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Tips for Avoiding Pitfalls of Two-Step Acquisitions

Two-step acquisitions (or two-step mergers) are common in the business world, particularly when there are significant uncertainties as to cost/valuation, the “fit” between acquiring company and target, potential market directions, and other issues. A two-step acquisition can be a solution, but can also generate new problems.

An example might be something like this: Target business is an equipment installer for governmental facilities. Government contracts almost uniformly require bonding — that is, a written instrument (like an insurance policy) purchased by the contractor to assure fulfillment of the contract. If the contractor does not meet its obligations to the government, the bond assures payment of any loss sustained if, for example, the government has to hire a replacement contractor. The level of bonding that can be obtained is directly related to the financial strength of the contractor.

Problem identified: Thus, a contractor that is struggling financially will be limited in its ability to obtain certain levels of bonding and, as such, will not be able to bid on larger government contracts.

Potential solution: If the target company, “seller”, is struggling financially in this manner, the seller might investigate finding another company as a buyer which has a greater ability to obtain bonding.

Potential problems: But, as can be seen, there is great risk here for a potential buyer. Even if the buyer can help with the bonding requirement, what if the target company still cannot successfully win bids for government contracts? What is the target business worth? What profit margins can be obtained?

Potential solution: As noted, a two-step acquisition is a potential solution. A two-step acquisition is where a transition period exists during which there is joint management of the target company. This gives all the parties involved an opportunity to assess the risks and benefits of fully consummating the acquisition.

Let us continue our example and assume that the target government contractor finds a buyer and that the two companies agree to a two-step acquisition. In our example, the buyer pays $1 million up front for 60% of the business and the transition period is for three fiscal years. During the transition, the target business is to be co-managed as a limited liability company with the previous owners/senior management remaining to continue operations but with the buyer appointing the specific LLC Manager/CEO to be “in charge.” At the end of the transition period, it is agreed that the price for the remaining 40% of the company will be contingent on the sales, revenues, net profits, and other quantifiable performance metrics during the transition period. The price will have a floor of $1 million and a ceiling of $5 million.

Potential problems: There are a host of potential problems in the example described above including the most obvious: the buyer — who is appointing the Manager/CEO — might make business decisions that will cause the value of the target business to be less than it could be in order to pay the least amount for the remaining 40% of the company at the end of the transition period. There is also the obvious potential conflict between a new Manager/CEO, who might have a new “vision” for the company, and the old-line senior management, potentially, wedded to old sales models and methods.

Solutions: Good Contract Drafting, Common Sense, and Collegiality

In terms of avoiding the downsides, good contract drafting is essential. A San Diego corporate attorney with extensive M&A experience is needed. As much as possible, the acquisition and purchase documents should cover as many eventualities as possible. For example, an operating/management agreement will be essential and, in that operating agreement, protections for both buyer and seller should be set out. Some business decisions might require seller approval (a vote by 75% of the ownership). These might include decisions like:

  • Any single capital expenditure or disposition above $10,000 or
  • Agreeing to any single contract above $3,000,000 or
  • Entering any bid competition requiring a bond above $2,000,000.00 or
  • Entering a bid competition projected to have a gross profit level below 10%

Other issues should also be considered up front and resolved such as what happens if performance is lackluster during the transition period but it is clear that performance will exceed expectations in years four and five?

Common sense, collegiality, and good faith will also be necessary particularly if the seller’s senior management is expected to stay on after the transition. The buyer wants a viable company so will not likely make bad business decisions intentionally. In a similar vein, the buyer should make every effort to keep the seller’s owners and staff reasonably enthusiastic. Otherwise, the purpose of the acquisition will be frustrated and, likely, everything will end in costly litigation.

Contact San Diego Corporate Law

For further information, contact Michael Leonard, Esq. of San Diego Corporate Law. Mr. Leonard has the experience and dedication to provide all the legal services needed for the sale/purchase of a business and for mergers and acquisitions. Contact Mr. Leonard via email or by calling (858) 483-9200. Note: the example described above is based on the case of Glidepath Ltd. v. Beumer Corp., Case No. 12220-VCL (Del. Ch. Feb. 21, 2019). Like us on Facebook.

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