Practical Aspects of Risk Management in M&A Transactions
Management of risks typical of M&A transactions (mergers and acquisitions) can be easily structured according to stages of this business operation. There are three main stages of the M&A project:
- Due diligence of a company being the subject of the transaction, including documentary;
- Negotiation and execution of the company sale and purchase agreement;
- Integration of the acquired company into the existing business.
This division is quite provisional, as the mentioned stages may coincide, intersect in time or be supplemented by other tasks.
Identification of Risks at the Stage of Prior Due Diligence of the Company
Due diligence is usually carried out before the execution of the transaction. It may include financial, legal and operational and technical parts. The main purpose of due diligence is to identify the risks.
Among the major risks subject to identification, the following can be singled out:
Such typology is rather generalized. Different business areas may contain other specific risks.
The buyer determines the period of the company activity subject to due diligence and the extent of the latter as well as the criteria of risk substantiality for business. If the level of identified risks is acceptable for the buyer, it shall decide on continuation of negotiations, formation and revision of the sale and purchase agreement. Without going into the theoretical concepts of risk acceptability, in this case “acceptable” shall be the risk, which is, first, subject to management and, second, the costs of eliminating the negative effects of which will not exceed the expected positive effects of the transaction. Risks, which are usually considered unacceptable, are the risks related to the defect of title, the existence of disputes over the ownership of share/shares, or improper powers of sellers under the transaction, i.e. risks, which can lead to the loss of acquired business in the whole or a substantial part thereof.
Risks identified in the course of due diligence are classified and assessed according to the criteria of substantiality and probability, following which the list of terms of the sale and purchase agreement is drawn up.
Risks Management in the Company Sale and Purchase Agreement
Terms aimed at minimization and elimination of risks may be implemented through the use of various contractual structures: first, risks may be regulated by establishing conditions precedent to the completion of the transaction, which oblige the seller to take certain actions for elimination or reduction of identified risks. For example, according to the results of due diligence in one of the transactions in the telecommunications sector, the seller’s obligation to terminate or amend agreements with affiliates, which in debt the company being the subject of the transaction, was secured as a condition precedent. Other transaction secured the seller’s obligation to bring the SORM system in accordance with the requirements of Federal Law On Communications. In both cases it was more profitable for the sellers to fulfill these conditions rather than to agree to a reduction of the purchase price.
The other risk management tool is payment terms under the transaction. The structure of the transaction may involve deferred payments, which amount and payment is contingent upon the fulfillment of certain actions by the seller or neutralization of risks after the transaction completion. For instance, in a number of transactions sellers were to carry out consolidation of their business – accumulate subscribers, receipts, equipment within one legal entity. After these requirements had been fulfilled, the seller received the deferred payment, the amount of which depended on the fulfillment of the conditions.
Third, minimization of risks may reside in the seller making representations and warranties as well as in a priori exemption of the buyer from liability. Such mechanism stipulates that in the event of any breach of the provided warranties, the buyer shall be entitled to claim compensation for the resulting damage. Obviously, it is more profitable for the buyer to combine the seller’s representations and warranties with the deferred payments mechanism as it makes possible to withhold part of the purchase price as compensation. For example, under the terms of certain transactions the buyer may be entitled to reduce the price unilaterally in the event of breach of warranties and, therefore, provide the seller with a possibility to litigate the relevant settlement. In other transactions more complex mechanisms are used engaging the third party, which could confirm the accuracy of claims; a condition that the buyer’s right to withhold the deferred payment is not created automatically, but must be established judicially is also possible. In the latter cases, the amount of deferred payments can be deposited to escrow account.
Fourth, the agreement may contain other specific conditions, which are also aimed at minimization of risks, for example, no competition, no enticement of employees, and etc. Such terms may be used when there is a risk that upon acquisition of the company the buyer will face competition on the part of the seller that has already established himself/herself as a successful entrepreneur who has established the company, and in this regard his/her potential is now enhanced thanks to financial resources received from the buyer. In this regard employees are inclined to continue working with the familiar director rather than stay with the new owner. These conditions together with other mechanisms of risk reduction can work quite effectively.
Fifth, the choice of the applicable law and jurisdiction over disputes can be used as a risk management tool. Of course, the Russian law is the only applicable law in transactions between the Russian companies. However, the inclusion of arbitration clause into the text of the agreement makes it possible to subordinate the dispute to the competence of arbitration or intermediate court at the parties’ option. If there is a foreign element within the transaction, the choice of both applicable law and jurisdiction is much wider. Foreign law, such as English law, is often chosen as an applicable law, and therefore, the dispute is subordinated to international arbitration or a court of the state of the applicable law. In this way the risks related to political and legal situation in the country of investment, as well as risks related to possible abuse of rights of the counterparty under the transaction are minimized, since the proceedings in international arbitration are usually incomparably more expensive and take more time than dispute consideration carried out by Russian courts.
In addition to the abovementioned warranties provided directly by the seller, his/her beneficiary may provide warranties on his/her behalf – this option is used if the seller is a structure, the recovery of funds from which is a definitely difficult task, for example, a company registered in a low tax jurisdiction.
Identification and Management of Risks after Business Acquisition
After the company sale and purchase agreement becomes effective, it is expedient to gain control over the business as quickly as possible, and at the same time examine in depth the state of affairs of the company. In this case control means the aggregate of corporate, financial and operational control.
To exercise corporate control it is important to have documents of title (constituent documents; corporate resolutions of boards of directors, general meetings of shareholders or members). Absence of these documents creates certain difficulties in making decisions related to legal registration of the company. Although it is not critical since the documents can be restored, it creates additional time and financial expenses. Regarding foreign offshore companies it is also important to ensure no powers of attorney and instructions from the previous owners had been issued earlier to companies offering secretarial services.
It is expedient to resolve the corporate control issues at the time of transaction completion.
To gain operational control it is required to ensure
- First, the control over the new owner of the sole executive body. Upon the completion of the transaction it is recommended to change the sole executive body. In this regard the previous director general may remain in the company management, but by virtue of power of attorney. It makes it possible, if necessary, to gain quickly control over the company by terminating the power of attorney without the need to comply with deadlines for termination of powers of director general set in the employment and corporate legislation.
- Second, control over the equipment, for example, over the communication and network equipment in the telecommunications sector. It is important to control network in the area of broadband Internet service in order to prevent unauthorized access. Certain difficulties may arise with determination of rights to certain fibers within the optical cable by which traffic is transmitted.
- Third, loyalty of employees. First of all, this problem affects the top management and other key employees for business. It is obvious that if the company instantly loses key personnel, it will affect the continuity and may create serious problems for business. As a rule, most employees of the acquired company tend to continue working at the same place. The goal of the new owner is to keep competent staff and strengthen the team, if necessary, by hiring new employees and transferring part of the staff from the existing business to the acquired company.
- Fourth, availability of information on key customers and other counterparties of the company and on contacts with them. It is important to gain control over the customer base as quickly as possible. It is obvious that deterioration of customer service even for a short time can result in the loss of a key customer and in losses. The same applies to important suppliers of the company.
- Fifth, access to information on previously established rules and procedures. It is useful to study the existing rules and procedures of the acquired company, its business processes in order to reduce the number and consequences of violations of its ordinary activities at the stage of integration of the company into the parent organization.
Financial control means control over income and expenses for which the following is required
- First, bank signatory – accordingly, signature cards should be changed in banks;
- Second, control over bank accounts – access keys to online banking and passwords must be received at the time of transaction completion;
- Third, the right to sign documents involving occurrence of liabilities for the company (agreements, guarantees, promissory notes, and etc.). It is expedient as early as at the stage of preliminary due diligence to collect information on persons in the company authorized to make relevant decisions. If necessary, terminate issued powers of attorney by restricting the scope of such authorized persons.
- Fourth, control over the rate policy (control over the cost of services and goods, particularly for major clients) and control over procurement process. This task must be accomplished to rule out the possibility of abuse as well as inefficient pricing.
- Fifth, physical access to accounting systems (accounting, billing, production process, and etc.). It means to access keys, source codes in case of self-recording systems, and etc.
- Sixth, control over channels of income proceeds (receipt of money in cash, through payment systems or agents). This process should be taken under control from the very beginning of integration of the new company.
Also after the transaction completion it is expedient to conduct a complex analysis of the acquired company to achieve several purposes: first, verification of conformity of factual information about the company, which was previously received, in order to be able to exercise the right to compensation in case of violation of the warranties stipulated under the sale and purchase agreement; second, for the purposes of identification of new risks and an in-depth study of previously identified risks.
Post-completion due diligence may include:
- Inventory of property. This process may be quite complex and long depending on the company size and amount of property. It is desirable that such work would be carried out prior the company acquisition, but in practice this measure takes a long time, requires serious involvement of staff and eventually turns out too expensive. Therefore, at the stage of agreement execution the buyer is usually limited to obtaining warranties of the seller, and the inventory is carried out upon the transaction completion;
- Verification of accounting and reporting systems and accounting policies – the specified systems are brought to conformity with the applicable procedures of companies within the group;
- Verification of documentation which includes review of contractual framework, internal regulatory documents (decrees, regulations, instructions) and primary accounting documents;
- Verification of IT systems – document management, billing, CRM, ERP, and etc. Systems must be controlled, clear, transparent and manageable. If technically possible, it is useful to make the database backup. It is necessary in order to reduce the risk of loss of information in the event of human factor in the first place;
- Analysis of the customer base and suppliers: it is important to understand who are the major clients and suppliers, have tools for collaboration with them (contact details, history of relations, formal and informal conditions of working with them) as well as the analysis of procurement process;
- Composition and quality of staff – it is important to analyze the employees’ reaction to the change of the owner, the degree of conformity of the staff to the goals of the new owner; the willingness of every employee to continue working in the new environment.
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