Of the hundreds of deals that pass a private equity professional’s desk in a given year, only a handful will result in meaningful conversations — and even fewer in closed deals. Since passing this initial barrier is difficult, it is important for both parties to work together to ensure that the opportunity is not lost due to minor risks or disagreements.
According to Member Lee Miklovic of Opus Capital Partners, early stage derailments can occur even with the NDA. “Although sellers don’t realize it, a poorly structured NDA…can negatively affect the outcome of a transaction and otherwise reduce the number of quality buyers attracted to the deal,” he explained.
“We will not move past the first stage of a deal if the banker or broker is not willing to accept changes to an NDA that is otherwise one-sided and not market-based,” continued Miklovic. “The unwillingness to incorporate edits and changes ultimately reduces the number of higher quality, prospective buyers and ultimately hurts the client. Private equity firms that are in the business of reviewing deals on a recurring basis will have certain minimum standards.”
As it turns out, Miklovic has historically “passed on 25% of deals because of the language in the NDA, the rigidity to changes, or time required to make such changes.”
Miklovic shared insight into some of the red flags that buyers watch out for before signing an NDA:
Limitations to Employee Conversations: According to Miklovic, some bankers and brokers include “provisions regarding the inability to have discussions with owners, management and employees.” Not only is this clause logistically difficult since many private equity firms like to speak with employees and managers before signing an LOI, the clause can also become particularly problematic if there is a falling out between the banker/broker and the client.
The Duration of the NDA: Sometimes bankers or brokers try to keep the NDA open-ended with no expiration date — which “will not work for qualified buyers.” Miklovic explained, “Most potential buyers prefer a time period of 18 months, but no more than two years.” While many business owners prefer to keep their information confidential for as long as possible, aligning an NDA timeframe with a typical deal timeframe is a reasonable metric.
The Over-Confidentiality of the NDA: While an NDA implies a certain level of confidentiality, a qualified private equity firm may seek to enlist the help of, “attorneys, accountants, consultants, and financing sources as it relates to the diligence and general structuring of the transaction,” explained MIklovic. If the PE firm is unable to share the company’s information with these service providers, it can create challenges. He continued, explaining that the parties that can be privy to the information need “to be specifically defined in the agreement.” If the banker or broker is too strict with the confidentiality, it will severely hinder a private equity firm’s ability to do comfortable due diligence.
Included Attorney Fees: One of the biggest red flags in an NDA for Miklovic is a provision in which “the prevailing party in a disagreement is awarded attorney fees and other punitive damages.” He — and many other PE firms — find this clause particularly problematic, “since the agreement is one-sided and the protected party has minimal or no downside to bring suit against the prospective buyer.“
Governing Law and Venue: Another frequently-changed clause of the NDA is the state of choice for legal precedent and governing law.“Many brokers will use the state in which the broker (not the selling client) is located and is not likely the best option,” explained Miklovic. Since New York and Delaware have “the depth of case law precedent,” they tend to be the most appealing options.
Although selling to more stringent private equity firms can be more work upfront, it’s important to seriously consider their recommendations. Oftentimes institutional and corporate investors tend to be the most qualified buyers and can be much less risky to work with.
While you always want to maintain your clients best interests in mind — and realizing you aren’t going to be able cater to every potential buyer’s wants and whims — you don’t want to miss opportunities for the wrong reasons. A thoughtful, well-drafted NDA might be the difference between a perfect buyer and an unhappy client.