’s a $10 million problem.” And then they’re going to have the leverage to whack the deal value.


Raj Kothari: Yeah, 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 when we run the process competitively, many buyers will overlook those operational issues and just say, “Oh, it’s part of a deal. We’ll deal with it.” It protects you later on.


Peter Roth: 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. So, if you think about somebody that maybe hasn’t filed a tax return in the state where maybe they arguably should have, the accountants can say, “Well, there’s no statute of limitations, actually, because you never filed a return. 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—it’s 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.


Raj Kothari: And as lawyers, we’re looking at a lot of the business issues, environmental and things like that. Often, 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?


Peter Roth: 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 is signed and the Second Amendment is signed, but the First Amendment’s not signed, we’ll identify that and then we’ll fill that gap and fix it.

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 are answered before they ever ask.


Raj Kothari: And that becomes really important, right? In terms of making sure, “Hey, you can find those minute books. 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 has been really helpful that you guys have been able to pull out because our clients are typically thinking about the commercial terms. But you and I, we’ve got to think about, “Well, what’s the impact of a transaction?” I think that insight you and your team have been able to provide on transactions has been really valuable and critical to make sure we’re identifying issues.


Peter Roth: Thank you. And that’s a good point 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? Your contract might be perfect from a commercial standpoint, but if it says, “You cannot assign this contract to a buyer,” 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.

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. A similar issue that we’ve run into is some exclusivity type provisions. We’ve 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 is going to worry about that same sort of non-compete or exclusivity clause.

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


Raj Kothari: Well, 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 makes a big difference in the transaction and how we negotiate upfront. Either how we’re going to structure 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, we’re not going for that consent,” the buyer has got to take that risk,” But by knowing it upfront and then defining it upfront, we maximize the positioning for our collective client as we’re going to the marketplace.


Peter Roth: Yeah, I think that’s a really good point. Where you guys have been great is, 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, “Tell us all of the conditions, tell us all the things that you’re going to require to get to a close,” and we can put those consents right out there and say, “Okay, if buyer one is saying we need to get ten different third parties to consent, buyer two is only saying, “We’ll need two of the ten.” You’ve got that likelihood of closed. Deal certainty.


Raj Kothari: So, one of the things that we’ve started using a lot more is representation and warranty insurance, and it 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.

Can you talk about how you think about rep and warranty insurance in that in that perspective?


Peter Roth: Yeah, maybe we should define what rep and warranty insurance (RWI) is. So, historically what’s happened is a seller is going to make representations and warranties in the contract—promises about the business. Things like: “I haven’t violated the law, I don’t have any breaches of contract, I don’t have any labor issues.”

And then there’s indemnity to backstop that. So, if one of those representations is inaccurate, the buyer can say, “Hey, I was harmed by that and you need to give me some of the money back.” So, the seller gives the 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 where instead of the seller having to stand behind those reps and warranties, an insurance company does, which is really handy for both buyers and sellers.

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


Raj Kothari: They know the certainty of what their exposure is.


Peter Roth: Right, “I sleep at night. I don’t have to give 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 isn’t true, they go and they get the insurance company to pay them back. It has changed diligence, though. 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.

They require a buyer to do pretty exhaustive diligence, have a written diligence report, you have to have an underwriting call with the insurer and all their advisors. So, when we’re on the sell side, having that all pre-packaged and ready to go. 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.


Raj Kothari: And really, it also helps with the negotiation because as representing the seller, we’re willing to take more robust representation and warranties to give the buyer more confidence because, at 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…


Peter Roth: They’re offloading the risk.


Raj Kothari: Right! Removing that risk profile. And I found that the buyers like it because they take all the emotion out of raising an indemnity claim because if I’m going to my partner or the selling shareholder, who is often in 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.

And sellers are, you know—instead of putting 6, 7 or 8 percent in escrow, they now got a half a percent chance that they’re exposed. And we find that’s a great way to get sellers comfortable and, again, protect or create a good offense around those things that you just can’t predict.


Peter Roth: You know, one of the things we’ve been seeing—and I’d be interested in what you see, Raj—are deals that, some are insurable and some aren’t. 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 on the pressure.

What do you see in that?


Raj Kothari: Yeah, we definitely saw it late last year as as the market really tightened up. But the way we were 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?”

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, 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 representation and warranty insurance at the beginning of the process when we’re talking to the seller and just before we go to market.

As part of what we’re presenting to buyers, it’s 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 insurance is in play.

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


Peter Roth: Yeah, and going back to your sell-side clients, it allows them to really offload that risk and sleep at night—”I’m not going to have to give my money back.”


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

So, in that case, we’ve both used that one together to help us.


Peter Roth: And it’s a huge differentiator. If you’re somebody who is looking to be a winner in an auction on the buy-side and you say, “I need the seller to escrow $10 million,” and then somebody else says, “I need them to escrow $500,000,” that’s going to swing how a seller looks at the two buyers.


Raj Kothari: You mentioned at the beginning of our conversation about environmental, and environmental is one of those big ugly ones that can get particularly messy. I know when we’ve worked through environmental issues, we’ve been very thoughtful about making sure the buyer understands regulatory elements around environmental issues, particularly here in Michigan, but also 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.

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


Peter Roth: Sure. I think a lot of times, if we’re running a process for a seller, we’ll get a phase one. If there’s not a current phase one, we’ll get the environmental test. And, maybe you have to pay $10,000 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. 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, then you can educate the seller and you got to fix it and you got to deal with it. But if it’s clean, which a lot of times it is, then you can educate your buyer that it’s 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 cleaner.


Raj Kothari: Well, we find that phase one is 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 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 And do we take care of it upfront and make this a non-issue, or do we let it sit?” And the buyer is educated and knows that’s the case.


Peter Roth: 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 a $100,000 problem and they’re going to turn it into $1,000,000 problem. We put it up on the table when we’ve got options, get somebody locked in and it’s only $100,000 problem. 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.


Raj Kothari: And I think that’s the core, right? At the end of the day, what we’ve talked about today is, “Hey, how do you use a good offense to protect against defense?” And that work starts upfront 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. So, they’re not being found at the end of the deal when you’ve lost all your leverage and you’re down to that single buyer.


Peter Roth: Yeah. That leverage shift is a huge thing for what we’re talking about and a lot of other things. I tell people that leverage starts— especially if we got bankers running a good process like you guys—it starts with the seller and it shifts all the way through the deal until the buyers have all the leverage at the end. And, if you’re the seller, you want to fight a fight here, not there. And vice versa.


Raj Kothari: 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.


Peter Roth: Well, thank you, Raj. Appreciate it.


Listen to more expert insights by tuning into our other Cascade Conversations episodes!