Lawyerless Acquisitions (Much) More Expensive Than You’d Think
This is a guest post by Eric Hsu, Founder and Owner of Clear Focus Law, PLLC, a law firm that helps entrepreneurs that are working on business acquisitions in the small-to-medium sized business acquisition space.
Thinking of DIYing the Legal on Your Next SMB Acquisition? Read this First.
Many Entrepreneurship Through Acquisition (“ETA”) searchers are tempted to DIY their deal with minimal or no lawyer involvement. How can you blame them? I mean lawyers usually don’t win awards for being fun to work with and who doesn’t want to save thousands of dollars on their acquisition?
Bottom line: I know lawyers can be a pain in the you-know-what to deal with but guess what? Doing a deal without a lawyer can be an even bigger, more expensive, and longer term pain.
Consider this article to be a cautionary tale about all the things that can go wrong with your deal (or even the future of your acquired business) if you choose to skip the lawyer.
As a bonus, I’ll also be sharing tips on how to find the right lawyer for your deal (including ways to get more pricing predictability)
The M&A Lawyer’s Role (More than Just Drafting Docs):
When you hire a lawyer for your M&A deal, you’re actually hiring two advisors in one. Pretty cool deal huh?
Most people see a lawyer’s role as just drafting up the documents to finalize (or “legalize”) the deal.
Obviously this is a very important role. Having well written, comprehensive, and legally enforceable contracts IS essential. No deal can afford not to have them.
But this isn’t a lawyer’s only role.
A good M&A lawyer will also help you with
- Deal structure and negotiation
- Pre-vetting
- HoldCo or Acquisition Entity selection and formation
- Legal due diligence
- Getting together the right advisory team
What can Happen If I Do a Deal with no Lawyer?
Sometimes I’m hired to “fix” deals that have gone sideways. Most of the time this is because my (buyer) clients thought it might be a good idea to do things themselves and then found themselves in a bind.
Here are some of the problems I’ve seen or can imagine with these lawyerless acquisitions.
(Hint: most of the time there may be very little that a lawyer can do to fix these):
Deal structure problems or missed points in LOI:
I’ve seen some pretty bad LOIs including ones that confuse the deal structure (is it an asset purchase or stock purchase?), have contradicting terms on the purchase price, improperly identify the assets to be purchased, and even include confusing terms from other types of deals (like real estate deals).
Pro tip: NEVER let a broker provide you with an LOI to use. They are, almost without exception, horribly written, and written in favor of the seller.
Many ETA investors underestimate the importance of a good LOI. True, LOIs are non-binding but really that just matters if you’re wondering if you can walk away if you don’t like the deal. If you’re WANTING the deal to work out, then you’d better regard the terms in the LOI as at least “quasi-binding.” Buyers and sellers alike (as well as their advisory teams) almost always look to the LOI as the blueprint for the deal. Sure, if things come up it’s not uncommon to have minor deviations from the LOI terms but the key is “if things come up” and “minor deviations.”
Due Diligence Issues:
Without a deal lawyer to help you with due diligence, it is easy to miss key legal due diligence red flags. These red flags can have financial or risk consequences ranging from regulatory fines or fees to complete loss of the value of the company. Here are a few examples of what I mean:
- Liens or security interest. Anyone who has a lien or security interest has a right to the same assets that you’re buying (and almost always with a higher priority than you). Bad news.
- Unpaid taxes. Many searchers think that as long as an acquisition is structured as an asset purchase, they aren’t responsible for any unpaid taxes. However, this is not true. Under certain circumstances (which are more common than any acquirer should be comfortable with) both State taxing authorities, as well as the IRS, can hold acquirers responsible for unpaid taxes of the seller, even well after an acquisition deal.
- Improperly maintained entity. Most small businesses do a very poor job at observing the formalities to properly and legally maintain their legal entity. Sometimes the entity they think they are running may even have been administratively dissolved for such things as failing to file annual reports. While this is an obvious and huge problem with a stock purchase, it is a big problem for asset purchase deals as well since any company authorization instruments provided by the seller can be therefore invalid.
- Employee vs independent contractor issues. When employees are improperly classified and paid as independent contractors, under either state or federal law, it can result in significant tax and other penalties (like UI contributions or leave accruals) that can haunt you long after you buy a business. An expert analysis here is critical.
Purchase Agreement Missing Key Points:
Much worse than missed provisions in LOIs is when they’re missing from the actual purchase agreement. Here are some common ones and the potential consequences.
- Financing contingency
If your purchase agreement doesn’t have a financing contingency, then it means that you’re on the hook for completing the purchase whether or not your financing goes through! So if you don’t have a financing contingency, at best you’ll lose all your earnest money and at worst, the seller may even be able to force you to go through with the deal or even sue you for damages they suffer when you aren’t able to close!
- Warranties and representations
Warranties and representations are critically important parts of your purchase agreement. This is where the seller confirms that everything they shared with you to help you evaluate the deal is accurate. This is also where you would have recourse if something that was shared with you (like financials, asset listings, questions answered during due diligence) was not accurate. The recourse could range from damages, to the ability to rescind the deal, but only if the warranties and representations section is written right. If not, you may have NO RECOURSE even if everything the seller told you was a lie.
- Improperly identified assets
In order to be a binding contract to purchase assets, the assets must be clearly identified. I’ve reviewed asset purchase agreements that were written so badly that essentially the acquirer was purchasing nothing.
- Tax allocation not set out clearly
An IRS 8594 Return needs to be filed by both buyer and seller. To avoid an audit, the allocation of the purchase price must be identical in both buyer and seller filed versions. The best way to do this is to make sure that the allocation is clearly identified in the purchase agreement. I’m still surprised by how many agreements I review that are missing this.
When should you get a lawyer on board? Earlier than you think…
Remember how a good M&A lawyer is actually two advisors in one?
Well, one quick caveat: their ability to be those two advisors depends on when you engage them.
Get them involved in your deals early and they can help you shape your entire deal including helping you with negotiation, structure, and blind spots.
On the flip side, engage a lawyer too late in the process and most your deal terms, good, bad or indifferent, are already set. At this point, even the best lawyer can’t do much more than draft good deal docs to protect you, or if the deal really stinks, advise you to back out.
Here’s a visual of what I mean:
I like to think of deals like working with cement: hire a lawyer while the cement is still wet and the lawyer can help you shape the deal as needed. Hire a lawyer when the cement has set and all they can tell you is whether it looks good or not.
Need a deal lawyer for your next deal?
Whether you’re a searcher, individual entrepreneur, or fund sponsor, I’d love to help, and the sooner the better!
Feel free to book a complimentary meet & greet directly on my calendar so we can see if we’re a good fit to work together.
Happy acquisitions!
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For more information on Clear Focus Law, PLLC, please visit the company's website: https://clearfocuslaw.com/ New Paragraph