Most M&A practitioners have a healthy skepticism regarding the ability of confidentiality agreements alone to adequately protect the rights of their clients, given the difficulty of proving a breach in the first place and then the amount of damages. Moreover, the lack of jurisprudence and precedents in Central Europe on this subject make enforceability even more difficult, hence the need to rely on a combination of all four approaches.

a) Confidentiality agreements or non-disclosure agreements

Most agreements cover only information received from the company rather than information available from public sources. The duration is typically negotiable between one to five years, with two to three years being the norm. Generally speaking, boilerplate agreements do a poor job of properly representing the interests of the parties concerned; this is an agreement that requires careful thought and specific focus. One common flaw is that many confidentiality agreements do not state that the mere information that the company is for sale, or is contemplating a transaction, is in and of itself confidential. Furthermore, companies typically try to stipulate liquidated damages (e.g. predefined damages if a breach of confidentiality is proven), whereas investors are typically reluctant to accept such damages.

b) Delay in the transmission of information

There is a general principle that should be observed in these transactions: the volume and degree of confidential information transmitted by a company should be in proportion to the degree of commitment given by an investor. For example, in the first stage of information disclosure (typically a teaser or information summary), as there is no commitment from the investor usually there is not sufficient information to ascertain the identity of the company (although there should be enough to allow the investor to decide whether or not to proceed further (e.g. sign a confidentiality agreement)).

Once a confidentiality agreement is signed, the company typically provides investors with an information memorandum. Information memoranda typically divulge a considerable amount of information about the company, including its identity, key market and financial data, staffing, backlog of contracts, etc. In cases where certain information may be extremely sensitive (e.g. the identity of clients), the name or identity of clients is sometimes withheld and instead the information memorandum might refer to client 1, client 2, etc., with an understanding that the identity of clients, or other sensitive information, would be revealed at some stage before closing.

After the information memorandum is received, investors generally proceed to the next level of commitment which is to provide a non-binding offer. Once the parties agree to the terms of an offer (often finalized in a term sheet), the company then allows access to the data room, where source documents such as contracts, title documents, intellectual property, etc. are made available. Once again, highly sensitive information may be withheld until prior to closing, bearing in mind that if such information is not according to the investor’s expectations, the investor will generally reserve the right to back out of the transaction. Withholding sensitive information may also hinder the bidder’s ability to nail down the purchase price and a sensible compromise must be found at this important stage.

After the data room, the investor then must decide whether to make a binding offer. After a binding offer, the parties usually negotiate a sale and purchase agreement (SPA). After signing the SPA, the investor should then insist on receiving all the information about the company, with absolutely nothing withheld.

As a past client of ours stated when selling their business, “We had to dress down to our underwear, and beyond.” And, indeed, dressing down is the quid pro quo for the investor putting millions of dollars or euros at risk.

c) Deal with a reputable party

A confidentiality agreement, or indeed any other agreement, is usually not worth the paper it is written on unless signed by a reputable party. Given the difficulty of verification of any transgressions and proof of damages, a judgement call needs to be made about the character of the individual or corporate recipient and there must be mutual trust in order for a deal to work. This is of course especially true when providing sensitive information to a direct competitor and so the ethics and reputation of the firm in question are vitally important.

d) Not dealing with direct or indirect competitors

Most business owners have a healthy reluctance to share information with competitors. The more direct the potential competitive threat, the stronger the reluctance. If a business owner has other potential investors, he might choose to negotiate first with parties who do not pose a threat. Alternatively, once again, the release of sensitive information could be delayed. However, in doing so there is a trade-off, in that this may also delay obtaining a bona fide offer.

Think of the process of information disclosure as a ritual or dance: step by step. Do not let one foot get too far ahead of the other!

Often earn-outs are used in owner-managed companies, and generally require that the sellers remain in the management of the company in question, to ensure that performance targets and a smooth transition are achieved. Earn-outs are becoming increasingly popular in Central Europe.

What gives rise to earn-outs? Simply put, the owners of companies usually have more confidence in the future performance of their companies than prospective buyers do. This is usual, because sellers tend to have an emotional attachment to their businesses, whereas buyers tend to place more emphasis on possible risks associated with an acquisition. The discrepancy may sometimes be quite wide, resulting in a valuation deadlock. The buyer may then graciously agree to break the standstill by improving an initially conservative offer, but on condition that the business plan or level of performance portrayed by the seller materializes. It is a perfectly natural reaction for an investor or buyer to decide to share the upside with the seller, as it creates strong motivation for the selling shareholders to remain involved and maximize the performance of the company. This helps minimize transition risk for the buyer.

Yet the implementation of earn-outs remain devilishly difficult, primarily because of five factors.

First, setting the performance benchmarks that should be achieved is tricky, such as determining if the earn-out should be tied to revenue, operating margins, profit, or a combination of these benchmarks. The sellers should have an excellent business plan or budget that gives a relatively accurate estimate of future performance, or else the earn-out can become meaningless. Establishing performance benchmarks can be the subject of protracted negotiations, with each change in benchmark potentially impacting on valuation.

Second, there are issues of control. Compensation of the sellers is tied to performance, but under earn-outs, operating control is usually ceded to buyers. Hence, there must be an elaborate system of checks and balances, usually in the form of veto rights, that give at least a degree of operational autonomy to the sellers (who remain in management). They would be foolish to accept deferred compensation if they had no control over the conditions in which the earn-out might be achieved.

Third, it may be difficult to accommodate unanticipated events during the earn-out period such as what happens if the business plan changes for whatever reason, or if an unanticipated capital injection is required, or if there is a force majeure occurrence? It is simply impossible to anticipate every eventuality in a contract.

Fourth, it is difficult to account for the synergies between the buyer and the seller’s company, which questions like what happens if the buyer brings new orders to the sellers company? The buyer might feel that the seller is achieving a windfall that benchmarks are being achieved even if the seller is delivering less than promised. These issues must be carefully discussed, as it is important to avoid misunderstandings.

Lastly, sellers will typically want to protect themselves against fraudulent or arbitrary actions by buyers aimed at shortchanging them on their earn-out proceeds. As with any form of deferred compensation, there may be temptation on the part of the buyers to find a justified or unjustified pretext for deducting from those proceeds.

As a rule, drafting a sale and purchase agreement requires a high-degree of legal sophistication; drafting an earn-out takes the level of sophistication even higher. Legal fees may increase due to a high number of hours as well as higher-than-normal billing rates for top-notch legal counsel.

However, even the best laid plans may go awry. For example, those sellers who negotiated an earn-out a year ago will need to work exceedingly hard to achieve targets that were established before the worst of the financial crisis arose.

As the reader has no doubt discerned, earn-outs are not for neophytes: both buyer and seller should have at least one or two people on their respective teams who have structured at least half a dozen earn-outs. While there is enormous potential to create a genuinely “win-win” solution between buyer and seller, there is also potential for disaster. Earn-outs deserve serious consideration when structuring transactions.

Owners and managers of businesses always have the option of financing a business by way of either debt or equity. For any business, there is usually an optimal debt to equity ratio that best fulfils the objectives of owners and managers and which depends on a number of factors.

There are numerous advantages to financing via debt. Debt has the advantage of generally being tax deductible (although tax regimes in some countries do set a limit on the amount of debt which is deductible), and debt financing has the advantage of avoiding dilution of equity ownership. The cost of debt financing is therefore lower than the cost of equity.

However the big disadvantage of debt financing is that it increases the level of risk in the corporation (i.e. there is a higher risk of default). Moreover, as the level of debt increases in a company, the cost of such debt also tends to increase so as to compensate for the additional risk.

There are also a number of cyclical factors that may have an impact on the debt to equity ratio. The expected debt to equity ratio varies depending on whether markets are bullish or bearish, whether the economic sector to which a company belongs is more sunrise or sunset, or indeed whether a company is in an early development phase or at maturity.

During the last economic boom, most business owners would have preferred a higher mix of debt to equity as debt was readily available, interest rates were lower, companies had more accurate earnings forecasts, and earnings tended to rise over time. Expansion could be financed via debt, while existing equity owners remained in control and interest was tax deductible.

However, during the current recession, earnings are much more difficult to predict (companies often have trouble forecasting the coming quarter, let alone for the year) and debt is less readily available as a result of the much more conservative lending policies the banks are adopting. While interest rates such as Euribor, Libor, etc. have decreased by several percentage points, the spreads over Euribor or Libor have generally increased by anywhere from 100 to 400 basis points for most companies, meaning that the real cost of debt financing (after adjustment for inflation) has generally increased.

The word ‘deleveraging’ often arises during the current recession. The dynamics described above often force companies to substitute equity for debt. However, equity has also become more difficult and costly to source compared to 18 months ago. Despite this, beefing up the balance sheet with a healthy dose of equity is an option that the majority of business owners and managers should be considering today.

In addition to the option of equity injection, hybrid instruments (which contain features of both debt and equity) may also strengthen a company’s financial position. Two common hybrid instruments are preferred shares (which have an obligation to pay a certain dividend rate) and convertible debt (where the lender may be willing to accept a lower interest rate in exchange for having the option to convert the debt into equity at a later date). Hybrid instruments typically have a level of risk that is higher than debt but lower than equity, and therefore the cost of financing also lies somewhere between the cost of debt and the cost of equity. (Hybrid instruments will be the subject of subsequent columns).

A strong balance sheet can be even more of a source of strength and competitiveness in a recession than during a boom. It is no accident that even strong banks such as HSBC are raising equity, not because they are undercapitalized, but to take advantage of opportunities in the marketplace. Equity may also be viewed as a financial cushion, something that could help companies weather a deepening recession in the event that the much-touted recovery does not occur as soon as expected.

Yet businesses run by One Man Shows often run into challenges when trying to engage in any type of equity transaction, whether that be raising capital or selling their company. This has to do with the real or perceived risks of doing transactions with such companies:

• Should a One Man Showbecome sick, incapacitated or leave the firm, the firm may become ungovernable or lose profitability. In this event, key relationships with clients, staff or suppliers may be lost, causing further disruption, which may substantially add to the risk associated with investing in a particular enterprise.

• Executing a transaction, in particular satisfying the informational requirements of a due diligence and managing a complex negotiation, often requires the collective efforts of a team. A One Man Show may become the bottleneck within his own firm, simply incapable of handling the daily operations on top of the demands placed on him by the transaction.

• Enterprises run by One Man Shows frequently lack the systems (whether IT platforms, accounting systems, or corporate governance procedures) that can sustain profitable growth. The methodology behind the company’s operations may exist only inside the head of the One Man Show, have been jotted down on the back of an envelope, or be left in an excel spreadsheet, never having been communicated throughout the organization. The lack of such systems makes the potential loss of one key individual all the harder for the enterprise to bear. It also creates various limitations to growth. One should be particularly careful of projecting past rates of growth into the future without making appropriate investments in systems and staffing.

Of course, whether a business is run by a One Man Show is seldom a question that is black or white. When assessing an acquisition target, an investor should assess the degree to which their target is run by a One Man Show as it may have a serious impact on the valuation (e.g. in a Discounted Cash Flow Model the appropriate investments to sustain growth should be reflected) or may even in the end be a deal breaker. One of the reasons that larger firms are typically more attractive to investors is that they are less beholden to one owner-manager. Similarly, publically-traded stock exchange-listed firms typically trade at higher multiples than owner-managed firms, in part because they have greater depth and breadth of management.

As an investor in a firm managed by a One Man Show, there are ways of mitigating risk. For example, one might consider an earn-out transaction, where a portion of the purchase price is paid after closing (see our earlier article on this subject). Or one could appoint staff to work alongside the One Man Show.

From the other side, what can a One Man Show do to avoid being disappointed in the valuation of his firm, or even becoming a deal breaker himself? In a nutshell, empower people and build systems. This is easier said than done and may run counter to the personality of the owner-manager, who often enjoys exerting a high degree of control. Some owner-managers are so dominant that they are unable to attract into their immediate circle individuals who are highly empowered and capable of taking decisions on their own. However, perhaps the realization that empowering people and building systems may add substantially to his own net worth may provide the One Man Show with sufficient financial incentive to consider such a course of action. Ultimately, it may mean the difference between being able to raise financing for one’s business and eventually sell one’s business or not.