Run Your Business In The Normal Course
Purchase & Sale Agreements for Manufacturing M&A transactions have both Buyer and Seller Covenants. Buyer covenants include coming to the closing table with the agreed-upon amount of cash. In exchange, the Seller’s covenant usually includes a promise to run the business in the “normal course” and to do nothing to damage or diminish it between contract and closing.
Recently a client asked me why a clause of this type was necessary. I explained that Sellers sometimes go on cruise control and disengage from the business during this critical time before closing. The clause is designed to force the Seller to maintain the manufacturing company until the buyer takes over. However, disengagement on the approach to retirement isn’t the only temptation the Seller faces while their manufacturing company is under contract. And if you’re thinking about acting on the particular temptation I describe below, realize that it could very well blow the entire transaction.
Temptations Can Sour A Deal
In most transactions, the Seller retains any cash on hand. Manufacturing company Sellers are sometimes tempted to invoice and collect early, even before the work is complete. They reason that if the cash is in the bank, it belongs to them rather than the Buyer. If invoicing in that fashion was not in the normal course of business, the Seller is violating their contractual Seller’s Covenant. In doing so, it’s possible to blow the entire transaction. When such an act is uncovered, many times the Buyer can contractually walk away from the deal.
Sellers are also tempted to play around with the accounts payable and receivable. Often the buyer will receive a “normalized” A/R and A/P. By normalized I mean the spread that usually exists in any given month between A/R and A/P. This provides the buyer with a certain amount of working capital to run the business until they begin making their own sales. Lending banks will REQUIRE there to be a certain amount of working capital in the deal as a condition of them funding the transaction. Sellers can be contractually protected with clauses that call for any cash flow over the pre-determined “normal” amount to credit back to the Seller in increased purchase price.
Sellers get into trouble when they try to manipulate the accounts payable and receivable to their benefit. Many times they feel that they are entitled to the money, more than the buyer. Successfully selling a manufacturing company of $2-$15 million usually takes 8 months to a year. Sellers should consider how long it took them to get an appropriate buyer at an appropriate price.
In Conclusion
If Buyer walks away because you’re manipulating the numbers, are you willing to wait another year to get a different buyer? What if the economy tanks in that year? What if your health begins to fail in that year and you can’t provide a new buyer with the appropriate transition assistance? So many things can happen in this scenario to hurt your retirement. Don’t make the mistake of walking over millions to pick up pennies! Before playing games with the books, consider the consequences of these common Seller temptations.
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