Legal Pitfalls in the Acquisition Process
FIRST SEEN IN BPN Magazine | Navigating legal pitfalls is a challenging exercise during the acquisition process. While most issues are ultimately resolvable, it should be a goal of all parties involved, including sellers, buyers, attorneys, and advisors, to work together to complete the transaction successfully. Being aware of potential concerns allows the parties to plan, mitigate, and make the acquisition transaction process run as smoothly as possible.
While a selling company may be aware of some of its legal and liability issues, the seller may not be aware of how it may impact a potential buyer. Typically, existing issues will surface when the buyer goes through the due diligence process, which is an investigation by the buyer of the seller’s business to confirm facts or details that the seller has represented. Due diligence requires examining many aspects of the business, including financial records and operations of the selling company. Due diligence usually occurs after a non-binding letter of intent has been signed by both parties. The buyer wants to confirm that it is buying the business that it thinks it is buying. The buyer uses the due diligence process not only to detect potential legal and operational issues but also to find out information that will help it in its integration of the business after the transaction.
For a seller who knows that it will be selling in the near future, it is recommended that any outstanding legal and compliance matters are resolved before putting the company on the market. If there is pending or threatened litigation, the seller should try to resolve as much of this as possible before marketing the company. A buyer may be concerned that unresolved matters may lead to future loss of customer goodwill.
In due diligence, the buyer typically requests information on safety, compliance, and customer contracts. The buyer will be reviewing customer files to see if there are contracts with customers leasing storage tanks from the company and if the seller can verify that it owns the tanks at customer locations. The buyer will want to confirm that tank inspections, “Duty to Warn” notices, Training Certificates related to CTEP programs, DOT files, and other compliance matters are up to date and in good order. A transaction goes smoother if these items are addressed before marketing the business for sale. Tank ownership is particularly important in the propane industry. If the seller cannot prove tank ownership, it may result in the buyer holding a significant part of the purchase price in escrow until ownership is confirmed.
It is always beneficial to have the seller’s books, records, and organizational documents in good order and up to date. Formation documents of the company will be asked for, and in larger transactions, copies of corporate minutes and board resolutions will be requested. Quite often, especially in smaller companies, many of these documents are held with the company’s outside counsel’s office. Collecting these documents may present a concern if a company has changed attorneys over the years.
Once the letter of intent is signed for a purchase and sale transaction, the formal due diligence period begins. Due diligence can be a rigorous process; however, by presenting detailed information before marketing a business, the seller will be better positioned to propose mitigation measures leading to a successful sale of the company. In addition to financial due diligence, the buyer usually performs diligence regarding customers, compliance, environmental matters, human resources, material contracts, technology, intellectual property, litigation, cybersecurity, real estate, insurance, and general corporate matters.
Although all of the above items are important, this section will focus on three potential due diligence issues; environmental, material contracts, and cybersecurity.
Generally, if the seller has a bulk plant consisting of propane storage only, environmental due diligence is not a major area of concern. However, if there is a bulk plant with storage for heating oil, diesel, or gasoline, the environmental diligence will usually be extensive and time-consuming. For these multi-fuel facilities, the standard is to perform an ASTM Phase I Environmental Site Assessment (ESA), which researches past use of the property or current Recognized Environmental Conditions (RECs) for conditions that diminish the value of the property. The Phase I could take several weeks to schedule and complete, as sometimes it may take weeks to access environmental files at a state level. The ideal outcome is that the Phase I comes up clean with no areas of concern or RECs. However, if the report comes back with areas of concern or RECs, then a Phase II environmental report would usually be required, which could add weeks or months to the closing. Worse yet, if contamination is discovered, it could lead to the buyer backing out of the deal. However, even if contamination is found, it can often be handled by escrowing money as part of the purchase and sale agreement once its extent is delineated.
Perhaps the most extensive aspect of due diligence is reviewing all of the seller’s material contracts. The buyer will want to know the seller’s commitments and determine if it wants to assume them. Contracts of major concern are customer and supplier contracts, employment agreements, and agreements from previous acquisitions or divestitures that limit the territory the seller can be active in or restrict the seller’s product line. Additional contracts that may be reviewed include real estate purchase agreements, leases, and insurance contracts. Issues often arise with master agreements for propane supply contracts. For many selling companies, the master agreement may be over ten years old and misplaced. Sellers are reluctant to ask the supplier for a copy of the master agreement contract for fear that it will start a rumor that the company is for sale. However, ultimately a copy will probably need to be provided as supply contracts usually require the supplier to consent to the contract assignment. In some cases, the supplier may not want to extend the same credit terms to the buyer as it did to the seller, which can also cause delays.
An area of concern that has emerged more recently is cybersecurity. The extent of the buyer’s diligence on this matter will depend on whether the buyer will continue to use the existing networks and systems post-closing. The buyer wants to be assured that any existing data compromises that the seller may not be aware of do not penetrate the buyer’s systems or continue after the closing. The buyer will need to understand the network’s architecture and how data flows. Usually, there will be third-party consultants on both parties’ sides involved in this diligence phase. If the buyer plans to use the seller’s network and systems after the transaction closes, it is important to know if third-party providers require any consents of software and network services. If the third party is allowed to charge a fee for the transfer of a software license, it often becomes a point of negotiation determining which party, buyer or seller, will pay the fee.
The issue of asset allocation is more prevalent in propane transactions than heating oil transactions due to the value of company-owned tanks at customer locations. Typically, the seller wants to have the lowest number possible allocated to hard assets such as vehicles and propane tanks since capital gains will be taxed at lower rates. Sellers also look for a low number on non-compete agreements as its payment comes to the owner as ordinary income and is taxed at higher rates. The seller wants the customer list as high as possible as it is typically taxed at lower capital gains rates. Meanwhile, the buyer prefers a high allocation on the vehicles and propane tanks since the seller is allowed to take a “stepped-up” basis on its newly acquired assets resulting in greater depreciation post-closing, allowing a deferral of future tax payments. Negotiation of the purchase price allocation can often be a challenging discussion and further delay the closing.
Another potential issue that often arises in transactions is the scope of non-compete and non-solicitation agreements. Although this is not often an issue if the seller is retiring, it may be an issue if the seller has children working for the company. While the seller wants to provide as much flexibility to the children as possible, the buyer does not want the seller or his children competing against the buyer in the same market. Typically, non-compete and non-solicitation of customers and employees agreements are effective for between three to seven years. The size of the restricted area ranges from the current market area served by the company to sometimes all of the states in which the seller markets to customers.
Many other items may also disrupt the transaction process. The seller should be willing to engage competent professional advisors experienced in purchase and sale transactions. Competent advisors and attorneys assure that the seller receives a good price for the business and increase the likelihood that the deal will close.
A transaction process will be much smoother for the seller by planning for the buyer’s due diligence and the potential issues that arise from it. Getting ahead of potential legal and due diligence issues always leads to a more successful transaction for both the buyer and the seller.
Fred Lord, Director at Cetane Associates LLC, has over 40 years of experience in the delivered fuels industry in various operational and financial management roles. Over his career, he has worked on over 60 completed acquisitions. He has been active in industry trade associations and is currently the treasurer of the Connecticut Energy Marketers Association.
First published in BPN Magazine, June 2021 edition
- A Comprehensive Guide To Due Diligence Issues In Mergers And Acquisitions (forbes.com)
- 7 Mistakes to Avoid When Buying a Business | M&A Lawyer (cenkuslaw.com)
- 7 Costly Mistakes to Avoid When Selling Your Business (cenkuslaw.com)
- Top Ten Issues in M&A Transactions – Mergers Acquisitions (morse.law)
- Environmental Due Diligence (currenenvironmental.com)
- Explaining Legal Side of Mergers and Acquisitions Transactions (dealroom.net)