Corporate

Be cautious when red flags show up in acquisition process

By AdvocateDaily.com Staff

While profitability and a healthy balance sheet are often top of mind for companies looking at potential acquisition targets, they should also be on the lookout for possible warning signs during the due diligence process, says Toronto corporate lawyer Sammy Redlick.

In addition to financial health, most acquirers — whether they are financial buyers, such as private equity funds interested in growth potential or strategic buyers looking for synergies — also favour strong management teams in a target company, says Redlick, partner with Torkin Manes LLP.

“They want a strong management team that they believe is going to be around for a while, is going to be incentivized and have their interests aligned with the acquirer, which is why oftentimes in these acquisitions you will see that it’s a condition of closing that long-term employment contracts are signed with key people in the organization,” he tells AdvocateDaily.com.

However, Redlick adds, when the primary owners of the target company are also the key members of its management structure, this should be considered a potential red flag.

“If you don’t structure the deal adequately, then you run the risk of the owners not being incentivized to stick around and help transition the business, and you run into problems,” says Redlick.

“One thing that acquirers are looking for is a business where a lot of its knowledge and goodwill is not locked into a small group of people who are usually the owners because then there’s a big risk if those people don’t stick around after closing. Much of the goodwill and knowledge that you thought you were acquiring may have left with the owner. If they have strong relationships with customers or suppliers and they’re not around anymore — and you haven’t built adequate protections into your deal terms — then you can find yourself in trouble,” he adds.

Acquirers should also exercise caution when the due diligence material requested from the target comes in ‘dribs and drabs,’ says Redlick, or, for example, when a complete list of contracts was provided, but it is obvious that material contracts are missing.

“When you find yourself constantly questioning the quality or the wholesomeness of the due diligence that you’ve requested, it causes concern that you’re going to close the deal and find out afterward that there’s more that wasn’t disclosed to you. So that’s definitely a red flag.”

Targets with a high concentration in a few large customers can also be a concern, says Redlick.

“Oftentimes in those scenarios, you want to make sure that part of the due diligence process is having an opportunity to meet and interview with those customers to get comfortable that that relationship is strong and you think you’ll be able to continue to transition it after the acquisition,” he explains.

“Depending on the nature of that relationship, negotiating into the deal terms some protections so that if you were to lose one of those big customers or if the volume of business they provide decreased in any material way after closing, you make sure that you, as an acquirer, protect yourself.”

At the same time, not all concerns mean the deal should be called off, says Redlick, as some issues can be worked out through legal negotiation and risk allocation.

“That sometimes happens if there are gaps in due diligence or concerns about the target — we will deal with it.”

For example, if there is litigation risk with the target, corporate lawyers can aim to structure the transaction to ensure you don’t acquire a company that ends up getting sued for millions of dollars the next day, Redlick says.

“Part of our job as lawyers is — it’s not like you do a deal or you don’t do a deal — it’s you can do a deal, but let’s be creative and make sure that we’re able to protect you, and at the same time, get the deal done,” he says.

Aside from obvious issues with the target company, Redlick says deals can be a challenge to complete when a business doesn’t have sophisticated professional advisers — such as lawyers and accountants — as they may not have the requisite expertise to deal with a transaction of this nature.

“Quite frankly, many times, the business outgrows their professionals, but because they have long-standing relationships, or maybe they’ve never had a need, they’ve never made a move to align with a larger law firm or accounting firm or the right people with the right expertise. Then, when it comes time to execute on the transaction, they’re simply not equipped to do it,” he says.

Larger transactions can also go awry in cases where the target — perhaps because they already know who the buyer is — has chosen not to engage an M&A adviser or investment banker, Redlick adds.

“What ends up happening is the business owners just don’t understand the volume of work and the time involved in actually completing an M&A transaction, and the deal drags on. They don’t appreciate the buyer’s due diligence requests, and they don’t have a good understanding of what are market terms and conditions, or the timeline expectations.

“Even if you already know who the acquirer is going to be, I still think it’s advisable to engage an M&A adviser because they can lead the due diligence process. They can facilitate the negotiation of the deal terms, and difficult discussions that need to be had sometimes between the principals of the two companies are better served by going through an M&A adviser,” says Redlick.

“I’ve seen deals go off the rails or drag on for a year because that wasn’t in place,” he adds.

Ultimately, says Redlick, it is also a good idea for a corporate lawyer to get involved in the process sooner rather than later.

“That will typically involve making sure that a good non-disclosure agreement is signed right at the outset if you’re representing the target side of things. If you’re representing the acquirer, making sure that a fulsome due diligence request list is provided to the target right up front, so they appreciate the volume and time involved in actually producing the material and you make adequate requests for due diligence.

“I think it’s important to start flagging issues early so that you don’t get too far down the road — two or three months into it — you’re negotiating purchase and sale agreements, you’ve spent a ton of money in professional fees and then a major due diligence red flag comes up,” Redlick says.

Lawyers, he says, will discuss how the business wants to structure the timeline of the acquisition. For those who are looking for a quick closing, legal agreements and financial, legal and tax due diligence will all have to be negotiated at the same time.

“The risk is if you find something out that you don’t like or you want to walk away from this deal, you’re going to have to pay some professional fees,” says Redlick.

For businesses that are less concerned about time and more sensitive to incurring costs for a deal that doesn’t go through, he says, the alternative is to stage the due diligence process, starting with financial.

“You’ve got to get comfortable with the financial diligence, which ultimately leads to the valuation and what you’re willing to pay for this business. And only once you’re there, we can stage your tax diligence and your legal diligence and then we’ll get to drafting and negotiating legal agreements, and so the deal might take longer, but there’s less risk that you have broken-deal costs.

“We’re happy to accommodate our clients and do it either way, and it’s really just about balancing time versus the risk of there being broken-deal fees,” says Redlick.

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