Spend the money to ensure a subsidiary’s legal documents are in order or risk having to accept a discounted price if you’re trying to sell the entity, a Deloitte report finds.
“When buyers have unanswered questions about their target’s subsidiary management, they’re likely to delay the deal … hedge their bets, double down on other concerns and lower their offer,” says the report, which looks at the ways legal entity management, if done poorly, can kill or slow deals and force companies to sell a subsidiary at less than its valuation. “Deals are priced on the assumption that entities and their records have been managed carefully.”
“It’s a credibility issue,” Shon Glusky, a partner in the corporate practice group at Sheppard Mullin, says in the report. “If I’m going to give you $100 million, I want to know that the company you were running was run properly.”
Strategic implications
Legal entity management applies to the documents that substantiate the ownership and governance of a subsidiary. It’s not something that’s often given much thought outside of the general counsel’s office, but if it’s dismissed as a housekeeping matter, it can have strategic implications to the extent a buyer walks away from, or seeks to change the terms of, a deal because of it.
Buyers can be affected strategically, too, if an acquisition it was counting on can’t close because of a loss of confidence.
“If … a business hasn’t exercised care in maintaining its entities’ corporate records, buyers may start to wonder what else has escaped the management team’s focus—and what other problems they may be buying with this deal,” the report says.
Questions raised
In its research, Deloitte finds that almost two thirds of executives would question if the parent company even owns the entity it’s trying to sell if the legal documents are disorganized or incomplete.
In one case, the report said, a private equity firm that had offered $47 million to buy a company pulled its offer and replaced it with one that was discounted after it found that leases hadn’t been executed properly and only half of the stock option agreements were signed.
“Poor legal entity management leads buyers to draw one of two conclusions,” the report says, “either the seller’s legal team is inept, or the seller is hiding something.”
Insurers can balk, too. They might force a deal to get delayed, not close at all, or close at a lower price because of changes they insist on to underwrite the deal.
“An insurance company might say, ‘We found a bunch of stuff that we can’t insure on and we’re not going to take the risk,’” says Glusky. “This can certainly cause a repricing of the deal.”
M&A impacts
When looked at from a high level, poor handling of documents can impact a company’s M&A in half a dozen ways:
- Slow deals down—or even kill them
- Increase deal risk and introduce personal liability for directors and officers
- Drive deal price down
- Force deal restructuring with attendant tax disadvantages
- Grossly inflate professional fees
- Jeopardize the credibility of the company and its management
Red flags
The signs of bad document management can be big or small:
- It’s hard to trace a subsidiary’s capital structure, stock interests, subsidiary ownership, options, puts and voting rights
- Director and officer appointments and resignations aren’t clearly recorded
- Minute books are poorly organized and can’t be found without a search
- For entities that have been wound down before a sale, intercompany balances they share with the parent company remain on the books
- Due diligence memos are inaccurate.
- Leases haven’t been executed properly or not all stock option agreements are signed
Investment costs
Cleaning up substandard entity management isn’t cheap, the report says. It can typically cost between $20,000 to $30,000 for a legal team to go through materials prior to a sale to make sure corporate governance and subsidiary matters have been handled appropriately.
In one complicated transaction, the report says, the buyer and seller ended up paying $2 million to clean up corporate documents.
These costs and the risks associated with not cleaning up problems would make it a good investment to make resources available to a company’s legal team to ensure a subsidiary’s legal documents are in order well before steps are taken to sell it.
“Companies that are organized can do better price-wise because it’s going to come through the financial statements and provide better cash flows and a lower risk profile,” John Easterday, a Deloitte Tax partner, says in the report. “I’ve seen that lead to a better purchase price for the seller.”
