The role of the M&A lawyer is to step in and “paper the deal”: The client has already decided to buy a company, and the lawyer’s job is to draft the purchase agreement and get the deal done. However, one of the benefits of being an M&A lawyer is the sheer volume of transactions we see, which presents an opportunity to learn from myriad successful companies and acquisitions as well as various notso-successful ones. In that vein, the purpose of this article is to highlight some of the key patterns and considerations (setting aside the supreme consideration: purchase price!) we’ve observed in connection with acquisitions. While the weight of these considerations can vary across buyers and deals, they should be taken into account with each buyer and each deal.
Contracts With Customers and Employees
While this article does not address the scope of legal diligence considerations (we will leave that for another day), we do note that with regard to contracts, in successful companies, patterns quickly emerge. First, think about how the target company negotiates and abides by its contracts with its customers. Specifically, does it insist on longer terms (with limited termination rights) or accept shorter terms (in exchange for some other benefit, such as higher pricing)? Once a contract is executed, does the company hold customers to payment terms, or does it often go “off contract” and grant discounts to customers? Second, although it’s unavoidable in certain industries where there are only a few, big customers (e.g., the automotive space), a company whose top five customers constitute 90 percent of revenue or more faces significant risks if its contracts are not long-term and locked in. Regarding employees, especially for companies in technology-based industries, consider whether key employees have work-for-hire, non-competition and/or non-solicitation agreements. Companies that allow key individuals to develop software or other intellectual property and then take that intellectual property to a competitor do so at their peril.
Whether your client is a strategic or private equity buyer, time and time again, one of the foremost considerations is the quality of the target company’s management. Successful acquirers ask the following question when evaluating the relationship between the company’s success and its management: Is the company successful because of, or in spite of, its leadership? A buyer’s thoughtful assessment of the quality of the company’s leadership will include determining its management style and willingness to support your goals as the buyer. Find ways to integrate current management into the process to illuminate and mitigate issues that could otherwise hold up the deal or result in inconvenience, liability or losses down the road. Key questions include: Is the management team organized? Do they get along? What are their short- and long-term goals? Are they onboard with the notion of being acquired or will egos get in the way?
Though it may seem like a “soft” or inconsequential detail, a target company’s culture is vital to its potential as a successful acquisition. A culture dominated by short-cuts or sloppiness will be marked by slow response times when seeking records, a lack of quality control procedures (as discussed below), an absence of timely employee evaluations or other indications the company doesn’t encourage organizational growth. Further, other indicators such as employee turnover rates, employee evaluations and employee complaints often reveal how satisfied employees are. Additionally, read between the lines when tracking employee benefits and pensions. You want to look at these not only to get a sense of liability—for example, are the benefit plans consolidated between different entities or is there a mess of complex plans?—but also to infer how loyal employees will be in light of an acquisition. Unsatisfied employees with poor benefits may be less likely to put up with the sweeping changes that often accompany an acquisition.
More applicable for highly regulated businesses (health care and food industries among them) or for international acquisitions, consider the additional risk, time and costs associated with regulatory and statutory compliance postacquisition. For instance, in highly regulated industries, is there a nuance in the target’s business that will require an entirely different set of permits or subject you to completely new regulations? In international acquisitions, what are the accounting standards, labor laws or other regulations (e.g., environmental, health care) that inhere in the new market? Failing to understand these challenges at the outset can cause meaningful growing pains post-acquisition.
Red flags often appear when a buyer delves deeply into accounts and reporting. If the company is a manufacturer, you want to investigate its work in progress (WIP) reporting practices. If it deals in services or licensing, you want to make sure the company is recognizing revenue appropriately. Additionally, new revenue recognition guidelines such as ASC 606 are coming soon; is the company on top of these industry standards and requirements? If not, not only might you wind up with expensive business costs as you attempt to fix problems, but you might also be stuck in lengthy, costly litigation as you try to recover from noncompliance sanctions. If auditors have observed material weaknesses or gaps in financial reporting, the numbers may be inflated and the company might not be as great as it first appeared.
Organizational Structure and Internal Controls
You can discern compliance risks from the structure and organization of the company. Also, look at the company’s approach to segregation of duties: Are there redundancies or gaps in management? What are the internal controls to promote accountability and reliability? Successful companies often have established quality control procedures and methods for receiving complaints, from employees and customers alike. Companies that don’t have such procedures and methods in place are not only unable to report problems they’re not aware of, they also leave themselves (and by corollary, the buyer) open to potential sanctions, lawsuits or criminal charges. In a business showing signs of, say, sexual harassment issues, unethical supply chain practices, lackadaisical or noncompliant accounting, undocumented corporate decisions or disorganized records, there will likely be ongoing post-closing risks even if a smart buyer has robustly indemnified itself in the purchase agreement.
A buyer’s diligence can seem (to both the buyer and the target company) unending. The above considerations represent a list of key issues that can help a buyer contemplate how the target fits in with its plans and priorities. The best way to minimize cost and risk is to truly understand the business you are buying. Without question, when it comes to acquiring a company, what buyers don’t know can hurt them.