A dozen things that can go wrong in a mergers and acquisitions deal
Recently, I’ve been working on a series about things that can go wrong in a deal or that could make it flounder and fail. I had a discussion with a number of folks that have done merger and acquisition (M&A) transactions to gain a better understanding of the lessons learned and the pitfalls that have led to less-than-stellar results and even caused deals to collapse entirely.
While I haven’t been through all of these myself, I’ve experienced more than a few of them and know they can make a seemingly sweet deal turn sour. So, let’s dive into the 12 things that commonly go wrong with M&A transactions.
1. Asset classification
The IRS requires the buyer and seller to come to an agreement on the classification of the assets of the transaction. The form is 8594, and both parties have to file the document with the same allocation of assets so the government gets its fair share of your money.
Often, this gets discussed and defined before the transaction closes, but I’ve seen and experienced the challenge of closing and then getting this defined post-deal. One important lesson to keep in mind is that all leverage is pretty well gone after the documents are signed and the money is transferred.
My recommendation is to get this done and agreed to as part of the deal, so it’s documented and ready to report on the 8594. You might be wondering if it matters and the answer is yes, it matters very much—specifically because these classifications are taxed at different rates.
Capital gains tax is currently around 20%. Your personal tax rate, which will likely be at the high end of the scale with a transaction, is probably close to double that—and with state taxes, it may be even more.
Specific allocations are referenced on the IRS form and are broken down as follows:
- Class I: Cash and bank deposits
- Class II: Securities, including actively traded personal property and certificates of deposit
- Class III: Accounts receivables
- Class IV: Stock in trade (inventory)
- Class V: Other tangible property, including furniture, fixtures, vehicles, etc.
- Class VI: Intangibles (including covenant not to compete)
- Class VII: Goodwill of a going concern
Unless you’re a tax pro or attorney, this list probably doesn’t makes much sense to you. But it really matters. So make sure to have competent counsel in your CPA, tax, and legal resources so you don’t end up paying more tax than necessary. Trust me, the government will get more than their fair share, even if you have great counsel. This classification can mean hundreds of thousands of dollars to your bank account, so take it seriously.
2. Employment agreement/contractor
One area that many sellers are not ready for is what happens after the sale. Do they want to stay? If so, for how long and doing what? Or do they want to go and ride off into the sunset? Knowing the answer to these types of questions is critical to having a transaction that brings joy rather than regret.
This is another area that sometimes gets left until after the transaction, which is ill advised. Sellers need clarity on what they want to do post-close. Emotions will take them on quite a ride, and that’s not the time to be making decisions about the future.
One consideration is whether the seller will be an employee or a contractor. Both have different benefits and requirements. In my case, with the sale of HTS, I had a one-year contract. It didn’t come with any benefits or perks, and it turned out to be just another form of payment because the new CEO didn’t really want my help, but it looked good to the team that I was still around.
Another consideration is compensation. Will it be a straight salary, some sort of bonus and incentive structure, or both? What will the job title and description be? What is the “out” for both sides? Can either side end the agreement in 30 days, or is it a longer-term contract? If terminated, are there any provisions for severance? What happens if there is a change of control while the seller is still working?
Sometimes, there are earnout provisions in the sale document that require a seller to stay engaged. It’s important to have that clearly defined with timelines and responsibilities. Often, this will be the first time in a long time that a seller has a boss and must report to someone other than themselves. That’s an experience that most are not ready for and have never dealt with before, and it can cause real heartburn.
The reality is that the new boss won’t do things the same way the seller did them. Those changes may be better, or may not be, but there will be change, and no one likes that. It is especially frustrating to the seller who feels like “their way” is the right way. But they’ll be asked to do it the new way anyway. Ouch.
My counsel is clear on this one, too:
- Know what you want to do post-transaction as a seller
- Know if you want to be an employee or contractor
- Know the timeline you are willing to commit to if you stay engaged
- Understand the connection between your involvement and any earnout in the purchase agreement—negotiate this as part of the transaction, not after the fact, and write down details of expectations and measurements
- Communicate clearly with your spouse, family, and others what your intentions are, as they may be less excited about you staying long-term or at all
- Once you come to an agreement, don’t second guess—execute and then prepare for your next chapter!
I experience people with a lot of heartburn around this area. They failed to gain clarity in the process, or didn't record enough details in the contract, or had expectations that didn't align with the buyer, etc. The list goes on and on. If this isn't done well, an event that should have been filled with joy and bright hope for the future can sour quickly. You don't want to make that mistake.
3. Non-compete agreement
Part of an employment agreement is often a non-compete agreement that limits what the seller can do post-transaction. On the surface, non-competes are common in many companies. Whether they are enforceable or not is dependent on your state, but they are a common tool to keep an employee from leaving a company and then directly competing with that organization.
On the surface, it seems pretty normal, but I’ve seen some pretty aggressive non-compete agreements that seem way out of the scope of reasonable. Some key areas that are often included are:
- Duration: I’ve seen up to five years, which is excessive, but the normal range seems to be one to three years.
- Geography: I’ve seen limits up to the entire country, but the normal range seems to be a city, region, or state, depending on the business.
- Restricted activities or industries: I’ve seen non-competes limit anything in the tech space. The agreement should define what constitutes "competition" and specify the scope of prohibited activities. This might include working for a direct competitor, starting a competing business, or soliciting the company's clients or employees. The norm seems to be competing activities or companies.
- Confidential information: I’ve seen it limit any information the seller or buyer company has for perpetuity. The norm seems to be competitive or proprietary information.
The reality is that when you transition a company, it is reasonable for the buyer to expect you not to compete directly. But it is also reasonable that you be allowed to make a living, likely in the same or a closely related industry, since that is where your expertise lies.
Non-competes are a normal part of a transaction. The key is to know what you want and negotiate to get as close as possible to that outcome. Carve out specific things you know you want to be able to do.
One thing to note is that a non-complete is a class VI asset from our earlier discussion around asset classification. To be legally binding, non-compete agreements typically require some form of consideration, such as compensation or access to confidential information. This is usually taxed as ordinary income.
The requirement for putting a value on the non-compete ensures that the agreement is fair to the employee or contractor. This matters from a tax perspective, and again, you’ll want to negotiate what part of the purchase price will be allocated to this asset class.
The non-compete agreement can potentially blow up a deal if there becomes an impasse between buyer and seller. There are times when one side or the other is unreasonable in their requirements. When you enter the negotiation, be sure to understand your non-negotiables around this and carve out exceptions for those things. Usually, all sides can come to terms as long as both are negotiating in good faith.
My advice is to understand how the buyer will approach valuing the non-compete and know what areas are not negotiable for the seller. Are there specific things you want to be able to do post-event? Do you already have interests in other companies or products that you want to continue? If in doubt, make sure to specifically carve it out. Do not assume!
4. Non-solicitation agreement
This is another very common part of a M&A deal. The buyer wants to limit the seller from soliciting customers or employees to do business with them or change companies. It is a reasonable concern, as the seller often has a long tenure with both their customers and those who have worked for them.
This agreement is usually time-bound and again can be difficult to enforce depending on your state. It is often part of the employment agreement on non-compete. I do see buyers enforce this aggressively, as it protects a significant part of their investment.
It can also include protection from the theft of customer lists or other proprietary information around the seller’s customers or employees. Some employees may exit and attempt to take their book of business with them, which would be covered through their own non-solicitation, which is typically part of the HR packet they signed when becoming an employee.
5. Working capital
In the world of doing a transaction, nothing is more confusing or causes more deals to fall apart than the working capital calculation. It is complicated, doesn’t always make sense, and is just plain confusing in every way. The idea here is to determine how much money is needed to keep the business operating without the need to put money in on a monthly basis.
When an asset transaction occurs, the cash items on the balance sheet belong to the seller. That is all cash beyond what’s needed for working capital. A lot of owners believe that leaving money in the company is a poor idea as you approach a transaction. But in an asset sale, which is by far the most prevalent type, excess cash in the business has been earned, and taxes paid on it in previous years, so it can be distributed to the seller.
The confusion around working capital is that there is not a standardized format to determine how much money is needed for the business to operate. Thus, it becomes a negotiation. And unless you have a financially savvy person on the seller team, the calculation is often tilted toward the buyer who will always want more money left in the business. This becomes a push-and-pull kind of negotiation and it can definitely create the potential for collapse.
Where it becomes particularly challenging is when the seller has taken distribution of most of their earnings each year, so there really isn’t much money left on the balance sheet to fund the working capital needed to run the business. That requires the seller to either put cash in or reduce the sell price by the negotiated amount. That is never a happy conversation.
The biggest challenge with working capital is usually the lack of understanding of the why and how much. It’s not something that is usually discussed in the normal course of business outside of a transaction. Often, the formula is agreed to and an estimated working capital amount is put in as part of the purchase agreement with a true up of the formula 90-120 days post-deal, or once things get settled back into a normal day-to-day run rate again. Things around the deal can get a bit wonky with the financials, so doing a true up some months later is a good way to get the number right.
The counsel here is to begin discussing it early and often. Don’t let this be pushed to the end. If it’s going to be an issue, get it on the table early and communicate about it all along the way. You don’t want to get 99% of the way to close and find out that you are far apart on the working capital number. This is one of the more likely problems that will tank a deal.
6. Assignable contracts
For some, having contracts at all can be a deal-maker or breaker. Many like the idea of 3-year contracts, but there are often outs for a number of things, so they may not have nearly as much value as you might think. However, they can be a plus in the valuation column.
What’s not a plus is having contracts that do not contain an assignability clause, which allows a new owner to assume the contract and keep it intact going forward. It needs to be specifically listed in the contract.
Why does it matter? Any time there is a change in how business happens, the customer pauses and evaluates whether they want to continue the agreement. In an assignable contract, it doesn’t become a decision point because it can automatically transfer to the buyer. But if the contract is not assignable, the only way to address that shortcoming is to have the customer sign a new contract on the buyer's paper, which gives the customer the opportunity to look around and potentially change providers.
During the transition of an M&A, that’s the last thing you want to happen—to force a customer to decide whether they want to continue to do business with a new company they may not know or have any kind of relationship with. You want to avoid that and the simple way to do that is to have an assignability clause in your contracts.
Another area that can become contentious during a deal has to do with the possibility of an earnout as part of the deal structure. The truth is, getting a deal is the easy part. The devil is in the details, and a big part of that is how the deal is structured between cash, seller note, earnout, roll forward, and other considerations. Most sellers want an all-cash deal. Most buyers want to mitigate risk by using other tools in the deal structure.
An earnout ties payment to performance. And far too often it is muddy at best, and totally impossible to understand and calculate in other cases. Negotiating the amount of the earnout available to be earned is one thing, but creating the system to measure performance is even more difficult.
For the seller, it needs to be tied to something they can control. If it isn’t, the buyer can do things that literally make it impossible for a seller to achieve the earnout. For example, revenue alone is a poor measurement. Buyers can close markets, drop products or services, limit the customer profile, and more to make it impossible to hit a revenue number. Things like gross profit or even service margins can be easily manipulated by how staffing and expenses are managed.
So this has to be negotiated well with lots of bumpers and guardrails. I hear often from sellers that they felt taken advantage of by the buyer, who changed the rules and how things were done which made it difficult or impossible to achieve their earnout.
Sometimes reporting is a challenge, and it can take significant effort to try and get accurate information to even calculate the amount earned.
My advice to sellers is to keep earnouts low as a percentage of the deal and only accept it on things you can control. You should also make sure the measurement is easy to understand and the data is accessible to you. There’s nothing worse than looking back post-deal and feeling like you left money on the table because of your earnout.
8. Employee alignment
While we sell and service technology as an IT solution provider (TSP), we are in the people business. And it is people working with people that makes a business succeed. So, making sure there is alignment with the employees who will be joining the company is important. As a seller, you typically are concerned about your people landing in a good place. And as a buyer, you want to keep the people around for continuity in serving the customer. Churn is one of the biggest problems that can plague a transaction, and people are usually at the root of churn issues.
Understanding the employee base in the selling company is tricky. Typically, the seller doesn’t want their team to know the business is for sale. So, there is usually little to no access to those people beyond the high-level sharing of their HR information. The reality is that buyers go in pretty blind to the people they are bringing on.
Typically, the majority of people come along with the sale of a company. Retention of those employees can vary greatly between keeping them all around long term, to having the majority or all exit within 12 to 24 months. I’ve experienced both scenarios over my career and while there were some indicators, I would never have guessed either of those outcomes.
Once in a while, there is one person or a few key people who may attempt to hold a deal hostage by threatening to leave or take key customers. If the proper HR documents don’t prevent that action, it can put a deal in jeopardy, and that usually isn’t identified until very late in the deal process—if at all.
This is a very challenging area of the deal process. Buyers need to do all they can to observe and understand the people they will be adding to their team. Sellers can potentially enhance their offer by finding ways to expose a strong team to the buyer in the process. Often bringing in a “consultant” or having some peers do a “SWOT” analysis visit can be ways to expose your team to the potential buyer. There is risk whenever you have people involved in anything, so be prepared for the unexpected.
Effort spent here can save you a lot of grief down the line. One big area to check is the HR paperwork completion. More often than not, documents are not completed or signed, even though the seller believes they are. That’s something you can review and understand during diligence.
9. Target customer profile alignment
Another area that is often overlooked is the target customer profile (TCP). Many companies don’t really have a well-defined TCP. In those cases, if they want to buy something and can pay for it, they are the target. But as a company matures, they quickly discover that all customers are not alike and there are traits in customers that can help determine the success and profitability of serving them.
This leads to them defining a TCP. It can be a combination of a number of traits, including:
- Size of the business
- Industry they are in
- Service needs they have
- Breadth of engagement
- Geography to be served
- Type of relationship they want
There certainly can be a lot of other characteristics as well, depending on the desire to narrow down the potential customer base. In an acquisition, this becomes important to ensure there is alignment between the current customer base and the acquiring company.
The location can be a problem if you acquire customers in places you can’t service. The size of the customer is probably the biggest disconnect I see, as often the acquired customers are too small for the acquiring company and it creates challenges in servicing them.
Another big challenge is the breadth of the relationship. In some situations, the customer has only engaged in small services and the revenue is below what the target TCP dictates.
These types of differences are often the cause of churn post-transaction. Often the churn is desired by both sides, as the relationship just isn’t a fit for either of them. But, it’s important to know this prior to the deal so it doesn’t surprise anyone post-transaction.
10. Financial investor alignment
In the growth of many companies, they come to a point where they need additional capital to support their needs. Often, they look for investors to help make the next curve jump in their growth strategy. While the need for money is the driver, the determination of success when working with an investor is alignment on the strategy for how growth will happen.
How much of the growth needs to be organic and driven by the team versus the amount that will happen through acquisition? The amount of cash required for organic growth is not insignificant, but it pales in comparison to buying companies—at least in the short term. So, alignment on that strategy is critical to having a strong partnership.
The addition of vertical expertise, new service lines, or moving into new geographies are all areas where there can be disagreement on the when and how. While these things often aren’t discovered until after the investment happens, it is much better to have the discussions pre-investment rather than getting into a relationship filled with conflict and disagreement.
Sometimes these same areas are problematic in a company with two or more owners before they involve an investor. It’s important that alignment happens there before talking with any potential investors. All owners need to be on the same page before complicating it even more with outsiders.
The other side of investors is how it changes the company. Most entrepreneurially-led companies are customer and employee-focused, as they are who is being served. When an investor gets involved, there is a third focal point, and it often becomes the priority—making sure the investor receives a return on their investment. This can create conflict with the other two areas and cause heartburn and frustration all around.
My advice here is to take on an investor with eyes wide open. They are doing this for one reason—to get a return on their investment. You have to be willing to make that the priority, which means customers and employees will at times be second fiddle to the primary driver in the business.
11. Accounting pre-pays and balance sheet errors
One of the biggest unknowns in a deal is how far you can trust the data—particularly the financials. Very few business owners are accountants, and they don’t know what they don’t know about GAAP or just correct accounting standards. So, it’s essential you do diligence and review things. However, it’s impossible to find all the creative ways that people do their accounting.
In every one of the eight deals we did, there was a surprise in the numbers. It is amazing how creative many owners can be with their accounting. In most cases, it is a matter of not knowing what the right way to do it is. But that doesn’t change the reality that bad financial data is a problem for the buyer.
The obvious answer may seem to be calling it out as a violation of the reps and warranties—the guarantee that the information provided is accurate and truthful. The challenge with that is unfortunately, it happens late in the deal process, and ending the transaction carries a lot of already sunk costs. So, you have to determine if the bad financial data is worth killing the deal.
My counsel is to dig deep into the financials. Many small companies do not have experienced and trained financial people, so mistakes happen. You can’t take people’s word for what they have done—you have to dive in and validate it yourself. And even then, expect the unexpected. It’s almost impossible to catch it all.
12. Unwritten commitments
Often, there are things that have been committed that aren’t written down anywhere. Business owners sometimes make commitments in lieu of compensation to their team, benefits that may apply to employee families, promises made to customers—the list of creative commitments can go on and on.
I’ve seen a number of these in the deals I’ve done. Once, an owner promised to educate an employees kids through college in exchange for no raises. Another promised a new car each year to one of his people. Yet another had promised product pricing at cost because of a long-time friendship.
These are things that an owner can certainly do. The problem comes when a transaction happens and the employee or customer believes those commitments should continue. There is usually no documentation, so it is a word-of-mouth commitment that seldom ends well post-deal. In every case, we had to draw a line that those commitments were with the previous owner and did not transcend the acquisition.
The outcome was to lose the affected employees and customers, but there really wasn’t any other option. We attempted to meet in the middle, but that still left them feeling unsatisfied, so we just said no and moved on.
My advice on these kinds of commitments is to specifically ask for any unwritten expectations or commitments and document any that are potentially still expected. Ask the previous owner to have the conversation to explain how those commitments end with the transaction and if important, that owner can honor his commitments outside the deal.
So there you have it. A dozen things to watch out for that could potentially go wrong during an M&A deal before close. You’ll want to monitor and manage these things before you get to the last hour and watch months of hard work go up in smoke. All of these challenges can be successfully navigated, but failure to be on top of them before the final hour could prove to put an end to a lot of hard work and emotional investment.