We are going to be doing a series of posts on issues that arise in most mergers and acquisitions. In this post I am going to discuss what “sandbagging” is with respect to an M&A deal and how to prevent it.
Here’s the scenario: You are looking to sell your company and have signed a letter of intent with the acquirer who will pay you $1,000,000 for the company’s assets including customer accounts. They will pay you half ($500,000) at closing and have a holdback for six months of the other half to account for post-closing verifications of accounts, taxes, etc. The acquirer starts and completes the due diligence process. The asset purchase agreement is signed, after some negotiation, by the acquirer and you on behalf of the company. The asset purchase agreement has the standard representations and warranties that the seller has to make to the buyer about the sufficiency of their accounts business, tax filings, etc. Then you close on the transaction (note you can sign the APA prior to the closing or at the closing depending on the situation). You get a check for $500,000 and think all you have to do is wait the next twelve months and get the rest. Then, the next day (or sometimes immediately after the closing), you get a letter from the acquirer on official letterhead putting you on notice that you have breached a representation in the agreement which said that all of your accounts were in good standing and no events had occurred which would affect your customer base. Lo and behold, and unbeknownst to you, your largest customer making up over half of your company’s revenue filed for bankruptcy five days before the closing. You had no idea, but the acquirer in doing its due diligence investigation talked to a higher up in the customer and found it out. Now the acquirer is going to keep the entire holdback amount ($500,000) because of this. You think “that’s not fair, the acquirer knew about it and still chose to close with the knowledge of the issue.” What happened is that you got sandbagged. And technically the seller is perfectly able to do this, although you could try to claim it was not negotiating in good faith (but if there was a representation or warranty you made as to the customers, the seller is able to rely on it).
To prevent this from happening, M&A practitioners have historically added an “anti-sandbagging” provision to the deal documents. This provision essentially states that the acquirer has had an opportunity to do its due diligence investigation and if it chooses to close on the transaction, it can’t then turn around after and claim a breach for something it knew of prior to closing. It forces the acquirer to bring up any issues and work it out (through adjustments to purchase price, holdback, contingencies, etc.) with the seller prior to closing. This isn’t an overly complicated provision but can save sellers from a lot of grief. Note however, that this provision is not going to allow the seller to make representations and warranties that it knows are untrue at the time they are made.