Common M&A Post-Closing Disputes . . . . . . And how to avoid them.

Mergers & Acquisitions Supplement - Mergers & Acquisitions Supplement

January 13, 2016
Jordan Fox
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When it comes to either selling or buying a pest control company, any owner who is involved in doing so will invariably tell you that the transaction is complex. Expanding a company through acquisition or selling a company can involve all kinds of difficult roadblocks and risks. So PCOs should understand the elements of how a purchase or sale agreement is crafted and then consult a qualified CPA and attorney to help guide them through the process.

“Without that expertise, you can trigger litigation landmines and face accounting disputes,” said John Corrigan, attorney with the law firm of Corrigan, Baker & Levine. “If you’re contemplating a deal, make sure you have your CPA and attorney act as your key business advisors.”

Corrigan and Dan Gordon, CPA, owner and president of PCO Bookkeepers, recently discussed common post-closing disputes during a PCT-sponsored M&A Virtual Conference and advised participants how to avoid those situations.

PRECISE KNKOWLEDGE NEEDED. According to the two professionals, your advisors should have precise knowledge about the pest control industry and be well versed in how M&A deals are structured. They should be knowledgeable about factors in the proposed deal that could cause problems for the inexperienced.

In discussing the important details of the deal, they suggested that buyers first create and utilize a questionnaire to learn about the weaknesses and strengths of the selling company. They emphasized that you should get as much pertinent information as you can about its employees, customers, revenues, expenses, etc.

“Then, as you get into due diligence, the key, whether you’re a seller or a buyer, is to zero in on anything that could be quirky or unusual about the other company,” Gordon explained. “In this industry, although there may be 80 percent commonality, different businesses are not all the same. Different owners have different ways of doing business. You can’t be comfortable and assume that everything is boilerplate, especially when drafting a purchase agreement, which memorializes all the specifics of the transaction. If some pertinent information is left out and not properly disclosed because your attorney wasn’t part of the conversation, that could come back to haunt you.”

CLOSING CONTRACT GAPS. If some of that critical information is missed on the first draft, this is what Corrigan calls a contract gap. “If that’s the case,” he said, “make sure your professional will close that gap by carefully reading the draft and not giving it short shrift. Your advisor must be highly focused, like a laser, on the things that are unique and problematical for the seller or the buyer.”

The disclosure schedule, an item that every asset purchase agreement must include, he said, should precisely spell out additional information about the selling business and discuss what’s been determined to be problematic or uncovered during the due diligence process. “It should give the seller an opportunity to describe ‘sensitive’ matters and possibly shift risk on specific things that may be problematic for the buyer,” Corrigan said.

“For the buyer, it should clearly contain needed information and data about the seller,” he added. “But that doesn’t necessarily mean the buyer will ultimately assume responsibility for those ‘problems’ disclosed by seller. If the buyer doesn’t like what’s quirky about the potential acquisition, he or she is going to be skittish and disclaim any assumption of potential liabilities.”

According to Corrigan, careless use of language and information in the disclosure schedule could possibly result in a subpoena from a tax or regulatory agency because of potential liability to third parties. “The buyer doesn’t want to end up with the seller’s liabilities for past acts under what is known as ‘successor liability theory,’” he said. “Creating a seller’s disclosure schedule is a lot of work because it’s an ‘art form’ in itself and is sometimes highly contested after the deal closes and a problem surfaces.”

VALUING A COMPANY. Gordon, in discussing ways to determine the final purchasing price, said that valuing the seller’s company is an important factor. “When you’re buying a service business, you’re valuing revenue streams and making certain assumptions about the revenue stream(s),” he explained. “When you’re talking to your associates about value, you may hear them say that certain pest control companies are selling at a 1 times revenues or a 1.25 times revenues or even a 1.5. That seems to be a common way for everybody to talk about it. But that’s not how they’re really valued.”

According to Gordon, when those “in the know” are valuing revenue streams, they will look closely at a company’s commercial, residential and wood-destroying work and will then create a potential cash flow statement to see what the return on investment (ROI) is.

“Let’s say there’s a million dollar-revenue company that’s throwing off 20 percent net income (bottom line) to the owner, and that company sells for a 1.0 time revenue. It’s actually selling for 5 times net earnings — the price/earnings multiple. If it’s selling for 1.2, that would be equivalent to 6 times net earnings. But taking a look at all the revenue streams is a rather simplistic way of looking at it. In most circumstances, a final price won’t actually be known until after the transaction is closed because of post-closing adjustments tied to the changes (up or down) to the revenue streams purchased.”

That’s where the topic of post-closing issues really becomes important, said Gordon and Corrigan. After closing, there can be adjustments based on things that were misunderstood, or the existence of factors in the valuation that didn’t pan out the way the buyer or the seller thought they would.

INTANGIBLE ASSETS. “Once the tentative purchase price has been agreed upon — let’s say the 6 times net earnings has turned into a 1.2, the seller then thinks he’s receiving sales proceeds of $1.2 million for his company,” Gordon said. “But that’s not necessarily so because most deals are based on the performance of certain intangible assets, such as the customer list and the value of accounts receivable.

“Say there’s $100,000 outstanding and that’s part of what was sold to the buyer, but you’re only able to collect half that total post closing. In order to protect the buyer, usually the holdback of sales proceeds is required; we see that in most deals. The retention holdback is usually 10 percent of the sales price, even if it’s a cash deal, and it will be held until a certain amount of time has passed. There could also be a purchase price clause for things that don’t pan out, such as a smaller than anticipated cash flow,” Gordon said.

According to Gordon and Corrigan, one of the biggest post-closing issues or purchase price adjustments comes from retention of customers or guarantee of revenues. “Really, it’s all in the definition of revenues,” said Gordon. “For instance, when we value a business, we see the company has a certain amount of quarterly customers, a certain amount of monthly customers, a certain amount of weekly customers, a certain amount of annual customers, revenues from customers not under contract, etc. We add those different revenue streams to get the expected total revenues of the business.”

SKIPS AND CANCELS. The pest control business has a recurring revenue model, but the problem with that model is there are skips and cancels that happen with the customer base. However, just because a customer skips doesn’t necessarily mean he’s cancelled a scheduled visit. If you have a $100 per quarter customer, the annual revenue he generates is $400. And if that customer skips, it’s now $300 unless the service was just rescheduled for a later week in the quarter. What do you do with that fact? How does that affect the definition of revenue being sold to the buyer? If a customer skips a quarter and returns in the next quarter, sometimes that could be counted as a cancel when in actuality they’ve returned. If the purchase price was based on $400 of revenue for that customer and it comes in at just $300 then the seller will be facing a 25 percent reduction of the sales price paid for such customer. The buyer gets to benefit from that factor in the valuation if the purchase agreement defines how revenues are calculated post-closing.”

CLEARLY STATED DEFINITIONS. Gordon cited another example of a controversial situation that can affect the deal: “If the seller’s customer has a contract that promises free retreats, but skips a quarter and takes service the following quarter and then wants a free retreat — is that considered an extra service for a fee or is that a free retreat? It’s quite important to create clearly stated definitions. The amount of the selling company’s original purchase price is usually adjusted downward as a result of falling below contractually defined customer annual revenues.”

“So, how do you define skips and cancels?” asks Corrigan. “All of that and other important factors need to be hammered out by the seller and the buyer. That language in the contract must be very, very clearly defined.”

If some pertinent information is left out and not properly disclosed because your attorney wasn’t part of the conversation, that could come back to haunt you.” — Dan Gordon