Big Deal Small Business: Live Deal Process Update (01/05)
January 5, 2022 | Issue #57
Happy New Year! My SMB deal is the heart of document negotiations right now. Today’s issue is part of an ongoing ride-along series chronicling my live SMB deal process. I’m doing my best to provide a window into what that process looks like, balanced by general confidentiality and process disruption dynamics.
Four prior posts related to the deal:
12/02 Update - discussed seller relationship
12/15 Update - discussed investment memo
12/23 Update - discussed APA elements
The holidays slowed us down a little bit, but pleased to report real progress:
Got through the first turn of Asset Purchase Agreement and Noncompete with the Sellers
Waiting on first comments from Sellers on various other documents (consulting transition agreements, seller note, etc.)
Closing checklist processes have begun, such as life insurance, business insurance, business bank accounts, etc.
There’s still real wood to chop, but I’m feeling better now that we got through the first iteration of the APA. A lot of deals can die at that stage as issues arise that weren’t discussed at the LOI stage.
To be clear, they pushed back hard on the APA draft I sent, but a lot of it was their attorney being aggressive. Basically, I sent a buyer-friendly draft, they sent back an aggressively seller-friendly draft.
My initial worry was that the Sellers actually wanted those positions. But once I discussed it with them live, it became clear that their attorney inserted those aggressive changes because she anticipated us agreeing on something in the middle of the two drafts.
All in all, cautiously optimistic we’ll be able to push through the documentation process. That said, I want to dive into market practices around Reps & Warranties today as that’s a crucial element of document negotiations.
This Post’s Sponsor: System Six
As a former searcher, Chris understands the challenges present in the financial data and systems of small businesses. Now, as the owner of an outsourced accounting and financial operations firm, he’s here to help.
From bookkeeping to payroll processing to bill pay to invoicing to KPI reporting, System Six accurately and affordably handles all of your back office financial needs.
So, if you are under LOI or currently own a business, and are thinking about outsourcing, or even a clean-up project, please reach out to Chris to discuss how System Six can assist!
____________________________________________________________
Reps & Warranties - Background
I provided a basic overview of what Reps & Warrants (and Indemnifications) are in my prior deal update.
But we didn't talk much about what is "market" or reasonable to expect. I posted a Twitter poll on the subject and had several personal conversations, all of which coalesced around a pretty standard view of "market", so I thought I'd share.
Disclaimer: Please note that I am not a lawyer and I am not your lawyer. I'm just sharing what I've seen & heard through my PE and SMB deal experience. Nothing contained here should be considered any form of advice. Please get your own legal, financial, tax, or other advisor when doing your own deal work.
So first, a few key definitions:
Fundamental vs Non-Fundamental Representations
Fundamental representations are super basic in nature. They are items like:
Title to Assets - the Sellers actually own what they claim to own
Power & Authority - the Sellers actually have the power to enter into this agreement
Think of it as getting title insurance for your home, but provided to you by the Sellers.
Non-Fundamental Representations can be basically any other representation you want them to make to you, such as:
Environmental - they have been complying with all environmental laws
Employees - they have been verifying employees' worth authorization upon hiring
Vehicles - they have been maintaining vehicles and they are no known issues that would render them useless
Non-Fundamental Reps can come in a lot of flavors. Your lawyer will help you put together a basic "reps & warranties package" that captures all the fundamental reps and a good selection of non-fundamental reps.
Note that reps are most important in stock deals because you are acquiring the Seller's liabilities, not just their assets, so you need them to accurately represent all liabilities to you.
Survival Period
The representations & warranties made above only last for a certain period of time, called the Survival Period.
But the reps are still generally made as of Closing -- you just have the Survival Period to figure out that a rep was wrong and raise the issue.
Indemnification Caps & Escrow/Holdback
This governs how much money you can go after the Seller for in case there is a breach of Reps & Warranties.
For example, if there is a breach of a representation that causes $750K in damages to you, but the indemnification cap is only $500K, you're limited to pursuing them for $500K.
To make it easier to chase that money, there is often an escrow or holdback at the time of sale. That money is released at some point post-closing, often when the non-fundamental reps expire at the end of their Survival Period.
Reps & Warranties - Market Practices
Survival Period
First, linked here are the results of a couple Twitter polls I posted.
Adjusted for "See Answer" responses, the Survival Period poll shows 23% at <= 1 year, 60% at 1-3 years, 16% for 3+ years.
In hindsight, this was a poorly worded poll because in practice there are often different Survival Periods for Fundamental Reps vs Non-Fundamental Reps.
Fundamental Reps should really have a Survival Period that is indefinite or only limited by the respective Statute of Limitations. For example, if anyone EVER turns out to have a claim on the Assets that the Seller sold to you, you should have recourse against the Seller.
The one other representation that usually also has indefinite survival is Fraud (basically the Seller representing that they have not been fraudulent in any statements they made to you).
On the other hand, non-fundamental reps tend to be much shorter.
The poll results dovetail nicely with what I heard in DMs/private conversations as being market for Non-Fundamental Reps Survival Period. Anywhere from 12-36 months appears to be standard (median sounds like ~18 months), with Buyers obviously pushing for longer and Sellers pushing for shorter.
Indemnification Caps & Escrow/Holdback
Again, these are different for Fundamental vs Non-Fundamental Reps.
For Fundamental Reps & fraud, you should be able to push for a Purchase Price cap i.e. you can go after the Seller for the full purchase price.
The reason is that fundamental reps are covering super basic stuff - if it turns out the Seller didn't actually own the business, you should be able to pursue them for every last dollar you paid them.
This really could happen - the Seller may have run the business for 20 years, but it might technically be owned by his bedridden, 90-year-old great-uncle. The Seller pockets the sale proceeds. The great-uncle's heirs finally sue you 10 years later when the great-uncle passes away and his will still includes the business assets. He never signed the purchase agreement after all.
On the other hand, buyers can be more reasonable on non-fundamental reps. Remember that you'll have to prove damages to collect on an indemnity cap anyways.
Let's say you manage to get a 20% cap (20% of purchase price) and your deal is $3 million - that means you have a $600K cap. Think about the real-world practicalities of what it would take to prove $600K in damages. If you can think of easy ways to end up there, you may need a higher cap. If you can't, you can be more flexible if the Seller pushes for the cap to come down.
I heard a wide range for non-fundamental caps, but generally in the ballpark of 10-30% of purchase price, with smaller deals at the higher end and bigger deals at the lower end most likely.
Couple other things to note:
It's common to include a "deductible" i.e. for the first $X thousand dollars, you don't go after them. This stops you from nickel & diming them.
I didn't get a good sense for market on the escrow amount, but keep in mind that you can use the seller note (if you have one) as an offset also. So if you have a 10%-15% seller note as is customary in SMB deals and a 10%-20% indemnification cap, you probably don't need an escrow at all.
____________________________________________________________
Closing
Home stretch! If all goes well, I should be signing the APA and closing the deal in the next 3-4 weeks...
Lots to do, but I'm pumped up and ready to go.
Just another reminder that I have an open job posting for you to come work with me at the new business! Applications are due this Monday, January 10th, but interviews are already underway so please apply ASAP.
As always, I’d love to hear your thoughts & feedback. You can hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing