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Privately held company mergers and acquisitions include a variety of significant legal, commercial, human resource, intellectual property, and financial challenges.

Understanding the dynamics and problems that regularly come up can help you manage the sale of your business successfully. Over the years, India has seen a steady increase in the number of mergers and acquisitions where domestic and foreign companies are consolidating their positions or expanding into new markets. However, M&A activity in India is not without its challenges.

In this article, we offer advice on a few crucial factors to take into account from the standpoints of the seller and its management in mergers and acquisitions (M&A) involving sales of privately held businesses.

Valuations are negotiable

It is important to understand that all terms of M&A are negotiable and most importantly of all is the valuation of the company. Since a private limited company’s shares are not publicly traded, its valuation is the outcome of negotiation depending on a number of factors some of which are listed below:

• Market benchmarks: Are your comparable peers doing 5x or 10x EBIDTA? Evaluation of the benchmarks of your peers in the industry would provide a benchmark for negotiating your numbers.
• Previous financing rounds: If you have already raised a round of financing, early stage or otherwise provides an indicator to your numbers.
• Numbers: Your financial numbers and projections.
• X Factors: The strength of the management team or the value of the technology that is being developed has a bearing on the valuation numbers.
• Legal oversight: The Companies Act 2013 mandates that a valuer registered with be used to determine the value of the company’s shares and in case the shares are being acquired by a foreign company or a Foreign Owned or Controlled Company, a valuation in accordance with the Foreign Exchange Management Act of 1999 certified by a chartered accountant or a merchant banker registered with the Securities and Exchange Board of India would need to be undertaken. 

Due Diligence

The M&A diligence process ensures the best fair-value price for both parties and enables the buyer to get a driver’s seat look into how the target is managed and provides the ability to plan based on advanced knowledge to maximise profitability and minimise challenges in a transaction.

M&A transactions almost always involve a significant amount of diligence by the buyer on all aspects of the seller’s entity and business. The purpose of this exercise is to make sure that the buyer has a thorough understanding of what is being bought, the obligations being assumed, the nature and extent of the seller’s contingent liabilities, impact from financial statements, material contracts, litigation risks, intellectual property related matters and so on.

Off late data breaches, sexual harassment liability and cyber security issues have gained prominence. A diligence exercise generally commences when a Term Sheet is executed.

When a buyer is able to gather important data on a company, there is a lower risk of unexpected legal and financial problems. Strategic and venture capital and private equity buyers usually pursue a methodical and strict diligence process that entails an intensive and thorough investigation of the target company by teams advising on the financial diligence as well as the law firms advising on the legal diligence. In some instances environmental or real estate diligence is carried out separately.

Deficiencies from a diligence process that are uncovered can often be a point of debate. Issues discovered will need to be mitigated before closing the transaction.

Financial statements–devil in the details

If there is one item that a buyer looks under the microscope in a transaction, it is the financial statements and revenues, costs, profit margins, working capital, debt, cash flows, receivables and other KPIs of the target and the expectation that these numbers are prepared in accordance with generally accepted accounting principles (GAAP) as applied in India and consequently the target is expected to make a fair presentation the results of operations, financial numbers, and cash flows for the periods indicated in accordance with Indian GAAP.

The buyer will expect the target to be behind this representation, the buyer will be concerned with all of the selling company’s historical financial statements and related financial metrics, as well as the reasonableness of the company’s projections of its future performance.

Disclosures

There are times when promoters are reluctant to share negative information about their businesses.

However, it is always recommended to share everything and be upfront since everything will come out in the due diligence process and it is better to get in front of the potential issues and control the narrative. The logic of this approach being that as a promoter you do not want a potential buyer to find out about problems in your business for the first time in due diligence which can then be used to re-open the valuation.

However, it is recommended that all disclosures come with a plan to rectify to the extent possible the issues that have been disclosed to the buyer.

Transaction structure and closing

Typically in most transactions, when the buyer makes an offer through a term sheet, a transaction structure for completion and closing is also proposed. This however, can undergo changes once a diligence is completed based on tax considerations, approval requirements and risk allocation based on contours of the deal.

The parties will need to determine whether the signing and closing can occur simultaneously, or if the time between signing and closing will be required to provide for securing financing, obtaining regulatory approvals and/or securing third-party consents. If sign and close does not occur simultaneously, interim stand still covenants and other closing and termination provisions will govern the relationship of the parties during this period and be documented in the transaction documents.

Transaction documents are usually sent by the buyer’s counsel and denotes a stage of hectic negotiation with marked-up contracts going back and forth.

An exercise up to this point in time could usually take six to 12 months or more depending on the complexity involved and this is where valuations are looked at twice.

The first stage is where the buyer makes an offer through the term sheet and the second round is typically after the completion of the legal and financial diligence where the numbers represented by the seller at the time of the term sheet are put under scrutiny by the interested buyer.

As an elucidation, let’s say the offer price in the term sheet is $100 million. This offer price in most cases will be subject to an adjustment where the buyer would encounter risks or disclosures not made at the time of making the offer through the term sheet and the buyer will look at a discount to step into the shoes of the seller.

This discount caused by the issues found in due diligence can impact the valuation from 5% to 20% depending on the issues uncovered. Several transactions don’t see the light of the day due to negotiations on the valuation at the last leg of a transaction.

Negotiation on documentation

While the tips and techniques to negotiating transaction documents would consume the entirety of a book, the intent is to encapsulate the sum and substance of what negotiation entails in an M&A transaction.

The seller will typically be required to make detailed representations to the buyer to provide comfort on various aspects of the business being acquired. Typical representations relate to title of shares/ assets being sold, authority and compliance with law, accuracy of financial statements, taxes, absence of undisclosed liabilities and absence of a myriad of liabilities.

The seller will typically seek to qualify its representations with knowledge and materiality qualifiers to limit its exposure to risks of which there was no awareness or those that are beyond the control of the seller. Because every business has its normal share of liabilities, the seller will be permitted to schedule exceptions and qualifications to its representations, and depending on the counsels on either side and the general contours of the transaction, generally the seller would see inoculation from certain liabilities.

All M&A contracts permit for indemnity claims which permit the parties [in most cases the buyer] to ring-fence their post-closing liabilities and pursue the seller for matters such as fraud and intentional misrepresentation. The nature and form of indemnities are also subject to negotiations and they are customised to varying degrees and may include survival periods, broad-based caps and buckets, deductibles etc.

An M&A process can be very daunting and one that most promoters are not prepared for.  It is therefore critical to map the due diligence process and to focus on the exit planning and having a real transition plan leading up to the M&A process.

In all M&A transactions, the buyer is highly motivated to enter the target at a value based on the diligence process and the ability to address the potential risks identified while the seller is mostly concerned with its post-closing liabilities and indemnity claims. A well-crafted transaction takes the concerns of both parties into account while closing the deal.