By: Hillel Goldman
In preparing to either buy or sell a small-medium sized business, there are four extremely critical elements:
First, it is critical to assemble a strong professional team of advisors (the “Team”). The Team should have experience in buying and selling businesses and be kept up to date on all elements of the transaction.
Second, the Team must be formed BEFORE there are ANY communications commenced with the other party. If a party to a transaction fails to do this, it will only come back and bite them. Several important cases will be examined to emphasize these points. First, is the seminal letter of intent case, Pennzoil Co. v. Texaco, Inc., 481 U.S. 1, 4 (1987). Second, is a troubling trend of cases addressing non-reliance provisions in merger and acquisition transactions beginning with the 2006 Delaware Court of Chancery decision in ABRY Partners V v. F&W Acquisition, 891 A. 2d 1032 (Del, Ch. 2006). Also, there is a recently released 2012 Delaware case we will examine, RAA Management, UC v. Savage Sports Holdings, Inc., De. No. 577, 2011 (May 18, 2012) (“RAA”) which held that language in the non-disclosure agreement between parties that disclaimed seller liability for any inaccuracies or incompleteness in the due diligence materials it provided to the buyer prior to the execution of a definitive agreement disclaimed liability for fraudulent or intentional inaccuracies as well.
Third, the parties MUST communicate with their respective Teams and the members of each Team must always be in contact with each other BEFORE any decisions are made and communications with the other side concerning the transaction occur. Without this, critical and costly mistakes may occur which can produce irreparable results. This communication is important prior to the parties signing something as basic as a non-disclosure agreement, let alone to such critical decisions as determining whether the deal should be an asset .or equity transaction.
Fourth, the Team MUST know their client and its business. Although most people view due diligence as occurring between the seller and buyer, the Team must do its own due diligence on its client in order to perform their respective jobs most effectively. This also gives the Team the opportunity to work together to determine which other professional advisors should be added to the Team. Questions, like: Who will do the market analysis?; How will the business be valued?; Whether there is a need to secure a business broker for the transaction contemplated?; and, Whether there is a need to involve an investment banker or other types of financing professionals?; should all be addressed at this point. I often use the analogy with my medical clients that spending more time with them to get to know them and their issues prior to going into a negotiation is like the difference between giving a 10 minute physical and an hour physical. There is less chance that something important can be missed.
Prior to commencing the business sale process, the Seller may want to prepare a “Teaser” about its company for prospective buyers to review. Teasers are used by sellers to provide potential buyers with basic preliminary information about their companies to see if there may be a fit. There is certain information that should be disclosed and certain information that should not. The Teaser should NOT disclose the name of the seller’s company. The company’s industry, financial profile, markets, distribution networks, and business history are some important nuggets of business information that should be disclosed. The seller clearly should state what its goals are for the proposed transaction. The Teaser should be concise and look professional. Like most resumes, the Teaser should not be longer than a page. Finally, the Teaser must be accurate. If the information disseminated in the Teaser is inaccurate or deceptive, any chance of consummating the transaction will be extinguished as soon the potential buyer learns of this.
As the two sides begin to talk, non-disclosure agreements become important. Although many clients believe that they can sign this document without attorney review, I highly discourage that practice. Additionally, in light of the RAA case, it becomes even more critical for the attorney to not give short shrift to the NDA. In RAA, Delaware Justice Holland clearly states that:
“In the NDA, RAA agreed that Savage was making no representations or warranties as to the accuracy or completeness of any information (the “Evaluation Material’,) being provided to RAA, and that Savage would have no liability to RAA resulting from RAA ‘s reliance on such information, except for breaches of representations and warranties that Savage was to later make in an executed “Sale Agreement.” Paragraph 7 of the NDA states:
You [RAA] understand and acknowledge that neither the Company [Savage] nor any Company Representative is making any representation or warranty, express or implied, as to the accuracy or completeness of the Evaluation Material or of any other information concerning the Company provided or prepared by or for the Company, and none of the Company nor the Company Representatives, will have any liability to you or any other person resulting from your use of the Evaluation Material or any such other information. Only those representations or warranties that are made to a purchaser in the Sale Agreement when, as and if it is executed, and subject to such limitations and restrictions as may be specified [in] such a Sale Agreement, sba11 have any legal effect.
In the NDA, RAA also waived any claims it might have in connection with any potential transaction with Savage unless the parties entered into a definitive sale agreement. Paragraph 8 of the NDA provides:
You [RAA] understand and agree that no contract or agreement providing for a transaction between you and the Company [Savage] shall be deemed to exist between you and the Company unless and until a definitive Sale Agreement has been executed and delivered; and you hereby waive, in advance, any claims in connection with any such transaction unless and until you shall have entered into a definitive Sale Agreement.”
After signing the NDA and the Letter of Intent, but prior to signing the Definitive Sale Agreement, RAA discovered during its due diligence, potential Superfund liabilities, an NLRB issue, and a multi-million dollar lawsuit against Savage. None of these “issues” had been previously disclosed. RAA terminated the deal and claimed it was entitled to the return of the $1.2 million it had already spent on its due diligence. Due to the terms set forth above in the NDA and described above, RAA’s complaint was dismissed.
After reading the RAA case, I wondered if I could have prevented this result by reviewing the NDA. My conclusion, unfortunately, is maybe yes and maybe no. I reviewed an NDA that I’ve used in the past (attached). Notice the sentence highlighted on page 2. I’ve protected my clients with this provision, but I wonder how many times I’ve let my purchaser clients sign an NDA with it.
The next step in the negotiation process is negotiating and signing the Letter of Intent. The seminal case on Letters of Intent is Pennzoil Co. v. Texaco, Inc., 481 U.S. 1, 4 (1987). This case developed when Pennzoil attempted to acquire Getty Oil. Texaco came in at the 11th hour and attempted to acquire Getty. The question decided was whether Pennzoil had a binding agreement with Getty. “To avoid questions, if a binding agreement is intended, this intention should be clearly stated; likewise, if the parties do not intend to be bound by their agreement, the agreement should state even more clearly that it creates no legally enforceable obligations. To make sure that no argument can be made that negotiations have created a binding contract before the lawyers get all the details worked out, careful lawyers will often have the parties execute a document containing language like this:
“Although the parties may exchange proposals (written or oral), term sheets, draft agreements or other materials, neither party will have any obligations or liabilities to the other party unless and until both parties’ authorized representatives sign definitive written agreements. Exchanged terms are non-binding to the extent they are not included in such definitive written agreements. Either party can end these discussions at any time, for any reason (or for no reason at all), and without liability to the other party. Each party remains free to negotiate and to enter contracts with others.”
Robert M. Lloyd, Pennzoil v. Texaco, Twenty Years After: Lessons for Business Lawyers, 6 TRANSACTIONS: THE TENNESSEE JOURNAL OF BUSINESS 321, 352 (2005).
For an excellent article that examines the unpredictability of Letters of Intent and the importance of how they are drafted, see Holsen, “Letters of Intent in Corporate Negotiations: Using Hostage Exchanges and Legal Uncertainty to Promote Compliance”, 162 University of Pennsylvania Law Rev. 1237 (2014). Additionally, in a newly released Connecticut Appellate Court case that should be near and dear to our collective stomachs as it relates to a New Haven, Connecticut restaurant institution, Sally’s Apizza, the court held that a comment sheet circulated by the seller to the prospective purchaser in response to the prospective purchaser’s proposed purchase agreement did not constitute a binding counteroffer and therefore no agreement existed between the parties. Al Dente, LLC v. Consiglio, 171 Conn. App. 576 (2017).
These cases are other examples of why the Team assembled must be strong. The Team must be formed before the parties to the transaction begin any communication. The Team must work well together and have clear and constant communication among its members and their client. Finally, the Team must do its own due diligence of its client before the deal is structured, let alone prior to when the due diligence of the other party is commenced.
I would be remiss if I did not introduce one more area of due diligence that must now be explored. With the meteoric rise of cybersecurity issues and of data breaches, no buyer wants to discover that the company it has just acquired was hacked prior to the date the transaction closed. Any due diligence checklist now should include a review of the privacy and cybersecurity practices of a target company. Privacy and data security risks will depend upon a number of factors including industry type, relevant regulatory requirements, the jurisdiction and the applicable laws. The due diligence checklist must be customized accordingly based on the specific transaction.
For example, a privacy and data security due diligence checklist might include:
- A copy of the target company’s policies pertaining to information security (physical, administrative and computer, and including service providers).
- A copy of the target company’s policies related to incident preparation and response to breaches of data security or unauthorized access to personal
- A description of all incidents involving potential violations of privacy or data security laws/regulations, resolution of those incidents and whether individuals/regulators were notified.
- A copy of the target company’s employee training materials related to data privacy and security awareness.
- A copy of the target company’s policies regarding the protection of privacy of employees, customers and consumers.
- Copies of the pertinent audits and a description of the process for employee background
- A list of the individual(s) responsible for privacy and information security standards for the target company (chief privacy officer, chief security officer) and any identification of any applicable certifications they may hold.
Therefore, the Team must now include a qualified IT professional.