Private M&A Transaction Process

In this first part of a two-part series on the subject, I will discuss the typical private M&A transaction process. (Private M&A refers to a transaction where the shares of the target company are not traded on a securities exchange.) In the second part, I will discuss the timeline for a typical negotiated public M&A deal.

Step 1 — Conception.

Every M&A transaction begins as an idea, perhaps conceived by a seller in need of liquidity, a target seeking strategic or financial benefits or a buyer hungry for market share or looking to supplement its cash flow or asset base. During this initial stage, sellers and targets (which, for simplicity, I will jointly refer to as “sellers” for the rest of this post) may survey the market and identify potential buyers and may consult with financial advisers about available options. Different transaction structures may be contemplated, including dispositions of assets or lines of business that do not comprise the entire target company’s operations. Models may be prepared and the pros and cons of various alternatives will generally be considered in light of their relative impact on the seller’s or buyer’s competitive position, capital structure, risk profile and prospects.

This phase may range in duration from nearly instantaneous to several years. It ends when a seller determines to pursue a sale or when a buyer identifies a target or assets it wants to acquire.

Step 2 — Preparation Before Contact.

The next phase for a buyer is straightforward and, usually, brief. Once a target has been identified but before making first contact, to the extent it hasn’t already done so, the buyer often will interview and engage legal, financial and other advisers. It may also conduct preliminary due diligence on the target company using publicly-available information, which is usually quite limited for private companies. It may also prepare a form of exclusivity agreement that it will ask the seller to sign and form an internal working group of buyer employees and advisers, which may include key personnel from different functional areas, such as human resources, accounting, operations, legal, IT and so forth. Throughout this phase of the process, however, experienced buyers will keep an eye on the budget and endeavor not to invest an excessive amount of time, money and other resources in a potential transaction, which, at this point, has only a remote chance of reaching closing.

For the seller, this phase of the process may be substantially more involved as it begins to prepare for the transaction. As with the buyer, if it hasn’t already done so, the seller may interview and engage legal, financial and other advisers and form an internal working group. In the seller’s case, to avoid the potential disruptions that may result from premature disclosure of an impending sale transaction, including, for example, increased employee attrition or lost sales, this working group is frequently required to maintain strict confidentiality around its activities, which at times may interfere with necessary deal preparations.

Depending on the company, the seller may also need to begin some organizational “spring cleaning,” which often involves organizing and, as needed, updating contracts, permits, Board records, accounting records and intellectual property portfolios among other things. In fact, the seller working group may begin to set up and populate a virtual data room through which due diligence information may be accessed by prospective buyers. For many companies, this is a labor-intensive, time-consuming process, which distracts internal personnel from their day-to-day responsibilities.

There are a number of other actions sellers may take during this phase, including determining how to market the company or subject assets. An auction may or may not be the optimal approach. Together with their advisers, sellers may prepare a confidential information memorandum, create projections, draft a form of confidentiality agreement for prospective buyers, consider implementing employee retention incentives and prepare virtual data room procedures. Many sellers may even commence reverse due diligence, through which the seller working group will look to identify target company characteristics that may adversely affect the marketability of the target, such as areas of significant litigation exposure, inchoate tax liabilities, hazardous environmental conditions or expiring material contracts. Where a seller is looking to transfer ownership of a division or other subset of its assets and liabilities, sellers may also commence an internal reorganization to decouple shared assets and situate relevant assets and liabilities within the same subsidiary.

This phase may range in duration from as few as a few days to as long as several months.

Step 3 — First Contact & Early Discussions.

[N.B. The discussion that follows assumes that the transaction is not proceeding through an auction process. M&A auctions will be discussed in detail in a later post.]

In initial communications, senior representatives of the parties, or their financial advisers, will express their mutual interest in a transaction and discuss the broad parameters of a deal, focusing mainly on a purchase price range, which is always subject to the terms of the transaction, buyer due diligence and other contingencies. If the consideration offered to the seller is to consist of anything other than 100% cash to be delivered at closing, that would normally be discussed at this point, as well, and any buyer financing risk may be raised.

If the parties are within striking distance of each other’s respective positions, they then proceed to sign a confidentiality agreement, otherwise known as a non-disclosure agreement, or NDA, through which, among other things, the buyer and its advisers will be restricted in disclosing to third parties the existence and substance of the discussions between the parties as well as information about the target company and its operations obtained by the buyer from the seller. Buyers often attempt to include an exclusivity provision in the confidentiality agreement (or in a stand-alone letter agreement), which restricts the seller’s ability to pursue alternative transactions with other prospective buyers. These are generally resisted by sellers, who wish to keep as many options open as possible and pursue a sale that maximizes the value to be paid for the subject company or assets.

After the NDA is signed, the parties and their advisers may convene in-person or electronic meetings to discuss further key transaction terms, including purchase price, transaction structure, post-closing governance, timing, antitrust and other regulatory issues and conditions to closing. Sellers may also permit the buyer and its representatives to commence legal, financial and operational due diligence while negotiations are ongoing. If there is a meeting of the minds on key terms and conditions, these may be set forth in a non-binding letter of intent (LOI), sometimes referred to as a term sheet or memorandum of understanding (MOU).

This phase may range in duration from as short as one week to as long as two months. It won’t often extend beyond that because parties will usually know fairly quickly whether a deal is likely to move on to the next phase.

Step 4 — Negotiations & Due Diligence.

Purchase Agreement

If the parties are sufficiently interested in pursuing a transaction to invest more substantial resources, the time will have come to prepare and negotiate the primary transaction agreement. Depending on deal structure and drafters’ preferences, this may be a Stock Purchase Agreement, Asset Purchase Agreement, Merger Agreement, Agreement and Plan of Merger or simply Purchase Agreement. In most cases (other than M&A auctions), it is customary for attorneys for the buyer to prepare the first draft.

In average private transactions, outside counsel will need one to five days to prepare the first draft and send it to its client, which will then provide feedback for the lawyers to incorporate into a revised draft. The draft may proceed through multiple iterations between the party and its lawyers before being sent to the other side. This process is designed to ensure that the transaction document reflects the priorities of the principal, the agreed-upon deal structure and other terms (as may have been set forth in an LOI) and the client’s perception of areas of heightened risk. With few exceptions, it is written in a manner that is more favorable to the party preparing it than to the party on the other side of the deal. This means, among other things, that a draft prepared by the buyer’s counsel will typically be longer than one prepared by the seller’s attorneys. The greater length for a buy-side draft is generally attributable to more numerous and detailed seller representations and warranties and more extensive covenants and conditions to closing.

When the draft is ready, the buyer’s lawyers will send it to the seller and its lawyers. This version of the document may include numerous annotations and bracketed phrases and, even though it was written by the buyer and its lawyers, is subject to supplementation and change by the buyer to reflect specialist input (particularly from tax counsel) and new information that may come to light as due diligence progresses. Once received, the seller and its counsel will review the draft. Depending on client preferences, they may then discuss material issues presented by the document, or the attorneys may prepare an issues list for client consideration.

Practice varies, but the seller may then reengage with the buyer to discuss key deal points that may need to be resolved before investing attorney hours in turning a revised draft back to the buyer. Alternatively, the seller’s lawyers will begin making revisions to the draft to make it more favorable to the seller and reflect the seller’s priorities and concerns. This generally takes two or three days but may require more time, particularly if the revisions are being prepared by an associate attorney before being reviewed by a law firm partner. As with the buyer’s first draft, the seller and its counsel may undertake multiple rounds of internal revisions before sending the document back to the buyer and its lawyers, together with a document comparison highlighting differences between the drafts, a so-called redline or blackline.

The parties and their lawyers will then trade competing drafts and negotiate the terms of the purchase agreement over the ensuing weeks.

Due Diligence

Meanwhile, the buyer and its advisers will have simultaneously been conducting financial, operational and legal due diligence on the target company or assets. This involves reviewing contracts, permits, financial statements, accounting records, correspondence, policies, organizational documents, Board minutes, benefit plans, litigation records, patents, filings and other documents and materials relating to the target company or assets. Buyers may also conduct inspections of facilities and environmental site assessments and hold meetings with key personnel. All of this will be facilitated by the seller and its legal and other advisers, and is typically run through an online portal known as a data site or virtual data room. Information identified during the due diligence process may impact the structure of the transaction and the terms of the purchase agreement.

Disclosure Schedules

Toward the end of this phase in the process, the seller and its lawyers will prepare and deliver to the buyer a seller disclosure schedule, which is an attachment to, and part of, the purchase agreement. Disclosure schedules perform a dual purpose. First, they will list out information required to be disclosed by certain representations and warranties. For example, a section of the disclosure schedule may identify all real estate owned by the target and another section may list all ongoing legal proceedings. Second, disclosure schedules qualify and limit the scope of certain representations and warranties. For example, a seller representation may state:

“Assuming that all consents, approvals, authorizations and other actions described in Section 3.07 have been obtained, the execution, delivery and performance of this Agreement by Seller do not and will not (a) violate, conflict with or result in the breach of any provision of the Organizational Documents of Seller or the Company, (b) conflict with or violate (or cause an event which could have a Material Adverse Effect as a result of) any Law or Governmental Order applicable to Seller, the Company or any of their respective assets, properties or businesses, or (c) except as set forth in Section 3.06(c) of the Disclosure Schedule, conflict with, result in any breach of, constitute a default (or event which with the giving of notice or lapse of time, or both, would become a default) under, require any consent under, or give to others any rights of termination, amendment, acceleration, suspension, revocation or cancellation of, or result in the creation of any Encumbrance on any of the Shares or any of the Assets pursuant to, any Contract to which the Company is a party or by which any of the Shares or any of the Assets is bound or affected.”

Inclusion of such exceptions in disclosure schedules accordingly results in a shifting of risk between the parties and may have profound effects on the economics of the deal. They are thus often subject to extensive negotiations between the parties and their attorneys.

Ancillary Documents

Also later in this phase of the M&A process, the parties will begin to prepare and negotiate ancillary agreements and other documents necessary for signing or closing. These may include:

• escrow agreements,
• transition services agreements,
• commercial agreements,
• employment agreements (and officer and director resignations),
• leases,
• certificates and
• legal opinions.

This phase of the transaction process comes to a close when all of the transaction documents are fully drafted and negotiated, including disclosure schedules and all ancillary documents, and due diligence has been completed. It generally ranges in duration from as short as two weeks to several months, depending on the complexity of the deal, scope of due diligence, responsiveness of the parties and contentiousness of negotiations.

Step 5 — Signing.

In the past, parties would meet in person to sign the final versions of agreements, referred to as definitive agreements. Today, signature pages are usually executed by the parties and circulated among the deal participants by one of the lawyers on the deal via email together with soft copies of the definitive agreements.

In some smaller deals, signing and closing of the transaction—that is, the actual consummation of the sale—occur simultaneously. In most cases, though, there is a period of time after signing and before closing.

Step 6 — The Gap Period.

Why is there a gap period?

There are several common reasons why many M&A transactions cannot close at signing. First, if the transaction value for an M&A deal equals or exceeds $76.3 million (as of the date of this post; the threshold is adjusted annually), a premerger notification filing with the Premerger Notification Office of the Federal Trade Commission (FTC) may be required under the Hart-Scott-Rodino (HSR) Act, and the parties must wait 30 days to consummate the deal. This waiting period is subject to exceptions and is usually terminated early by the antitrust authorities if the transaction does not present any competition concerns. If, on the other hand, the transaction does present competition concerns, the waiting period may be extended, and the parties may receive a “second request,” a request for additional information and materials, which may add several months to a transaction timeline.

Second, consummation of a sale may require third party and, less frequently, governmental approvals. Contractual counterparties, including, for example, lenders and landlords, may have the right to block assignments of contracts (or changes in control of the party that signed the contract). Although it may be technically possible to secure such consents prior to signing definitive agreements, thus allowing for a simultaneous sign-and-close, most sellers are not prepared to engage with important commercial counterparties and solicit consent to a deal that is not yet certain, particularly given sensitivities around premature disclosure of the transaction.

In highly-regulated industries, governmental approvals may also be needed. For instance:

• In the banking industry, the acquisition of more than 5 percent of a bank-holding company by another bank-holding company would require prior approval of the Federal Reserve Board. A merger of two banks may require both federal and state regulator approval.
• Electric utilities must obtain prior approval to combine from the Federal Energy Regulatory Commission under Section 203 of the Federal Power Act.
• The Committee on Foreign Investment in the United States (CFIUS) reviews deals in which a foreign person will obtain control over a U.S. trade or business,  so-called “covered transactions.” CFIUS’s review focuses on the national security implications of the transaction.

There are many other, less common, reasons why transactions may not close simultaneously with signing. Indeed, any milestone that the deal parties wish to establish as a condition to closing may require a gap period. These may include, for example, the buyer’s need to obtain financing, completion of a restructuring of the target or acquired assets, completion of due diligence, obtaining stockholder approvals or remediation of environmental conditions.

What do the parties do during the gap period?

Under the typical set of private M&A transaction agreements, the parties will be required to exercise efforts to cause the conditions to closing to be satisfied, and once those conditions are satisfied the transaction will be consummated. In the meantime, the seller may also be required:

• • to operate the target company in the ordinary course and obtain buyer approval before taking certain actions,
  • to provide the buyer and its representatives with  access to the target company’s facilities and records,

• to facilitate the post-closing integration of the acquired company or assets and
• to notify the buyer of (1) any occurrence or non-occurrence of any event that may cause any representations or warranties of the seller to be inaccurate, (2) any failure by the seller to comply with its covenants and (3) the failure of any closing condition.

The pre-closing gap period may range from as short as a few weeks to as long as several months for transactions facing antitrust or other regulatory challenges.

Step 7 — Closing.

Once all conditions to closing are satisfied, the parties proceed to consummate the transaction, typically within a few days. At closing, which, like signing, usually transpires electronically, the buyer will pay any cash consideration by wire transfer to the seller’s bank account and/or issue shares constituting any stock consideration. Simultaneously, the seller will convey the acquired shares or assets through appropriate instruments of transfer. (This process differs slightly for a merger, which involves the cancellation of the target company’s shares and their conversion into the right to receive payment of the merger consideration.) A portion of the purchase price may also be transferred by the buyer to a third party financial institution serving as an escrow agent. Various closing certificates will also be exchanged, and some ancillary agreements, such as a transition services agreement, lease or employment agreements, may also be signed and become effective.

The buyer now owns the acquired company or assets, and the seller has received all of the purchase price, except for any amounts deposited into escrow.

Step 8 — After Closing.

The relationship between the seller and buyer does not cease at closing. On the contrary, there may be significant ongoing ties between the parties. Initially, the parties will likely cooperate in determining and, if necessary, paying an adjustment to the purchase price to reflect the amount of working capital or other net assets of the acquired company or assets at closing. For a period of time, a seller with ongoing operations may provide transition services, as well, such as IT support or access to facilities or personnel, until the buyer can secure such services independently.

In addition, after closing, sellers are usually required to indemnify the buyer and hold it harmless from any losses it incurs as a result of any false representations or warranties of the seller or any breached covenants. All or a portion of any such indemnification obligations may be paid out of an escrow account. This residual exposure may exist for several years after closing.

In some transactions, a portion of the purchase price may be allocated to an “earnout,” payments that are contingent upon some future achievement of one or more specified milestones. These may be financial targets, like revenue or net income goals, or operational objectives, like receipt of Food and Drug Administration approval for pharmaceutical products. In these deals, the parties may be working together extensively for years in an effort to achieve the agreed-upon milestones.

There are many other potential post-closing covenants that may bind, and be enforceable against, the parties, including with respect to non-competition, non-solicitation of employees, confidentiality, tax cooperation, environmental remediation and more. These may remain effective for several years post-closing.

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