In previous posts (March 2010, April 2010, and May 2010, I have discussed various aspects of a letter of intent used for a sale or acquisition of a business or other M&A transactions. I’ve described how there are significant benefits for both sides in a potential acquisition or merger transaction to using a LOI. I’ve also explained the rationale behind typical terms found in a sample LOI that is used in an asset sale context. In this post, I will explain the rationale and reasons behind the remaining terms contained in the sample LOI, which you can view by clicking here.
In this final installment I will describe the pros and cons of dealing with indemnification obligations of the seller and, to a lesser extent, the buyer, as well as briefly explaining the risk-reduction benefits that can be achieved by the seller under a well-crafted indemnification term in the LOI. Finally, I will examine the last term in the sample LOI, which addresses the seller’s employees.
I would argue that the seller's indemnification obligation is the second-most important of the major terms in an acquisition or merger transaction, just below the transaction pricing and payment terms. As a seller, what you are being paid for the business is of utmost importance. However, once the seller is offered a fair price on acceptable terms, the seller’s focus should immediately turn to how much of the deal price is at risk and the terms that govern the likelihood that the seller will be able to retain the full deal price.
As previously discussed, the representations and warranties of the seller that will be part of the definitive acquisition agreement will determine the allocation of risk in the transaction. In general, the more comprehensive and detailed the representations and warranties of the seller, the more risk the seller will bear, especially if the extensive representations and warranties are absolute and not qualified by knowledge, materiality or other limiting language. However, even if the seller must yield to the buyer’s demands for extensive and absolute representations and warranties, the seller may be able to reduce risk to an acceptable level by insisting on indemnification provisions that cap the seller’s potential liability for a breach of any representation or warranty.
Because of the importance to the seller of negotiating reasonable indemnification provisions, it is critical to address up front with the potential buyer the scope of those provisions. If the basic scope of seller’s indemnification is left to the definitive agreement negotiations, it is likely that the seller will lose some leverage. In my experience, the seller generally has more leverage at the LOI stage than later, when the definitive agreement is being prepared. The seller should have a better opportunity to negotiate more favorable dollar caps and time limits, during the LOI negotiation. As you might expect, the down side to covering the scope of the indemnification up front is the potential delay caused by doing so, especially if the buyer is particularly resistant to addressing indemnification before due diligence is conducted. And in some cases, with a stubborn buyer, the delay and the acrimony caused by the seller's insistence that the indemnification issue be addressed in the LOI can be substantial. Nevertheless, I contend that, until the basic scope of seller’s indemnification is addressed, the seller cannot intelligently and accurately assess the overall value of the deal being offered by the buyer.
Leaving out the basics of seller’s indemnification obligation is almost like knowing the price but not the payment terms, or the buyer leaving out a financing contingency that is requested by the buyer at a later stage. Leaving out important terms creates a hole too big to try to fill later.
Turning to the sample LOI, the seller has limited exposure for breaches of its representations and warranties and for any other liabilities that may be traced to the seller’s operation of the target business prior to the closing of the acquisition to 20% of the acquisition consideration . In addition, seller’s exposure for any breaches discovered by buyer or claims arising from seller’s operation of the business is limited in time to the one-year period after the date of closing . Depending upon a multitude of factors, the dollar cap typically ranges from 10% to 50% and the time limit typically ranges from one to three years. An experienced M&A attorney can provide much needed assistance in negotiating appropriate and reasonable caps, time limits, deductibles (sometimes structured as baskets) and any holdbacks to assure funding of the indemnification obligation (if needed), as well as exceptions to such items. An experienced M&A attorney also will make sure that the indemnification obligations of seller are the exclusive remedy so that the buyer is not able to circumvent the risk reduction provisions.
The buyer’s indemnity is typically less contentious to negotiate as the buyer faces much less unknown risk or overall exposure than a seller, and generally accepts the broader and more open-ended indemnification scope that is found in the sample LOI as a necessary and appropriate business risk that comes with acquiring an on-going business. Nevertheless, to avoid an unexpected hard-line position taken by the buyer when the definitive agreement is being drafted, the buyer’s indemnification should be addressed at the LOI stage, as well.
The final term in the sample LOI (retention of employees) is more typically found in an asset sale transaction in which the buyer is not acquiring the on-going legal entity operating the business, together with all of its property and other assets, and subject to all of its liabilities and other obligations, including its employment obligations. It can be important also to address employment retention in a stock or merger transaction to protect the continuity of the business and its operations and the goodwill value of the business. Such protection may minimize the likelihood that the target business will suffer a decline in its operations or value or encounter other problems that may lead to the buyer questioning whether full and accurate disclosure was made by the seller, which in turn can lead to possible claims by a disgruntled buyer that the seller breached its representations or warranties, triggering the indemnification provisions. In addition, if there is an earn-out component of the purchase price for the business being acquired, the seller can increase the likelihood that the earn-out will yield future consideration for the seller if the buyer makes a commitment to retain key management team members for some reasonable period of time.
As indicated in the previous installments of this post, an experienced M&A attorney can provide significant value to the seller when involved at the beginning of any negotiations with a potential buyer over the terms of an LOI. This also holds true if, as sometimes happens, the buyer sends the seller a signed LOI with a 24 or 48 hour “deadline” for a written, signed acceptance. If you are a seller, do not make the mistake of signing an LOI that you believe is non-binding in the belief you can negotiate any problems or missing terms later. This will inevitably lead to a less desirable result, and could cause much greater problems, for the seller.