The Sell Side Masterclass for Tech Services Founders: Definitive Agreements and the Final Stretch

Key takeaways

• The LOI is not the final deal. It is more like a handshake on price and core terms, while definitive agreements create the legally binding structure of the transaction.
• The focus shifts from headline economics to risk allocation, including representations, warranties, indemnification, escrows, working capital, and earnouts.
• Sellers should expect multiple transaction documents, including the purchase agreement, employment or transition agreements, non-compete and non-solicit provisions, disclosure schedules, and sometimes escrow or lender-related documents.
• An M&A advisor should protect deal momentum and economics, while legal counsel should focus on legal exposure. Letting attorneys drive business negotiations can create delays and unwanted tradeoffs.
• Disclosure schedules require a major lift because they support the reps and warranties in the agreement and must fully disclose contracts, employee matters, vendor agreements, litigation issues, notices of termination, and other material business details.
• Closing day is often surprisingly anticlimactic when the deal has been well managed. Most signatures are already in place, wires are released, and the team confirms final execution and funding.

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Mike:
Hello, and welcome to this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters in Bloomington, Minnesota. For those of you that are new to Revenue Rocket, we are the world’s premier M&A advisor to tech-enabled services companies. Today with me are my partners, Ryan Barnett and Matt Lockhart. Welcome, guys.

Matt:
Awesome to be here. Ryan, I know you don’t like it when I do this, but I’m going to give away a little timeframe here because we’ve got to congratulate the United States women’s hockey team on their gold medal. So that’s pretty exciting. I know we’ve got members of the audience who are not from the United States, but we need to root for something these days. We’ll take that. What’s going on, Ryan? We’re continuing on with the master class.

Ryan:
Absolutely. And I apologize to our friends in Canada. We also love you too, but we’ll take a win for the USA here today.

We’ve been working through a master class, and Mike and Matt, you’ve been really helpful in this process. The point has been to help educate leaders and owners of IT services firms who are looking at a potential transaction either now or in the future.

What we’ve looked at so far has helped listeners understand what it takes to get ready. That means starting with the discussion and decision of whether they should be selling, walking through valuation, finding buyers, the process of getting into an LOI, and signing that LOI. Last week was really focused on due diligence.

Today, we’re going to go past that phase and picture yourself in the situation where you’ve had an LOI signed, diligence has been going really well, and you’ve been able to show a buyer your business. They get to a point where they say this looks great and they’re going to start crafting definitive agreements.

The focus today is this: if we survive the due diligence process, what does it look like to get from three quarters of the way there to all the way there? Mike, help me understand this. If a seller thinks the deal is done with an LOI, what really changes as you start to move to definitive agreements in this process?

Mike:
Yeah, thanks Ryan. Great question.

First of all, you’ve got to understand that the LOI is like a handshake agreement. It is not binding. It’s not legally binding and generally aligns around price and terms, and that’s it. You have to craft all of the legally binding agreements in the definitive agreements. It really should be called definitive agreements because there are a lot of them, and we’ll talk more about that later in the master class.

The focus shifts from just economics around deal terms, price, and terms to risk allocation and how the buyer evaluates the risk of your deal, and how you may share in fortifying that risk for them. It’s frankly where deals get reshaped.

It’s critically important during this phase of moving toward definitive agreements to have a strong cadence around momentum because you can get bogged down. You can definitely get bogged down in the legal language in the definitive agreements, but also in what you’re representing and warranting in the business. We’ll get into that in a minute.

Ryan:
Thanks for getting us going, Mike. So if we think of the LOI as the handshake, the binding agreement becomes the definitive agreement. You start to decide things like an asset sale or a stock sale and everything that comes with it.

The parties at the table change as well. Matt, maybe you could dig into that a little bit for me. If you think about that definitive agreement phase, and as Mike mentioned, a ton of documents, what documents are included in that phase and what should owners be aware of?

Matt:
Yeah. You started it out right. The purchase agreement is the big one, and you’ll often see an APA or an SPA, so an asset purchase agreement or a share purchase agreement. That’s the big one.

But there are others that matter a whole bunch to sellers. Employment agreement, for example. Regardless of whether you’re selling in or selling out, likely there’s going to be a certain period that you’re involved. If you’re selling in, then certainly an employment agreement is going to be appropriate. If you’re selling out, then oftentimes there’s a transition services agreement. Think about it as a contract for a period of time. Both of those are obviously extremely important.

The employment agreement is especially important because you’re setting the stage for your future employment and what the conditions there are. The purchase agreement, and most likely the employment agreement, will also have non-compete and non-solicitation aspects to those agreements. Those things are obviously super important as well.

Then there are the tie-alongs to the purchase agreement that are critical, including the disclosure schedules. Mike will talk more about those. There’s also the escrow agreement, if that’s going to be included in the purchase agreement. If there’s escrow being set aside, that matters too. Then there can be others. There can be lender agreements and so on.

So there’s a lot of paper and there are going to be multiple signatures. The most critical pieces are the final purchase agreement, the employment agreements, and any associated non-competes and non-solicitations.

Ryan:
So there’s a lot to go through, is what it sounds like. All of this, when you think about the weight that goes on, you’ve been running your business this whole time, and then in this last push to close, there’s a big focus on the fact that the business is going to go to someone else. To put everything together and understand what you’re signing up for, there’s a lot that goes on. Sellers can oftentimes underestimate the scope that’s involved.

Mike, when you think about all these documents, who should really be driving at this point? If you think about the people involved such as an M&A advisor, an attorney, and a CEO, who’s driving the bus? What’s the best way to get through this from an advisor capacity?

Mike:
As I’ve often said, it takes a village to get an M&A deal done, and you pointed out some of the people that live in that village.

Certainly, clear lanes of responsibility are important. The M&A advisor protects the economics and the deal momentum. Remember, we just talked about how momentum is important, moving forward at a reasonably quick cadence so you don’t get bogged down. Working around roadblocks or stoppers that come into play is the advisor’s role. The advisor keeps everybody moving toward a close date. Otherwise, it’s too easy to reschedule the close date.

We say around here that time kills all deals, and that’s true. Things come up, distractions happen, the economy changes, the Fed changes interest rates. There are a million things that can impact a deal if you spend too much time getting bogged down.

The attorney’s role is more around protecting legal exposure, and they should stay in that lane. The CEO really protects the relationships that have been developed in a positive way with the buyer and keeps the business running.

Without the appropriate village assembled, this can become a real problem. We know many stories of people being approached by buyers, larger companies, private equity firms, and sponsored companies where they underestimated the amount of time diligence would take. It was like death by a thousand cuts. While they were in the diligence process, their business suffered because they weren’t paying attention to it and they weren’t running it.

When that happens, buyers can use that as an excuse to retrade the business. If there’s softness in the deal, they’ll use a reason to change price and terms. They’ll say that over the last several months during diligence, your sales are down or utilization is down or the business is not performing the way it was when we started talking. And they have a point.

So it’s important that you let the advisor ride herd on all of this. A good advisor has a strong diligence defense team so they can answer a lot of the questions, gather information from you in an orderly manner, and manage that defense. There are still going to be a lot of questions in diligence, and there are areas where you’re going to have to weigh in, but you want to minimize those distractions.

The cardinal rule of what not to do is to not allow just your attorney to try to run the deal, defend economics, and manage all of this. The reason is they already have their hands full managing legal exposure. Most lawyers want to do this role if they can because it means additional billable hours, even though they are ill-equipped to do so. Attorneys are a critical component to getting a deal done, but like all things, you need to have the tools and the talent to do your role effectively.

We think it’s best to keep your attorney in the legal defense lane, have your M&A advisor manage the project and keep the wheels on, and have the CEO running relationships and keeping the business running, while bringing in other spot advisors around tax and related issues.

Ryan:
Mike, I’ve heard a phrase from you that in this phase it’s often common for lawyers to trade deal points. What I’m hearing here is that it’s important for the M&A advisor to keep this moving so you don’t have the lawyers in the back room going off script, which could potentially endanger the deal or include a point that may not be in the best interests of everyone at the table.

Matt:
I would say for sure that’s the case, Ryan.

Ryan:
Perfect. If I turn that a little bit into what the teams are working through, and I’m trying to get to what are maybe the three or four things that are always going to be negotiated or most often negotiated, what are three things that matter most to the seller in a definitive agreement?

Matt:
Yeah. Let’s bracket that into the purely legal side and then maybe the more business-oriented agreements or understandings.

From a purely legal perspective, there are some real critical aspects in the purchase agreement. Indemnification, warranties, indemnification caps, baskets, and so forth. Oftentimes that’s the number one area with a spotlight around risk mitigation that your M&A attorney is going to be all over, and appropriately so in protecting you as a seller.

When I talk about the business aspects, something that often surprises founder-led businesses and first-time sellers is the working capital agreement. That will be included in the purchase agreement, but there is generally a well-understood market view that there will be a certain amount of working capital to operate the business for a period of time that will be left behind or provided by the seller. Sometimes that’s a surprise.

We educate sellers very early and make sure they understand that when they’re doing their spreadsheet in terms of what’s going to be left behind, there’s got to be a stub in there for working capital.

If there is an escrow requirement as part of the deal, then what does that escrow agreement look like? When is it released? How much is it? What is it for? What are the stipulations around it being released?

Then the last one, and this can be a sticky one, is an earnout. If an earnout is applicable as part of the deal structure, then that’s a negotiation and an agreement that will continue forward, and obviously it is very critical to the seller as well as to the buyer.

We often say an earnout or a gain share means there’s a target that needs to be met, and the buyer and seller should be on the same team trying to go get that target. We always communicate to buyers that if they want to include an earnout and it’s appropriate, then the seller is accepting some risk. Because of that, there should be additional gain for a seller through accepting an earnout.

It’s in the best interest of everybody for the seller to achieve the earnout because that means the business is performing and growing and continuing to hit the agreed goals.

Those are some of the things that are ongoing negotiations. If you keep legal focused on legal risk, they will be after all those legal risk terms like indemnifications and warranties. The business negotiations that also get incorporated into the purchase agreement should really be the responsibility of the M&A advisor or the investment banker because they are alongside you the whole way and are best positioned to drive the best agreement.

Ryan:
I think those are the big ones that we see. There’s definitely pushback back and forth in those areas. The next question I have is where do you see some of those logjams?

Matt:
Any and all of them can be, if not managed appropriately. This really goes to accentuating Mike’s point around keeping momentum and also keeping the spirit of the LOI in mind. Everybody has the intent. Everybody wants to meet the finish line. So keep that momentum, start those discussions early, and keep the pedal down. Being a Minnesotan and a hockey fan and an old hockey player, it’s okay to be ready to get your elbows up at the right time.

Ryan:
Absolutely. If we switch gears a little bit and say the large part of the definitive agreement is done and agreed to, Mike, this often comes down to the last week or two before close and sellers get to what we call disclosure schedules. Can you help define what those disclosure schedules are, why they matter, and why they take more effort than sellers might expect?

Mike:
Yep. Think about all of the details associated with every contract you have written that’s active in the business, all your employee agreements, all your non-competes, all your non-solicit agreements, complete sets of your financials, any vendor agreements, and this one’s a big one, whether that be with your internet provider, your landlord, your utility provider, your coffee provider. Every agreement associated with running that business needs to be in the disclosure schedules.

That can be a big lift. Not to mention the fact that you’re going to warrant that the disclosure schedules are everything tied to your warranties. There’s a lot of discussion about representations and warranties. The representations you make and the warranties you make are supported by the paperwork in the disclosure schedules, and you’re going to warrant that they are fulsome in their disclosure.

You may sign disclosure letters that say you don’t have any pending litigation or you don’t have anyone who’s given notice of termination or that you have whatever the case may be. That’s going to be part of the definitive agreement.

Now, if someone has said they’re going to terminate or sue you or do something that you have represented as not being the case, then you have to disclose it in the disclosure schedules. Otherwise, you’re in breach of the agreement.

So it’s super important that it’s done in a very fulsome way and that it’s fully transparent. I would never encourage someone to hold anything back. You need to be fully transparent in the disclosure schedules so that you can make exceptions where needed.

For example, maybe you said no one has given notice of termination, and then a week before close someone says they’re going to terminate. You have to disclose that termination in the disclosure schedules so that the buyer doesn’t come back and say you didn’t disclose that, it impacted the economics of the deal, and now they have liability claims against you.

If it’s in the disclosure schedules, they reviewed it as part of diligence and signed off on it, then it won’t impact the deal post-close. Think of it like an insurance policy. You need to be fully transparent and factual about the state of the business.

A lot of people think maybe they don’t need to disclose something because it seems minor. But if the buyer doesn’t think it’s minor or it turns into a major thing, then you’re going to be on the hook for it if you didn’t disclose it.

The issue is that in disclosure schedules there is a lot of paper. Even if you have your records in great order, all the parties want the most recent version of those records. Oftentimes, you have to pull them together right toward the end of the transaction. Almost everyone underestimates the time involved. It can take hundreds of hours to pull together all of the disclosure schedules.

For the disclosure schedules that are not time sensitive, and I would say most of them are not, you can pull them ahead of time. If you need a copy of your lease for example, or certain things that are not time sensitive, get them ready.

One thing a lot of people overlook is consents. This isn’t technically a disclosure schedule, but it’s often related. Your bank may need to have a consent or a release of a filing pursuant to your line of credit. Your landlord may have to agree that the buyer is creditworthy enough to take over your lease if that’s what’s going to happen. They may need to provide consent for the transaction.

Those are often related to the disclosure schedules and come out of them. When a lawyer reviews your lease, it may have very specific terms for how it can be transferred. These are the kinds of things that crawl out of the rocks when you begin putting together your disclosure schedules.

I would always encourage people to start early, start often, and disclose as much as possible as quickly as possible in order to close. We’ve had deals get delayed because people cannot assemble the disclosure schedules in a fulsome way based on the time they allocated to do it. It’s critically important that you assemble a team, focus on it, and get to work so that if there are encumbrances, issues, or things that need to be resolved, you still have time to complete them.

Ryan:
That’s a great summary, Mike. So to take that, you’re going to have to disclose quite a bit and start preparing early. Make sure you’ve got all your documents in line. This is something that’s really going to stay with the transaction post-close. If you’re going to come back to something, it’s often going to be in these disclosure statements, and that’s backed by the representations and warranties of the deal, which might have some holdback language. Making sure that you’re nailing that is really important.

Mike:
I’d add another point. There’s this legal precedent called, is it in the four corners of the document? I should really say, is it in the four corners of the documents, meaning is it in the definitive agreement as referenced and supported by the reps and warranties and the disclosure schedules?

If it’s not, it’s not considered to be pursuant to the transaction. If someone mentioned it in passing but it’s not documented accurately in the definitive agreements, it doesn’t exist in the eyes and minds of the law.

So it’s critically important that everything has been communicated, clearly defined, and captured in all of the definitive agreements in a fulsome way. That’s how you avoid future liability. You might think, well, I told them that a particular client was rolling off, but if it didn’t make it into a disclosure schedule, too bad. You didn’t disclose it. It wasn’t in the four corners of the document, and you would have liability in that case.

Ryan:
Great. That makes sense. Let’s say all of this has been done, all the work has gone through this whole process, and we finally get to closing day. Matt, walk us through what closing day looks like. What are the logistics? What does it look like, who is doing what, and what should a seller expect?

Matt:
I’m chuckling because oftentimes we hear from sellers, well, that was kind of anticlimactic. Because pretty much on closing day, if it’s done correctly, and it doesn’t happen all the time, but most often when it’s well managed, closing day is just the period at the end of the paragraph. Everything should already be done.

You should already have put signatures on the documents. Those signatures and documents haven’t necessarily been released to the other parties yet, but they’re in place. So all of the agreements are done on closing day. We like to have a ceremonial call where everybody confirms the deal is done and the money is starting to be released.

All the signature packets are delivered, the final schedules are in place, and the various wires are released. If there are lenders that need to be paid off, those wires are going out. If there’s an escrow agreement, those wires are going out. Often the payment flow is also paying your providers, your lawyer, your advisors, and so on.

Those things are kind of out of your hands. You have a closing call, thank everybody, and move forward. Again, when it is well managed, everything just transpires from there.

That’s where we often hear, wow, okay. And then really, most importantly on closing day, have you figured out how you’re going to celebrate? Whether that’s a big dinner, getting together with your team, or going to a quiet place and having one of your favorite libations, plan something to celebrate because you’ve reached the finish line.

So again, when it’s well managed, all those things are in place. If it’s not well managed, you are still tying out final pieces. And if it’s managed horribly, you’re still negotiating something on the last day. We don’t let that happen, and sellers shouldn’t let that happen either. Ideally, closing feels a little anticlimactic because everything important has already been handled.

Mike:
I would add to that, Matt. If everything’s been done well, this can be done in an hour or less typically, routing documents for signature digitally and releasing wires.

Everything else should have been done and considered ahead of time, either signed ahead of time so those signatures are with your lawyer in escrow, or executed in a way that your lawyer can release all those documents. There shouldn’t be a lot of drama on that day.

Sometimes there are documents that get digitally signed that day, but more often than not these days it’s done ahead of time and held by your lawyer because there can be a lot of documents to sign. If people are online with connectivity issues or digital authentication problems, those technical wrinkles can slow things down.

To get around that, we’ve had most of our clients circulate digital signatures ahead of time to be held by their lawyer. That means when they release signatures, it’s really more about wiring logistics.

Depending on where wires come from and originating banks, that can take some time. International wires especially can take a day or two to clear, and that’s not uncommon. The advantage of having your lawyer hold the signatures is that they hold them until the funds are received. Technically, the transaction is not closed until the funds are received.

That can be received by your attorney in their trust account or sent directly to you. There are some logistics that need to be managed that day, but to Matt’s point, it’s mostly anticlimactic and ultimately more about getting people paid and beginning the journey of integration.

I think the best firms begin an integration plan ahead of close, but most of them start celebrating and thinking much more about integration once all these documents are finalized and they’re effectively at the closing table.

Ryan:
This has been a really helpful discussion. If you’re at this phase of the process, it is an exhilarating one and at the same time, anticlimactic, which is usually a sign of something done well. You’ve done all the hard work and it’s a day to reflect, celebrate, and look at what’s next.

When we look at this master class, we’ve gone through the process of starting to think about what a transaction can be and we’ve gotten all the way to the end of what it is. The next topic we have is what the next 100 days look like after an acquisition, so we’ll cover that in our next podcast.

Mike, Matt, thank you both so much for sharing a lot of wisdom here. I’m glad that we’ve actually had the opportunity to get to that final stage many times, and you’re speaking straight from experience when it comes to this podcast. Thanks for your great work there.

With that, I’ll turn it over to you, Mike, for any closing thoughts.

Mike:
Sounds great, guys. Thanks a lot. With that, we’ll tie a ribbon on it for this week’s Shoot the Moon podcast. I encourage you all to tune in next week when we unpack further new ideas and share our experience with M&A and the IT services space. With that, make it a great week.