The Anatomy of a Deal Newsletter December 31, 2018
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
What is it?
Although no one likes to talk about it, sometimes deals go south after closing. In those cases, the Buyer usually looks for ways to recoup some of its investment from the Seller. If the Buyer is able to prove the Seller breached the agreement, what types of losses can the Buyer recover from the Seller?
While it seems like a simple question, there’s actually a lot that goes into what types of “Losses” are recoverable by a Buyer. For example, here’s some sample pro-Buyer language defining the types of losses for which a Buyer can recover:
"Losses" means losses, damages (including incidental, consequential, and special damages), liabilities, deficiencies, diminution in value, actions, judgments, interest, awards, penalties, fines, costs or expenses of whatever kind, including reasonable attorneys' fees and the cost of enforcing any right to indemnification hereunder and the cost of pursuing any insurance providers.
What does it really mean?
While not apparent in the language, there’s actually a lot to unpack here.
First, the reference to “diminution in value” in the above definition is very important. Diminution in value simply means that, as a result of the Seller’s breach, the Buyer’s investment isn’t worth what the Buyer thought it was.
To illustrate, let’s assume that the Buyer can prove that the Seller breached a representation by failing to disclose a $100,000 liability in its financial statements. You might assume that the Buyer would be entitled to be repaid the $100,000, and that’s the end of the story, right? Maybe not. Because the Buyer typically prices the deal at a multiple of the target company’s earnings, the existence of that liability, if properly disclosed, presumably would have changed the Buyer’s pricing of the deal (unless it was truly a one-time liability). So, if the Buyer in our example had assigned a 5x multiple on the target company’s earnings, the Buyer could claim damages of $500,000 (5 x $100,000).
There’s also another very important concept in this definition: consequential damages. Consequential damages are losses that are not directly caused by the breach, but are incurred as an indirect result of the breach. For example, if the target company failed to maintain a permit required to conduct the business, the Seller would generally be responsible for the Buyer’s cost of obtaining that permit after the closing. Let’s assume the Buyer can replace the permit for $10,000. So the Buyer gets $10,000 from the Seller. But, let’s say that the Seller’s failure to maintain the permit caused the target company to lose a customer that accounted for $500,000 in annual profit. The loss of that customer may not itself cause a breach of any of the Seller’s representations and warranties, but it is a consequence of the Seller’s breach of its representation regarding the maintenance of required permits.
If the Buyer has the ability to pursue consequential damages, then the Buyer can recover for the lost profits associated with the key customer so long as the Buyer can show that, at the time the target company lost the permit, it was “reasonably foreseeable” that the target company might also lose the key customer. If, on the other hand, the acquisition agreement prohibits the Buyer from seeking consequential damages, then the Buyer could only recover the direct cost of obtaining the permit. In our example, this change in language represents a difference of hundreds of thousands of dollars. If the Buyer also has the ability to claim diminution in value damages as described above, the $10,000 permit may actually result in millions of dollars of losses for which the Seller is responsible.
So, it’s clear that both diminution in value damages and consequential damages have a material impact on the amounts potentially recoverable by the Buyer – and the amounts for which a Seller may be responsible. Given their importance, it’s fair to assume that the acquisition agreement would clearly spell out what types of losses are recoverable. However, a recent American Bar Association study shows that 70% of deals in 2016-2017 remain completely silent on the ability of a Buyer to recover diminution in value damages, and 52% of deals during the same period remain silent on the ability of a Buyer to recover consequential damages. The same study further shows that these types of damages were expressly prohibited in 23% and 39% of deals, respectively, and were expressly permitted in 7% and 9% of deals, respectively.
Why Should I Care?
Buyer: From the Buyer’s perspective, the acquisition agreement shouldn’t restrain the Buyer from recovering all types of losses, so long as the Buyer is able to prove those losses with reasonable certainty. Remaining silent – as appears to be the current market trend – probably leaves the Buyer with the ability to make these types of claims in most cases, but then it’s important to pay attention to which state’s laws govern the acquisition agreement. Certain states may not permit recovery of these types of losses, or may impose additional hoops that the Buyer must jump through in order to recover. Furthermore, even if permitted to recover these losses, the Buyer has the burden of proving that it should be allowed to recover these losses in a particular case. That means the Buyer has to convince a judge – or, more problematic, a jury – that it should recover more than just its out-of-pocket losses. That could prove a difficult burden with some judges or juries.
Seller: As a Seller, diminution in value damages and consequential damages are the types of potential losses that might keep you up at night because they’re potentially very large and also unpredictable. So, Sellers with leverage should insist on explicitly excluding these types of damages in the acquisition agreement. Sometimes Sellers offer a compromise position on consequential damages that permits the Buyer to recover consequential damages only to the extent the Buyer has to reimburse a third party for consequential damages resulting from a breach of the Seller’s representations. While this compromise does give some important coverage to the Buyer, it still represents a win for the Seller. If the Seller is unable to get these damages excluded in the agreement, the Seller would at least prefer to maintain silence in the acquisition agreement so it has a chance to argue later that the Buyer’s entitlement to these damages is at least limited.
Next Month: Caps and Baskets
Read last month’s piece: What Goes in a Letter of Intent