Print | Share | Discuss | Reprint

Bulletproof your exit

by contributors Noah Hagey and Matthew Borden, BraunHagey | Published November 1, 2011 at 3:00 PM

No one acquiring a company would skip due diligence in favor of "hoping for the best" -- but that is precisely what most private equity firms do when preparing to sell a portfolio company. Serious due diligence helps buyers assess the value of their potential investment; it is just as important for sellers.

Funds routinely suffer delayed or ruined company exits and needless post-sale exposure by failing to examine and correct legal and compliance risks in their own portfolio companies prior to marketing them.

Studies have borne this out. Shareholder Representative Services LLC showed that out of 88 randomly selected private acquisitions, 66% had post-closing price adjustments and 95% had carve-outs extending long into the future to protect against unknown contingencies, often leading to arbitration between the parties.

Hundreds of deals fall apart each year, and countless others wind up in years of expensive litigation as a result of legal issues that could have easily been corrected before the sale, and especially, before buyer due diligence identified a problem, affecting enterprise value.

PE firms preparing companies for sale should perform a "pre-exit legal audit" -- a privileged and confidential review by independent counsel to identify (and help correct) problems with a company's legal compliance system or litigation and regulatory management before third parties examine the business. Several recent cases highlight how a legal audit could have helped resolve issues before a sale.

The pre-exit dilemma. During a sale, PE managers and their bankers are focused on perfecting the target's financial and operational presentation. Legal compliance is an afterthought and rarely perceived as adding "value" to a proposed transaction. This is particularly true in the period leading up to an offering. This is a sometimes a defensive mechanism -- PE sellers and company management are concerned that a critical legal review will expose weaknesses that could delay the sale or create unwanted disclosure obligations. These concerns are valid, but they come at a great and underappreciated cost. In case after case, we have seen that the failure to critically evaluate a company's legal situation before an exit leads to exit delays, price renegotiations and post-sale disputes.

The cost of lax legal compliance. A portfolio company's lack of regulatory compliance, absence of solid internal legal compliance policies and exposure to unknown litigation are leading factors why many deals fall apart during negotiation or end in post-acquisition litigation.

Federal and state dockets are replete with acquisition-related litigation over alleged legal violations by the target. Although a significant amount of post-acquisition litigation relates to alleged financial misstatements, many "financial" issues are actually operational ones that can also be detected through pre-exit legal due diligence. For example, in Coleman (Parent) Holdings Inc. v. Morgan Stanley & Co., the buyer alleged, "Sunbeam recognized revenues from 'sales,' even though customers did not actually pay for or even take delivery of the products, which continued to sit in Sunbeam's own warehouses" and engaged in "channel stuffing." A simple site visit to the warehouse, along with a review of inventory standard operating procedures may well have revealed this "accounting" issue.

Importance of early disclosure. In our practice, we have seen many deals stall at the eleventh hour because of newfound legal or regulatory issues. This often arises when the buyer's legal counsel discovers a problem that was not disclosed or known to the buyer's deal personnel, raising the familiar refrain of "what else are they not telling us?" Usually, the answer is "nothing," but one red flag often is interpreted to mean that others are not far behind, causing deals to flounder for no reason.

Discovering such issues during the buyer's due diligence process can be problematic for other reasons. Many sellers do not realize that third parties' due diligence activities are nonprivileged. Thus a buyer's due diligence work product can be subpoenaed to serve as a litigation road map.

Designing the legal audit. There is no cookie cutter answer to prevent these problems, and legal counsel has to be flexible enough to both protect the company and let a deal get a done. Many companies will encounter lightning-fast sale events that proceed too quickly and with insufficient time to engage in a meticulous review of the company's legal compliance. However, other companies may require greater attention; their sale should be managed with great care.

Either way, a confidential presale legal review by independent counsel is a good idea. We have found that having litigation or regulatory specialists perform a legal risk audit prior to putting a company up for sale provides significant value to funds seeking an exit. A presale cleanup of regulatory compliance and standard operating procedures issues can be worth millions to the sale price, and save numerous post-sale headaches. Moreover, presale legal review may have prevented each of the instances set out above, either through eliminating the alleged violation, or explicitly accounting for it in the deal documents.

Such an investigation, accompanied by recommendations, eliminates possible impediments to a deal for many reasons: Most compliance problems can be fixed quickly and cheaply, and once they have been corrected, buyers will perceive that the company has sound practices and procedures; a legally healthy company increases the seller's negotiating leverage, and the costs of achieving compliance are usually far less than the discount a savvy buyer will demand; any problems discovered, and any legal advice rendered during counsel's investigation should be protected by the work product and attorney-client privileges; such privilege will likely protect against discovery by third parties, providing that there has been no disclosures to third parties (for example, investment bankers); and the recent assessment of the company's key risks facilitates responding to due diligence questions by potential buyers.

Bulletproofing the sale: components of the pre-exit legal audit. A competent presale legal audit involves several key components at the portfolio company level.

Counsel should review the company's litigation work product and any documents that have been publicly filed in present or past litigation and interview outside litigation counsel and key witnesses. The goal is to determine why the litigation arose, whether the problems have been addressed, whether there is any likelihood of similar litigation recurring and whether any admissions were made in depositions, paper discovery or pleadings that could expose the company to ongoing liability. Although buyers (represented by deal lawyers, not litigators) often fail to conduct "deep dives" into litigation files, these are often a treasure trove of information about the company and any secrets management would prefer kept hidden -- and thus a good source for identifying issues to solve before a company is put out to market.

Counsel should examine all correspondence with regulators and interview general counsel and outside litigation counsel. The purpose of the review is to assess the company's relationship with regulators, and whether there is any possibility that the company will face regulatory action (for example, a warning letter), or investigations, audits or any other form of heightened scrutiny.

Counsel should review nondisclosure agreements, employment contracts, licensing agreements and interview general counsel and any outside litigation counsel to determine whether the company's intellectual property is at risk from internal or external threats. (Ideally, this form of IP "health checkup" would be performed periodically every year or so.)

Counsel should review internal compliance procedures and guidelines to determine whether these systems are sufficient to prevent regulatory violations or other legal problems. Counsel also should interview key quality control personnel to ensure that the staff responsible for implementing the policies understands the policies and has sufficient resources to do their job. This latter step can be critical in isolating latent noncompliance issues where the written policies would otherwise be adequate. In some cases, interviewing suppliers and visiting facilities may also be indicated.

Conclusion. A pre-exit legal audit conducted by independent counsel, accompanied by a privileged attorney-client protected report, helps eliminate possible impediments to a sale and increases the seller's leverage. Most compliance problems can be fixed quickly, and once they have been corrected, buyers are more likely to perceive that the company has sound practices and procedures, resulting in shorter due diligence periods, lower escrows and higher company valuations.

Noah Hagey is the managing partner of BraunHagey & Borden LLP, a trial boutique based in San Francisco, and Matthew Borden is a litigation partner at BraunHagey.

Share:

Private Equity

Bulletproof your exit

Free preview

Meet the journalists

Movers & Shakers

Video

Nasdaq explains acquisition strategy

Sectors