Dan
Welcome to Sound Business Insights. I’m Dan Watkins. This episode’s about the keys to a successful stock purchase agreement. This podcast is not intended to provide legal advice.
Neil
Dan, when it comes to business, a stock purchase transaction is one of the most legally and financially complex transactions that a business or an investor can go through, don’t you think?
Dan
Yeah.
Neil
So there was a recent article in Harvard Business Review where they took a summary of studies. They took 18 huge, massive studies, and they summarized them down and the net conclusion is 70 to 85% of business acquisitions fail. And they said it’s either because they did a poor job of valuing the business, they did terrible due diligence or the inability to merge the cultures after the deal. Is it really that hard to have a successful stock purchase transaction?
Dan
Well, it’s hard, but we’ve been successful. I mean, those numbers don’t really make any sense to what we’re doing because we’ve had a lot of success over the last 20, 30 years, and probably because we do more small entities and also because of type of transactions we do, we are in a market where we get a lot of return business and we work with clients who have a formula when they do things. And also we have really experienced attorneys working here.
Neil
We’ve been doing this for 40 years. That’s true. And
Dan
More, well, 35 for me and 45 for Chris Popov. And I guess everybody’s pretty old around here.
Neil
How many are we talking about? Hundreds, thousands. How many of these transactions have we really done
Dan
Over the last 30 years? I would say thousands. Definitely thousands.
Neil
There’s two ways to basically buy business assets. One is an asset purchase and one’s a stock purchase. Can you just tell me the advantages of a stock purchase? Most people want to do an asset purchase that’s in the buyer’s best interest usually. What’s the advantage of a stock purchase? When does it need to go into a stock purchase? When
Dan
You buy through an asset purchase, you’re buying and you’re taking the assets and you’re going to change it all around, change the structure, come up with your own brand new business entity, brand new agreements, brand new everything. And that happens a lot, and there’s some tax advantages to that. However, sometimes sellers are motivated to deal with stock sale and also sometimes they’ve got a system set up with employees. You’ve got the credit worthiness of a long-term business. You’ve got banking relationships. You’ve got accounting firms already in place. You’ve got everything set up, and you’re just coming in to stand in the shoes of the seller. And in those cases, you’ll have the seller stand in for three years maybe to help with the transition. And so it can be a lot smoother, and you end up with an entity with a long history, and also you end up with an entity you can resell.
Neil
Yes.
Dan
When our clients come in and they want to do an asset sale, they want to maintain the value of that company. There’s three things you have to do when you buy or sell a company. You have to have a good transactions lawyer that understands business. Absolutely. You have to have a good accountant that knows more than just filing taxes. How to do help you with due diligence to make sure that your books are ready to go. So you can sell for top dollar and also a banking relationship. Now, if you’re going to do a stock sale or stock purchase, that company may have everything ready to go in place. You break it all apart. You got to start all over. You’re coming in, just change the name on the shareholder and do a really good due diligence on your own. You end up with a company that’s supposedly able to repeat everything it was doing that gave it that value in the first place.
Neil
Protect the brand, protect the momentum, protect the money maker, so to speak,
Dan
And it’ll motivate the seller because they get a better situation tax wise.
Neil
Yes. Are there any disadvantages to a stock purchase?
Dan
There’s risks, right?
Neil
Right.
Dan
I mean, you’re the new husband. You’re taking overall dads all obligations, anything out there in the weeds. But what we do is in that situation, we can do things called a carve out or clauses in the agreement that slow the progression of payments until mile markers are made and hit and contingencies are achieved. So yeah, there’s ways to draft anything to give everybody’s concerns, attention and spread the risk and make it worthwhile.
Neil
Spread the risk is a great way to put it, but also just to balance out the equation so that yeah, if this works, you’re going to get your money, you’re going to move on and go on to your next project, whatever. If there’s a bump the road, we’re not going to swallow the whole thing and you’re going to take this risk with us,
Dan
Right? You are afraid to buy something and the seller knows he’s selling something quality. Yes. So he says, you know what?
Neil
I’ll walk with you.
Dan
I will walk through this deal with you and pass the close of escrow to the point where milestones will be hit and I’ll get paid. And that’ll bump the price up for the seller because you’ve got a seller backing it up, and it’ll also give the buyer some comfort. Buyer’s financing will appreciate that. So all those factors, and the accountant has to approve it because as a good CPA is not what you make, it’s what you keep, right?
Neil
That’s absolutely
Dan
It. So that’s
Neil
The whole point of business.
Dan
That’s what you keep, what you keep, including Uncle Sam. So you get all those three factors, you get the right banker, the right lawyer, the right accountant, then you can get a deal that makes sense and is beneficial to everybody.
Neil
Another issue in some of these transaction, Dan or minority shareholders, I don’t know of another thing to call them, but there’s people that can gum up the works. How does that come into play in a stock purchase transaction,
Dan
In a stock purchase transaction? Those are all factors, but there’s more than just minority shareholders. There’s different classes of stock, and then you’d have to have due diligence. Now, if you have a good CPA who can look at things before you even sell, if you’re thinking about selling your company, have your lawyer and your CPA set up months in advance so that you can make sure that somebody asks, well, if I’m buying the company, I’d ask this. Or the CPA can say, well, I’d be concerned with that, or they’re going to want this report and that report,
Neil
Or we need to restructure this and that, so it’s a little cleaner and a little crisper.
Dan
Let’s prepare it. So when you do get an offer and they say, send over this and that, you say, no problem. In that afternoon, they got the paperwork, you’ve got the deposit in your escrow account. They’ve got the paperwork deal’s already moving fast towards closing, and they’re not worried about whether you’re just going to go make something stuff up.
Speaker 2 (07:52):
And a lot of times people forget about the entity itself, right, Dan? I mean, there’s corporate governance that needs to be, if you want to get the most for your business, you need to do some work ahead of time to make sure that the apple’s polished.
Dan
Like the article said, not all due diligence is the same. Right? And a lot of deals fall apart during due diligence because the seller wasn’t prepared. And the questions and due diligence are very similar. So you can find out ahead of time and be that Maybe that’s why we close so many deals when we talk to them before we let them get down the road, we say, okay, go meet with this consultant. Let’s go talk to this accountant.
Even financing too, if you have a CPA that can set things up where outside financing would accept that kind of a protocol and value it perfectly or better, great.
Neil
We’re at that glowing first moment where we got somebody who wants to sell their company and we got somebody that might want to buy it. What’s the first move? Well,
Dan
Usually everything’s different. By the way, everybody’s different. Every transaction. Different people who own companies that sell companies have colorful personalities and they’ve gotten successful by doing things in a certain way, and you have to be able to work with them on their terms. So you meet with them, you find out what they want. You run some ideas by them, you run it by their accountant, and then you come up with a letter of intent. Or if you’re the buyer’s counsel, or even if you’re the seller’s counsel, you start discussions off and then somebody turns it into a letter of intent
Neil
And the letter of intent, it seems like such a soft thing because it’s not binding and we’re just starting, but actually the letter of intent’s a crucial piece of this process. Is it not Dan?
Dan
Well, it can be one of two things. A letter of intent can be an offer, and a letter of intent can be, this is our understanding. In fact, we sometimes call that a memorandum of understanding. So you’ve got your LOI and MOU. So if you have these kinds of discussions, they’re just outlines for how to close a deal, and that’s all a good lawyer needs is a one or two page outline. And we can take it and put all the what ifs in there and ask you a whole bunch more questions and have the accountants ask you questions, and whoever’s financing, if that’s the case, ask for what they want and bring it all together into an agreement that ends up closing.
Neil
So that letter of intent, that’s usually an exclusivity period, right? Okay. You’re not going to talk to anybody else for some amount of time. How does exclusivity really work and why is it so important?
Dan
Well, that’s a negotiated thing, okay, now you’re getting down into the strategy on who am I representing? Am I on the buyers or the sellers?
Neil
The buyer’s the one that wants,
Dan
Right? In a hot market, you got to really pay for exclusivity in a dead market, maybe not. And so your business lawyer should know this and be aware of what you’re giving up and also know how you’re marketing it. Is this a friend of a friend transaction or do you have a broker? So all those factors have to come into play when we’re advising you.
Neil
What about the responsibility of each party to act in good faith? What does the law have to say about that?
Dan
The covenant of good faith and fair dealing is implied in all contracts. And then there are disclaimers. If you’re watching all the trials and the disclaimers President Trump put into the bottom of his term sheet, well, those are disclaimers in certain circumstances. They have some weight. So you have to take those seriously. And those are also put in place because they want to be aware of the fact that there is a covenant of good faith and fair dealing. So it’s a complex area and it should be addressed. It’s addressed in the agreements, what you can and can’t rely on, and often in much more detail than one statement
Neil
Valuation. A seller wants to get as much as they can. A buyer’s job is to make sure they’re getting a fair price for what they’re acquiring, that they’re paying a fair price. What are some of the keys to evaluation, Dan, in your mind?
Dan
The valuation is the responsibility of the buyer and the seller. With that said, if you ask your lawyer or your accountant or your finance person, they’ll give you opinions, but it’s still your responsibility and it’s your job to do your own due diligence and to look into it. You can do a better job of your due diligence if you ask your CPA yes, and they can give you terms and help you with your search, what your EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) is, how your accounting’s set up. Also, not just how much it can get. What are your personal goals? When we have companies that we sell or buy, we take into account what our client’s goals are. Just like a certified financial planner, would you want to be in the stock market and you’re 33, you’re going to be put in different investments than if you’re 70, right? You don’t want to put your whole nest egg in there for the high risk stuff at different times in your life, or if you have a whole bunch of cashflow or very little. All those things are important to describing and advising a client on valuation. And also you can get a valuation expert to tell you what it is worth in the market. I see this a lot by the way, on valuation, people will sell their company and they won’t want to spend that $5,000 on the valuation expert because well, they know what’s best.
Neil
It’s all part of the dance.
Dan
And to be honest, sometimes valuation experts are wrong. Yes. I mean,
Neil
And there’s several ways to look at, there’s numbers, there’s goodwill, there’s brand, there’s so many things to value.
Neil
For example, we’re talking about stock sales. You can predict how much at and t is worth, but as you go into the other markets, into the pink sheets and the farther down the totem pole you go, then the riskier and harder. It’s to tell what the real valuation is of a company, and then you’re selling a private company. It’s really hard to tell what the real valuation is. So that’s why I say it is ultimately the buyer or the seller’s decision, but you should definitely get as much input as you can in coming to that decision. And
Neil
There’s a lot we do to help our other clients with that process, right? Yes. Regardless of who we’re representing,
Dan
We might not say, Hey, it’s not worth that, but we will say, we’ll, look at the books and Did you do an EBITDA multiplier this, or are you worried about the cashflow? Let’s get into this deeper.
Neil
Yes. Here’s the warts.
Dan
One example you wanted me to tell you about was this whole buying a company with their own money.
Neil
Yeah,
Dan
Right?
Neil
A scam in effect.
Dan
Well, it feels like a scam. It’s totally
Neil
Ripping off while you’re ripping off something.
Dan
It’s totally legal. Yes. But you buy a company and the guy wants a million dollars and it’s a manufacturing company, and so they say, you want a million dollars. So you look at it and you go, okay, I’ll pay you a million dollars over five years. Right? Companies generating $300,000 a year. Okay?
Neil
It’s an interest free loan,
Dan
Right? And it has an accounts receivable at 700,000. So if you get a good accountant or a good lawyer and you put the numbers together, you can figure out that this company’s actually costing you 7% on your money and you’re making 25% and with the low risk on conservative estimates. So you can do those kinds of numbers with your CPA, your broker, and to some extent your lawyer will encourage you to do that.
Neil
So you mentioned the thousands of transactions we’ve done over so many years, Dan,
Dan
Tens of thousands
Neil
Out of that has come a proprietary, our own internal refined, battle tested proven checklist. That’s what due diligence is really all about, isn’t it? Knowing what to look at, knowing how to look at it, having a thorough process for doing it.
Dan
No agreements the same, and the agreements that you have in your legal books that you pay for online are there. They can be close. But having a law firm with all of those agreements, we pay for pretty much every periodical and every program. We can pay for it, but it doesn’t take the place for having, in addition to that, a database of our own of sample agreements that are even closer to the deal. You want to do
Neil
Deals we’ve done before.
Dan
So everybody wants different things, different stages in their life, different things going on, and different agreements, and they want different clauses. And so if it’s not exactly in the books, but it’s close and it’s worked before we have them, and so we are able to probably close more deals because of it.
Neil
Absolutely.
Dan
And no, you can’t have any of our forms.
Neil
So Dan, there’s a reason why the national average of 70 to 85% fail, and we’re looking at that number going, not in our world. Due diligence has got to be part of that answer, right?
Dan
Oh, yes. Well, part of the reason they’re not working is because the larger the transaction, the more professional due diligence happens. Yes. I’ve been in transactions where you’re in the warehouse and the bean counters come in and they have this gizmo on their hip that’s tied to their belt, and they flips up and they scan and they count and they scan and they count and they go through massive warehouses with inventory, and they go through it all, and then they put it into their software programs and identify it and age it and all these things that go into it. And so sometimes when a seller is selling and then a buyer spends the time and money for the millions of dollars they’re going to spend, the due diligence won’t match the paperwork that they’re selling, and then there’s a renegotiation or there’s a cancellation of the deal.
Dan
And so we don’t do that as a law firm. Some of these giant law firms do that. They’ll go through it all and they’ll hire their own vendors and subcontractors and go out there and do all these things. We don’t want to do that, but we will help you and guide you with preparation of schedules and all the items that you have done in your due diligence to comply with the due diligence request. We’ll put those together in organized fashions. We’ll work with our sellers and say, okay, the buyer wants this. The buyer wants that. We’ll help them put it together and create the schedules for our due diligence. But most of the time, 99% of the time, it’s the seller or the seller’s CPA or the seller’s consultants that get these documents to us, and then we make sure that they’re organized and they’re presentable, and we send them over after they’re approved by the seller, and then we close the deal.
Neil
So in these situations, you’ve always said, Dan, if you’re off by a penny, you’re off by a pound. If you’re off by a little, something’s up. When you’re in these deals and you’ve invested time and money and something’s off, how do we handle that? What’s our role in that with our clients?
Dan
Well, we let them know, look, you want to be anchored on this. Don’t think they’re not going to check and every deal’s different, but if you prepare these things with a good CPA or a good accountant or the client’s accountant, and you make sure someone’s gone through the books on their side, because what we do and when we run our own companies, we get used to the way we do business and it works and we’re profitable, and so we don’t want to change it. The rest of the world wants gap, generally applied accounting principles. And so you have to be close to that to try to get a deal done. And then once we know if your schedules are perfect, or a lot of times they’re not, we can put that into the deal itself and say, look, these schedules are the best we could do, or this B or seven or whatever you want to call it, this is based on the most we know, and you should do your own investigation on this part, and you can still get a deal closed that way. But it’s just getting it all organized, working with the client, everybody’s different and putting together a transaction that a buyer will take.
Neil
We’re hinting at the idea that sellers will stick around for a period of time to help make sure that the goodwill passes and that it’s a smooth transition Sometimes.
Neil
Does that kind of discussion happen at the end or is that ongoing all the way through? What is it like at the end when you’re trying to button these things up?
Dan
There’s no such thing as an identical deal. I wish there was, but No, there’s different personalities want different things. And so those type of situations arise when somebody is unsure or somebody wants something or somebody asks for it, or the parties are having a hard time closing the deal. So that’s when you go to your lawyer and say, well, what can we do to bridge the gap or make them accept us? Or what can we do to get them to sell? The schedules are not what we wanted, so we want to lower the price or we want assurances. And so there’s a lot of ways we can make proposals or suggest ideas to close the gap,
Speaker 2 (22:11):
And that’s the real value we bring to the table, right?
Dan
Yeah. That’s what all those decades of experience gives you is you remember back when there was a deal that wasn’t going to close, but we suggested this.
Neil
So there are times where the answer is, yeah, you don’t want to do this
Dan
Lots of times.
Neil
And then there are answers of we can make this work. Here’s how we’re going to do it. Correct. Anything else from your experience in these transactions, Dan, where you say, if you’re going to go through this process, keep your eye on?
Dan
We’re probably more afraid than clients are because we’ve done the litigation side too. Yeah. So there’s some times where we’ll say This is risky, and they’ll still close, and then nothing will happen, and they’ll be all happy and they’ll tell you, told you so it was a great deal. And you’re like, oh, I know. I know. Okay, good for you. Good for you. And sometimes there’ll be risk, but the buyer will have their own ideas and they just wanted the market share anyways, and they’re like, I’m winning. No matter what happens, I’m a winner here. And they’ll be right. They’ll end up using that market share and just tripling the money they paid for the deal. And so yeah, we’re not business advisors, we’re not brokers or gurus who can tell the future. We’re just the lawyers that help draft agreements. And then sometimes we come up with ideas that we can, or the client will come up with ideas that we can put into motion in the form of agreements,
Neil
And that’s putting the deal together in a way that’s enforceable and that gets them from A to B2C.
Dan
I always say, that’s part of the team. The teamwork gets Deal done.
You can learn more about the Watkins firm at https://watkinsfirm.com or call our office at (858) 535-1511.