A bargain-basement price, however, does not come without risk. Distressed companies typically face deteriorating assets, lender pressures and legacy liabilities. Those purchasers prepared to tolerate such risks can realize material returns on a distressed acquisition if risk is properly priced. Two important ways to price such risks are to (1) conduct due diligence and (2) utilize an acquisition structure that best accomplishes the goals of the purchaser given the distressed company’s financial circumstances.
Due diligence: As with any acquisition, it is important to understand the legal and financial challenges affecting a distressed company. However, the ability to do thorough due diligence in these scenarios is often very limited. This may be due to poor record keeping, disorganized management or the fact that the financial pressure on the business compels a speedy transaction. Regardless of the situation, a purchaser should try to best understand the financial condition of the business and be comfortable enough with the purchase price given limited information. Thus, it becomes particularly important when there is limited due diligence for a purchaser to structure the transaction in a way that best mitigates risk associated with the distressed company.
Asset sale: A basic option is to conduct a simple acquisition of the distressed company’s assets. This option is the quickest, but it is also the riskiest. In a typical asset sale, a seller will often give representations and warranties that are supported by an obligation of the seller to indemnify the purchaser if those representations and warranties turn out not to be true. In a distressed situation, a seller is often not in the position to give full representations and warranties about the business. Furthermore, any representations and warranties that could be given would not be supported by a viable indemnification provision because the seller will likely either be out of business or not have the money, or the ability to hold back money, to reimburse the purchaser for any damages relating to the pre-closing distressed company.