Insights

  • We’re Not Going Into a Recession – Here’s Why
    POSTED 12.3.19 M&A

    As the song goes… it’s the most wonderful time of the year. The holidays are upon us. Aside from time with family and friends, my favorite part of the season is the Wall Street Journal’s Economic Forecasting Survey, specifically – the Recession Expectations forecast question: “When do you expect the next recession to start?”, which comes out every September or October.

    It’s a survey of several dozen economists, who chime in on the current health of the economy and when they think the next recession will hit.

    It’s one of many coming-year prediction articles, presentations, commentaries, etc. that come out every year around this time from various financial publications, investment banks, and others. As 2019 draws to a close, it’s worth taking a closer look.

    I wish you could place bets on this sort of thing because I knew exactly what the Wall Street Journal piece was going to say even before I read it.

    How is that possible? Because it’s pretty much the same every single year – and the predictions for 2020 were no exception.

    What to Expect in 2020… or Not

    As is usual in the Journal’s survey, economists are very pessimistic about the economy in the coming year. In fact, they are certain a recession will happen in the next 12 to 18 months. Before you sound the alarm, let’s go back to this time in 2018… 2017… 2016…

    These economists said the same thing: recession in the next year or so. But I don’t remember being in a recession the last few years. Do you?

    I don’t think we’ll be facing a recession in 2020. And, as far as M&A activity goes, there will certainly be no or negligible impact from economic conditions next year. That’s not just for lower middle market, but for M&A at all levels.

    For a different point of view than the usual dour economic forecast, I like to turn to Christopher Thornburg, PhD, a founding partner of Beacon Economics.

    He maintains mainstream economists think that a recession is inevitable every seven to eight years and that because things have been so good – too good – for so long, we’re well due. Not so, says Thornburg.

    Looking at the leading economic indicators, he says we’re in good shape.

    The ongoing “trade wars” are no issue. The GDP is solid. Consumer spending is stable, if not going up. Consumer savings is up. Debt ratios are lower than they have been in years.

    There is one constraint and caution: There are more job openings in the country than people eligible to work. That will slow down businesses because they have so many jobs to fill.

    But overall, we’re in a good economy, so businesses are expanding. And that means more M&A activity.

    What M&A Activity Will Look Like in 2020

    There are other factors that will encourage M&A activity in the coming year:

    • Interest rates remain stable – so the cost of borrowing is not going up, which is one less hurdle to getting deals done.
    • There remains a lot of dry powder held by PE funds – it’s still in the trillions. So there is a lot of cash on the sidelines waiting to be used.
    • There are more emerging, startup PE funds being created now than a year ago, which means more prospective financial Buyers on the playing field.

    And because M&A deals are easier to get done and costs are coming down, we’re seeing other side impacts as well:

    • Smaller PE firms can be successful as deals flow down to them. It’s not just the big institutions that are taking all the action.
    • Because there are more M&A deals being done, the top 100 law firms that used to handle the bulk of the transactions – and charge more money – just can’t keep up. That means smaller firms, especially regional firms, are getting more billable M&A legal work.

    In general, this “spreading of the wealth” is a good thing. As more revenue associated with M&A is going to more players, services will improve. That’s especially true with Representations and Warranty (R&W) insurance.

    The Outlook for M&A Insurance

    We’ve seen that there are already more R&W insurance placements because there are more insurers offering this coverage. Even deal sizes under $20 million can be covered. With this increased supply, costs are coming down. And the process for setting up R&W insurance to cover a deal is easier than even a year ago.

    So not only will 2020 be a banner year for M&A activity, but I expect a corresponding increase in R&W insurance policies written as Buyers and Sellers recognize not only the above factors, but also the many other advantages of this type of coverage:

    • It removes the need for cash to be held in escrow.
    • It removes the need for extensive negotiations on the indemnification clause in the Purchase and Sale Agreement, as the indemnity obligation is transferred from Seller to insurance company.
    • If there are any breaches in the reps, the Buyer can file a claim with a third party (the insurer) and get paid promptly to cover damages.
    • In short, all the risk goes to the insurer, which makes Buyers and Sellers happy.

    R&W coverage also makes negotiations between Buyers and Sellers much smoother. In some cases, it’s the make or break for a deal.

    As you look ahead to 2020 and consider your acquisition strategy (or plan to sell your company), it’s worth taking a close look at how Representations and Warranty insurance coverage could give you the edge.

    If you’d like to get all the details on how, please contact me, Patrick Stroth, at pstroth@rubiconins.com. Let’s chat before we all get so busy during the holidays.

  • Case Study: Rep and Warranty Insurance Helps Smooth M&A Deal in the Tech Sector
    POSTED 11.5.19 M&A

    When lower middle market PE fund Broadtree Partners expressed an interest in acquiring the small HR software solutions provider RedCAT Systems (which works with Uber, LinkedIn, and NYSE, among many other major firms), it looked like everything was going smoothly.

    RedCAT’s management team and founders felt that Broadtree’s post-closing plans for the company meshed well with their core values of not growing too quickly in order to best serve existing customers, which have complex needs, especially with benefits for well-compensated workforces.

    Broadtree was enthusiastic about RedCAT’s impressive customer base and how they had filled a hole in the marketplace with a unique and vital service. They felt, with their management resources and capital and the RedCAT team’s contacts and experience, that they could take the company to the next level – with smart growth.

    The sticking point: one of RedCAT’s partners felt that Representations and Warranty (R&W) insurance should be part of the deal.

    This specialized type of coverage, created especially for M&A deals, transfers all the risk, including the indemnity obligation, to a third party – the insurer.

    It eliminates the need for money to held back in escrow and for an indemnification clause – which makes the Seller happy. This is why the partner wanted the coverage: to make sure his proceeds from the sale were safe and not held back. They had previous experience with lawsuits from a corporate perspective and saw this as a potential area of risk.

    But there are benefits for the Buyer, too. If there are any breaches to the Seller’s reps, the Buyer can file a claim and is quickly compensated with no hassle by the insurer.

    Deals with a transaction value as low as $15M will be considered by insurance company Underwriters for R&W policies. With a transaction value under $25M, the deal with RedCAT certainly qualified. But this is a development within the last year or so, which is one of the reasons why the Buyer was somewhat reluctant, at least at first, to make this accommodation to the Seller.

    Another new development is that deals under $20M can be insured by R&W coverage for up to 75% to 100% of the transaction value. In the case of RedCAT, the parties were seeking a policy covering up to 75% of the transaction value. For larger deals, unlike this new lower middle market segment, Underwriters are only comfortable going up to 30%.

    How R&W Insurance Changed the Deal for the Better

    For Broadtree Director and Portfolio Company CEO Rob Joyce, this was the first time he had taken R&W insurance all the way to the finish line. So they were familiar with, but weren’t aware of, all the potential advantages for both parties.

    “[Rep and Warranty] on my end was really used primarily as a tool to help one of the Sellers become comfortable with the transaction, and that was based on their prior experience,” says Rob. “This person was very, very concerned about this, and Rep and Warranty insurance pretty much mitigated the issue. This was something that could have been really, really time intensive had we not used the solution, and it could have derailed the deal.”

    This is the perfect example of one of R&W insurance’s biggest benefits: it smooths negotiations, removing the contentious elements of escrow and holdback, which also speeds up the journey to a final Purchase and Sales Agreement and eventual closing.

    For the Buyer, it gives reassurance that they will be paid promptly if there is a breach in one of the Seller’s reps, without the need to go after money held in escrow that would normally go to the acquired company’s management team… that could now be, as is the case with RedCAT, part of the Buyer’s organization.

    Overcoming Other Complications That Delayed the Deal

    As negotiations progressed and the due diligence process began, other issues began to emerge. And what happened should provide helpful tips for other lower middle market companies contemplating a sale by showing them what they can be doing now to prepare.

    The issue was the financials. As a smaller company, RedCAT didn’t have the amount of financial data required, and it wasn’t in a format Broadtree was familiar with.

    This often happens due to lack of resources. For example, in RedCAT’s case they didn’t have an investment banker or adviser actively pushing the deal. The founders were working on the deal, which takes significant time, as they continued to run the business.

    The financials themselves were good, but the quality of the data reflecting that was different than you see in larger companies. The other issue was the technical diligence, which is vital with a software company. But soon enough, Broadtree understood the software development process, code base, and related items. Having R&W backing them up was an unexpected, but welcome benefit.

    What’s Next for Broadtree

    Broadtree Partners, after this positive experience with R&W insurance, now consider this coverage to be part of their strategy for acquisitions going forward.

    Instead of being reactionary to a Seller’s requirements (for example, a banker who needs it on the deal) as they have in the past, this PE fund plans to introduce it early in the deal process because of the benefits it offers both Buyer and Seller.

    “This is an immediate part of my toolkit, one that can allow some risk mitigation on my side if I feel the need, and, two, I think it’s also a great tool to help overcome some Buyer discomfort if they’re worried about the sort of risks to the deal that Rep and Warranty insurance can cover,” says Rob. “I would not hesitate to use it again.”

    At this point, RedCAT Systems is well on its way to growing to the next level. They’ve acquired new customers and are gearing up for a big hire to push further growth. And it might not have happened, had Representations and Warranty insurance not entered the picture.

    Note: This is Part 1 of a two-part series examining the Broadtree Partners acquisition of RedCAT Systems, focusing on the use of R&W insurance. Here we covered the deal from the Buyer’s perspective. Coming up next time, we’ll check out how the Seller saw things develop.

    If this case study has interested you in Representations and Warranty insurance, contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • The “Marriage Proposal” of M&A
    POSTED 10.22.19 M&A

    The Letter of Intent (LOI) – sometimes called a term sheet – is a vital first step in many M&A transactions. With an LOI, Buyers show that they’re serious about acquiring a business. And it allows the Buyer and Seller to have conversations to discover whether the vision each has for the deal lines up with the other… before they spend time and money on negotiations and due diligence.

    It’s like the marriage proposal before the wedding, which is when the deal closes and the purchase sale agreement – which often contains very similar terms to the LOI – is signed.

    An LOI is non-binding. But it shows commitment, outlines the basic structure of the deal, lays out a path forward, and contains an agreement to not talk to any other potential Buyers.

    What Should Be in a Letter of Intent

    LOIs typically vary in length from about two to 10 pages, depending on a number of factors. Some argue a shorter LOI can help speed up the negotiating process as it centers the conversation around the most important elements of the deal. If there’s not agreement there, the logic goes, there’s no need to discuss other factors.

    But in general, it pays – literally – to be very detailed in your LOI, especially for Sellers. What’s dangerous about a simple, two-page LOI is if there are any questions or disputes about terms, the Buyer has all the advantage and leverage. So you want to have as much spelled out as early as possible. This makes terms much easier to agree to later – and you can always pull out a term. But it’s a lot harder to add language to the LOI after it’s signed.

    During the LOI stage, Buyer and Seller should talk indemnity. This, of course, is when the Seller is liable to the Buyer financially if the Seller’s reps and warranties weren’t accurate and not uncovered in the due diligence process. There’s a remedy that makes this discussion virtually non-confrontational.

    It’s at this point that the Seller should build in an option for Representations and Warranty (R&W) insurance. Any escrows or withholds (which will be substantially reduced) will be based on the amount of R&W insurance in place. And if there is a breach, a third party – the insurer – will pay the damage, so the Buyer is protected, and the Seller is off the hook.

    At the LOI stage, you don’t need to determine how much coverage is needed, or the cost. As a Seller, you just want that option there. But you should reach out to a broker. With the proposed purchase price, details on how much indemnity the Buyer is expecting- say 10% or 20% of purchase price, and what, if any escrow or withhold the Buyer is seeking, the broker can come back with a quote and a proposed policy. Having knowledge of the R&W cost in advance provides leverage when negotiating who pays (equal shares is very common).

    With that info, the Seller can say, “We agree to the escrow and indemnity cap if we can have R&W insurance to cover it”. That puts some power back in their hands. This usually also accelerates the Seller’s acceptance of the LOI, shows good faith, and removes fear on the Seller’s part.

    The other components of an effective LOI include:

    • Purchase price
    • Deal structure

    Is the transaction a stock or asset purchase? What are the forms of payment? This can include cash, stock, seller notes, earn-outs, rollover equity and contingent pricing.

    • Exclusivity period

    When the parties agree not to shop around. The Seller can’t talk to any other potential Buyers. This is typically a binding clause requested by the Buyer, who wants to ensure that Sellers are negotiating in good faith. It’s typical for Buyers to request an exclusivity period from 30 to 120 days, while Sellers will typically want as short a period as possible.

    Because the Seller has taken themselves off market, if the Buyer drags their feet, the target can go back out to market. It happens often enough. On this note, Sellers have to be very careful when Buyers offer big topline numbers subject to lots of terms that are left nebulous.

    • Confidentiality agreement

    Sensitive information shared during talks will not be shared. The Buyer can’t share the secret sauce recipe. Both parties have likely already signed an NDA earlier in the process, but this clause further ensures that all discussions regarding the proposed transaction remain confidential.

    • Closing date

    An agreement for the signing and closing to be at a specific target date. It’s always subject to change. But if the Seller sets this deadline, it incentivizes the Buyer to take action.

    • Closing conditions

    What are the tasks, approvals, and consents that need to be obtained before or on the closing date? For example, the amount of cash that should be in the business at closing, what happens to employees – what percentage remain, and debts or obligations that must be resolved/paid. The company must also be operating at the same level as it did as negotiations began.

    NOTE: Closing conditions are viewed by courts as literal. If the condition was for $400K in operating costs to be left in the business, and at closing you only have $375K, it’s a serious violation of the terms. The Buyer will deduct the shortfall from the purchase price, or the Buyer can literally walk away from the deal with no liability.

    In short, Buyers don’t want to acquire a company to find they defaulted on lease payments or loans or has other issues.

    • Breakup fee

    Compensation if either party stalls or delays. This clause is also typically binding, though breakup fees are less common in the lower middle market. In larger deals (>$500MM), breakup fees of approximately 3% are typical.

    • Management compensation

    Which members of the senior management will stay on? Who will be provided equity plans? This aspect of the deal may be vague at the LOI stage before due diligence has been conducted.

    • Indemnity
    • Approvals

    Does the Buyer or Seller need any approvals (e.g., from a board of directors, regulatory agencies, customers) to complete the transaction?

    • Due diligence

    How will due diligence will be conducted? This includes the nature of information (financial, technical, etc.) that will be disclosed and the manner in which it will be disclosed. A sample term would be the need to speak with three of the Seller’s largest clients. Or a requirement to interview certain people in management.

    • Indemnity Provision

    Includes size of escrow or holdback. This is the IDEAL place to include wording referring to Indemnity to be paid by R&W insurance. This will not appear fully until the purchase agreement, but sometimes the Buyer will include summary terms of their expected escrow terms for holding back some percentage of the purchase price to cover future payments for past liabilities, and this is where the Seller can counter (reduce) the Buyer’s amounts using R&W.

    • Representations and Warranties

    This also may not be finalized until the purchase agreement, but if there are contentious or non-standard terms, the Buyer may include them in the LOI.

    Where to Go from Here

    The Letter of Intent (LOI) is an important step in most M&A transactions. It serves in some ways as a preview or summary of the deal terms that would be expected to appear in the purchase agreement down the line. 

    It’s not unheard of for Buyer and Seller to skip over the LOI and go straight to the purchase agreement. However, an LOI can be useful for a number of reasons.

    It helps ensure that Buyer and Seller have similar (or at least similar enough) expectations around deal structure, scheduling, and other big concerns. It also means that any potential deal-breakers come up earlier in the process, so that the parties can either a) stop the transaction process before significant resources are spent on due diligence and drafting deal documents or b) figure out a resolution sooner.

    The LOI is also a nice way to ensure that Seller and Buyer are on the same page about how due diligence will be conducted. In addition, the LOI’s terms serve as important protection for all parties in a deal (e.g., exclusivity periods protect Buyers, while breakup fees protect Sellers).

    Representations and Warranty insurance can be a key part of your next M&A deal, and timing is critical. It’s vital that this coverage and its impact on the indemnity cap and amount of withhold be included in the LOI.

    As a broker, I’d be happy to discuss this specialized coverage with you at your convenience. Please contact me, Patrick Stroth, to set up a call at pstroth@rubiconins.com.

  • Let’s Talk Indemnification 
    POSTED 9.24.19 M&A

    After an M&A deal closes – and there are breaches of any of the Representations and Warranties from the Seller – the Indemnification provision protects the Buyer from the resulting damages. In most cases, a portion (10% of the transaction value) is held back from the Seller to pay for these financial losses.

    Indemnification provisions, which are enshrined in the Purchase and Sale Agreement, are an ideal way for a Buyer to mitigate risk. But at the same time, Sellers aren’t too pleased with having a significant amount of cash they expected from the sale of their business held in escrow in case of a breach.

    In short, Buyers want very “broad” Indemnification provisions, covering any potential loss, while Sellers strive to narrow the scope of what breaches are covered, the amount to be potentially paid out in case of a breach, and how long Indemnification provisions can be enforced – the survival period.

    As you might expect, Indemnification – and all the elements that go into it – is one of the most hotly contested deal points when an M&A deal is being negotiated.

    As an advisor in an M&A deal or an owner/founder who is selling their company, it’s important to understand just how important Indemnification is – it’s definitely not an afterthought but rather a critical part of negotiations with the Buyer. It could have a tremendous impact on the amount of money you take home after a deal closes and have ramifications for years down the road if any liabilities pop up that the Buyer blames you for.

    Here’s a quick analogy to break this down into simple terms:

    You want to buy a Tesla. You ordered it, gave the dealer your specs, and put down a down payment. You don’t want to show up at the dealership and be given a Nissan Leaf. If that happens, you want your money back. That’s the mindset of the Buyer.

    But, from the Seller’s point of view… they sold you a car. Once you drive off the lot (the deal closes), it’s not their problem anymore. They want no liability for what happens after. They expect the Buyer, after having done their due diligence, to assume all the risk.

    Indemnification Provisions and Survival Period

    Reps can be divided into fundamental and non-fundamental, with fundamental being core reps covering the basic operations of the business, like stock ownership, authority to sell the company, or tax issues. Of course, this isn’t set in stone. Buyers want to move as many reps into the fundamental category as possible (such as intellectual property), with Sellers resisting that effort. For good reason…

    In general, survival periods can run from six months to two years on non-fundamental reps. However, when considering so-called fundamental reps, the survival period is longer.

    Of course, that’s where negotiation comes into play again. Buyers and Sellers will often disagree on what constitutes a fundamental rep. For example, environmental liabilities can be very expensive and time consuming to clean up… and often these issues don’t come up until long after closing. Buyers would prefer these to be fundamental reps.

    Some items are subject to survival periods negotiated separately. For example, say the target company is the subject of a government investigation – that may or may not go to the courts. Buyers will advocate for a survival period for “special” Indemnification provisions for any related reps and warranties that is indefinite – because the legal process could be very slow.

    Indemnity Cap

    Not only do Sellers want to limit the time Indemnification provisions are in force and which types of claims can be brought, they also want to “cap” how much they might have to pay out in case of a post-closing breach.

    The indemnity cap is typically a percentage of purchase price. A portion of that cap is held in escrow for at least a year or until the survival period ends. That’s money that the Seller doesn’t get to take home or distribute to shareholders at closing. The feeling is that the money might never come home because Buyers will find any reason to retain it.

    A Better Alternative

    Indemnification is such a contentious topic that it can slow down or even shut down deals entirely. There is a way to sidestep all of this.

    Representations and Warranty (R&W) insurance is a specialized coverage that transfers all the indemnity risk to a third-party – the insurer. If there are any breaches of reps and warranties post-closing, the Buyer simply files a claim and the insurer covers the Buyer’s damages. And unlike other types of insurance, this coverage is affordable (costing less than ½ of 1% of the transaction value) and more widespread than ever, with about 20 insurers now offering this coverage, even for deals under $20 million.

    Savvy PE and VC firms, as well as corporate strategic buyers, are recognizing its benefits to smooth out deals and mitigate risk and increasingly making it a must-have in their M&A deals.

    With IP becoming a standard fundamental rep, R&W insurance is ideal for small technology companies, at $20M or less, being sought after by larger firms. And if the Buyer is not interested in R&W coverage, which can often be the case for big companies, it is possible to insure only the IP reps in the deal. The premiums are just $125,000, with $30,000 in underwriting fees. A small price to pay for the Seller’s peace of mind.

    If Indemnification has your M&A deal hung up, or if you’re a Seller concerned about this issue because you’re about to put your business on the market, I’d invite you to speak with me about Representations and Warranty and other types of M&A focused insurance that could protect you.

    You can reach me, Patrick Stroth, at pstroth@rubiconins.com or (415) 806-2356.

  • The First $1 Billion R&W Insurance Policy Issued – and What It Means for the Industry
    POSTED 9.10.19 M&A

    It’s a landmark moment in the world of M&A. Marsh JLT, the world’s largest insurance brokerage, has announced they successfully placed the first Transactional Liability policy at a $1 Billion Dollar Limit, the largest such policy ever written. As impressive as this may seem, it’s only a matter of time before a larger policy Limit is placed on an even bigger transaction. This is just one of the many data points outlined in the Marsh JLT 2019 M&A Trends report.

    The biggest takeaway is that if you have a billion-dollar deal – you need look no further than Marsh JLT. They have the resources and experience to handle these very opportunities. I’ve always believed the world needs the Mega Brokers like Marsh JLT because “someone” has to insure Disneyland! 

    This is just one indication of how the benefits of transactional insurance, especially R&W insurance, is being recognized by Buyers and Sellers and made an essential part of a growing number of transactions, even for transactions going as low as under $20M.

    According to Marsh JLT’s June 2019 Transactional Risk Insurance Report, which looked back at trends in this space in 2018, there are 25 firms offering this specialized type of insurance. That’s a sizeable increase from the handful offering this coverage just a few years ago.

    More policies are being written as well, with Marsh JLT alone experiencing a 40% increase in policy count, from 359 in 2017 to 504 in 2018. The median transaction value for those insured deals was $135M. The size of the average R&W policy placed is about 10% of the transaction value.

    Industry-wide, the number of M&A insurance policies rose for the fifth straight year, according to the Marsh JLT report, driven by strategic acquirers who are gaining confidence with this product. The number of R&W transactions conducted in this sector increased by 21% from 2017 to 2018. PE and other financial acquirers are already comfortable with this insurance, with PE being the majority users.

    Of the policies written, 99%, were Buy-Side R&W, leaving only 1% as Sell-Side R&W. Buy-Side policies continue to represent the vast majority because they provide broader protection (i.e. covering Seller fraud) and because they best facilitate a “clean exit” for Sellers, with no indemnity obligation and less, if any, money held in escrow.

    This allows the Seller to have most of the sales price in hand when the deal closes so they can move on to new investments or distribute funds to shareholders and investors. That’s the reason why Sellers, in many cases, are more than happy to pay for this coverage.

    Looking at trends and what the future holds, it’s clear that the increase in usage of R&W is the direct result of three factors that aren’t changing anytime soon:

    • On-going price reductions from the growing number of insurers entering the M&A space. The favorable pricing environment is expected to continue into 2020. Deductibles for R&W policies are just 1% of enterprise value for most transactions. It’s just 0.75% for deals over $500M.
    • R&W insurance is increasingly being used on larger transactions as past experience has strengthened consumer confidence in the product.
    • More strategic buyers are using the product for both competitive reasons and as an accommodation to target companies. Again, both sides of the table are coming to recognize the value of this coverage.

    It’s also important to note that Underwriters have more experience than ever in writing R&W and other transactional risk policies. This allows this component, including due diligence, to become a seamless part of an M&A deal.

    All this is taking place with a very healthy M&A environment as the background. The Marsh report notes that global M&A activity jumped 11.5% from 2017 to 2018 to $3.5T, even as the total number of deals actually fell. That’s the fifth year in a row that deal values have topped $3T. PE firm buyout activity, meanwhile, was valued at $557B, which is the highest level in 10 years.

    Expect to see increased use of R&W and other transactional risk insurance in the rest of 2019 and beyond.

    The great news for specialty firms, such as Rubicon M&A, is that Marsh’s growth into the billion-dollar deal level opens a wider gap of underserved deals as there are far more sub-$135M deals out there with the exact same needs for protection and service. We’re thrilled to have Marsh JLT out there to serve the mega-deals. We’ll handle the rest!

    To discuss how Representations and Warranty insurance can impact your next M&A deal, contact me, Patrick Stroth, at pstroth@rubiconins.com or 415-806-2356.

  • The Key Differences in Mindset Between Buyers and Sellers in M&A
    POSTED 8.27.19 M&A

    Going into an M&A deal there is always a “courtship” period where the Buyer is wining and dining the target company. If things go well, this leads to a Letter of Intent, which essentially states that the Buyer wants to buy the company, and the Seller agrees.

    This is where things get more complicated. The courtship – and romance – is over.

    Considering that a typical M&A deal is about as hard to complete as a Hollywood blockbuster, it’s a miracle these deals ever go through. There are so many elements that could derail them at any stage until the purchase and sale agreement is signed and the closing takes place.

    So what happens?

    If you’re a target company, you need to be aware of the mindset the Buyer takes on when approaching a deal.

    It helps you manage expectations when you sit across the table. As the target, you must realize that as desirable as you may be, you might not have as much leverage after the Letter of Intent.

    The Buyer’s attitude is that if they’re paying full price, then the target company has to perform to expectations or better once they assume control, even if there are unknown factors that come into play through no fault of the Seller. The Buyer believes the shareholders of the target company should take on all risks of the unknown, despite the due diligence they have done.

    That’s why in these types of deals, a significant portion of the sales price (8% to 10%, generally) is held in escrow for a period of a year or more, with the Buyer basically free to take funds if there have been any breaches with the representations and warranties in the sales contract to pay for the financial losses. They can even clawback more money beyond that amount.

    Understandably, Sellers aren’t eager to take that risk… or take home significantly less funds at closing… money which owners and shareholders are eager to use to retire or invest in new projects.

    A Unique Insurance Product

    But, as we’ll see in a moment, there is a remedy that allows Sellers to protect themselves and not be required to leave any funds in escrow. In fact, they no longer have an indemnity obligation at all.

    On the other side, the Seller maintains they can only give assurances for issues they know about and outline in the representations and warranties in the contract. The target thinks the Buyer should take on all the risk after those issues are outlined.

    Clearly, the two sides are at odds. And this can make for difficult negotiations.

    But there is an insurance product that can make both sides happy, remove the need for money to be held back in escrow and fulfil any indemnity obligations in the event of a breach of the Seller reps. Deals as low as $15 million will be considered by insurance company Underwriters.

    Representations and Warranty insurance does this by transferring the indemnity obligation from the target to a third party – an insurance company.

    For example, say a chain of restaurants is purchased. But post-closing, the Buyer discovers that there are $1M of gift cards out there yet to be redeemed. Without R&W insurance, the Buyer would have to go after the Seller to cover their financial losses. But with this coverage, they simply file a claim with the insurer.

    Another big bonus: with this coverage in place, a deal is EIGHT TIMES more likely to close. Because the indemnity obligation has been removed from the Seller’s shoulders, that’s one less thing to negotiate. The process becomes that much smoother.

    The Nuts and Bolts of R&W

    The vast majority of policies are “Buyer side,” where the Buyer is the Insured Party, although often the Seller is the one to pay for it, and happy to do so, considering all the benefits.

    Securing this coverage is easy, and its cost is low. To secure a policy takes a couple of weeks at most, as the Underwriters review the due diligence performed by the Buyer. The rate is 2%-3% of the Policy Limit, including Underwriting fees and taxes. The price of R&W insurance has dropped considerably in the last several years, while the number of insurers offering this coverage has increased.

    Timing is critical. If you want R&W insurance to cover your next M&A deal, there should be a provision made at the Letter of Intent stage. If it’s put in place at that time, it can always be removed.

    If you’re interested in making Representations and Warranty insurance part of your next deal, contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • ERPs
    POSTED 7.30.19 M&A

    The Software You Need to Scale Up Your Business

    As a company is scaling up, especially a startup, it wants to stay nimble and always moving forward to maintain momentum. At the same time, the systems they used in their startup phase – like QuickBooks – just might not be robust enough to manage their new incarnation.

    There are too many financial reports, people, and processes to keep track of with simple accounting software or spreadsheets. Not evolving and finding an efficient way to keep track of it all, and meet the needs of your growing company, will cause growth to stall.

    There is an ideal solution to help you put the systems you need in place to properly scale up your business. It’s a comprehensive software solution that can boost productivity and efficiency while decreasing costs by integrating:

    • Accounting
    • Human resources
    • Sales
    • Operations
    • Service
    • Your CRM
    • And more…

    … in one system. It gives you a 360-degree view of your business, 24/7, from anywhere in the world.

    An Enterprise Resource Planning (ERP) software solution can improve productivity, increase efficiencies, decrease costs, and streamline processes, and much, much more by automating front and back office processes like…

    • Financial management
    • Revenue management
    • Fixed assets
    • Order management
    • Billing
    • Inventory management
    • And more…

    What Makes an ERP So Powerful

    For any startup ready to take their business to the next level and grow, as well as make itself an attractive acquisition target, a solution like this is necessary.

    Cloud-based software NetSuite is the ERP system of choice. Forty thousand organizations across 160 countries use NetSuite to run their businesses. Seventy percent of all startups are transitioning from other legacy systems to NetSuite ERP.

    An ERP can be used by low level staff, as well as top managers, because the level of access can be customized to each user. NetSuite is ideal for companies scaling 1 to 10 to 100 people and expanding to multiple locations and is perfect for a workforce that is spread across multiple locations, has a large percentage of employees who work from home, or has a team that is regularly on the road or in the field, like salespeople.

    Because it’s cloud-based, it can be accessed by any computer around the world. And it also features an API that is easy to integrate with other systems.

    NetSuite features different “modules” that are added on to its core suite, including modules like financial management, payroll, order management, fixed assets, ecommerce, and more. It can be fully customized to meet a company’s needs.

    You can add or switch out modules as you need them – perfect for a rapidly growing business that needs to adapt quickly to the needs of the market.

    NetSuite grows as you grow, allowing you to add features and functionality as your business grows.

    All the Data You Need to Make Decisions in One Place

    This ERP gives real time visibility through dashboards and reporting throughout your organization. It’s a single platform that handles multiple services for your organization.

    Dashboards allow you to analyze and track system data on a variety of levels, including tracking KPIs like account balances and outstanding bills. But they can also organize deadlines, meetings, calls, and more.

    The order and billing management module integrates sales, finance, and fulfillment operations to be more efficient, improve quote accuracy, and reduce billing mistakes. It also automates your approval, invoicing, and payment management responsibilities.

    Fulfillment errors can be reduced with a module that centralizes customer, order, invoice, and shipping information, while integrating with shippers like UPS and FedEx.

    You can monitor your supply chain from end to end, procurement to payment. And it improves collaboration and communication between vendors and customers.

    But NetSuite doesn’t only tell what happened in the past or what’s currently happening in your business.

    Importantly, with NetSuite dashboards, you can conduct the financial planning that helps you achieve your company’s goals. You can conduct “what-if” financial modeling to help budgeting and forecasting, which allows you to plan your next move more effectively.

    The impact on your business is felt in several other ways.

    Employees can be more productive because you can reduce spreadsheet-based processes by up to 70%. With NetSuite, you’ll have one backoffice system that handles financials, fulfillment, inventory, and sales. Using real-time dashboards, scorecards, and KPIs you can constantly and accurately monitor the daily cash balance.

    You also enjoy reduced IT costs; it’s estimated that companies can save up to 93% in IT costs because they don’t have to maintain, integrate, and upgrade different applications that NetSuite does in one place.

    Next Steps

    If you’re ready to move out of the startup phase, it’s clear you need an ERP to help manage your business. But it’s not a matter of a simple download.

    In order to truly optimize this powerful tool, it’s best to engage an Authorized NetSuite Provider (ANSP) who can walk you through the process from concept to integration (including training) to ongoing servicing.

    An ANSP will ensure that companies realize their full “NetSuite potential.” Particularly, for companies that currently use NetSuite, engagement with an ANSP can be of tremendous value.

    Looking for an ANSP? Drop me an e-mail at pstroth@rubiconins.com, and I’ll send you the contact details for the leading ANSP in Silicon Valley.

  • Sub-$20 Million Dollar Deals Can Now Be Covered By R&W Insurance
    POSTED 7.16.19 Insurance, M&A

    As more players in the world of M&A come to realize its tremendous value, there have been several big changes in the use of Representations and Warranty (R&W) insurance to protect Buyers and Sellers post-transaction. (Any financial loss resulting from a breach of the Seller’s representations in the purchase-sale agreement are paid by the insurer because they take on the indemnity obligation from the Seller.)

    I’ve mentioned previously that the number of insurance companies offering this specialized type of coverage is more than 20 today, compared to just four in 2014.

    There are also more policies being written than ever before. A part of that is the fact that just a few years ago insurers only felt comfortable insuring deals of $100M or more, and then only with audited financials.

    Now, they are offering coverage for deals under $20M… in fact, they’ll now go as low as $15M… without requiring a strict financial audit during the due diligence process.

    The reason? The R&W market has matured, so to speak. Insurance companies are more comfortable with it as they’ve had successful experiences with larger deals. Underwriters are familiar with the product and the claims process. (Only about 20% of deals result in claims.)

    Now, insurers are looking to increase their bandwidth and increase the number of clients they cover. And that means they have to look at smaller clients.

    The risks are smaller and can’t be mitigated as much as with larger clients. But by bringing down the rates enough, they can cover the small deals. And because the amounts involved are so low, there isn’t much financial risk.

    Still, sub-$20M deals are different in a few key ways:

    • Fewer insurance companies are willing to cover the small deals.
    • There are few Brokers who truly understand R&W insurance and have the right experience.
    • Of the Brokers who do understand it, there is an even shallower pool of those who are willing – or able – to do work on smaller deals. (Many Brokers prefer the larger risks – and the higher commissions – that come with the big transactions.)
    • Brokers working these small deals need to know which insurance companies will take on these deals and the Underwriters with the right experience on these policies.
    • In smaller deals, you have less experienced parties on the buy side and sell side. For most, it’ll be the first time they’ve encountered R&W insurance, and the Buyer is not inclined to learn about it, so it’s critical that an experienced broker is engaged to guide the parties through the process.
    • The Seller really drives demand on this product, often not being willing to move forward on a deal without it. And for good reason, as they can’t afford to have millions of dollars of exposure out there. They’re not serial entrepreneurs who can survive that loss. They’re ready to collect more cash at closing so they can pay out investors and move on with their lives.
    • Despite the smaller deal size, pricing is still in the $200,000 to $300,000 range, including all fees, premium, and taxes, which is similar to what policyholders pay for much larger deals. Insurers aren’t willing to take any less to make it worth their while.
    • Buyers must do third-party due diligence on the acquisition target’s tax situation, IP, financials, operations, HR, and more as those are the biggest exposures out there.

    There are many more M&A deals on the smaller side that don’t get the press of the big-name transactions. And I think the use of R&W insurance to cover transactions at any level can only go up as it becomes more well-known, especially among PE firms and VC funds.

    I’m an optimist by nature. But if there is a slowdown in the economy, you will see a lot of owners and founders running to the door to close out business – that’ll cause a spike in sub-$100M transactions.

    And in order to capitalize on their return and secure more cash at closing in uncertain economic times, they’ll want an R&W policy covering the deal.

    If you’re involved in an M&A deal under $20M and are interested in the protection that comes with Representations and Warranty insurance, I’d invite you call me, Patrick Stroth, at 415-806-2356 or send an email to pstroth@rubiconins.com. I’m experienced in deals of all sizes and I have the contacts at the insurers to secure the coverage you need.

  • Craig Lilly | 3 Reasons Foreign Companies Are Looking at U.S. Acquisitions
    POSTED 7.9.19 M&A

    When we usually see cross-border deals, it’s a U.S. company acquiring a foreign business. But increasingly the reverse is happening, says Craig Lilly, corporate partner at the Palo Alto office of Baker McKenzie, and there are three primary drivers for that trend.

    But cross-border deals with foreign buyers aren’t without their pitfalls, especially with newly enacted regulatory and anti-trust and merger controls – at that’s just the start. Just look at what is happening with Chinese telecom giant Huawei.

    Cross-border M&A is far from a done deal. Foreign companies are still acquiring U.S. companies, says Craig, but just engaging experts like his company to shepherd the transaction.

    We talk about where cross-border M&A is headed in 2019 and beyond, as well as…

    • The two biggest concerns in cross-border deals
    • How changes at CFIUS have vastly changed the playing field
    • When a cross border deal isn’t really a cross border deal – and why
    • How American companies are taking advantage of Asian company’s hesitancy
    • And more

    Listen now…

    Mentioned in This Episode: www.bakermckenzie.com and Winning Strategies in Cross Border Deals Tips for Success Presentation

    Episode Transcript:

    Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters where I speak to the leading experts in mergers and acquisitions and we’re all about one thing here. That’s a clean exit for owners, founders, and their investors. Today I’m joined by Craig Lilly, M&A and corporate partner at the law firm Baker McKenzie in their Palo Alto office. Craig’s practice focuses on acquisitions, divestitures, joint ventures, and strategic investments.

    But it’s in complex cross border deals where he’s really developed great expertise and he’s now thought of as an industry leader. Craig’s been a regular contributor on Bloomberg, the Wall Street Journal, and other M&A specific publications. Craig, welcome to the program and thanks for joining me today.

    Craig Lilly: Thank you, Patrick. I’m glad to be on the program.

    Patrick Stroth: Well, Craig, now that we’re getting past the first quarter here in 2019 rather than just focusing on cross border deals which we’re going to get into in depth. Tell me what your perspective is as an expert on what the state of M&A is here in 2019.

    Craig Lilly: Well, I think MNA is very strong and still in 2019, the values is increasing even though the volume may be slightly lower. 79% of executives say that the M&A will increase in or remain the same in 2019. We’re seeing record amounts of a private equity raise as well as venture raise which is really good for the ecosystem in mergers and acquisitions. In the last 12 months alone, we’ve seen over 3.6 trillion in deal value over 19,000 deals in US and Europe. So that’s a very strong technology M&A is up 20%.

    Also, we’re seeing M&A more institutionalized. 20% of all targets, Pat, are backed by either private equity venture firms or professional investors. Also, there’s record levels of what we’d call dry powder or money to make acquisitions. The PE dry powder is estimated to be over 1.7 trillion and also, the top five tech companies alone have over 340 billion in dry powder. And that includes Apple, Google, Microsoft, Facebook, and Amazon. So the key M&A drivers that we’re seeing are really for strategics are customer expansion and diversification. And so those are all I think big drivers for M&A and which will continue in 2019.

    Patrick Stroth: Well, we’ve got just a confluence of changes that have been happening over the world where you’ve got either the world getting flatter or a lot of capital looking for places to be put and maybe people aren’t looking at their backyards anymore. They’re looking overseas. They’re looking cross border. And which is why I wanted to come speak with you about this. But before we get into the technical issues on cross border and the ins and outs of it. Give us a little bit of context for you. What brought you into becoming an M&A attorney first and then to specialize in cross border acquisitions?

    Craig Lilly: Well, I had a background in financing and accounting so I was always interested in M&A and investments which really drew me into it. I originally worked in private equity back in the cottage days of private equity when it was a very early industry. And then I started working in technology over the last 16 years or so. And one of the things to that really interests me about the technology and in M&A is that companies at earlier and earlier stages are expanding internationally which is a big driver of cross border M&A. So those are the things that really interest me is the international aspects, the complexity, and also getting to learn new industries and verticals.

    Patrick Stroth: So what makes a deal a cross border transaction? Is it as simple as we think just anything outside the US borders?

    Craig Lilly: Well, really it’s really any deal with foreign aspects. It could be the buyer or the seller or material assets or it could be a US company acquiring another US company that has material foreign assets as subsidiaries. So typically almost every kind of major US corporation has some type of foreign aspects. So all those acquisitions even though it may be a domestic acquisition really is a cross border because of the foreign aspects or subsidiaries that a US company may have.

    And we’re seeing this in an earlier stages of the companies. A lot of early companies are young companies are expanding overseas whether to develop technology, develop manufacturing or to acquire customers through diversification.

    Patrick Stroth: A lot of times we’re thinking of US going outside and looking to foreign markets for acquisition targets. But it’s also on the flip side, according to what you just told us where you’ve got foreign-owned companies coming to the US which intuitively we think that the US is too expensive a market for targets. But that’s not necessarily the case. There are things that must be driving these foreign-owned companies to come and invest in the US. What drives the demand from their side to come here?

    Craig Lilly: I think it’s three primary drivers for foreign companies to want to make acquisitions in the US. The first one obviously is technology. We’re seeing the fourth industrial revolution happen here in United States where technology is embedded in almost every different vertical or industry whether it’s automotive or manufacturing or artificial intelligence within industrial manufacturing. And so that’s spurring a lot of the investments and acquisitions by foreign acquirers here in the US.

    The second is just customer acquisition. Companies are looking to acquire customers and essentially diversify their base. And a third driver really is not only the diversification within a customer base but diversifying their own different revenue streams where they could be diversifying in a new analogous business that maybe is very synergistic with your existing line of businesses.

    Patrick Stroth: I agree. One of the things that changed my perspective when we talked about this a while ago was that the focus always on customer basis and so forth. People immediately think China or India where they’re billions of potential customers out there completely overlooking the fact that while we may not have the largest population. We probably have one of the richest. So if you can make a stand here in America with a very friendly consumer base, you’ll do very, very well. And that was one of the things that really came up when you and I were talking about the US being such a great target for them. This can’t all be that easy. What are the challenges that are germane to cross border deals versus ups or domestic deal?

    Craig Lilly: Well, there’s definitely changes or challenges in regulatory, whether they are antitrust or merger controls. Obviously, CFIUS which we’ll get into later is a major challenge for companies investing in the US and CFIUS is the Committee on Foreign Investments in the United States. And also, structure and tax issues. Furthermore, key issues when a foreign company comes here is complying with employment laws. It could be unions or the WARN Act. When you want to terminate employees. Intellectual property, data privacy, and security are a major concern as well.

    You’re seeing often more and more companies are having inadvertent data breaches. So that’s a key issue for any company in any type of transaction particularly for cross border where you could have cultural issues and other different challenges in data privacy. Also, anti-corruption is always a big challenge for companies and having internal compliance programs implemented to correctly deal with those types of issues. And obviously, in any type of transaction diligence, culture, deal execution, and also, post-closing integration is a major issue. And in post-closing integration, something doesn’t start after closing. It really starts very early in the acquisition process.

    Patrick Stroth: Can I ask you this is a little off topic but with all of those challenges that are there that’s probably a role that you and your firm will give guidance to if you can’t have absolute on the ground consulting recommendations you have resources or can provide resources to companies to address those various areas of concern?

    Craig Lilly: All right. We have great breadth in over 45 countries around the world and have over 70 offices. So we have experts in all these areas. And really that’s what you need is a specialist or cross border specialist teams because of the numerous landlines involved in foreign deals and some of the really kind of two big areas that companies are very concerned a bit right now obviously is data privacy. But also the anti-corruption issues that are involved and because of the stiff penalties can be imposed and that’s really you outbound or inbound.

    And so we see companies take a very in-depth look at that. One of the things we also look at every transaction, we try to very early on the process is sit down with a client and discuss what are the really high-risk areas, where is really the concerns for the company, where’s the value? It could be in the intellectual property and so we’re going to really take a deep dive in intellectual property to potentially a freedom operate analysis to make sure that they’re protected. And if they do buy the company that they have the freedom to use it the way that they intended to have synergies with their existing businesses.

    Patrick Stroth: Talk about CFIUS a little bit. Should every company now be aware of it, not just the ones that are the traditional chemicals and military applications number one? And then number two, CFIUS is US. Explain what happens if other countries have something similar.

    Craig Lilly: Well, the Committee on Foreign Investments in the US or CFIUS is where a foreign company proposes to acquire a target a US business that generally either produces designs, test, manufactures, fabricates or develops one or more critical technologies. And because of the recent changes in the law, even a 1% investment in a company with critical technologies could trigger a CFIUS filing. So its critical technologies has been expanded for CFIUS and includes such things as defense articles, and defense services, commodity software, and technologies on commerce control list or controlled for reasons relating to the national security, chemical or biological weapons, missile technologies or for reasons relating to regional stability or surreptitious listening.

    It also can include energy and things subject to Department of Energy regulations such as nuclear equipment, software, and technologies, and also includes emerging and foundational technologies which is not to be defined which is very broad. There’s actually currently 27 pilot program industries identified by NAICS code which will require mandatory filings. Also, CFIUS applies if the target owns, operates or manufacturers or supplies critical infrastructure or real estate.

    And critical infrastructure is broadly defined. It can include systems and assets so vital to the United States that the incapacity or destruction would have a debilitating impact on national security. For example, the purchase or lease or incession of a foreign person to a foreign person or any of real estate is located in the United States and is located within an airport or a maritime port or close in proximity to a US military installation that is sensitive for national security reasons.

    And why should an acquirer be concerned about CFIUS? Well, US Treasury which oversees this can unwind the transaction or impose very harsh equitable remedies and fine. Also, each party can pay up to the amount of the purchase price for the fine. And yes, other countries do have similar laws. The EU also has a similar law. Seven transactions last year were blocked by the EU and we had over 14 deals either blocked or abandoned during the last few years. Over 240 deals were actually formally reviewed by the US in last year. And so CFIUS has very wide overreaching kind of application.

    Previously before the recent changes, a company that was making an acquisition in the US could make an investment of 9.9% or less without being subject to CFIUS. But now it applies even to a 1% investment in critical technologies and that’s a mandatory filing. So it’s a very broad expansive type of law and it’s not just only in the US. EU also has these laws as well and a lot of people also are also concerned about China. And why is China’s such a huge presence in cross border here over the last decade? Well, in 2008, China inbound was 1 billion. However, eight years later, by 2016 inbound was 48 billion.

    So that alone has led to a lot of the concern over CFIUS. Also, there are a lot of changes in capital markets and venture capital. Previously DARPA was very heavily involved if there was some type of sensitive technology being developed. But because of the expansion in private markets and venture capital, there’s all types of new technologies that are being developed where DARPA is not involved at all anymore. It used to be decades ago, DARPA would be almost involved in any type of development of critical technologies because it was usually done by larger companies. Because of the expansive venture capital over the last 20 or more years. Now we’re seeing critical technologies being developed even with very small companies.

    Patrick Stroth: At what stage are you filing for CFIUS? Is this where you pass a letter of intent and you’re beginning to get things structured up there or is it something where it can be preemptively checked before advancing too far into an M&A transaction?

    Craig Lilly: Well, generally, we will recommend clients to do a CFIUS assessment of the risk very early on prior to the letter of intent stage. Typically, companies will be even talking with the Treasury even during this letter of intent stage. And that’s generally what we recommend so that we can basically get some initial advice from the Treasury as to whether this is a very high-risk type of assessment which would require a filing. And in most cases, it can be a mandatory filing.

    But typically, you will file this generally right around or medially before the execution of the contract. And that’s just to sign a contract where you may later do the acquisition usually in a two-step type transaction.

    Patrick Stroth: The other question for you. Its something we didn’t talk about. But you triggered my thought process here. Compared to a US deal, I know every deal is different depending in industry and size and everything but are cross border deals routinely larger? And if so, how much larger than a domestic deal for technology or pick a case study?

    Craig Lilly: Well, historically, we saw a lot of large investments but now we’re seeing even the very small investments. There has been just a rush of investments over the last decade of all types of foreign and Asian investors in the US it was particularly with technology companies and so that’s helped a big surge in venture capital investment as well. But we’re seeing across the board obviously, some of the investments by some of the Asian investors has decreased over the last year just because of some of the CFIUS concerns in the regulatory landscape. But there’s no particular size for cross border or a foreign investment we’re seeing across the board all different shapes and sizes just like you would see with a domestic acquisition.

    Patrick Stroth: And assuming that CFIUS gets taken care of. There are the other kinds of risks out there that are germane to M&A. A lot of those risks can be mitigated or controlled or completely eliminated with ensuring a deal through rep and warranty insurance and it’s been used at an increasing rate in domestic deals. How has rep and warranty impacted cross border M&A?

    Craig Lilly: Well, representation and warranty insurance actually was more expensive in the EU and in Europe before it really came to the US. And so it’s very prevalent in Europe and generally, there’s lower price premiums as well. As you know, representation and warranty insurance essentially allows sellers to walk away with more cash at closing while giving buyer’s interest protected in the form of an insurance policy against loss.

    So typically whether it’s in domestic buyers in Europe or otherwise, there’s been the landscape for representation and warranty insurance and in Europe, particularly is fairly widely accepted. And because it’s a less litigious type environment to typically the prices and premiums and risk retention’s are much lower for a Europe-type acquisition.

    Patrick Stroth: Craig, you mentioned China before and how they ramped up very extensively of going from a billion dollars in deals and then a very short term, they come up to $48 billion in transactions. What do you see aside from the slow down right now which could be temporary but what do you see going forward both in Asia and cross border M&A overall? What trends do you see there?

    Craig Lilly: Well, it definitely a cross border M&A has slowed down because of CFIUS and you’ve seen with the recent trade restrictions that were imposed on the Huawei by the US that that’s a definitely an impact on perception at least for Asian investors here in the US. I definitely think it’ll probably be very slow for a lot of the Asian investments in the US. I do think you’ll see more and more US buyers throughout the world whether it’s in Asia or in Europe. I think some of the big drivers for that though is just because there’s a lot of dry powder available for not only private equity funds but also a lot of the large institutional and strategics.

    As I mentioned before, the top five tech companies are 340 billion in dry powder. But also you’re seeing a lot of kind of old-line companies that are really trying to expand whether it’s through technology whether it’s a FinTech or an agricultural tech or some other kind of emerging tech or they’re trying to diversify their customer base or their revenue streams. And also you’re seeing obviously you see continued outsourcing whether it’s through manufacturing or assembling happen and that’s throughout Asia. And also we’re even seeing a lot more in Mexico and Latin America because of the close proximity and probably the more respect or for the cultural aspects of the United States including protection of IP.

    So I think we’ll see kind of more and more US companies do a lot more cross border. The acquisition of tech is obviously a very driving aspect but obviously, the customers diversification, aqua hires, and other things too. And I think you’re seeing this across all different types of verticals whether its artificial intelligence or robotics, FinTech. Of course, auto tech’s been a very big area servicing a lot more of different transportation companies that are trying to expand and drilling through multiple verticals here. It’s a whole… Electric car, autonomous vehicles. The communication slash smart car and also ride sharing too as well. Those are all things that are kind of driving the transportation industry and I think we’ll continue to see that.

    Patrick Stroth: So we’ll be doing a lot more US buying outside our borders as opposed to the last couple of years where we’ve had predominantly Asians coming and buying into the US. That trend looks supportive because it seems that there are more and more service providers out there and advisors such as Baker McKenzie that can make things easier for US buyers to go abroad where they probably were reluctant to do that because of a lot of the bear traps out there that they didn’t know what they didn’t know. And they’ve got resources like yours now that they can bring to bear that will help. At the same time, CFIUS is making it harder for the foreign-owned companies to come in and maybe easier for us to go out. So it may have not the same sustainability or robust outlook as you do domestic but it’s still fairly positive. Would you agree?

    Craig Lilly: No, I agree. And also we’re seeing kind of a trend that’s really developed over the last few years is that you’ll see a US slash Delaware Corporation basically as a holding company but really their operations are really abroad and even though any M&A or acquisition is of the Delaware company as a domestic acquisition, essentially the company is a foreign company. And so we’ve seen a lot more of those types of transactions and that’s obviously been spurred by the not a venture capital investment here in the United States as well. And I think we’ll see that continue.

    That’s why I’m saying M&A is also becoming more institutional-wise where 20% of all targets are backed by some type of institutional investor whether its private equity or venture capital. So I think we’ll see that continue. Obviously, we’ll see a lot of I think secondary private equity sales. And what that means is one private equity funds selling a portfolio company to another private equity fund. Now those type of exits account for somewhere close to 30% now of all private equity exits. I think that trend will continue as well.

    Patrick Stroth: Well, you’ve got a lot there for us to consider, particularly just not the cultural differences but a lot of the other regulatory and compliance traps and so forth and just how things are different outside. But that shouldn’t stop you from taking advantage of some great opportunities out there. And if there are organizations like you and Baker McKenzie that can be brought to help smooth that transition, that’s all the better for a lot of owners and founders out there. Craig, how can our audience reach you? Because I’m sure they’ve got a lot more questions than I can give you.

    Craig Lilly: Well, I’ll have a presentation which I’ll have on Rubicon’s website after this. And then also you can reach me at our website or my email address which is just craig.lilly@bakermckenzie.com. Also, you can reach me through my phone number 650-251-5947 plus I’ll have a cross border presentation that I’ll post on Rubicon’s website that can be accessible and will have my information as well.

    Patrick Stroth: Well, that’s absolutely fantastic. Thank you very much. And you can check the show notes here under the insights tab at Rubicon, R-U-B-I-C-O-N-I-N-S as in Sam, rubiconins.com. Go to the insights tab there and you’ll have the show notes along with a link to Craig’s presentation and you can also reach out to Craig directly. Craig, very informative. You cracked open a lot of different avenues of thought there so I greatly appreciate it. My audience will appreciate it as well. Have a good day. Thanks so much for joining us today.

    Craig Lilly: Thank you, Patrick, very much.

     

  • An Overview of Tax Liability Insurance
    POSTED 6.18.19 Insurance, M&A

    With any merger or acquisition, tax liability is a major concern because when you buy a company you assume its tax obligations. And you can bet the IRS is keeping close tabs on every transaction for taxable events, not to mention state tax authorities.

    Not paying attention to tax treatments that apply to acquisitions could cost a Buyer significantly, and perhaps negate any advantage they had in the deal at all. For example, say a Buyer purchases because they think it has favorable tax deals, but the taxing authority disagrees. Then they’re on the hook for the tax bill.

    But for a low premium, tax insurance, with policy terms generally set at six years, would protect against that disastrous event. Think of tax insurance as an “add-on” to Representations and Warranty insurance, kind of like you add earthquake or hurricane coverage to your homeowner’s policy.

    That might be putting it too lightly, actually. Tax insurance protects a taxpayer (in this case, the acquiring company) if there is a failure of tax position arising from an M&A transaction, as well as reorganizations, accounting treatments, or investments.

    A few examples of where tax liability insurance would be applicable (thanks to RT ProExec Transactional Risk’s recent white paper for this info and other helpful tips in this post):

    1. Historic tax positions of a target entity in an M&A transaction
    2. Investment in clean energy (e.g. solar), new market, rehabilitation, and other investor tax credits
    3. Real Estate Investment Trusts (“REIT”) and their representations as to their REIT status in an acquisition
    4. Foreign tax credits
    5. Preservation of (or availability of exceptions to any limitations to) net operating losses and other tax attributes following a transaction
    6. Transfer pricing
    7. Tax treatment of reorganizations, recapitalizations and/or spin-offs
    8. Debt v. Equity analysis
    9. Capital gain versus ordinary income treatment
    10. Deductibility of expenses (as opposed to capitalization)
    11. Excessive compensation
    12. Deferred compensation
    13. Whether withholding taxes are imposed
    14. Whether distributions constitute a “disguised sale”
    15. Valuation risks
    16. S Corporations and 338(h)(10) elections

    Checking tax status is, of course, part of any Buyer’s due diligence. An outstanding tax bill is easy to find. But certain tax treatments the Seller insists are correct and up to standard, may not be. The Buyer, relying on its tax attorney’s specialized tax expertise, can insist those issues be taken care of pre-sale because they are exposures.

    In the past, Sellers could go to the IRS and ask, “Is this an exposure?” and get a Private Letter Ruling okaying the request. But with the IRS swamped these days, they’re not really issued anymore.

    Where Tax Insurance Comes In

    When there are tax issues that come up for debate during due diligence for an M&A transaction, both sides bring in tax attorneys and each side makes the best determination in their opinion if this is a taxable transaction or not. They could take a light touch or be very conservative.

    The Buyer will likely insist that a portion of any tax liability goes to the Seller, whose expert says they don’t agree with that determination. If there is a disagreement – get tax insurance.

    Underwriters will get letters from tax attorneys from both sides outlining their arguments, along with supporting documents. It’s quite simple underwriting.

    Underwriters want to see:

    • Name and address of the insured.
    • Covered tax descriptions of detailed descriptions of the underlying transaction and the relevant tax issues.
    • Draft opinion from a tax advisor.
    • The tax backgrounds of the Buyer and Seller.
    • Limit of liability the insured would desire.
    • A potential loss calculation, including additional taxes, interest, penalties, claim expenses, and gross-up.

    It generally takes the Underwriters about three to four days to deliver a preliminary response.

    In some cases, M&A transactions can become tax-free transactions or tax-free exchanges. Of course, the IRS can always disagree and insist on back taxes and fines.

    Some things to keep in mind:

    When Underwriters aren’t confident about a specific tax position, they may set retention at where they think the tax authority would settle. When they are more confident, they will be okay with minimal retention by the insured or none at all.

    If a tax memo convinces them that the IRS agrees that it is not a taxable event – good. If not, the IRS triggers an inspection.

    The insurance will pay the legal costs to fight the IRS, as well as taxes, penalties, and fines if they lose. And, get this. If your insurance win was, let’s say, $5 million and the IRS says, “You just made $5 million in income,” the insurance will pay tax on that as well. That is known as a “gross-up.”

    Tax liability insurance is more expensive than R&W (it generally costs between 3% to 6% of the limit), but it makes sense as the stakes are higher. So it should be an important part of any M&A transaction.

    If you’d like to discuss how to protect yourself with tax liability insurance and how it coordinates with R&W coverage (because R&W does not include a Seller’s identified or disclosed tax risks), please call me, Patrick Stroth, at (415) 806-2356 or email me at pstroth@rubiconins.com, to further discuss this vital insurance protection.