The idiom “nobody’s perfect” is part of our language. Disney character Hannah Montana even has a song by that title. Sellers of businesses should remember an alternative version of Hannah’s song: “Nobody expects every business to be perfect, so disclose to buyers your company’s problems. That way they won’t discover and magnify them in due diligence.” Buyers understand that every business has blemishes. Among the ones I have seen are:
- Equal Employment Opportunity Commission or other employee litigation.
- Existing or threatened commercial litigation.
- Customer disputes over product performance.
- The looming expiration of customer contracts.
- Supplier threats to terminate or modify their contracts.
- The existence of strong direct competitors.
- Deficiencies in filing tax, safety or other regulatory paperwork.
- Environmental incidents or exposure.
The practical reality is that every buyer is, through the process of due diligence, going to learn about the seller’s problems. But if the buyer uncovers even one material undisclosed problem: 1.) The buyer will become suspicious about every aspect of the business, complicating and delaying the sale process and 2.) The buyer may even walk because he or she distrusts the seller. Voluntary disclosure also makes sense because problems a buyer doesn’t uncover will generally be covered in the purchase agreement’s representation and warranties, giving the buyer rights to a post-closing lawsuit. The most egregious case I have ever seen was a plating company that had been dumping its chemical waste behind its factory. The dirt was an iridescent blue-green. “Don’t worry about it,” said the CEO. “By the time we bring in buyers, there will be snow on the ground.” (Needless to say, we did not follow that course.) The wise seller recognizes that every business has flaws. So, sellers should recognize these flaws, remediate them to the extent possible and then disclose them. (Delaying a sale until the most significant problems can be solved often creates substantial value.) The disclosure of problems upfront builds a foundation of trust that is key to every successful sales transaction and enables the seller to present the problems in a manner that won’t exacerbate the buyer’s worst inherent fears. Some major problems that I’ve seen sellers disclose upfront with minimal or no impact on purchase price include:
- Accidental spilling of hazardous chemicals in its factory.
- Use of asbestos in products previously manufactured.
- The threat of a $100 million lawsuit by a disgruntled customer.
- Catastrophic failure and retrofit in the field of a new product.
- Non-renewal of the seller’s lease.
- Challenges to the seller’s trademarks in foreign countries.
We surmounted the problems because we were able to mitigate them and/or frame their presentation to buyers. Face it, Hannah Montana is right about this one. Every business has problems, and it is well-nigh impossible to keep them secret. Wise sellers frame how the problems will be disclosed. Managing this disclosure maintains credibility, while not making the problems seem bigger than they really are. Mark A. Filippell is a founding partner and managing director at Western Reserve Partners, a division of Citizens Capital Markets. He co-heads the firm’s industrial practice and leads restructuring and bankruptcy practice. He is also the author of the 2011 book, “Mergers & Acquisitions Playbook: Lessons from the Middle-market Trenches,” published by John Wiley & Sons Inc. He can be reached at (216) 589-9532 or [email protected]. Related post: Dealmaking is all about understanding the motivations driving the transaction
