Big Deal Small Business: Live Deal Process Update (12/23)
December 23, 2021 | Issue #55
My SMB deal is now in the documentation stage. 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.
Three prior posts related to the deal:
12/02 Update - discussed seller relationship
12/15 Update - discussed investment memo
In the past week, we’ve cleared a couple important hurdles:
Completed investor equity fundraise
Gotten through debt underwriting & received a commitment letter (shout out to Live Oak for being great to work with as expected)
Delivered a first draft of the Asset Purchase Agreement (“APA”) to Sellers
Tons of deals die in the documentation stage, so I thought today I’d talk about the APA in more detail.
The reality is that lawyers kill deals. They don’t mean to, but it’s their job. Their job is to protect their clients from taking on risk, and the lowest risk approach is to simply not do a transaction. If left to their own devices, they will kill the deal.
As a result, you HAVE to be heavily involved in the documentation stage. Do not delegate to your lawyer and hope they’ll get it figured out with the Seller’s lawyer. That is a recipe for a dead deal.
This post is organized into two sections: Key Elements of an APA and How to Negotiate the APA
Read on below!
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Key Elements of the APA
This is a quick hits version just to get you accustomed with the elements of an APA. Your lawyer should have a template available off-the-shelf for you. Read every word. This post is just a "reader guide" to help point you to key elements.
Key Purchase Terms
Whether broken out into 1 or several sections, there will be a list of the key acquisition terms, including:
Purchase Price
Assets Included, Assets Excluded
Liabilities Included, Liabilities Excluded
Net Working Capital agreements
Representations & Warranties
All of the stuff the Seller told you about in due diligence should be memorialized here. Your lawyer will have a good list of Reps & Warranties, but to give you the flavor:
Seller represents that they have title to all Assets and that they are free & clear of all Liens (unless specifically disclosed)
Seller represents they are in compliance with all applicable Laws
Seller represents they have delivered true, accurate, and complete copies of financial statements and tax returns
Seller represents there are no outstanding lawsuits, whether current, pending, or threatened
And on & on. These are your protections -- when something goes wrong post-closing, there's no "he said, she said" about due diligence. If it's not memorialized in the R&W section, consider it effectively not said.
There are also R&W of Buyer, but those are usually pretty short, generally just confirming that we are in good standing with the State, have the authority to sign the deal, etc.
Indemnification
This section covers what happens if there is a breach of a rep or warranty. In effect, it says that in that scenario, the Seller will "indemnify" (i.e. hold harmless, cover costs, whatever) the Buyer.
For example, if a customer sues the company for work done pre-closing, you as the Buyer need an indemnification from the Seller that those issues will be their liability, not yours.
Another example is if the Seller didn't pay taxes properly and the taxman comes after you for repayment. You need an indemnification from the Seller to make you whole.
Likewise, the Buyer will have to indemnify the Seller for anything that happens on your watch.
This section should also outline the procedure for indemnification -- how do you actually claim damages, who mediates, etc. For example, you might require they keep X% of the purchase price in escrow for 6-12 months to see if any breaches occur.
Closing / Closing Conditions / Other Covenants
This section tries to capture 1) what needs to happen before the deal can close and 2) what happens at & after closing to effectuate the transaction.
Some examples of pre-closing / closing condition items:
Sellers has to re-affirm that all R&W from above are true
Seller has to have continued to run the business normally
Seller has to sign the consulting agreement, a non-compete agreement, and other agreements
Buyer has to have secured financing (sometimes called a "financing out", which Sellers may push back hard on)
Some examples of closing & post-closing items:
Seller will provide a Bill of Sale
Seller will assign trade names to the Buyer
Seller will hand over control of the website and social media accounts
Seller will transfer over phone numbers & email
There's a ton of other stuff in the APA, don't get me wrong, but those are the big sections to dig into. Devil is in the details of course.
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How to Negotiate an APA
As a buyer, the APA is your protection, but only in theory. It's very tempting to go all out and draft as extensive of an APA possible that ties up the Seller in every way.
For context, in my PE life, I have worked on a deal where the purchase agreement was ~100 pages and the exhibits to the purchase agreements were literally 900 pages. It's a 1,000+ page document.
That's a great way to scare off a first-time Seller & kill your deal, especially if they're working with an inexperienced attorney.
Further, as Reg states below, you can't document away risk. Even to the extent there is a breach of the document, given the size of deals we're talking about in SMB, it probably won't be worth the attorney costs to sue.
So let's be pragmatic. As the buyer, your attorney should create the first draft of the APA (yes, that costs money, yes it's worth it to have the pen on the first draft).
Guide them upfront to creating a simple, straightforward document that provides needed protections without overdoing it. That's a tough line to walk, but experienced attorneys can walk it (start by hiring a good SMB M&A attorney, not your Uncle Joe who does divorces for a living).
Deliver it to your Seller with the following suggestions:
Take a few days to read & review with your attorney.
Come up with a list of questions / comments / concerns.
Let's sit down in-person next week (just Buyer & Seller, not lawyers) and talk through it live.
After that, have your attorney make edits to the document based on the discussion we had
If you don't do that, you'll be in the redline jungle aka lawyers trading markups of the document for weeks on end. Get in front of that by sorting out issues between principals.
There will still be some markup back & forth between lawyers, but that should be limited to basic legalese drafting. Any real issues should be taken away from the lawyers and handled between you and the Seller.
In terms of handling the real issues, this is where you need to rely on the rapport & relationship you've built with the Seller over the prior weeks/months.
You can't argue over points. You can only explain your perspective, appeal to their sense of fairness, and hope they are reasonable. If they aren't, try to think of ways to accommodate their ask while covering your risk in some way.
Ultimately, you'll have to decide if you can live with the risk if they are adamant on some text staying in or out. You're never going to "convince" someone you're right about a legal point because they are, by definition, up to interpretation.
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Conclusion
Heading into the home stretch on my deal! Deals die much further along than where I'm at, but I'm cautiously optimistic we'll reach that finish line.
And a quick teaser for those of you interested in working for a searcher-backed company - I'm posting a job posting next week for an "Associate, Corp Dev & Strategy" type role (title TBD) to join me from the day we close this deal.
Basically, my right-hand person, reporting to me, solving problems, and helping us grow. If that sounds interesting, stay tuned.
As always, I’d love to hear your thoughts & feedback. You can hit reply to this email or find me on Twitter.
Merry Christmas and hope you enjoy a restful holiday with your loved ones!
Thanks,
Guesswork Investing
P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, located in Seattle or the Bay Area).