M&A Monday: Deal Stories: When Things Go Very Wrong After Closing.

What happened and how we dealt with it.

The lower middle market is the Wild West of M&A and in the last two years, I have closed more deals than most lawyers in their entire career. This Deal Story is about, a deal that went very wrong, warning signs that were missed, and what actions we took post-closing.

The buyers had careers, but were searching for a business they could buy and grow. They wanted something in the community they would be proud of. They talked about bringing their kids to the job site and the pride they would have running their own family business. They wanted to get out of the rat race and be there for their kids’ milestones. I really liked them from the first time we talked.

They found an off-market blue-collar business just outside of their neighborhood.

The seller was known around town as being a tough operator, stiffed some vendors, and was rough around the edges. But, that was not abnormal for the type of business and location.

The Business was making around $3m in EBITDA and buyer made an offer for 2.5x EBITDA. Seller would hold 30% in a promissory note (on standby for 2 years) (How to Get a Seller Comfortable with a Seller Note: See below). The rest of the purchase price came from cash from buyer and a personally guaranteed SBA 7a loan.

There was not a lot of diligence produced and seller was not responsive to requests. Again, not abnormal for a deal this size and type. Buyer conducted Quality of Earnings with a reputable provider.

We drafted a purchase agreement that was tighter than usual given the risk profile. We included a range of specific indemnities (Explainer on Specific Indemnity: Link Below) and an indemnification against any loss arising prior to closing.

We also included very strong offset language for indemnifications against the promissory note – since the note was substantial (Explainer on who and what must stand behind the indemnities: Here).

The docs were barely negotiated by the seller. The parties signed and after some celebrations, I went on to the next deal and they started running the business.

That is when the trouble started.

Immediately after closing they realized the first problem. The seller had been providing all sorts of benefits to employees off the books. He would pay them in cash, pay for their expenses, like housing, and vehicles. He also paid vendors under the table. None of these expenses were deducted from EBITDA, of course. The true EBITDA was about half of the $3m.

Aside from the tax and valuation issues, the employees expected these perks to continue and some of the employees were absolutely key to the business. There were competitors in the market who were already sniffing around their employees and one key employee had already left.

Second, after a couple of months, two top customers started purchasing less than usual. After some inquiries, the Buyer found out the previous seller was servicing those clients in direct violation of his non-compete.

The Buyers grinded it out for a year before calling me and said, Eli, what is our recourse? They had run out of runway and were asking what would happen to their personal guarantee if they went bankrupt when the seller note started to become payable.

There was so much pain in their voices. They had been fighting for a year, had an SBA loan hanging over their head and saw no end in sight.

I said, hold up, you are not paying the seller note. Let’s discuss this.

We reviewed the purchase agreement and promissory note together and came up with a list of claims and damage amounts. There were numerous breaches of the representations and warranties. There was also blatant fraud, and a breach of the non-compete covenant and the transition services covenant. As an aside, it is such a relief to go back to a purchase agreement and find out it was perfectly drafted.

The damages equaled almost the entire purchase price. First, we sent a notice deeming the promissory note offset by the damages. Our offset language in the purchase agreement gave us a unilateral right to offset in the event of an indemnification claim.

Then, we brought in a litigator to sue for the rest of the damages. I do not believe that we will ever get a dollar back from the seller. The problem is also that litigators cost money and we did not have much of that to go around.

The seller threatened to sue for non-payment of the promissory note, but the language in both the purchase agreement and the promissory note is very protective of the buyer.

There are a few lessons I took away from this one.

First, the seller had a bad reputation and was dishonest. I have a rule for myself: never deal with dishonest people. Run away at the first sign, even if the opportunity seems great. There were red flags here and the buyer should have paid more attention to them.

Second, you need recourse after closing (Explainer). This can be a seller note, an escrow account or holdback, rollover equity, or earnout (these last two are the worst of the four, because they will be worthless). A business is not a building. If one buys a building, they do a property condition report and can independently verify information. It is difficult to independently verify all diligence and often, we are reliant on a seller to provide accurate information.

Third, sometimes you can do all the diligence and quality of earnings in the world and it will be hard to find fraud. That is the risk of buying a business.

Fourth, build in protections for the worst-case scenario. This means arguing for a larger promissory note and tighter purchase agreement recourse. Unfortunately, in M&A, always assume the worst.

Finally, if you are buying a business, know what you are getting yourself into. It will take an iron stomach to get through the first year. It is not easy.

There are four more deal stories of deals that went wrong after closing. I will cover each in a future Deal Story.

*The names and other identifying information have been changed to protect the innocent.

How to get seller comfortable with a seller note: