"Don't Worry, The Buyer Signed Our Regular NDA ..."

… an exec told me, after he’d signed a letter of intent for the sale of the company without review, and he’d already begun to share confidential information with the proposed buyer.   To be fair, something is better than nothing, but in these circumstances not by much.  Most everyday confidentiality or non-disclosure agreements (NDAs) for vendors, suppliers, partners and the like have some big holes in them if used for the sale of the company.  The usual NDA defines confidential information as whatever you give the other party about the company that isn’t publicly available, requires the signer not to disclose any of that confidential information, and if the signer does, it gives you permission to (try to) get an injunction to stop disclosure. That’s it … and that’s usually okay for everyday disclosures between companies.  But it’s not good enough in the context of a sale.     

Here’s what’s missing from most ordinary NDAs that you’d want a buyer to sign:

• Prohibition on use of the information.  This seems obvious, but go look at your form NDA … it’s probably not there.   Nondisclosure is critically important, but you also want the buyer not to use your information in any way detrimental to your business.  If the deal breaks up, and that can happen for any of a thousand reasons, the buyer can hurt your business without disclosing your confidential information.  Without a prohibition on use, the former buyer can now market to your customer list, employ your pricing data and  strategies, etc. so long as it does not publicly disclose your information.  

• Data Compilations are Included.  Buyers usually compile the information presented to them in their own way: spreadsheets, summaries, financial analyses, etc.  If the deal blows up and the NDA only requires the buyer to return or destroy all the information supplied, it does not capture any of the buyer’s internally-prepared compilations, spreadsheets, analyses, etc., so the buyer gets to keep its own compilations of your information.  

• No Reps and Warranties.  If you’ve ever seen a purchase agreement for a company, you know that a significant portion of the document is made up of the seller’s representations and warranties.  These are affirmative statements the seller is making about the business to assure the buyer about the nature of the organization, the business, customers, litigation, etc.  That section of the agreement can go on for 20 pages.  The buyer is relying on those statements, and if they’re wrong, there will be a claim against the seller.  At the letter-of-intent-stage of a deal, the last thing you want to do is to make, or be deemed to have made, reps and warranties about the information you’ve supplied to the buyer, so make sure to exclude them in the NDA.

• No Disclosure of Proposed Transaction.   Both sides of the deal should be prohibited from disclosing not only of the fact of discussions taking place about a deal, but also any  terms of the proposed deal.

• Nonsolicitation of Employees.   This is a prohibition on the buyer trying to entice your officers, directors, and employees to come work for them for a certain period, usually a year.  A well drafted provision would exclude advertising to the public, employee-initiated contact that results in employment by the buyer, and incidental hires who have no knowledge of the prospective deal.  

On a related note, NDAs are often signed with just an indecipherable scribble; no name of the company, no name of the signing individual, and no title, so it’s not clear who signed the agreement, whether it was on behalf of the company, or whether the individual was even an authorized officer.  That’s a great way to make the whole thing unenforceable.  

The Privilege Problem When Selling the Company

Maybe someone should invent Snapchat for email, a read-once-and-it-disappears app for email so you never have to worry about being hacked, or in the case of a merger, having your private communications with counsel disclosed and used against you.  

Here's how that works.  After months of negotiating, countless drafts of documents, hundreds of emails, calls, and messages with counsel, you made it to closing and sold the company.  It was emotional, complicated, and full of difficult choices, and your pre-closing communications with counsel are suffused with those thoughts, decisions and emotions.  Now after the closing, the buyer, who’s in possession of the company email and voicemail servers, has the ability to look at all of those communications, drafts, and messages.  What? That’s crazy! you say.  It’s all confidential and subject to attorney client privilege!  If the buyer could see all our negotiation strategies, draft language, and disclosure discussions, it would be like handing them a gun to point at us.  

It is true that confidential communications between attorney and client are subject to legal privilege, which means they can’t be used as evidence in a court action.  But a line of cases in Delaware has held that the attorney-client privilege with respect to pre-closing communications is transferred to the buyer at closing along with all the other assets, liabilities and rights of the seller company in a merger.  When the privilege is transferred to the buyer, the buyer can simply waive it.  The buyer would then be free to use those communications against you.  Since it’s not uncommon for a buyer to sue the selling shareholders for fraud or breach of a representation and warranty, you can bet that those presumed-confidential, pre-closing communications between selling shareholders and counsel might be really helpful to the buyer in such an action.  Since those Delaware cases came down, lawyers have tried several approaches - so far untested - to keep this from happening, one of them suggested by a judge in one of the Delaware cases.        

Judges are criticized for opinions that include points not relevant to the case at hand, called dicta, so naturally, the judge in one of the Delaware cases wagged his finger at counsel saying that the parties could have avoided the privilege problem by contracting around the issue.  In other words, the lawyers should have added provisions to the purchase agreement which carved out pre-merger negotiations from all of the things being transferred to the buyer.  As a result of that unhelpful dicta, some attorneys now draft language in the purchase agreement to the effect that all communications between the sellers and counsel are subject to the privilege and the privilege does not transfer to the buyer regardless of the structure of the transaction.    Another related mechanism is to provide in the agreement that the privilege is transferred to the buyer, but the buyer can’t use pre-closing communications or waive the privilege to make a claim against the sellers. This after all is what we’re concerned about.  

Those attempts to draft around the problem sound great in theory, but they ignore the unwelcome reality that the buyer still has access to those communications post-closing.  That access alone may be a deemed waiver of the privilege.   Does the contractual prohibition against using privileged communications against you actually work?  Maybe.  It might chill a prospective lawsuit, but it certainly isn’t going to keep the buyer from seeing them, and if the buyer uses an email you wrote as evidence in an action against you, you’re left with a long and expensive fight to prove the buyer was not permitted to use it.   You can also bet that if there is a smoking-gun email that would help the buyer in a case against you, creative counsel for the buyer is going to find a way to use it, or since the buyer knows of its existence, counsel will try to get to that information another way.   

The more practical solution is not to communicate on company-owned equipment or systems. When talks about a potential deal begin, and counsel is engaged, stop communicating on company email servers.  Use a private non-company email account, and if you are using company computers and phones to access that email account, carve out the shareholders’ personal laptops, tablets, and mobile phones from the deal so that any residual information downloaded on those devices does not inadvertently fall into the hands of the buyer post closing.  Instead of letting the buyer see the communications and potentially having an expensive drawn out fight over them, it seems wiser not to put those communications in hostile hands.   

Size Matters - Terms Improve for Sellers as Deal Size Increases

Surprise ... it’s better to be big.   And more heft doesn’t just help in sports; it also matters when you’re selling your company.   Any M&A lawyer will tell you anecdotally that transaction size impacts the terms of a negotiated acquisition.  More money affects bargaining power and tends to gloss over smaller problems.     

Now a new study (Rauch and Burke, 71 Business Lawyer 835 (2016)) confirms that negotiated terms become more seller-friendly as transaction value increases.  The authors looked at five hotly-negotiated points* in most deals and found that across the board, as the dollar value of the deal increases, the more likely the parties are to settle on terms that are more seller favorable.  For example, in every deal the seller wants to cap its potential indemnification liability risk to the buyers. The seller wants a lower cap and the buyer would prefer a higher cap relative to the purchase price.  The authors found a progressive decrease in the size of the liability cap as deal size increased, implying that as the deal size grows, the buyers lose the leverage to force sellers to bear more transaction risk.   

The data don’t offer any rationale, but the results suggest that the market for smaller deals is weaker and the buyer has correspondingly more bargaining power to force the sellers to “take it or leave it” on deal points.  In larger deals, perhaps the massive cost and effort involved in mounting an acquisition team invokes the sunk cost trap (the more time and money invested in a project, the less likely one is to abandon it) in the minds of the buyers, making them more willing to acquiesce on significant terms in order to get the deal done.   

Interestingly, this study looked at the largest sample of data in any published M&A study (almost 850 deals over nine years) and the authors’ characterization of deal sizes departs from most common usage.  Many people toss around the term “middle market” with widely varying concepts.  According to the authors, the middle market comprises deals ranging from $10 million to $1 billion.  That’s a huge swath, and the $10 million floor probably makes some popular usage of the term pretty far off the mark.  

In case you were wondering, of course size affects deal prices too.   Seller valuations are often expressed as a multiple of earnings (EBITDA), and yes, as deal size increases, the multiple of earnings increases as well. See Are Values Commoditizing?, GF Data Resources (Feb 5, 2015).

*The deal terms reviewed were: liability cap, liability basket type and amount, sellers’ catch-all representations, the no-undisclosed-liabilities representation, and closing conditions.