TOP LEGAL ISSUES SEARCHERS FACE

SEARCHFUNDER INTERVIEW OF JON HERZOG, PART I 

We spoke with Jon Herzog of Goodwin Procter about common questions that we hear from searchers. In this Part I, Jon discusses the top legal issues that searchers face; money and time saving strategies; when a local lawyer might be necessary; and much more. 

How did you first get involved in the search community? 

Goodwin Procter was the first search fund law firm. We did nearly all of the original search fund deals. By the time I arrived as a middle market-focused Private Equity M&A attorney, we weren’t doing any new search fund deals. However, we still had connections to the original search funds. I was working with Pacific Pulmonary and Asurion, not even aware that they had started as search funds. After Pacific Pulmonary was sold, one of the executives left the company and asked me to represent him in his search fund. I negotiated his deal opposite one of the more prolific investors in the space. At the end of that deal, that investor said, “I think you did a really good job representing the entrepreneur. We need more experienced M&A lawyers in this space. Would you be interested in doing more of these?” I said, “Yes.” -- not knowing what I was getting myself into!  

Do you enjoy the challenges of this space? 

This space is not without its challenges. It’s a very good group of people. The comparatively small size of the community is a very good, natural check on people’s behavior. Everyone knowing that they are going to see each other in future deals causes a level of decorum that you don’t always see in traditional private equity. The tone is much different. We very much appreciate that. We love working with young hungry entrepreneurs. Our junior people like working with clients who are their age. It’s been a great experience for us.

The challenges are that a lot of the entrepreneurs are a little more green than other private equity clients. So, there’s a little more education on our end. As green as the entrepreneurs might be, the sellers are more inexperienced than the counterparties we see in traditional private equity M&A. That can present challenges and, of course, opportunities for the deal.

What do you do for searchers?

It typically starts with helping them to get ready to go out to the investor community to raise the fund. That involves reviewing and talking to them about the PPM. Sometimes those conversations are about how to approach investors. We may even get to the granular level of how to approach investors by geography. From there, we have conversations about the reactions they are getting from investors. Or, it can jump straight to preparing the necessary documents to bring in the capital. Once funded, we’re working with the searchers on LOIs, trying to slant the field in their favor before too much work is done – and sometimes before the seller has engaged counsel on his or her end. On acquisition, we are drafting and negotiating the definitive purchase agreement. We are structuring the transaction to the extent that if there are tax or economic benefits available, they end up on our side of the table. We are documenting and finalizing the transaction, including working through who gets wired what amount of money on the closing day. 

What are the top legal issues you address? 

In the M&A context, it varies greatly. The themes that seem to come up over and over again are (1) pre-closing tax issues where the Seller has not done a great job of paying state use and sales taxes; and (2) Labor and employment issues, where the Seller hasn’t properly paid his or her employees under the law. This isn’t a statement that they aren’t paying them fairly, but they are not structurally paying them in the right way. I’d say that if you looked at a large sample of search fund deals, and ask which legal issues come up the most when we look at target companies, those two would be at the top the list.  

Can you explain what that means? 

Sure. A lot of smaller businesses can be comparatively cavalier about how they treat two different situations. The first situation is whether someone they are paying as an independent contractor should truly be an employee. We find that issue a lot in these smaller, founder run businesses. The legal bias is always toward “people are employees” unless proven otherwise. A business can create some liability by treating some people as contractors that really should be employees.   

The second situation is that people are being paid a salary when the reality of their employment is that they should be an hourly worker who receives over time when they work more than 35 hours.   

The last thing we spend a lot of time on legally is making sure you are buying what you thought you were buying as a searcher:

• • You are getting the company.  
• • It has an appropriate level of working capital.  
• • It’s paid off all the debts and deal expenses that should be on the account of the Seller 
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When is the best time to contact you? 

I always say, “It’s never too early” because contacting us doesn’t cost any money. We may be able to introduce you to some investors. If you wait until it is time to form the fund and bring in the capital before talking to a lawyer, it will delay the process at a minimum of 2 weeks. Because it doesn’t cost anything to talk early, there’s no reason not to. 

I’ve spoken to a number of searchers as they get started. Some of them rely on forms that have gotten circulated around. My hunch is that you’ve seen them or bits and pieces of them. So, I ask, “What do you think of the ‘forms’ circulating around in the search community?”

By the time, I got into this community, there were already form documents floating around. Those documents were created by a cast of authors over time and through experience. They are probably not where I would have started had I been given the option but they are working. With that said, the search fund community has different and interesting terms than traditional M&A.

It’s a more productive approach to read them fully and decide whether there is anything in the forms that doesn’t feel right to you as the searcher, change those things and have a principled discussion about them with your investors and advisors. Otherwise, we’re re-arranging the deck chairs. You’ll slow down the process and delay your fund. You should change them only on principle, not because they don’t read the way you would like them or aren’t as clear as they could be. If the community decides to look at reworking the forms as a group, I’d be all for it!  

If I’m a searcher in Boston, looking at an acquisition in Tennessee, do I need a local lawyer or a search fund familiar lawyer or both? 

It’s very rare that you’ll ever need a local lawyer. Almost every issue that comes up in the M&A world will be governed by Delaware or New York law. All the national law firms are great at that and every national firm, including us, has employment law experts who know the law of every state. The local lawyers – you could find a great one – but the likelihood they will be a topnotch M&A lawyer anywhere outside one of the major M&A centers in this country is very small. Plus, this is a very interesting niche, where investors are accustomed to seeing the same purchase agreements and seeing certain issues handled the same way over and over again. Bringing a new voice into that room, even when that voice is speaking for all of the buyers (the investors and the searchers) opposite the seller, can be a distraction. That’s the reason there are 3 or 4 firms that do the lion’s share of the work.  

In sum, you don’t need a local lawyer. If we thought you did for some reason, we would tell you.  

What about searchers who are trying to straddle between getting funded in the US and then purchasing in Latin America?

That’s a great question. There you actually do need a local lawyer and a US search fund lawyer. You’ll need someone locally in Brazil, say, to do the M&A. Your deal will go far more smoothly having your local lawyer speak to the Seller’s lawyer. They’re speaking in a different language and addressing a different legal system and different legal customs in the documents. At the same time, you have a bunch of US investors, who are accustomed to certain documents about their relationship with the searcher. There are not too many law firms in the world who know how to do that. Introducing someone speaking a different language and with different documents is a recipe for making that part of the deal take 2x times as long as it should and, possibly, never even happening.

So, unfortunately, in this situation I do think you need 2 firms. As long as the deal is in the United States, there’s never a need for a local lawyer.  

What are your top money or time saving tips for searchers as they form their entity, prepare an LOI, an acquisition and/or begin operating their business?

In terms of saving time, it is invaluable to talk to other searchers who have been there before to cover questions, like:

• • how did you open your bank account?
• • how did you think about staging due diligence with your accounting firm?
• • how did you think of office space?
• • how often did you send out LOIs?

Other searchers who have recently done it are great source of time saving tips.  

In terms of saving money, we do a good job of cautioning searchers as to when to turn us on fully; that is, usually after a quality of earnings report has been prepared and a few investors have indicated that they think the deal will move forward.  

Searchers should be thinking of the same thing as they turn on other specialists and experts. 

How confident am I that this deal is going to happen before I pay for a quality of earnings report? The only way to get there is to involve your investors early and get some support for the idea that it makes sense to start spending money on the deal. Investor involvement is free. It’s the way to make sure that you are spending your time on something that makes sense. It’s frankly how the model was built. As the asset class has grown, the link between the entrepreneur and the investor isn’t as strong in some cases. But, that is how the community used to handle that issue and still does in many cases.