15 April 2024: Buying a Business: Protect Yourself!
When buying a business, the acquiring entity often wants to act quickly, especially if the market for the target business’ products or services is robust or growing. This is also the case in many acquisitions of businesses with significant seasonal cash flow because savvy buyers will see timing the acquisition to the beginning of the business’ most robust selling season as a way to recoup an outsize portion of acquisition cash quickly.
Examples of such businesses are landscaping contractors (which are hot right now) or distributors of recreational supplies (boating, fishing, beach supplies, etc. In each case from the buyer’s perspective, the ideal time to close the deal is early spring. Another example – and in honor of this being Tax Day in the United States – acquiring a chain of tax preparation services would be most timely in late fall, which should provide just enough time to get settled in before the deluge of work begins breaking on the shore of tax preparers everywhere.
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Buying a business involves dozens of considerations – both personal and professional – and trying to arrange the closing to coincide with the optimum time to capitalize on the target company’s cash flow can – and too often, does – cause a buyer to move more quickly than would otherwise be prudent to the detriment of a proper due diligence. Taking shortcuts during the due diligence phase is never a good idea but sometimes the increase in cash flow envisioned to start in, for example, 60 days, is just too tantalizing to miss and buyers sometimes have a tendency to rush through due diligence only to have the “cost” of that impatience come back to bite them down the road.
So, how do you protect yourself in such a situation?
Whether the transaction involves the acquisition of chain of 50 retailers located just off dozens of campuses selling licensed college gear – in which case the ideal time to close might be late spring – or a wholesaler of beach chairs, beach balls, tanning oils and other summer items – in which case the ideal time to close might be in late-winter or early spring – when buying a business a buyer has got to consider the tradeoffs of rushing through due diligence.
And those these are simple examples, the following topic – which we will be talking about at length in The Brokers Roundtable℠ in the next couple of months – pertain to any other business as well.
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Representations and Warranties
When buying a business, the seller’s representations and warranties are an extremely important aspect of the seller’s contractual obligations. Many business brokers and even some M&A professionals pay little attention to this critical component of the deal. And, the seller’s representations and warranties are even more important when the buyer wants to close quickly.
Representations and warranties are promises that a seller makes in the purchase agreement about the current and future state of the assets or business being acquired. Even if a buyer conducts limited due diligence, they may be protected by strong representations and warranties provided by the seller.
For example, if a target is appealing because of its intellectual property assets, a buyer should look for strong and targeted representations around the ability of the buyer to use and exploit those assets. Do any existing licenses transfer? Do they do so without cost, restriction or changes in terms? In this example, legal due diligence – an importance aspect of the overall due diligence process – is critical.
If the target business is regulated – for instance, a petroleum distributor – a buyer should want representations around the target’s regulatory history and potential regulatory enforcement or limits on the potential for growth. For example, does a 75-unit tax preparation firm operating in the mid-west as a master franchisee of one of the national chains have the right to open outlets in New York?
Representations and warranties are essentially promises the seller makes to the buyer and the buyer should insist these promises are incorporated into the purchase agreement, since most purchase agreements will expressly exclude any statements made by the seller to the buyer that are NOT so incorporated.
But one might reasonably question what these promises are worth without two very important considerations:
- Remedies in the event of breach; i.e., if a promise is broken or a written statement is discovered to be patently false, and;
- The “promiser” – the seller – having the capacity and motivation to indemnify the buyer of any cost, loss or over-payment suffered as a result.
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Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to accurately value and successfully sell businesses.
Remedies and Indemnities
Strong representations and warranties are only worth as much as the remedies provided for in any acquisition agreement and the ability of the seller(s) to fulfill and satisfy those promises. The agreement should provide not only a clear remedy for breach – what, if anything, the promiser must do to correct the breach – but also a practical method of determining damage suffered by the buyer and a source and means of reimbursing the buyer.
In many private company sales, sellers will often agree that the company selling the assets will indemnify the buyer. But after the sale of the assets, the selling company is rarely more than a shell. In such cases, the indemnities provided are generally worthless
Buyers can protect themselves by requiring the principals of the selling company to personally guarantee the indemnification provisions in the purchase agreement. With their personal assets and wealth on the line, sellers are far more likely to provide the proverbial “whole truth and nothing but the truth” in the representations and warranties section of the acquisition agreement.
Another useful tool for buyers might consider are time-restricted escrow funds or other hold backs to satisfy any indemnification obligations that arise post-closing.
The Bottom Line
As we’ve stated often over the years, buying a business ain’t for sissies. Representations and warranties are an important part of any acquisition but even more so if the buyer, in their haste to close, performs a less-than-completely thorough due diligence. In such instances, things can be missed or ill-considered. (Elon Musk infamously waived due diligence when negotiating the buyout of Twitter. The Guardian newspaper reports that, according to Fidelity Investments, the social platform now known as X has lost 71% of its value since it was bought by Musk.
So, what can a buyer do to avoid such danger, especially if a purchase is being accelerated to take advantage of a market condition, seasonal trend or any other reasonably anticipated upside? Make sure you have an experience professional business broker or M&A specialist and transaction attorney on your team. Representations and warranties are a crucial component of any acquisition agreement and can make or break the target company’s potential and future success.
We are lining up a reps and warranties specialist to join us for our monthly Expert Live Stream, a live discussion and Q&A in The Brokers Roundtable℠, in either May or June. Joining the discussion is free for Members (available to non-members for a modest fee). If you’re considering buying a business, this interview could save you both money and aggravation down the road.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at jo*@Wo*******************.com.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at jo*@Wo*******************.com