THE BLACK ART OF WINNING M&AAUCTIONS

THE BLACK ART OF WINNING M&AAUCTIONS Strategies for Buyers & Sellers Mergers & Acquisitions Section, Dallas Bar Association October 9, 2012 K&L Gates LLP Greg Hidalgo, Partner Greg.Hidalgo@klgates.com www.klgates.com McColl Partners Jamie Lewin, Partner jlewin@mccollpartners.com www.mccollpartners.com Insight Equity Eliot Kerlin, Partner ekerlin@insightequity.com www.insightequity.com 1

Speaker Biographies Jamie Lewin Partner McColl Partners Jamie Lewin is a Managing Director and co-founding Partner of McColl Partners. Mr. Lewin serves as the head of the firm's Financial Technology Group. His transaction experience includes sellside, buyside, and capital raising assignments within various sectors of the financial and business services industries, including analytics, bankruptcy services, IT outsourcing, security, and transaction processing. Previously, he was with Bowles Hollowell. Mr. Lewin also worked in the investment banking division of Goldman Sachs in New York and for Stampeder Exploration, a Canadian oil and gas concern. Mr. Lewin received a bachelor of arts degree with high honors from Queen s University and was a member of Queen s national championship varsity football team. Mr. Lewin received a master of business degree from The Fuqua School of Business at Duke University. Greg Hidalgo Partner K&L Gates Greg Hidalgo is a partner in the K&L Gates Dallas office. As a transactional and securities lawyer, Mr. Hidalgo counsels and provides innovative and client-centered solutions for publicly held and privately owned clients in the areas of mergers and acquisitions, joint ventures, securities transactions, corporate governance and other general corporate matters. Mr. Hidalgo's client relationships span a variety of industries, including business process outsourcing, commercial real estate services, consumer products, energy, health care, manufacturing, private equity, retail, and telecommunications. Greg began his career as a Certified Public Accountant with Ernst & Young LLP from 1987-1990. His law practice reflects his passion for collaborating with clients to achieve their business objectives and to develop meaningful and enduring client relationships. Eliot Kerlin Partner Insight Equity Eliot Kerlin is a Partner at Insight Equity. Prior to Insight Equity, Eliot served as Turnaround Manager for Bay State Paper Company while the company was in Chapter 11. Previously, Eliot was an Associate at Jupiter Partners, a New Yorkbased private equity fund. While at Jupiter, he worked extensively with portfolio company management teams, evaluated numerous potential transactions and executed over $350 million of portfolio company re-financings, add-on acquisitions and leveraged buy-outs. Before joining Jupiter, Eliot was an investment banker with Merrill Lynch in their global communications group in New York. Eliot graduated with honors from Texas A&M University where he received a BBA in Finance. Eliot completed his MBA at Harvard Business School, where he graduated with Distinction. 2

The M&A Auction Process Auction: A sale process designed to engender competitive bidding among potential buyers to facilitate the sale of a business or company. A Seller should use an auction when There are multiple potential buyers, and The characteristics of an auction favor the Seller. Advantages Reach more potential buyers. Competitive process maximizes price. More seller favorable deal terms. Seller controls sale process. Transaction documents. Due Diligence process. Disadvantages Not suitable for all businesses/circumstances. Limited marker sector with few potential buyers. Risk of driving away current suitor. Some buyers will not participate in auctions. Risk of premature disclosure. Higher Seller costs. Disruptive to ongoing Seller operations. Some competitors may use auctions as a fishing expedition. If auction fails, Seller may be tainted. 3

The M&A Auction Process The M&A process has four distinct stages that require multiple weeks. I. I. Marketing Preparation II. II. Deal Deal Marketing III. III. Pre Pre --LOI LOI Diligence IV. IV. Confirmatory Diligence Preparation Pre-Marketing Marketing Preliminary Bids Acquiror Due Diligence Final Bids & Negotiations Negotiate and Execute Definitive & Regulatory Filings Closing 3 to to 4 Weeks 4 to to 6 Weeks 4 to to 6 Weeks 6 to to 8 Weeks Initial due diligence. On-site kick-off meeting. Review of shareholder objectives. Prepare confidential information memorandum ( CIM ). Develop marketing strategy. Develop financial projections. Compile potential acquirors list. Begin organizing dataroom. Contact prospective acquirors/investors to execute confidentiality agreements. Distribute confidential information memoranda. Prepare management presentation. Finish compiling dataroom. Solicit and evaluate indications of interest. Select groups to move forward. Arrange and conduct management presentations. Provide dataroom access. Distribute draft purchase agreement and request buyer markup. Solicit and evaluate letters of intent and purchase agreement markups. Select final acquiror/investor. Enter into Letter of Intent ( LOI ), as applicable. Facilitate requests for information for confirmatory due diligence. Negotiate and finalize terms of transaction. Complete and execute documentation. Obtain regulatory approval and third-party approval process. Closing. EstimatedTimeline 3 to 4 weeks 7 to 10 weeks 11 to 16 weeks 17 to 24 weeks 4

I. Marketing Preparation Initial Due Diligence. Financial/Accounting. Operational. Legal. On-site kick-off meeting. Review of Shareholder objectives. Drafting of the Confidential Information Memorandum. Develop marketing strategy and financial projections. Compile potential buyers list and process type (broad vs. targeted). Begin organizing data room. Presence of pre-emptive interest. 5

II. Deal Marketing Contact potential strategic buyers and financial sponsors. Negotiate Confidentiality Agreements. Distribution of CIM. Prepare Management Presentation. Indication of Interest ( IOI ) instruction letter. Bid request including valuation, structure (asset vs. stock), timing, etc Initial diligence and formulation of indicative valuation range. Compile data room. Receive IOIs. Selection of parties for the Management Presentations. 6

Preliminary Considerations for Buyers Assess whether to participate in auction process. Do you have prior industry experience? Who are your likely competitors? Strategic buyers may make it difficult for financial buyers to effectively compete. Review bidding procedures for unusual requests. Reach out to Investment Banker. Have a candid discussion regarding Seller's expectations and concerns. Confidentiality Agreement. Attorney should review before signing. Ascertain ability to talk to other private equity funds (clubbing). Assess whether Buyer s affiliates are covered. Assess whether a non-solicitation/no hire provision is included. 7

Seller Bid Instructions Letter Purposes: To communicate a clear and definitive framework for the auction process and apprise all potential bidders of the procedures and requirements for successful navigation of the auction process. To shield Sellers and its advisors from liability in case a rejected bidder sues them over the auction process. Typical Elements of First Round Instruction Letters: Communications with Seller and Seller s investment banker. Date when bids are due. Number of expected bidding rounds. Required contents of Buyer s bid letter. Important disclaimers and reservations. 8

Seller Bid Instructions Letter (cont d) Typical Additional Elements of Final Round Instruction Letters: Requirement that the final bid be kept open through a specified date. Requirement that the terms included in the first round IOI be finalized. Required Contents of Buyer s Bid Letter: Bidder identity. Estimated valuation range of the total enterprise value of seller, together with applicable deductions and offsets. Form of consideration. Financing sources and steps taken to secure financing. Valuation assumptions. Statues, timing, and scope of Buyer s due diligence review. Required third party and regulatory approvals and other material closing conditions. Strategic plans for Seller s business and its management team. Buyer s industry experience. 9

Seller Bid Instructions Letter (cont d) Important Disclaimers and Reservations: Until the PA is signed, The bid instructions letter does not constitute an offer to sell the target. Seller is not obligated to negotiate with any bidder. No bid will be deemed accepted. Each potential bidder is solely responsible for its own costs and expenses. No representations or warranties made by Seller or its advisors as to the accuracy or completeness of furnished information. Reserve Seller s rights to: Consider all factors in determining the successful bid. Change, suspend, or end the sale process at any time. Remove a bidder from the process at any time. Negotiate with more than one bidder at the same time. Enter into the PA with any party. Decide to not sell the target. But see, e.g., Solow v. Conseco (the US District Court for the Southern District of New York denied Seller s motion to dismiss, stating that a Seller s reservation of rights would not extend to fraud or an unfair departure from the prescribed auction procedures; case never decided on merits). 10

Seller Bid Instructions Letter (cont d) Best Practices (gleaned from case law): Make auction procedures clear. Include disclaimers/reservations of rights establishing Seller s control of the process. Sellers have a right to amend/interpret the auction rules and procedures if the letter states that Seller has these rights. Written procedures govern, so follow them. Limit communication channels with auction participants. Be clear as to when clubbing is/isn t allowed during the process. Create a level playing field among auction participants. Document decision-making process. 11

Seller s Perception of Buyer Trust. Buyer reputation for renegotiating won auctions. Sufficiency of diligence to support their bid price. Financing Certainty. Difficulty in negotiations after winning auction. Intrusiveness Due Diligence (v. Other Bidders). Lifecycle stage of fund. Buyer s past performance. History of busted deals vs. closing deals. History of successfully obtaining financing based on the financing letters included with bid. Buyer s history after closing deals regarding purchase price adjustments and indemnification claims. Buyer s historical treatment of portfolio company management teams. Buyer s prior investments track record. 12

III. Pre LOI Diligence Management presentations. Provide access to data room. Facilitation of buyer diligence. Bid Procedures letter and/or distribution of a draft purchase agreement ( PA ). LOIs/contract mark-ups. Negotiation with bidders. Selection of exclusive party. 13

Data Rooms: Extranets and VDR s Virtual Data Room ( VDR ) Secure electronic environmental based on standard Internet/Web technologies to facilitate document management and review. Bankers control access to VDR. Bankers not required to be present in physical data room. VDR is accessible 24 hours a day, 7 days a week. No restrictions as to maximum number of visitors to data room at any given time. Bankers can continuously track activity in data room to determine potential buyer s level of interest. 14

Buyer s Balancing Act Buyer Favorable Terms Benefit of the Bargain Buyer s Desire to Win Auction 15

Winning the Bid A Delicate Balancing Act Price, Price, Price and More Price (No Right Approach). Form of Consideration Cash is usually, but not always, king. Contingent consideration when material uncertainties exist (i.e. pending litigation, known operating risk, changing regulatory environment). Transaction Terms. Seller favorable v. Buyer favorable. Risk Allocation (Representations/Warranties/Purchase Price Adjustments/Indemnities). Certainty and speed of Closing. Financing Status. Other walk away rights. Negotiation Posture (Know Your Seller and competitive landscape). 16

Winning the Bid A Delicate Balancing Act (cont d) Demonstrate Interest. Develop rapport with investment banker. Conduct appropriate level of due diligence. Active/Constructive participation in management presentations. Purchase Agreement Markup Too Much Black? Issues List v. Actual Markup (Contrary to Bid Procedures?). Conceptual comments v. Detailed comments. Management incentives. Buyer s Past Performance History. Investments track record. Industry expertise. Reasonable v. aggressive style. Management team treatment. Re-trades after winning auction. Reasonable v. Excessive due diligence requests/inquiries. 17

Pricing FACT: No matter where you rank in the process, Seller will likely ask Buyer to sharpen its pencil and increase Buyer s bid price at the end of each round. 18

Pricing (cont d) No right approach. Develop pricing parameters that make sense for you and stick to it. Remember... it's OK to take a pass. Will depend on competitiveness of the process. When in doubt, go with your gut instinct. Preliminary Rounds. Use a range of values. Seek guidance from Seller's banker: objective in the beginning of the process should be to get into the next round. Final Round. Bid what you're comfortable paying - not to win the auction. Leave a little reserve for the final "final" bump. Be Creative. Consider earn out or equity kickers to bridge valuation gap. Bonus arrangements for management. Equity kickers (seller retains some upside potential). Most investment bankers will continue to try and get you to increase your price until you say "No. 19

Buyer Beware: Seller Tricks Multiple bidding rounds (Chiseling approach). Seller will likely request modifications to contract comments to "put your bid on equal footing with other bidders. Leverage shifts to Buyer upon winning the auction. To counterbalance, Seller may try to create uncertainty in Buyer and have Buyer believe the runner-up is waiting on the sidelines. Seller may tell Buyer that its price was not the highest but was nevertheless selected because: Management preferred Buyer over the other bidders. Buyer had a better financing structure. Buyer raised fewer issues on the PA. 20

Buyer s Final Bid Letter (Letter of Intent) Purpose. Sets forth the parties understanding of the material business and legal terms. Typical Terms. Deal Structure and Key Terms. Asset vs. Stock acquisition. Purchase Price. Form of Consideration. Indemnification: Survival periods; Caps; Baskets; Use of escrow. 21

Buyer s Final Bid Letter (cont d) Material Conditions to Signing Definitive Agreement: Financing; Confirmatory due diligence; Execution of definitive agreements; Required Buyer approval consents. Exclusivity (i.e., up to 30 days generally). Ancillary Agreements (e.g. Employment Agreements; Non-Competition Agreements). Reimbursement of Buyer s expenses. Termination. Binding vs. Non-Binding. The bid letter should provide that other than specific provisions the terms are non-binding and are subject to further negotiation and the execution of definitive agreements. 22

Buyer s Final Bid Letter (cont d) Duty to negotiate in good faith: Courts may impose this duty on the parties even where the bid letter clearly states there is no intent to be bound. Typically Binding. Exclusivity. Confidentiality. Due diligence access. Expense reimbursement/breakup fees. Non-solicitation of employees. 23

IV. Confirmatory Diligence Confirmatory Diligence. Accounting/Financial/Tax. Legal. Operational. HR, Insurance, etc Environmental. Market Study. Negotiation of Purchase Agreement. Negotiation of employment agreements/non-competes. Financing requirements. Regulatory approvals. Closing. 24

Now that You re the Seller (Auction is final) Once the Seller grants exclusivity, the negotiating power shifts to the Buyer. Seller s balancing tactics. Make sure all material economic terms are agreed to in the Letter of Intent with the winning bidder. Keep other bidders warm, except as prohibited by exclusivity. Protect against price re-trading. Full and accurate diligence disclosure by seller to limited group of bidders. If withhold negative information, susceptible to price re-trade. 25

Now that You re the Seller (cont d) Consider two-finalist approach. May need to reimburse loser for incremental expenses (cap). Difficulty (resource constraints) conducting simultaneous negotiations. Seller should carefully track Buyer's actions during auction process. Important to determine if their level of diligence supports Buyer s bid price. Use of electronic data room helps monitor Buyer. 26

Ways for Buyer s to Avoid Auctions First-Mover. Team up with executive and/or company to leverage industry knowledge. Preemptive bidding (Price). Be creative in deal structure. Offer Seller the ability to participate in future upside: Issue equity (options; stock; warrants). Earn outs. Discuss continued role of management. 27

Disclaimer This presentation is intended merely to provide a general introductory overview of certain trends and developments affecting M&A transactions. This presentation is not intended to provide a complete analysis of the matters covered, but rather is intended to be used and referred to in conjunction with a more comprehensive oral presentation regarding those matters. Accordingly, there are potentially important exceptions and qualifications that are not reflected in this presentation. This presentation does not necessarily reflect the personal views of the speakers or the views of K&L Gates LLP, McColl Partners or Insight Equity. 28