When looking at the M&A process, signing the definitive agreement is an exciting time. Due diligence from the buyer has been completed, everyone’s agreed to the terms, checks are signed, and life as part of a new company is about to start. However, there are times in which not all parts of the business are known. There could potentially be undisclosed liabilities, but there is also a true up period. In this episode we are diving into each of these areas.
It is very common that new, undocumented liabilities appear post the closing of a transaction. Some due to timing and others due to issues with transparency within the selling organization. In this episode we will discuss the mechanism we put in place to account for these unplanned expenses.
Some questions we answer:
More covered:
Now what:
Summary:
Revenue Rocket can help with undisclosed liabilities before, during, and after a transaction. Connect with us to set up a no-obligation introductory call with our team: info@revenuerocket.com
Post Close Liabilities -Revenue Rocket
Mon, 7/11 12:12PM • 27:25
SUMMARY KEYWORDS
reps, liability, buyer, true, warrants, seller, disclose, business, definitive agreement, warranties, lawyer, balance sheet, risk, deal, pay, unknown, ar, close, m&a, disclosures
SPEAKERS
Mike Harvath, Matt Lockhart, Ryan Barnett
Mike Harvath 00:04
Hello, this is Mike Harvath with another shoot the moon podcast broadcasting live and direct from revenue rocket world headquarters in Bloomington Minnesota. Revenue Rocket is the world's premier growth strategy and m&a advisor for IT services companies. And I'm fortunate enough to be here today with my partners Ryan Barnett and Matt Lockhart. Hey guys.
Matt Lockhart 00:28
How's it going, Mike?
Mike Harvath 00:29
Today we're talking about post closing liabilities and how those are handled even if you don't know about them. And IT services m&a transaction, how the balance sheet is typically managed, how you get credit for working capital that's not collected, at the time of close, it's tied up in AR, for example. So a variety of kind of post closing items that hopefully you guys will find interesting. So with that, I'll turn it over to Ryan.
Ryan Barnett 01:03
Thanks for everyone for listening here today. And thanks for having us on here, Mike and Matt. Today, when you think about the m&a process, the signing the definitive agreement, it's a really exciting time, you know, your due diligence has been completed, everyone's agreed to the terms checks are getting signed, and your life is part of a new company is about to start. That said, there are times in which not all parts of the business are known, you may had some outstanding portions or liabilities, you may have some undisclosed things that we just did that just didn't come up in the process. And there's a what we often call a call and just a true up period. And today's we're going to drive into some of these areas that buyers and sellers run into once the once the check is signed, and the companies are starting to integrate and go from there. So, uh, Matt, I'm just gonna start off with a little softball question, you know, what is a true up? And and what's up mean for buyers and sellers?
Matt Lockhart 02:03
Um, well, I mean, when you when you close the deal, everything isn't known, right? I mean, if you think about it, there's accounts receivable for as a as a simple example. And that accounts receivable in terms of how that is negotiated regarding, you know, who's going to be taking that cash is an example. And then if, if an account isn't received, well, then you know, one party or the other is going to need to provide a true up, it's just making everything come even based upon, you know, the negotiated deal, right. And so, you know, I think that the big point in this is that everybody does their best effort, right to, you know, be as clean as possible, is towards defining everything in the definitive agreement. But sometimes there are things that are simply unknown at the time of closing. And so you need to have your arrangements in place in terms of how things will be trued-up in a relatively short period after closing.
Ryan Barnett 03:33
Okay, that helps. So it's something almost think of as a maybe an expense as accrued but not paid out, I could see like a, maybe an employee bonus might fit into something that might take away from a seller or on the on the flip side, something that came in or unexpectedly AR that wasn't account for net working capital true up, might hit either one, either side favorably or unfavorably. But there's a bit of a grace period in which kind of the big number has been solved, but there's some small numbers that that need to be cleared out. Mike, if you could help me understand there's this also their concept of representations and warranties they're more often called reps and warrants, this helps protect sellers from kind of meaningful disclosures or protect buyers from kind of meaningful changes in the business. Mike, how does that is? Can you help explain that and is that different? And how does that work up in a true up? Are those completely different concepts?
Mike Harvath 04:41
No, no, I mean, they're interrelated, right? So representations and warranties are when a seller represents that the business condition is a certain way, or warrants that it's in a certain way, or that things are known. So for example, they would represent everything that's on the balance sheet, the closing balance sheet is a liability that is known. Now as a practical matter, sometimes things get, you know, overlooked. And what I mean by that is they may think they're known, and they may, in fact, actually be known, but something as simple as, like a utility bill that covers part of the time when a seller owns the business and part of the time when a buyer own the business, the portion of that liability, that at that time was unknown, because they hadn't received the bill, right? As would be the part that was, you know, the utility for, say, your rent space, or maybe an Internet access bill or something would be the responsibility of the seller. And so their reps and warrants are still intact, because they didn't know of the liability. But there is a liability nonetheless, and the short answer is that liabilities in a true up are assets and a true up have to do with, you know, if you own the business, say until the first of July, anything that occurred before the first of July is your responsibility, everything that happened, you know, as it relates to a liability or an asset that comes into the business after the first of July is the responsibility of the owner. But where reps and warrants become important as it relates to a true up, is in the event that there is not full disclosure. So as we've talked about reps and warrants in the past, reps and warrants have to be accurate. If they're not accurate at the time of closing, based on what you're disclosing or attesting to, then you're putting, you know, you're risking that you're going to have legal issues with your buyer after close. So it's important that you know, those are clearly covered with your lawyer and that you understand and that you've made full disclosures. And if there's liabilities in particular that you know about as a seller, that they have been fully disclosed to the buyer, so that they can either be managed through the true up process, or it can adjust the purchase price and it can be resolved at close.
Ryan Barnett 07:27
So if I understand this right, the reps and warrants the, let me ask this discerning. What is the penalty of breaching a rabid warrant. So if if the doc if you've already been done in your, let's say, in this Trump process, and he in a rep and warrant does happen, what's the repercussions of that?
Mike Harvath 07:53
Well, there's some indemnity cap and basket and some withholdings that can be had by buyer, typically to cover their exposure on this item. And it may mean, you know, it's not uncommon to escrow a portion of the purchase price, sometimes as much as 10% to cover reps and warranties, right. So if there's a violation of a rep and warranty, that would impact the buyer negatively, they can reach into that escrow and take that money to cover that liability. Now, there's other ways to cover reps and warranties, like it's becoming pretty popular recently to have representation and warranty insurance policies. And there's insurance companies that write coverage after evaluating the risk of a rep and warrant violation. And you can for a much lower number than 10% of the purchase price, ensure that there will not be any reps and warranty violations, because it's very unlikely this as a practical matter, unless there's a bad actor, that there's going to be a rep and warrant violation on its face, because you've got all kinds of lawyers who are looking at it and asking their respective clients, you know, are these representation warrants accurate, right, because it exposes a seller if they're not accurate, let's say you intentionally left a liability off the balance sheet or you knew of a contingent liability that you didn't disclose, It's ultimately going to get discovered likely, and you'll have to pay it either out of your escrow for reps and warrants, or as part of a true up or as part of a earn off reduction or from the reps and warranties policy. So there's a variety of remedies that a buyer has in that situation. But it also depending on the size of that, of that violation, if you will, or or non disclosed liability, it could even, you know, warn or raise to the level of litigation if there's not enough coverage built into the way the purchase agreement or the escrow or the insurance was built.
Ryan Barnett 10:13
Okay. Okay. And if I add again, and the purpose of understanding here, it sounds like reps and warrants violation would be a fairly serious clause. Do you have an example of where that might be?
Mike Harvath 10:30
Yeah, I mean, someone may, for example, they may know that they have a risk of attacks, what liability, let's say they knew about it, that, Oh, I didn't pay sales tax or something in a previous year for a particular transaction that might be warranted, or maybe there's a franchise tax, that was no deal we're working on in a certain state, you know, Massachusetts, as a franchise tax for businesses under 9 million, you know, maybe that seller wasn't compliant with that, or there was some issue that they knew about, that the seller knew about, but didn't disclose the liability. Either because they were trying to skirt the tax, or they were just going to take a risk that they were going to get audited, or whatever. And then it comes to light, that that was intentionally left out of the disclosures. Well, you know, they're going to be responsible, it's always going to be responsible for that post close. Not only that, it creates, obviously a bad taste in the mouth of the buyer, if you're not fully forthright in your disclosures, your disclosures, in short, have to be absolutely accurate. And, you know, you have to most lawyers go to painstaking efforts and advising, they're advising you, if you're a seller to make sure that every statement you're making in those disclosures at the time of close is 100% accurate, if you do that, then you're not going to have these risks. Now, you may have liabilities that come up post close, which is really the topic of this podcast, that would impact the true up. Those are different, right, those are not things that you didn't disclose that you knew about, these are things that come up kind of post clothes that you you didn't know about. And and that's that's much easier to manage in a true up, a true up oftentimes is built, because there's a portion of the working capital reconciliation, that has to get paid after the new buyer collects the money in AR. And that's the primary reason for that true up. However, there are on this, you know, unknown liabilities, not undisclosed, but unknown liabilities that could come up, like you might have somebody send you a bill that wasn't in the books for whatever reason, maybe got missed somewhere. Or maybe, you know, there's this utility bill and, you know, Internet access type, you know, kind of connectivity billing, oftentimes utility bills or, or there's cam charges and your rent Bill, you know, rent that you hadn't fully amortized appropriately. I mean, there's a variety of things that can come up that just get missed, or you just didn't know about and those will also impact that true, you won't collect probably as much as you thought in that situation If you have unknown or liability challenges that come up later, you'll have to cover those just just like it would happen, there would be assets that you would get so for example, what happens is, if you cancel your professional liability insurance, or any insurance for that matter, could be in your office, you're gonna cancel you know, some sort of insurance, you're gonna get a credit effective on the closing date for any prepaid amount of that insurance. Well, that's your money right? You've already paid it. You're you probably haven't accounted for it maybe as a as something that you've prepaid on your balance sheet sometimes those things get missed. And so when it comes up, you go oh, yeah, I forgot that I had my you know, I'm canceling my liability insurance before the premium that I've paid through the end of the year. So I get a I get a credit and when that check comes typically will get deposited in the business but it'll be owed to you after the co op. So hopefully I add some clarity to to the question.
Ryan Barnett 14:38
And it certainly does. I think one of the few things that kind of makes me just wonder about, what is there a typical length for a true up? Is it 30, 90, 60 days or 30, 60, 90 days? Is it years? Is it forever?
Mike Harvath 14:59
No, it's usually 90 days, that's pretty standard in market because it also aligns to and collection period before AR is considered uncollectible. So, you should know that if you have AR, that's on your balance sheet at close, and it's owed to you, because it's part of a working capital reconciliation, that, you know, you actually, most buyers will say, Well, yeah, we're happy to, you know, pay it to you, but you got to collect it, you got to collect it first. Because what those buyers are worried about is when there's change of control, maybe a client will stop paying, or they'll issue the check incorrectly, or, you know, there could be something that would impair the ability of that buyer to collect the money. And as such, you're not going to pay it, right. Or if for whatever reason, maybe there's a change in business business conditions, on one of your clients and they choose to not pay an invoice, and so you're not going to collect that, right. So it's not, it's typical, that you have a 90 day kind of window for a true up, it gives an opportunity to collect the AR kind of close transaction that would be hanging out there that could be owed to you as part of a working capital reconciliation, and it's in everyone's interest to do so.
Ryan Barnett 16:28
And then are there you can dig it just digging in a little bit more, does this apply to any kind of urn out possibility, and maybe this question is, need some help with the question, but see, if you lose a customer after close, and they've decided after the acquisition that that they no longer being no longer want to be a customer, Is that something that that's would that be a rep and warrant issue? Is that a true up issue? Is that just the luck of the draw? Kind of what happens in some of those early customer transition problems? And feel this matter? Mike feel either one can answer this?
Mike Harvath 17:19
Yeah, what I would say is that it depends not to be vague with my answer. But you know, if it's not known, and you've warranted, that it's not known. And it comes up post close, let's say that we were kind of making a change anyway. And because it sold the business, we're gonna, we're gonna change, it is kind of a luck of the draw situation, the risks that buyers take, now, it could impact you as a seller, if you built an earn out, based on that, assuming that that client would stay, right. Just like your earnout should accommodate any new customers to get at it, right, you should get credit for those post closes, that's part of the deal, you're taking risk in those future periods. And you know, there's risk and reward and you gotta risk, and all clients could roll off and you got to, you know, get the reward if you get new clients. So now, everything changes if you didn't disclose, right, if you got notice a week before close, and you didn't disclose that that client was rolling off, and it's discovered afterwards, not only would it impact your earnout if you have it or not, but it would be a rep and warranty violation, and then your buyer would have the ability to reach into an escrow or leveraging insurance policy or maybe apply it or withhold the true up, a lot of that depends on how the document is written the definitive agreement. So it just comes back and re emphasizes that you want to be really clear and earnest about your reps and warrants so that they don't impact your true up or don't impact your earnout or don't impact in escrow that might be being held to cover those reps and warrants.
Ryan Barnett 19:14
Make sense, and thanks for all the clarifications here. It's a really interesting topic. Matt, I wonder what advice do you have to buyers or sellers on just minimizing the risks that are associated with any of these liabilities?
Matt Lockhart 19:29
Yeah, just you know, be very clear, but also very detailed about what you're disclosing that it's it's absolutely not worth, you know, trying to view skate or you know, keep something under a veil right. I think that it it also speaks to the goal to align cultural fit in a way, that if you demonstrate openness right out of the gate, you know, say for example, you know, you're, you're, you've got a challenging customer, right? And, here's how you're managing that customer, but just so you know, it's a challenging customer, well, everybody has challenging customers, right? Everybody has projects that, are at a certain amount of risk, right? And, and the more open that you can be about the state of the state of the business, assuming that you've got your you've got a well run business, that the easier it is going to be to negotiate all of these items, because you are, you're negotiating from a position of credibility, and, and truthfulness. And, and so, you know, from a seller's perspective, that makes a whole bunch sense. From a buyer's perspective, I think that, you know, Mike, we maybe didn't even touch enough on it is that, you know, absolutely important to protect yourself, and to protect from a, you know, could be bad actors or unknown things, but if you want to get a deal done, and you're trying to over protect yourself, right, you're, you know, you're just super risk mitigating, well, you you're at risk of not getting the deal done, of not getting the value that you're that you're looking for, I mean, we've had buyers that have tried to put, you know, 25 30% in reps and warranties, and it's like, well, no, you're never gonna get a deal done there. Right. And so, you know, I think that that's another another sort of piece of advice around, you know, the deal making and, and actually getting something done.
Mike Harvath 22:17
Yeah, as I often say, you know, win, lose deals don't get done, right, it's got to be Win win, you have to kind of walk a mile in the shoes of the other person on the other side, think through how you would handle it, if you were on the other side of the table. If you're approaching negotiations that way, as it relates to any of these topics in m&a, I think it'll help get the deal done. If it's one sided, It it's very unlikely, never say never, but very, very unlikely that the deal will get done. Because there's just too many scrutiny to much scrutiny from advisors with experience like Revenue Rocket, or lawyers on both sides or accountants, they're gonna be crying foul here, and saying, Hey, this isn't gonna work, I wouldn't recommend this because of the following reasons. So, you know, I think if you're down the middle of the plate, on a lot of these topics, you're reasonable, you're sort of keeping in mind what is really win-win, then, you know, you'll find a good place to, to land and, and ultimately, you know, be in a position to, you know, have folks be happy about the transaction years out from it.
Ryan Barnett 23:35
Yeah, to echo both your points that we want to look for those Win Win transactions that are that are the have the true intent of, of why the m&a process happened and the successful acquisition was done. Sometimes you do have these bumps in the roads, just understanding what's what's out there. And to that true up period helps companies successfully navigate what those unknowns may come through for a limited amount of time. And buyers also have the protection of the reps and warranties. As a matter of practice, I don't think we've ever seen a reps and warranties cap and basket ever, like be impacted, Mike, am I right in that we just have not seen violations of rep and warranty clauses?
Mike Harvath 24:27
No, we haven't seen it in our all of our time. 21 years. And in general, I think it's very, very rare. But if you ask any lawyer, they see challenges around reps and warrants that they come up post transaction, I think any m&a lawyer would tell you that in their entire career, they may have seen none to one or two would be in a you know 30 plus year career. So it doesn't really happen all that often, and I think that's just because, you know, the legal profession does a does a pretty good job at advising their account or their clients on, you know, making sure all the disclosure is fully disclosed what they know. Certainly, where we've said before, the true up comes into play is when you, you know, there are things that you don't know, that impact, you know, what would be the value of the business per se, like, collecting AR or, you know, liabilities you didn't know about or, you know, whatever it might be, whether it be an asset or liability. That's why a true up is structured the way it is, so you can fairly deal with those issues as the business is fully being transitioned and all that takes about 90 days.
Ryan Barnett 25:50
Okay, make sense. Matt, Mike, any parting comments?
Matt Lockhart 25:59
Work with a good advisor to smooth the path and healthy and negotiate, and I you know, I'd say that a little bit tongue in cheek, but it is absolutely the case, you know, some of these things can be complicated and you just you have to have somebody on your side. Right. So that's, that's it for me. Great topic, though. I mean, complicated stuff. And, you know, super interesting.
Mike Harvath 26:30
Yeah, I would echo Matt's comment that, you know, certainly this is an area and a perfect example of where, you know, skill advisory in your industry can add a lot of value. These are not very easy to navigate things. And, you know, there's both a business component, and a legal component, and that's why an m&a adviser can kind of handle off the business aspects of that negotiation. And the legal there, your lawyer can help you with making sure it's legally fortified and in a position to, you know, stand the test of time post close.
Ryan Barnett 27:12
Awesome with that Mike, take us out.
Mike Harvath 27:15
Sounds good. Thanks, everybody, for tuning in this week. With that, we'll tie a ribbon on it. Take care and make it a great week.