When you’re bringing two companies together, both sides will do their best to negotiate. But the balance of power is always skewed, says Joseph DeVito, partner at Howard & Howard.
“There are no mergers of equals,” says DeVito, who focuses his practice on business and financial transactions and real estate matters. “That just doesn’t exist. Someone is acquiring someone in every transaction.”
Once it’s clear who will play the roles of buyer and seller, the next step is sorting through the many details that must be ironed to complete the deal. “There are certain hidden liabilities and risks in every company,” he says. “Due diligence becomes critical on the front side of the transaction to understand each and every contractual commitment and contingent liability.”
We spoke with DeVito about how to control costs and minimize risk when preparing for a merger.
Study every detail
One of the first areas of concern when exploring a business merger is the change in control provision. It’s a contractual agreement that enables a vendor, customer or supplier to potentially get out of a contract with a company if there is a change in ownership.
“Some of the perceived value or synergies of an acquisition can dissipate very quickly if you’re not cognizant of that,” DeVito says. “It’s important to understand from a business perspective, but also from a legal perspective. Does the customer have the ability to terminate valuable contracts, which translate into earnings of the target company?”
This is where that upfront due diligence becomes so important. You need to know both what you’re getting and what you think you’re getting, but may not actually receive, if you close this deal.
DeVito explains, “You have to understand which contractual relationships are implicated. Those could be customer relationships or supplier relationships. It could affect ownership of intellectual property. All the consequences of the merger based on existing contractual relationships have to be analyzed.
“The question is, how do you do that in a cost-efficient and legal manner? It’s important to have a post-merger integration plan in place before you do the deal.”
Look ahead
Next, it’s time to take all the legal, financial, operational, human capital and IP due diligence you’ve collected and put it to use. What does it tell you about the future?
“You want a clear picture of the combined companies,” he explains. “Produce that on a pro forma basis before you conclude the transaction and then understand what all the risks and implications of that merger could be in terms of a change in control.”
What is your antitrust risk in terms of the Federal Trade Commission and the U.S. Department of Justice antitrust division? Could the government challenge this transaction as creating a monopoly? And if there are ways to mitigate a government challenge by divesting certain business units or divisions of the combined company post-merger, make a note. It’s always better to be prepared, even if you aren’t concerned that the risk applies to your business. A detailed forecast will be invaluable to your decision-making as you go forward.
Your goal should be to understand the integration plan from a financial, operational, legal and contractual standpoint, and know how it relates to executive personnel, labor unions, and your suppliers and customers, DeVito says.
“Test the waters as much as you can before entering into the binding transaction,” he says. “Properly documenting the transaction to reflect the desired result is critical.”
Account for hidden costs
Finally, beware of M&A opportunities that seem too good to be true, such as a troubled company that’s available at a cheap price.
“There can be a number of hidden liabilities associated with a distressed merger,” DeVito says. “So, while it seems like a value proposition for the acquirer to cheaply acquire a stock at an all-time low or a private company that has a lower valuation because its earnings are down, there can be any number of hidden liabilities in that target.”
The purchase price of a distressed target may be low, but the post-merger costs associated with putting out fires, dealing with warranty costs, fielding customer claims and losing customers can cost you more than what you paid, DeVito says.
“You could acquire a company for $1 million and walk into $100 million of undisclosed liabilities you were unaware of,” he says. “That winds up costing you capital. It then requires all the attention of your management team to triage the situation and bring it back to health.”
