1. The M&A process revisited
April 2016
M&A is a complex process with many
moving parts. In this short essay, and as
2016 shapes up to be another active
year, the professionals at 11T Partners
have tried to shed some light on some
of the thorniest issues often faced in
most acquisitions. We have summarized
below some of the key transaction
elements that require a greater degree
of scrutiny for the negotiating parties.
Transaction Structure
The structuring of
an acquisition is
often strongly
debated and
one of the most
sensitive aspects
of the
negotiation
process. At a
high level, the
two common
transaction
structures for
private transactions are an asset or a
stock purchase. In an asset deal, the
seller transfers all of the assets, including
intangibles such as intellectual property
and trademarks, necessary to operate
the business. In a stock deal, the
acquirer gets ownership of all assets
and liabilities through a transfer of the
shares of the target. As a rule of thumb,
asset sales usually benefit the buyer
from both a legal and fiscal standpoint.
Legally, the buyer has the freedom to
assume only specific or no liability at all.
This limited exposure offers the acquirer
protection against undisclosed liabilities
post-closing. Fiscally, the buyer will
generally obtain tax savings by stepping
up the assets’ tax basis to the purchase
price through higher future
depreciation expenses.
Still, there are exceptions where
asset purchases can be fiscally
detrimental to the buyer. The primary
exception is when tax savings from net
operating losses, not transferrable in an
asset purchase, exceed those
generated from the stepped-up basis
of the assets. As noted before, in most
asset deals however, the seller is
subject to two taxable events: (i) a
taxable gain from the sale of the assets
themselves and (ii) double taxation
upon
distribution of
the sale
proceeds to
shareholders.
When there is
a tax
arbitrage
opportunity
arising from
stepping up
the assets’ tax
base (i.e.
buyer saves
more in taxes than what the seller
pays), asset purchases can be
financially beneficial for the seller if
some of the tax savings are shared and
passed through in the purchase price.
When a buyer is willing to assume the
liabilities of the target post-closing but
wants to take advantage of a higher
stepped up tax basis, a qualified
purchase of stock under Section
338(h)(10) is a structure that should be
strongly considered. In summary, a
qualified stock purchase is a stock
purchase that is treated by the IRS as
an asset deal.
Earnouts When there is an important
gap between valuation expectations
of the buyer and seller, earnouts are
often the mechanism the parties fall
back on. The first contentious issue in
ACQUISITION
MOMENTUM IS
EXPECTED TO
CONINUE IN 2016
In the last year,
M&A reached a
record level in both
activity and value
and 2016 looks to
be another very
active year for
transactions. Buyers
continue to look to
expand lines of
business, customer
relationships,
technology, and/or
geographic reach.
In addition,
favorable credit
terms and
historically high
cash reserves will be
key factors in
continued deal
activity.
ONE OF THE STICKIEST
ISSUES IN THE LOWER
MIDDLE MARET M&A
PROCESS CONTINUES TO BE
POST-CLOSE PURCHASE
PRICE ADJUSTMENTS

2. devising an earnout is obviously which
milestones tied to the payments to
choose. For fast growing companies,
using profitability measures can prove
troublesome as it may misalign buyer’s
and seller’s incentives. For instance, the
seller may be inclined to reduce
discretionary spend in R&D and
marketing, potentially impeding future
growth. Tying earnouts solely to revenue
can also be damaging to the target’s
true financial health by taking on, for
example, less profitable business. Often,
it is wiser to have earnouts tied to both
generic accounting measures, such as
revenue or EBITDA, and benchmarks
specific to value creation objectives or
competitive advantages; such as
diversifying the client base, the grant of
patents or getting FDA approval.
Another aspect of earnouts that
needs to be carefully analyzed is how
the target will be operated post-closing.
Moreover, the portion of revenue
coming from upselling and which cost
savings will be included in the earnout
calculations also have to be addressed.
If the earnout is spread over more than
one year, a sliding scale or averaging
approach should be considered to
avoid an all or nothing scenario and
limit ensuing litigation risk. In our opinion,
the optimal earnout period is probably
2 years. For the buyer, running the
target company independently from
the parent translates into additional
administrative costs. It also makes
creating upselling opportunities
between the parent and target more
difficult. At the same time, the buyer
needs to protect itself against
overpayment for short-term
performance only. As for the seller, it
typically wants to get its contingent
payments sooner rather than later. Yet,
it is probably best for it to spread the
earnout risk over more than one year in
the event of short-term operational
hiccups, such as major client
implantation or product release delays.
Purchase Price Adjustments Studies
have found that over 80% of private
M&A transactions contain a post-
closing purchase price adjustment. This
is a definite trend in the market that
shows no sign of abating. A purchase
price adjustment provision in the M&A
agreement provides a means for the
acquirer to adjust the final purchase
price if there is a change in value of the
target between signing and closing of
the acquisition. Sellers need to focus on
several key issues when negotiating
purchase price adjustments, such as
defining working capital, setting the
baseline amount, specifying
accounting principles to be used, and
understanding indemnification overlap
with any working capital adjustment.
While post-closing price adjustments
can include adjustments that are
contingent on the occurrence of future
events, such as the performance of the
seller’s business and/or obtaining
certain regulatory approval, such as
FDA approval of a drug or 510K
clearance for a medical device, the
most common type of purchase price
adjustment is a working capital
adjustment.
Working capital adjustment
provisions are some of the most
complicated terms in a purchase
agreement and as such require
extensive negotiations. A great deal of
time is often spent in defining the
working capital accounts and
accounting methodologies used. Any
ambiguity can result in significant
financial consequences to the buyer
and the seller. Moreover, as working
capital accounts are not static, it is
important that the provisions protect
both parties. Otherwise, the seller could
be inclined to decrease the company’s
working capital prior to the closing,
effectively increasing the purchase
price as buyer will have to fund the
working capital. Likewise, the working
capital adjustment ensures that the
buyer does not receive a windfall if it
increases between the signing and the
closing.
After the seller and the buyer
determine the benchmark working
capital amount, the buyer and the
seller must agree on the mechanics of
any purchase price adjustment. There
are a number of methods that have
become standard, including a dollar-
for-dollar adjustment, a threshold based
adjustments or a capped adjustment to
name a few. Another key requirement
when considering a purchase price
adjustment associated to working
capital is to avoid double counting,
that is the overlap between the working
capital adjustment and
indemnification.
Representations and Warranties
In a typical M&A purchase
agreement, the seller provides the
buyer with exclusive representations
and warranties about the condition of
the business being sold. Key seller’s
representations in a transaction are the
accuracy of financial statements; the
existence and nature of litigation; tax
attributes; the protection the seller
enjoys over its intellectual property;
compliance with laws and permits;
good and marketable title to the seller’s
assets, free and clear of liens; third-party
consents to consummate the
transaction; and employment matters.
Disclosure Schedules As a rule of
thumb, disclosure schedules are
prepared by the seller, although heavily
scrutinized by the buyer. Most of the
schedules take the form of exceptions
to the representations and warranties in
the purchase agreement. It is wise for
the seller to complete a draft of these
schedules as early as possible in the
negotiation and for the buyer to review
them, and all subsequent changes,
carefully. Sellers should try, as best as
they can, to avoid representing that the
diligence materials provided were
“complete and did not omit anything
material”. It is much more prudent for
them to offer qualified representations,
discussed below. For their part, buyers
may want to obtain a representation
that there are no liabilities other than
those expressly identified on a
disclosure schedule or reserved against
in the financial statements.
Knowledge Qualifiers Sellers
typically make either absolute
representations or ones that are
qualified by actual or constructive
knowledge. This critical decision creates
an important allocation of risk in the
agreement on facts that neither party
may know. Striking the delicate
balance between the buyer’s total
accountability and the seller’s total
impunity often depends on relative
negotiating power and trade-offs made
on other key transaction elements.
Sandbagging Despite thorough due
diligence by the buyer throughout the
sale process, the seller is required to
make representations and warranties
concerning the business and schedule
out certain exceptions to its
representations and warranties on the
disclosure schedules. In the event that
the buyer becomes aware of a pre-
existing breach, it may be permitted to
bring a claim for indemnification after
the closing. This right is referred to as
sandbagging. However, anti-
sandbagging provisions are often

3. inserted in the agreement to protect
against such behavior.
Materiality Materiality is always an
important concept in the sale of a
business. Buyer and seller both know
that the representations and warranties
generally won’t be perfect and in
reality can’t be. Materiality adds the
cushion that both parties want and
expect, ensuring that time and money
won’t be wasted on immaterial
claims. Defining materiality, however,
can prove challenging. Many
representations and warranties will
contain a negotiated materiality
qualifier. This is reasonable and both
parties should mutually benefit by these
definitions and provisions. The concept
of a material adverse change, usually
referred to as a “MAC”, has a similar yet
somewhat different function. It
generally appears as a condition to
closing and governs the period
between signing and closing. A buyer
can elect not to close the transaction
should this provision be triggered. This
can be avoided altogether if buyer and
seller agree to a simultaneous signing
and closing.
Escrow Accounts When a buyer
claims a representation or warranty has
been breached; their most immediate
remedy is to proceed against the
escrow account, if one exists. A typical
escrow account ranges between 10 to
20% of the purchase price, is funded at
closing through a hold-back of
purchase price proceeds and is in
place for a period of 12 to 24 months. If
the claim (s) exceed(s) the escrow
amount, a buyer will revert to filing a
lawsuit against the seller, or sellers,
directly for the unfunded portion of the
claim.
Working Capital It is common for the
seller to give representations and
warranties in the purchase agreement
with respect to working capital items. It
is quite possible that when a seller
provides representations with respect to
working capital items, which are also
addressed in the working capital
adjustment, it may give rise to a claim
by the buyer for seller’s breach of a
representation or warranty. To avoid
any double-counting, the seller’s
representations and warranties should
be drafted with the working capital
adjustment in mind.
Basket and Cap Basket and cap
provisions limit the buyers’ recovery and
seller's exposure arising from claims for
indemnification under the
representations and warranties section
of the purchase agreement. The cap
concept limits the total amount
payable under the indemnity provisions.
This liability cap, which can be
expressed as a set dollar amount or a
percentage of the transaction value, is
vigorously negotiated by both parties
and can range from unlimited, in rare
cases, to the escrow amount. A sublimit
known as the "basket" establishes a
threshold which triggers an
indemnification procedure. As a result,
the buyer absorbs the first dollar of any
claim up to the basket limit amount.
Claims can be enforced using the "first
dollar" or the “claims exceed” method.
Under the former, the full amount of the
cumulated claims would need to be
paid if the basket is exceeded. The
latter is analogous to an insurance
deductible, hence only the excess
claims need to be indemnified.
Survival Periods Representations
and warranties are made at the time of
closing and “survive” for an agreed
upon period of time, indefinitely, or for a
statutory period; common in the case of
taxes, employee benefits or
environmental matters. A typical
negotiated period is in the range of 1 to
2 years. Survival periods only apply to
privately owned companies. For public
transactions, the indemnity period
doesn’t survive the closing.
Indemnity Insurance
Representations and warranties
insurance helps bridge the gap when
an impasse develops between buyer
and seller over a specific or various
representations and warranties. The
insurance acts as an extended
guarantee for the buyer, whereby it
expands the cap and/or lengthens the
survival period. Over the last few years,
insurance has become available at
much lower prices and thus increasingly
common. The cost of the policy can,
and usually is, split between buyer and
seller. Parties should also expect the
insurance process to delay the closing
by at least a few weeks as the
insurance company will most likely
conduct some fairly detailed diligence
on the target of its own.
11T Partners LLC, based in New
York, was formed to provide
mergers & acquisitions advisory
services, equity and debt
placement services, and strategic
advice to middle-market public
and private healthcare companies.
11T Partners has advised a range of
public and private companies
across healthcare segments that
include pharmaceuticals, medical
devices, healthcare services and
healthcare information technology,
both in the United States and
worldwide. More information about
11T Partners can be found on our
website: www.11tpartners.com
420 Lexington Avenue, Suite 2440 New York, NY 10170
AFFILIATE OF BILLOW BUTLER AND COMPANY, LLC, MEMBER FINRA