By Scott M. Lewis

The unsettled economic landscape and foment on the world stage over the past several months may give rise to opportunities to purchase, at relative bargain prices, companies that have struggled through the post-Great Recession “recovery” and will be unable to weather another sudden economic storm. Sellers that are either in a state of denial or who are determined to “wait it out” until the next inevitable economic turnaround occurs are often reluctant to adjust their sale expectations. This can lead to fire sales, foreclosure sales, private or public auctions, bankruptcy sales, and similar dispositions that make today’s earnings multiples and other value indicators an extremely attractive proposition for wistful sellers second-guessing themselves.

The capital markets are relatively active and generally more supportive of small and mid-market mergers and acquisition activity than they were, say, five years ago. But it is certainly more difficult to raise private capital and institutional and public debt than it was in the heady days of the mid to late 1990’s. Thus, the current climate is generally more attractive for the strategic buyer (someone who wants to buy the company to create synergy with his existing business) – that can fund an acquisition based on its internal growth or predicate the acquisition price on the success of the acquired business – rather than the financial buyer such as a leveraged buyout fund or venture capital group.

How to identify the financially troubled company? One can classify the warning signs by category – what are sometime referred to as “lagging indicators” and “leading indicators”.


Lagging Indicators

• Poor Reported Sales and Profits

• Qualified Audit Opinion from independent accountants

• Discussion of Poor Performance in Annual Report (for public companies) Downgraded Credit Rating

• Default on Bank Debt or frequent covenant waivers

• Poor Point-in-Time Financial Ratios – Debt: Equity – Fixed Charge Coverage (indicates a company’s ability to satisfy fixed financing expenses) – Current Assets: Current Liabilities (liquidity ratio; indicates a company’s ability to pay short-term obligations)

• Lawsuits

• Tax Liens


Leading Indicators

• Deteriorating 3 to 5 year trend in key financial ratios

• Failed projections

• Reacting to “crisis of the moment,” not initiating changes or improvements

• Personnel turnover

• Not Keeping Pace with Industry Developments

• Cash Drain; extraordinary measures being used to support working capital


The Stress Test

It is key to ask the Seller, at the outset of the discussions, “what has caused the working capital shortage?” at the outset of discussions because the answer will both reveal the credibility of management and assist the Buyer in focusing its due diligence efforts.

Common Causes of Working Capital Shortages include:

– operating losses

– loss of trade credit and vendor confidence

– sales I volume decline

– extended or uncollectible receivables

– inventory buildup or shortages (inability to meet delivery dates due to inability to purchase new materials and components)


The Symptoms

What will the Buyer be walking into, if it decides to pursue the company that is on economic life support? Characteristics of a troubled company environment include the following:

– Management can’t accept or will try to ignore the economic situation and the fact that many years of good business fortune have become a memory

– Trade payables are stretched to the limit

– Management finds it difficult to be objective

– Ownership and management are unfamiliar with sale process

– Lack of Planning Time; too busy putting out fires

– Lack of Management Credibility with employees, customers, suppliers, buyer, seller’s lender, and buyer’s lender

– Time is of the Essence – for everything

– Confusion Reigns with Internal and External Communication Failures

– Unhappy and unproductive workforce


A Buyer’s goal under these circumstances is to pay a specified price, and receive the value, on both an operating and financial statement basis, which it believes is inherent in the acquisition. To accomplish this, buyers conduct due diligence directly and through their representatives to verify financial statements, understand the obligations and contracts which are being assumed and verify assets. This verification is accomplished through physical examinations, confirmation with customers and vendors and other means that sellers in other circumstances might view as overreaching or intrusive.


The Letter of Intent – “Generally” Speaking

Since the investment in soft costs and the likelihood the deal will be abandoned is greater here, there is some benefit to signing, at the outset of substantive discussions, a general letter of intent outlining the most significant economic “deal points.” The conventional wisdom is that once a letter of intent has been signed, the deal momentum shifts from seller to buyer. This is even more true in the context of a distressed company acquisition. Another obvious reason why a general letter of intent is often favored by a buyer is to make sure there is a genuine willingness to sell and that the party ultimately calling the shots for the seller – often, the secured lender or the financial investor – has signed off on the basic economic terms. The cost of preparing and negotiating a general letter of intent is often less than the cost of conducting intensive due diligence and negotiations in a concentrated time period only to discover a critical negative fact or “skeleton in the closet” that makes the buyer walk away.

From a buyer’s perspective, the more general the letter of intent, the better, and the document should expressly provide that it is non-binding except for the non-solicitation (so­ called “no shop”) provisions, confidentiality covenants, and provisions granting buyer access to seller’s premises, and to its personnel and professional advisers and the right to conduct due diligence (including environmental testing). Another provision in the letter of intent that should be binding is what the bankruptcy attorneys frequently refer to as “breakup fees.” Even in the absence of a bankruptcy filing or private auction, it is not unheard of for a buyer of a distressed business to ask for a percentage of the total sale price – the ‘breakup fee’- if seller ultimately selects another bidder. This is intended to compensate buyer for the considerable up-front costs incurred in pursuing the acquisition and serving as a so-called “stalking horse” for the transaction.


The Warts and Blemishes

Only specifically identified liabilities should be assumed. Liability avoidance is critical. There are bona fide concerns over successor product liability, employee claims, unsecured creditors, successor liability under tax and labor laws, and environmental and ERISA liability. Even where the asset acquisition agreement (equity purchases are extremely risky in this setting and are to be avoided), supposedly “protects” the buyer from unsecured creditor claims, unhappy vendors or suppliers that are critical to the ongoing business operations may view the prospect of future business as inadequate. Thus, the buyer will need to dig into its pocket to satisfy the supposedly “unassumed” liability.


Labor Pains

Avoiding the Seller’s obligations is particularly important with respect to labor ­ related liabilities. The Buyer should review the health insurance and employee benefit plans to determine whether any unfunded liability exists and request a letter from the actuarial firm confirming the absence of underfunding. The Buyer will also need to examine the non-union hourly and/or salaried employment relationships and contracts.

Where a union is involved and the purchase occurs during the term of the collective bargaining agreement, the “successors and assigns” clause must be analyzed. The Buyer should also pay attention to whether the agreement contains any special conditions such as notice requirements or broad language requiring the buyer to assume the collective bargaining agreement.

Union strategy is usually to delay the transfer of a business unless the buyer is willing to either assume the collective bargaining agreement or, at a minimum, recognize the union. This delay tactic can consist of the filing a grievance, an unfair labor practice charge with the National Labor Relations Board (regarded by many as more sympathetic to organized labor in recent years) and/or a lawsuit in federal court based on breach of the collective bargaining agreement. Buyer should insist that the definitive purchase agreement provide that the union be notified of the purchase agreement, the contemplated sale of the assets, that Buyer is not assuming Seller’s obligations under the collective bargaining agreement and that Seller will bargain in “good faith” concerning the effects of Seller’s decision to sell the assets as required under federal and state law.

From the Buyer’s perspective, the purchase agreement should also require that Seller terminate all employees as of the closing date and that Seller remain responsible for all liabilities resulting from termination. These liabilities can include severance, accrued vacation, sick leave, medical claims, and any claims arising out of the permanent layoff or sale of the purchased assets. Under no conditions may the Seller be permitted to extend offers of employment on behalf of Buyer or otherwise communicate Buyer’s hiring intentions except in the presence of the Buyer. Efforts should be taken to ensure that Seller and its key managers will cooperate with Buyer during the screening and interviewing process, which often takes place following the signing of a definitive agreement but before the closing.

If Seller’s employees are covered by a group-health plan and will lose their jobs as a result of the sale. Buyer and Seller should determine and agree upon which party will provide COBRA notices upon the job loss or other qualifying event. The regulations that interpret these rules are dense and complex, and this apportionment of responsibility is much more easily dealt with by agreement than by statute.

If the business (as long as those 50 or more employees comprise at least 33% of the employer’s active work place) to be sold has at least 100 employees, more than 50 at which are the subject of a mass layoff, the Buyer should also require that the Seller comply with the WARN Act, requiring 60 days’ notice of plant closing or mass layoff. The Buyer also should check for and comply with any other state or local law of a similar nature. The 60 day period can be shortened in cases involving financial distress or emergency. Often Sellers will ask for a commitment from Buyers that it will hire a sufficient number of Seller’s employees (more than 50% of the workforce) to avoid the need to comply with the WARN Act.

Whether the Buyer is required by law to bargain with the union as a “successor” is a function of the composition of its new workforce. The Supreme Court has adopted a three-part test in applying what the labor lawyers refer to as a “successorship doctrine”: there must be a “substantial continuity” in Buyer’s business operations, the bargaining unit must remain “appropriate” after the sale, and Buyer must employ a majority of the former owner’s work force when Buyer reaches a “substantial and representative complement” of its work force.


A Cleansing Experience

Avoiding environmental liabilities is another major objective of the purchaser of a financially distressed business. The Buyer should insist on the unconditional right to walk away from the deal following the results of its environmental testing. Should the Buyer wish to proceed with the acquisition despite troubling environmental test results, it can either acquire a leasehold interest only (which does not automatically eliminate it as a potentially responsible party under federal law) or establish an escrow to remediate the contaminated property. The set-aside should be in an amount sufficient to cover engineering, attorneys and consultants’ fees. The baseline study, at least in theory, will create the “bright line” of liability for environmental conditions created by buyer or by seller or its predecessor owners and operators. Federal law offers buyers an “innocent owner” defense, which is of dubious validity, scope and usefulness. The specific language requires a purchaser to show that it undertook “all appropriate inquiry into the previous ownership and uses of the property consistent with good commercial or customary practice.” The standards for applying this test are, at best, unclear, and the defense does not contain a parallel provision giving the purchaser a private right of action against the predecessor owner for damages, lost profits or down time by reason of the environmental clean-up.

From a timing standpoint, the environmental testing is a due diligence item that requires a significant “lead time.” This includes both third party site visits and preparation of the site assessment reports. The purchaser should attempt to find out as much as it can about the environmental condition of the target business and its assets before beginning to draft the purchase agreement.


Structuring the Deal

The purchaser of a financially distressed company outside the bankruptcy context, can be structured in several different ways. Of course, each has its advantages, disadvantages, and complicating factors. If the transaction is a sale by the seller, with bank consent, the sale can take place on either a going concern or a forced liquidation basis. The seller may wish to utilize a financial advisor or investment banking firm to handle the sale via a private auction. If the bank is forcing the sale, the buyer may wish to explore the possibility of a private secured party sale. In that case, the bank would foreclose on its security interest or obtain the assets through an acknowledgement of loan default and a voluntary surrender by the debtor in lieu of foreclosure. Any secured party sale must be commercial reasonable as to method, manner, time and place. Both the bank and the purchaser should be prepared to defend the purchase price against claims by unsecured creditors, including fraudulent conveyance claims. Obtaining an independent business appraisal in advance of sale is often advisable.

A purchaser from a secured party at a private sale has some protection if it acts in good faith. Nonetheless, the following questions should almost always be asked before proceeding:

(1) Has valid notification been given to the debtor and creditors?

(2) What is the nature of the objections to the sale?

(3) What are the results of the lien search – UCC, tax and judgment liens?

(4) Has an appraisal been performed?

(5) What is the source of the secured party’s interest in the collateral?

The latter question is especially important since the purchaser in a private sale gets an interest only in those assets which the secured party had the power to convey. By contrast, in a public secured party sale, a purchaser takes assets free of all rights and interests in the collateral even though the secured party fails to comply with statutory requirements as long as the purchaser (1) has no knowledge of any defects in the sale, and (2) does not buy the assets in connection with the secured party, other bidders or the person conducting the sale.

Another way to acquire control of a struggling business is to purchase the senior debt position from the Seller’s bank. The attendant risks are similar to those facing a buyer in a private secured party sale, except that they are heightened because it’s now the purchaser, rather than the bank, that needs to conduct the “commercially reasonable” sale. And there is always the possibility that lender liability exists if the bank, or in this case, its assignee, is seen to be exercising management functions and control of the business.


Keeping It Together

A frequent concern for the Buyer is that to keep the acquisition process moving swiftly enough to ensure that there is still a business to buy, or at least a network of relationships with customers and suppliers. At the most elementary level, there is the case of the “disappearing assets.” This can be a consequence of poor controls and internal reporting procedures, employee theft, or providers of add-on services, such as tooling shops claiming equipment under self-help theories or under statutory or common law liens. Employee turnover at a financially distressed company is typically high, and those who remain may often be unmotivated or resentful. So-called “stay bonuses” may work at the management level. Yet at the lower end disaffection may run rampant, and security becomes a factor. Under these circumstances, asset verification must be rigorous, and the purchase price formula should provide for an adjustment if the buyer has trouble locating or accounting for the assets after closing.

Asset verification also applies to accounts receivable. With a financially challenged company, receivables are often overstated (or “under-reserved”). So, the Buyer should be skeptical when it is assured – even in a contract – that “the receivables are good.” The Buyer should protect itself by transferring uncollectible receivables back to the Seller through an escrow, holdback or “put right” (in other words, a right to require the seller to repurchase the uncollectible receivables at face value) after a defined period of time – all with the same economic result of transferring the uncollectible receivable back to seller. If this cannot be accomplished or if the Seller has not independently verified the sufficiency of the bad debt reserve, then a very substantial discount to face value is probably in order. Since the customers may have had disputes with the Seller over missed shipments, warranty claims and other issues, the acquisition agreement should provide as much as possible that customer payments will be applied per invoice or as directed by the customer.

With the acquisition target in financial distress, the due diligence process takes on heightened significance. This holds true whether it be a free fall or a steady, irreversible decline. Time is short. The data being provided by the seller is often unreliable or incomplete. A buyer must deal simultaneously with seller’s management, its lenders, nervous employees, unsecured creditors, disloyal customers, and professionals – attorneys and accountants – who are losing a client. These professionals may be taking a haircut of their own (or even working for free) and may not be as vigilant or responsive as they might be if they were on the other side of the transaction. Thus, the buyer needs to put together in short order its own teams – business, legal, financial and tax – to do as much of its own “tire-kicking” as possible. The Buyer should talk to the trade and ensure itself access to the resources and the personnel it needs – including the “new” management team that it will be forming. This way the Buyer can answer for itself the questions, “Why do I think this business will tum around under our ownership? What will I do differently that will change the situation?” Convincing all of the relevant constituencies that they should remain with the business and that the future under new ownership is far brighter than the recent past, is often a buyer’s greatest obstacle to a successful closing.


Money Can’t Solve Everything

The probability that the buyer detects an insurmountable problem – or the proverbial “deal killer” – during the due diligence process is higher than when acquiring a financially healthy company because sellers tend to bury problems or put an artificial gloss on the overall situation. The great products that are in the pipeline and ready to go to market can’t make it there if the company is losing its competent workers, or if suppliers of materials or critical services have cut them off. Another hidden problem to watch for is an eroding customer base. While it is often said that “everything can be solved by money,” there are some problems in a distressed company (i.e., environmental, “people problems”) – that simply cannot be fixed by throwing money at them, or, for that matter, through elaborate contractual protection. The vigilance, skepticism and verification techniques employed by a buyer’s due diligence team remain the foundation of a successful “bargain basement acquisition.”