|Oregon State Bar Bulletin OCTOBER 2009|
Marry in Haste, Repent at Leisure:
Acquiring Distressed Businesses
By Ronald A. Shellan
Shotgun marriages have been all the rage in business lately as the companies with money swoop in and acquire those on the verge of financial collapse. Witness Bank of America’s acquisitions of Countrywide and Merrill Lynch and J.P. Morgan’s acquisition of Bear Stearns. Buying a distressed business at a bargain-basement price can produce huge financial gains for the acquiring company. It can also result in severe financial indigestion, as the value of the purchased company can continue to fall after the acquisition. Further, the hoped-for synergies of combining two businesses may not materialize. When acquiring a financially distressed business, a buyer must consider a number of special issues and be prepared to conduct more than the normal levels of due diligence.
Blinded by Love
According to an article at Knowledge@Wharton (http://knowledge.wharton.upenn.edu), 50 percent or more of all mergers fail. Why? The lure of the deal is often too strong and buyers do not take the time or spend the money to realistically study the acquisition and determine its true economic costs and benefits. Acquiring corporations also frequently do not take the time to properly close the transaction and work through the many operating issues involved in taking over an operating business. There is a saying in business that the best deal a company ever did is the one it never did. This saying reflects the fact that a business in an acquisitive mode needs to be able to pass on acquisition opportunities that are not the right fit. Buying the wrong company can become a financial and operational nightmare.
There are many pressures to quickly close the acquisition. For a distressed business, the pressure is often to complete the acquisition before the target company’s goodwill and operating efficiencies are destroyed by its lack of cash flow. Often, an imminent default or threat of foreclosure on a bank loan creates the crisis to close. Sellers often feel that what little value can be obtained for their business will be reduced further if they cannot close quickly. On the other hand, buyers can often fall in love with a deal and the due diligence becomes an obstacle to be overcome instead of a true exploration of whether the target business should be acquired. Further, business brokers or investment bankers, whose task and incentive is often to close the transaction, can add to the pressure. Finally, many business owners do not actually realize the time and energy it takes to properly evaluate an acquisition and close it and are impatient with the process. The pressures to close quickly must be resisted — no one should marry in haste and repent at his leisure.
Preparing a Solid Foundation
What special steps should be taken when buying a distressed business? First, business managers need to take the time to fully analyze the business, taking special care to review issues relating to acquiring a distressed business. Second, once a decision to purchase has been made, set the closing date realistically, allowing for due diligence and a smooth closing and business transition. But what about the plunging goodwill? It is, of course, a concern. But often creditors will hold off taking precipitous action when a buyer is taking the steps to purchase the business. In addition, many business stakeholders are more understanding today of a business in financial distress and may not be too quick to stop providing goods and services to a business when they know that their relationship with that business will be forever destroyed.
Entering Into an Engagement
When buying a business, the first step after the initial review is to enter into a purchase and sale agreement or a letter of intent that is generally nonbinding, but includes key provisions such as no-shop and confidentiality provisions. The advantage for the buyer is that these documents prevent the seller from continuing to shop the business. Many legal and tax issues must be considered in drafting such agreements and are not discussed in this article. Typically earnest money is put down, some portion of which might not be refundable. The remainder is refundable under certain conditions until the due-diligence review is completed. This “pay to play” approach winnows out those buyers who may not be serious enough to make a financial commitment.
Develop an Intimate
Understanding of the Business
Fully analyzing a target business means obtaining and thoroughly reviewing due diligence on subjects including organization and good standing, financial information, assets, real estate including environmental matters, intellectual property, employees and benefits, taxes, material contracts, product and service lines, litigation and insurance. There also may be an opportunity to renegotiate loans with secured lenders.
Given the complexity of acquiring a distressed company, buyers should approach the analysis phase with a step-by-step approach. First, note that accounting reports and analysis are historical in nature. Carefully review trending to make sure that projections have fully considered the downward path in sales and possibly the upward path in accounts receivable. When a company is having cash flow difficulties, inventories tend to be reduced. Thus, future sales will be impacted because a business cannot sell what it does not have. Deferred maintenance on plant and equipment also tends to increase when cash is short. Analyze the trend for this type of spending. For example, deferred maintenance of $100,000 on a building can quickly turn into a $1 million problem as dry rot spreads and roofs rot.
Second, watch for human resource issues. For almost any business, the employees are critical to its future success. In this down economy, most employees are not about to switch jobs as readily as they have done in the past. But key sales, marketing and management personnel are still in demand and often still have options to work for other companies, some of which may be direct competitors. This means that personal interviews with key employees must be conducted to gauge their loyalty. The right to complete such interviews is a topic generally covered in the purchase agreement or letter of intent. There can be severe resistance to such interviews by many sellers. The more resistance by the seller, however, the more important it is that such interviews be completed. Retention agreements may need to be negotiated with key personnel.
Third, vendor or customer relations must be checked. Have vendors cut off the seller yet? Have contracts with vendors or customers been breached that could result in damages to the buyer or prevent the buyer from obtaining key goods or services needed by the buyer after closing? Are key customers ready to find a different vendor other than the seller? Again, actual interviews with key vendors and customers are vital to making an informed acquisition decision.
Projections for the Future
In any business acquisition, detailed and careful projections are a key not only to determining whether to buy the business and how to price it, but also to operating it once it is acquired. It is essential that a highly skilled and independent analyst team prepare the projections. The analyst team should not accept without review any information presented by the seller, its business broker, or its investment banker (or even other managers of the buyer). Each item of income or expense must be scrutinized and challenged. It is better to take the time to do it right. Finally, those involved in making the decision to buy the business should never directly or indirectly influence the projections of the analyst team.
For many smaller acquisitions, buyers may be reluctant to hire outside professionals to assist in the process. Cost is a factor, but so is a perception that the acquisition process will be slowed down. This is a huge mistake. Generally, the buyer’s existing staff does not have the time or the expertise to conduct all the due diligence. Who on the staff has the time or expertise to review hundreds of contracts to determine what issues might exist if the target company is acquired? There is generally far too much to do in a fairly short time to properly analyze the acquisition, and outside help from accountants, lawyers and even temporary employees is often needed.
Taking the Plunge
The decision to acquire or not acquire the business must eventually be made. If the decision is to acquire the business, the earnest-money deposit generally becomes nonrefundable and is often increased. The next step is to close the transaction. The timing to close is almost always made at the time the purchase and sale agreement is entered into. It is best to have as much time as possible after the decision to buy is completed to actually close.
What needs to be done prior to closing? Of course, the lawyers need to pull together the closing documents. But many other action steps must be taken, and these steps can be difficult to execute when the target company is having financial difficulties and its staff has been cut to the bone. Human resources must determine whether the target company’s benefit plans need to be modified, eliminated, or left as is. On a department-by-department basis, an analysis needs to be made as to exactly which employees will be eliminated, and when, to achieve projected cost savings. Accounting departments often need to be merged and inconsistent accounting systems harmonized. Duplicate offices, plants or warehouses often need to be eliminated. This detailed planning takes time and must often be performed by staff members who already have other pressing duties to perform.
If transition planning is not done right, disasters can occur. We all know of banks that have merged that are unable to get their statements out, or if they do, that make errors on them. The loss of goodwill to such a bank’s customers is incalculable. This is true for any business. Someone needs to answer the phones on the day after the acquisition. Taking the time to get the systems and procedures of both companies merged is going to help ensure the success of the combined companies.
Successful Unions Rely on
A lot of money is going to be made in the next few years when financially distressed companies are purchased at rock-bottom prices. But some mergers will end in disaster when buyers do not take the time to carefully review the seller’s due diligence with particular emphasis on distressed-seller issues or do not take the time to carefully plan the acquisition.
ABOUT THE AUTHOR
Ronald A. Shellan is a partner of Miller Nash in Portland. A certified public accountant, he has served twice on the board of directors of the Oregon Society of Certified Public Accountants and is the former chair of the OSB Taxation Section. He has been selected as an Oregon Super Lawyer by Law & Politics.
© 2009 Ronald A. Shellan