M&A Horror Stories – Deals That Go Bump in the Night

October 2017

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By Michael Williams, Managing Director, Transaction Advisory Services, BDO USA LLP

Occasionally deal makers have fleeting moments of fright about buying what may seem to be something of a haunted house. Some ghastly surprises may cast a pall on deciding to stay in the deal. With a few days – and late nights - of due diligence, we may find skeletons hanging in closets and monsters lurking under beds. Here are just a few ghost stories and some suggestions on how to remain steady.  

What was that?

There are many different noises that keep us up at night as we work through due diligence in an M&A deal. With careful attention, some matters rising through the noise, rightfully, may be alarming. They can be very real - and can spook a deal.
The horror stories not anticipated in the letter of intent or term sheet: Many key aspects of a deal are discussed by the parties early on in the process before a draft of a letter of intent is circulated between the parties. To avoid the perils of deal killers and last minute changes that may strangle a deal, transaction structuring and other major considerations are best discussed with key advisors early on in the process, preferably before the term sheet is drafted.   
That said, the drafting of the detailed transaction agreement, which often occurs later, typically addresses the finer points of the deal. So we caution you not to wait until the detailed agreement is circulated between the parties to attempt to influence key deal terms – it may be too late to negotiate what is viewed by the other side as a key matter. In addition to the legal team, some of those who should share thoughts on key deal terms earlier rather than later include members of the financial and operations deal team, human resources, and tax.
The ghost of expected synergies from combined operations: Buyers typically are looking for synergies from a contemplated transaction and expect to realize cost reductions by eliminating duplicative activities carried out by the seller. Also, synergies may be realized by leveraging distribution channels or broadening the buyer’s product line. More often than not, however, expected synergies from a transaction do not materialize as planned. In many cases, the failure to capture synergies results from the lack of proper integration planning and/or failure to conduct sufficient operational and commercial due diligence in the process. Any analysis for achieving synergies should be performed well before the deal closes. Trying to explain the ghost of these unrealized synergies to your governing board and stakeholders is a horror story in itself.    
The cross border nightmare in Transylvania: In the course of scoping a company as a potential target for acquisition, the seller may describe its non-U.S. operations. Sometimes the buyer is not aware of the actual extent of non-U.S. operations because most of the operations (or those most important to the buyer) may be in the U.S. Alternatively, there may be a number of non-U.S. branches which individually may not appear to be material. As due diligence proceeds, an understanding of the nature and extent of non-U.S. operations and their relationship with the U.S. target company is critical.
The difficulties in performing due diligence outside the U.S. may become an obstacle to the timely progression of the due diligence process. Information may need translation, language barriers may lead to misinterpretation, time zones could make communication difficult, cultural differences may influence the speed and urgency of conducting due diligence and the buyer may need a team on the ground in one or more countries. Managing this process could be a virtual nightmare for the buyer if all diligence requirements are not addressed early on. Do not let the draconian experience with the seller’s operations in Transylvania end up drawing your blood in the deal process. 
A zombie of a sell-side due diligence report: During the negotiation of the letter of intent or before buy-side due diligence begins, the seller may allude to the existence of a sell-side due diligence report. The seller may be of the viewpoint that the report was prepared by a reputable and independent firm indicating all is well. A reading of the report by the buyer, according to the seller, should eliminate material concerns.
This could be the case if the scope of the sell-side report is sufficiently comprehensive from the buyer’s perspective. If the scope of the sell-side due diligence report is limited, however, the value of a sell-side due diligence report to the buyer is limited as well. In addition, the time period covered by the report may have lapsed and rendered it stale requiring an update. That said, the report may contain findings that may be outside the scope of buyer due diligence which may prove to be helpful in evaluating the target company. For these reasons, the report should be read early on in the due diligence process to ascertain the degree to which it may be a source of relevant information and provide insights as to the amount of work necessary to validate its assertions. Even though the sell-side report exists, caveat emptor. The existence of a sell-side due diligence report may trick you – or treat you.
Phantom compensation arrangements: Principally seen in transactions involving a closely held target company, owners often have informal profit-sharing or bonus arrangements for key employees to share in the profits of the company, and potentially in the gains in the event of its sale. Employees who have contributed substantial sweat equity in growing the company are viewed by sellers as phantom owners. Promises may have accumulated and remain unpaid and/or deferred until a liquidity event. The amount and effect of these arrangements in a change of control can be significant and need to be taken into consideration as part of the transaction and after the closing.
Further, undocumented or undisclosed profit-sharing and bonus arrangements may exist for a wider range of employees which may have a significant impact in the year of the acquisition. How these amounts are measured and the timing for their payment need to be understood as they may be expected by the employees after the contemplated acquisition. Without inquiring about these potentially invisible arrangements, an unexpected impact on cash flow and working capital may arise after the closing of the contemplated transaction. 
These phantom compensation arrangements are just two examples of ghosts that may continue to haunt the buyer. If employees own equity in the target company, careful consideration should be given to whether the employees should transition their equity or be cashed out. This also raises important questions around the overall retention strategy for key employees, the need to set aside funds for a retention compensation pool, and how and when these compensation costs will be paid.  

Let’s get out of here!

A goblin of intercompany transactions: The word “intercompany” is enough to make a person conducting due diligence pause, if not stop and take a deep breath. When the word “intercompany” is added to other words it creates trepidation for due diligence: intercompany accounting, intercompany transactions, intercompany agreements, intercompany pricing, intercompany loans, and the list goes on.
Intercompany transactions create their own unique kind of monster in carving-out a target. The business to be carved-out of the seller is often dependent on some intercompany functions performed by the selling enterprise. This creates all sorts of issues which need to be considered for the post-close acquired company such as a transition services agreement with the selling entity and an immediate and forward looking plan of integration with the acquiring enterprise.
Unravelling and understanding the nature and complexity of pre-close intercompany arrangements is an important and challenging task in itself, even in situations where the target company is not being carved out. In the case of an acquisition of multiple entities, intercompany arrangements need to be understood and may require modification in connection with the contemplated transaction. Another layer of complexity is added when related entities are in countries outside the U.S.  
The horror of doing some asset deals: Imagine a due diligence process that produces ghoulish findings. Someone suggests the transaction should be changed to an asset deal to provide additional insulation from some troublesome exposures. If the target is a corporation (not a flow-through entity for income tax purposes), an asset sale could be subject to double taxation – once at the corporate level and then again as the net proceeds of sale are distributed from the corporation to its owners. Thus, the assets would be sold at great additional cost, unless there were tax attributes available to shield the tax. As a result, an asset sale may not be practical due to horrific tax consequences.

Who do you call?

Ghostbusters! Distilling the volume of information generated in due diligence and quickly focusing in on key issues are critical to the success and outcome of a deal. Key issues need to be prioritized, analyzed and balanced in the context of the overall transaction. Issue resolution requires an organized, measured and timely response. Best practices dictate the use of a diligence management office (DMO) to manage the overall diligence process while ensuring functional teams work effectively in large or complex transactions. Establishing a strong DMO with defined communication channels is key to running an orderly diligence process and avoiding a possible hair-raising experience. You need to be able to drive a stake into the heart of some problems.
Lastly, expect the unexpected. Should the unexpected begin to unfold, draw on the resources and perspectives of experienced members of the deal team and your trusted advisors.