Perhaps the most challenging area of risk mitigation in deals is accounting for the unknown
The prolonged seller’s market in the private company sector has increased risk reduction developments that are good news for exiting business owners.
That trend, which has its roots in U.S. deals, is now increasingly in Canadian transactions.
For several years, the private equity market has seen a combination of more capital looking to invest, fewer attractive acquisition targets, historically low interest rates, relative economic stability and many aggressive and innovative financing options. Despite this trend, sellers have still been primarily – and sometimes singularly – focused on maximizing price.
However, lawyers and investment bankers are urging their seller clients to also give great attention to mitigating risk, both before and after deal completion. Key risk factors to consider include whether the buyer is ready and willing to complete the deal – on time and without a “price grind”; whether the buyer’s external funding is in place; and what the seller’s exposure will be after closing the deal.
Mergers and acquisitions legal specialists acting for sellers are primarily focused on risk reduction. A key strategy is to clarify and negotiate all key business and legal issues before a client commits to deal exclusively with one buyer. That is because at the time of “going exclusive,” bargaining leverage shifts from seller to buyer. Doing one’s homework on the buyer, such as financial capacity, funding commitments, history on deals and reputation, can also reduce the risk of failure to finalize the deal.
Lawyers give even more care to reduce their clients’ after-closing exposure. The “indemnity” provisions (setting out the seller’s post-closing obligations to the buyer) in the purchase contract are key. In general, sellers want to limit such obligations by time, quantum and knowledge.
The time for which the seller retains responsibility for indemnifying the buyer after the deal closes has been steadily decreasing. In B.C. it now averages 18 months.
The percentage of the purchase price that the seller remains liable for after the deal closes is also falling, and the minimum threshold for claims is rising.
A key limitation sought by sellers is an overall cap on post-closing exposure. Another important way to reduce risk is by setting a “basket” or minimum aggregate amount (preferably deductible) that must be exceeded for a buyer to make a valid claim. A minimum per-claim amount is also desirable.
A review of annual studies on transaction terms for Canadian private deals (the American Bar Association’s Deal Points Study) shows that quantum limitations have recently been moving significantly in favour of sellers. What gets included in these time and quantum limitations is the subject of frequent and spirited negotiations.
Perhaps the most challenging area of risk mitigation in deals is accounting for the unknown. Sellers will be responsible for the accuracy of their representations and warranties as set out in the purchase agreement. Making sure that disclosures are full and complete is therefore critical.
But what about unknown or yet-to-be-discovered matters such as environmental contamination?
Sellers seek to shift the risk of unknowns to their buyers by qualifying their representations and warranties to what is known and by limiting a buyer’s ability to make a post-closing claim for things that the buyer knew about before closing.
Buyers try to return the favour by seeking to shift risk of the unknown in the other direction. The trend is again moving in favour of the seller. One other key change on the horizon is the potential use of representation and warranty insurance, which is becoming increasingly common in the U.S. and is still in its infancy in Canada.
With significant complexity involved in risk mitigation strategies and an ever-evolving deal landscape, owners selling businesses should seek legal and financial advisers who specialize in advising sellers in M&A transactions.
Peter Mogan is senior partner of Mogan Daniels Slager LLP, a leading Vancouver-based mergers and acquisitions firm. He also serves on the board of the Association for Corporate Growth British Columbia.
