S1-E6 | Phase 5: Purchase Agreement — Closing

Transcript

SPEAKER_00 0:02

Hi everyone, I'm Joshua Johani here in episode six of our Disciplined Framework MA series. We are now at the final phase. We're calling it phase five in episode six. The final phase of the disciplined MA process. And this final phase is about the purchase agreement. Stock purchase, merger agreement, asset purchase. It takes on a lot of different forms. And we're calling this closing with confidence. It's important for our audience to note that the purchase agreement is a legal document that needs to be drafted by an attorney. Ricardo and I are not practicing attorneys, but we have experienced a lot of these deals. And so our commentary on this phase is going to be largely related to deal mechanics and how to keep the deal moving. Whereas if you're interested in how purchase agreements work, you may want to consider going to law school. So, how are you doing today, Ricardo?

SPEAKER_01 0:56

Very well. Critical to make a disclaimer that I don't have the IQ to become an attorney. So that's it.

SPEAKER_00 1:05

Just in case any of our audience was wondering, Ricardo is not going to apply to law school. I'm also not going to apply for many reasons, IQ included. So, you know, the in middle market MA, a purchase agreement is the document you sign that outlines where all the payments are coming from and how they're going to be made and what the terms are for reaching each part of the transaction consideration. It is binding. And at the end of signing that document, you hand over the keys to the business. And there's a new owner now. We'll talk about reps, warranties, covenants, indemnification, working capital adjustments, earnouts, and escrow. We'll touch on all of these very quickly. But Ricardo, when you consider the purchase agreement from a technical founder's point of view, buy side or sell side, how would you advise them to work with their attorney or to navigate all of the different complexities of these new terms they're going to get hit with in the purchase agreement phase?

SPEAKER_01 2:07

That question reminds me of a 60s show called Lost in Space, where there was a robot which all of a sudden starts screaming, danger, danger, danger.

SPEAKER_00 2:21

So Will Robinson.

SPEAKER_01 2:27

So because the risk involved in this phase is that many professions may relax too early because once the letter of intent is signed, there's a sense that the deal is done. And in reality, this is where value is either secured or quietly eroded. And therefore, this relationship, this engagement with attorneys, which have to play a dutiful and very important role for both parties involved, is actually matter, it's extremely important. Extremely important. Because at the high level, the purchase agreement defines the final terms of the deal. And more importantly, it defines how risk is allocated. Every clause in the purchase agreement answers a version of the same question. If something goes wrong, who bears the consequence? Hence the attorneys. And that's why this phase is strategic, it's not administrative. You're not documenting the deal, you're defining its real economics under uncertainty.

SPEAKER_00 3:40

The key terms that sellers get confronted with, we referenced reps, warranties. The lawyer is the best person to advise on how to handle those. Covenants and indemnification have more to do with any kind of long-term tail liability of the transaction. Stock asset or merger agreements, we see most often used for a combination of tax considerations. Sometimes there's an advantage to doing a stock purchase over an asset purchase from a tax strategy perspective. And then merger considerations are often done if there's some kind of desire for the selling shareholders not to have to acquire signatures from every single minority shareholder. Mergers agreement can be useful. We've seen that used to avoid trying to get, you know, 120 signatures for some of these private companies that have raised a lot of money. The big key for sellers to think about from our perspective is as they're going through this process and they're inundated with requests and they're getting overwhelmed by both trying to run the business, thinking about this major financial transaction that's going to change their life, and simultaneously being thrown into this world of transactional legal jargon that they're really not familiar with, is how to consider what I would call tail risks. Sellers and individuals, the human brain in general, is not very good at thinking about a 0.01% chance of something happening where you could be in a significant legal issue versus a 3.07 chance of a legal situation happening. And as sellers go through this process, it's really important that they rely on their advisors, but also realize that it's impossible to sell a business at zero risk. The balance of risk is the claims that you've made inside of the purchase agreement, the cash and the money that you're receiving, as well as any additional consideration, which can be wealth building through marketable securities, earnouts, sellers' notes, et cetera. I think if sellers knew that they were going to have to accept, it depends on their personality, but a lot of more risk-averse sellers or people who might be more anxious have a lot of trouble with these tail risks. And they need to go into this process just accepting the fact that they're going to have to accept certain tail risks. That's just how lawyers construct these documents. Um, and they're just gonna have to make sure that, you know, they're honest with everything that they do. Ricardo, what about you when you think about the major considerations to just getting the deal across the line that these buyers and sellers will have?

SPEAKER_01 6:29

It reminds me of Daniel Kenneman's quote uh when he says that the brains of humans contain a mechanism that's designed to give priority to bad news. And I mean, very possibly that's true, even because I mean uh it comes from a very reliable and diligent source like Kenneman. And when you think about actually the allocation of risk and trying to translate and make it correspondent within the purchase agreements, we have to think that every clause must answer a version of the same question. If something goes wrong, who bears the consequence? And that's why this phase is strategic. So that's a critical point. So I think it's important to really, I mean, consolidate this constantly mind. And the other point is about representations and warranties, and this is where truth becomes contractual because everything you have said, explicitly or implicitly, now is formalized. And the question becomes are you willing to stand behind this statement legally? And the other problem that's come frequently appears on this one that needs to be solving is that inconsistent preparation surfaces, and at that very point. If your deals and responses were not disciplined, this section becomes complex and contested, and you have different groups of attorneys actually disputing positions, disputing clarifications. If your preparation was clean, this section becomes straightforward. And again, disciplinarity simplifies complexity later.

SPEAKER_00 8:20

It really gets into some of the earlier episodes in this series where we were talking about just being very matter-of-fact and being able to give the buyers the strengths and you know be transparent about any weaknesses as to why buyers would or would not acquire the asset. Selling a business is not meant to be salesy. And I know we said that multiple times in the previous episode. Uh, there are regulations, and you know, purchase agreement is an important part of one of these, but there's all kinds of securities laws. It's not meant to be hyperbolic. Uh, it's not meant to be something where there's a very high differential of what the buyer thinks they're getting and and what actually exists in the business. It's meant to be as tight as possible. And it's important that from the very beginning, that the sellers understand there'll be tail risks and that they just need to be matter-of-fact. The financials need to be accurate. Uh, the business has a growth trajectory that's based on the value of its products and services and its historical performance. And this is uh in a large part, you know, what the buyer is going to use to value the the asset.

SPEAKER_01 9:22

I mean, the the this particular topic is so rich that actually gives us an opportunity to expand it. Uh, but given the time limit we have for this episode, we have to really concentrate on some key points. Just to complement and offer a complementary side to your comments, we can think about earnouts, scroll, and working capital, just three other elements that are usually included or considered in the purchase agreements. Earnouts are often used to bridge valuation gaps, to your point, because the definition of the value of the business may not necessarily be straightforward calculated, but they must be approached carefully because earnouts introduce future dependency, measure complexity, potential conflict. And the key question is do both parties truly control the outcome being measured? I mean, most likely it's not necessarily, but an agreement, a common position must be reached in order to move forward. The other point about scroll and working capital adjustments, these are often underestimated, but financially material, these are critical, especially thinking about impairment tests, which will naturally come as a consequence of the whole deal. Scroll delays access to cash. Working capital adjustments can shift value at closing. And these are mechanisms which are not technical details, they are economic levers. Effective professionals model them precisely, not approximately, because small assumptions here can have large consequences. I mean, either for mid-sized business or large companies.

SPEAKER_00 11:14

When I think about takeaways for the technical founder and the kinds of jargon that they'll be hit with at closing that will be unfamiliar to them, I definitely zero on working capital. We'll talk about working capital in more detail when we get into some of our transaction case studies and sell side structure. It's important for sellers to remember that despite the fact it's called capital, it actually doesn't have anything to do with cash. Working capital is current assets minus current liabilities. And when businesses are sold, they need to transfer with a working capital peg. That working capital peg is determined based on historical financials. It's pretty much always a positive number. And so that means that when the business is transferred, it needs to have current assets in excess of current liabilities by a certain amount. And these are usually receivables, uh, just the balance of receivables and payables. And if it doesn't, because there's a spike in payables or there's a suppression of receivables, that can be a clawback from the purchase price. The challenge with working capital accounting is that it's really balance sheet accounting. And small middle market private companies almost always could improve their balance sheet reporting. Uh, people are really good at the PL, but not necessarily the balance sheet. But we have a series coming up on the balance sheet. Ricardo, is there anything else that you want to tell our audience before we leave them and uh we say goodbye to our MA framework series?

SPEAKER_01 12:41

With a touch of sadness, I must say, but with a sense of uh expected accomplishment, I would say that first of all, purchase agreements uh it's a phase that defines bioeconomics, not just legal terms. It depends on how value is preserved under certainty. Second point is that structure matters as much as price, so timing, risk, and control are embedded in the deal design. And thirdly, discipline must peak at the end because that's a moment that's for a marathon runner equivalent, is where all the participants are eager to see the crossing line and fatigue is at the highest point, so the risk involved here is of value erosion. So, but overall, I mean you have to bear in mind that close is not the end of the process, it's the moment, but everything becomes real. So, thank you very much. So, I'll hand over back to you, Joshua.

SPEAKER_00 13:42

We will see you on the last episode where we do lessons learned and about discipline data driven results. We look forward to continuing with our audience on this journey. Goodbye, everybody.