ABA Section of Business Law
ABA Section of Business Law
Business Law Today
November/December 1998
Going with the cash flow
Get to know this crucial factor in communications deals
By FREDRIC D. TANNENBAUMTannenbaum is a partner with Gould & Ratner in Chicago.
Operating cash flows and the broadcast and telecommunications industries: Are you ready to deal?
A confluence of factors, in near perfect alignment, has dramatically accelerated the trends toward consolidation in the broadcasting and telecommunications industries. Structural changes legislated by the Telecommunications Reform Act of 1996, an economy enjoying seven years of uninterrupted growth (until the recent downturn caused by the Asian depression), access to capital by virtue of very strong debt and equity markets, and managements' real or perceived desire for economies of scale and scope have all contributed to the extraordinary wave of mergers and acquisitions.
The size and number of these transactions is unprecedented. In the radio industry alone, according to government statistics, 4,000 of the 11,000 stations in the United States have changed ownership in the less than two years since the passage of the reform act, including more than 1,000 mergers, and more than 140 transactions requiring a Hart-Scott-Rodino filing. Three of the five largest mergers in corporate history have occurred in the telecommunications industry, including the recently completed $37 billion WorldCom-MCI combination, the pending $62 billion SBC-Ameritech merger and the $63 billion Bell Atlantic-GTE pending transaction.
Consolidation in the communications industry introduces a lawyer to unique jargon. Shorthand like POPs, MTAs, BTAs, MHz, OCF, EBITDA, PCS, SMR, Dbu, UHF, VHF, AM, FM, FCC, RBOCs, CLECs, LECs, LMA and CPM conjure up an alphabet soup of terms that causes even the most attentive eyes to glaze over. Transactions in this industry also sensitize a lawyer to a distinctive amalgam of legal and business issues.
One fundamental business concept is central to every communications acquisition, yet is often overlooked from the standpoint of legal documentation — operating cash flow (OCF). Actually, this element is present in every acquisition, whether in the telecommunications industry or in the widget industry. Focusing on the underlying fundamentals of the transaction will assist a lawyer in evaluating the issues that are truly important to the client and that are worth contesting. When lawyers often battle over the "usual suspects" (like representations, warranties, covenants, indemnities and the like), if they stopped and asked themselves how these battles affect OCF, the negotiations would be more principled — and hopefully productive.
If a Holy Grail exists in the communications industry, it is OCF. While many different definitions or approaches exist to define that term, it is essentially net income plus interest, taxes, depreciation and amortization, and plus or minus changes in working capital.
Since the prime balance-sheet asset of most businesses in the communications industry is the intangible license issued by the Federal Communications Commission, the business is therefore comparatively devoid of tangible fixed assets. There tends to be high amortization of intangible assets because of lofty premiums to cost basis paid by buyers in recent years. As a result, conventional valuation benchmarks such as multiples of book value and earnings are useless since they are sometimes meager or nonexistent.
Many communications transactions are financed in substantial part through debt. Lenders frequently relate the amount they are willing to lend as a function of OCF generated in a prior period (or, "trailing OCF"). Given the usual regulatory delays between signing and closing a communications industry transaction, the sustainability of OCF during the period between signing and closing can make or break the transaction.
For example, if the trailing OCF is $1 million at the time that the $7 million purchase price was agreed to between the seller and buyer, and the lender is willing to lend seven times OCF to enable a buyer to purchase a cellular telephone company, then if OCF remains constant or improves between signing and closing, the buyer will be able to debt finance the entire purchase price.
However, if the trailing OCF declined during this interim period, the multiple effect could be devastating. Under the previous example, if OCF declined from $1 million to $750,000, then the buyer would only be able to borrow $5,250,000 and would need to find additional sources for the $1,750,000 shortfall or attempt to renegotiate the transaction. Obtaining this additional financing this close to a closing date places considerable pressure on a buyer, diverts its attention from preparing to operate the business, and reduces its leverage in negotiations to raise this capital.
The need to document and assure the credibility and sustainability of OCF manifests itself in many ways. During the due diligence process, the buyer should evaluate OCF trends. For example, if the trends have been robust in recent years, but the client expects a declining economy in the next few years, caution should be exercised. Similarly, a buyer should investigate whether past OCF was due in part to a nonrecurring event.
For example, if one is buying a radio or TV station in the Atlanta market and based the price on 1996 numbers, the ability to replicate those numbers should be highly suspect since in 1996 Atlanta hosted the Olympics. It was also a presidential election year.
In the cellular telephone business, buyers need to analyze whether the market is already heavily penetrated by customers, or if there is still room for increased penetration. Are new technologies (such as personal communications services), likely to erode cellular market share or require a reduction in rates or an increase in capital spending? Is customer usage seasonal, such as in some southern markets where some residents may return north after the winter ends? Conversely, formulaic and mechanical reliance on OCF may be misplaced if, for example, the client intends to change the format of the radio station (for example, from religious to heavy rock).
During the contract negotiation and drafting phase, zealous focus on OCF may be directed to several areas. The seller's representations and warranties (reps) should address many issues to give the buyer comfort that the trailing OCF is reliable. The typical financial statement rep usually confirms (with or without a materiality qualifier) that the financial records fairly reflect the results of operations and are based on a specified accounting standard. However, this rep, standing alone, will not provide sufficient comfort regarding reliability of cash flow. Significant liabilities relating to past periods, as well as future periods, could loom and need to be analyzed.
While environmental liabilities are typically absent in communications transactions, the potential liability cannot be ignored and may surface based on the prior use of the business' property and the manner in which the property is held. For example, does the business use back-up generators with underground fuel tanks? How does it dispose of its batteries? The issue of liability for radio-frequency exposure, moreover, is unresolved, but few sellers will ever represent anything except that they have complied with all existing laws.
In an asset transaction, buyers usually exclude liabilities that are not expressly assumed. A stock or merger transaction requires far more due diligence, or indemnification protection, to assure that the buyer is not taking any risk that has not been factored into its OCF pro forma model. The practical world, however, may dictate that these liabilities may either need to be shouldered by the buyer — if not for prior periods, certainly for periods after the closing.
While reps may provide some assurance of the reliability of trailing OCF, they will rarely give any comfort that the operating cash flow is sustainable. Sustainability beyond closing is typically a function of both macroeconomic conditions as well as the operating talent of the buyer. However, reps addressing whether contracts are in default, notice of dissatisfaction or termination from major customers or advertisers, renegotiation of major contracts, notice of termination of key personnel and similar items, notice of complaints from customers, employees, suppliers or the government may provide an early warning signal to a buyer. While reps address the state of the seller's business and OCF in the past, at signing, and at closing, covenants are a typical means of contractually assuring that OCF will not be unduly manipulated during the period from signing to closing. For example, if a seller defers advertising expense or normal and routine maintenance on its facilities, that deferral will increase OCF but will require the buyer to shoulder that burden. Such deferral may also disguise deteriorating results of operations. A covenant that requires rates to be maintained within limits also is critical to assuring the reliability of OCF.
Many agreements do not address these items specifically and deal with them indirectly through a general requirement that the seller's business be conducted in the "usual and ordinary course."
However, a generic ordinary course of business (OCB) covenant is subjective in nature, while more specific provisions such as the two examples above can better guard against dissipation of operating cash flow. These covenants must be carefully crafted, however. Excessive requirements and restrictions on a seller may, in exceptional circumstances, be interpreted to have conferred premature "control" of seller's business on the buyer in violation of FCC rules.
Other contractual provisions protecting OCF are the conditions to closing. Many of these are common to all transactions (such as appropriate authorization of the transaction, accuracy of the reps and fulfillment of the covenants).
Two conditions are particularly germane to transactions in the communications industry and protecting OCF. A condition that financing be obtained is important to protect a buyer from a decline in seller's OCF for reasons explained above. A seller strenuously resists this type of covenant since it wants the certainty of closing and does not feel that it should be blamed for the decline in OCF. The decline may be attributable to general economic or industry conditions, the seller's business or a combination of these. Employee morale could drop during the period between signing and closing and customers may be taking a wait and see attitude, both of which suggests that the decline in OCF is merely a temporary blip.
For a seller to shoulder this entire blame, it contends, does not fairly allocate the risk. A buyer may retort that regardless of the reasons, or lack of reasons, for the decline in OCF, the fact is that OCF has declined and the business in its unbiased view may be less valuable, and is certainly less financeable. Compromise positions to reconcile a seller's desire for certainty with a buyer's desire to finance the transaction properly include:
- removing this provision after a certain number of days before closing,
- giving the seller a forfeitable escrow deposit,
- extending the closing date to allow the OCF to be restored, or
- converting the payment of the price to a cash portion and a contingent portion, the payment of which is predicated on OCF rebounding.
Further, while a mach in seller's "business, financial condition and properties" has actually occurred and may be analyzed based on the facts as known, sellers should resist a mach out based on a change in "prospects" since this calls for pure prophecy about future events. Sellers should also qualify a mach out based on changes in "properties" if such changes are covered by insurance or relate to intangible and conjectural properties such as goodwill or franchise value.
Sellers frequently attempt to qualify mach out clauses to exclude events affecting the economy in general or the industry in particular. They justify this qualifier on the grounds that the mach out should only apply to conditions caused by seller. To the extent that factors outside of seller's control propagated the mach, the seller should not be penalized.
Buyers try to resist these caveats on several grounds. Allocating blame between a seller's management fault or general economic conditions takes solomonic and, in reality, immeasurable precision. Regardless of the source of the mach, moreover, the seller's business has suffered, and it is not the same business that was the subject of the original bargain between the parties.
The parties less frequently attempt to devise an objective mach out clause. For example, the agreement may specify that a mach out will only be triggered if trailing OCF or revenues decline by 10 percent or more over the prior measuring period. If the parties agree with this concept, buyers try to tie the figure to a less manipulatable item such as revenues. While the buyer may fixate on OCF in other respects, tying a mach out clause to OCF is dangerous since many expense items may be deferred or revenue items accelerated to manage the OCF number. While contractual clauses may admonish such devices, they are often subtle and typically avoid detection until after closing.
Conversely, a seller may successfully negate the occurrence of a mach in certain situations. In the unconsummated MCI transaction with British Telecommunications, MCI specified that continuing losses in its local exchange business would not constitute a mach out. (In fact, MCI did suffer $800 million of losses in this facet of its business.) A seller might also argue that a mach out is inappropriate if the buyer plans to change the seller's format since past trends will not be predictive of future business.
Sellers also often try to negate a mach out clause by postulating that the buyer's prime interest is on the intangible license. This argument has particular credibility in a turnaround situation when the buyer is essentially purchasing the "naked stick" radio license in a breakeven or losing TV or radio station, or in a cellular phone business that has very low customer penetration but good growth potential.
Ratings announced between signing and closing raise mach issues. If there is a disappointing or calamitous Arbitron or Neilsen rating during this period, a buyer may try to claim a mach out. A seller might counter that no mach has been suffered yet and have a host of reasons explaining the temporary nature of the decline.
The parties should reconcile the mach out provisions with the casualty section. A lightning strike incapacitating a broadcast transmission tower is certainly a mach in the literal sense. However, since repair of the tower can be expected in a brief period of time, and no lasting impact on the business would likely be felt, it would be unfair for the buyer to avail itself of the mach out. Instead, the buyer should delay closing until the casualty is fixed (or close and receive an assignment of the insurance proceeds).
Finally, indemnification clauses provide the ultimate protection for a seller's breach of a rep or nonfulfillment of a covenant. A seller attempts to limit a buyer's indemnification rights in several ways and these are frequently the most fiercely contested donnybrooks in the agreement.
Battles involving indemnification are typically waged over:
- limiting the time period when the buyer may assert claims,
- the dollars that must be suffered before claims may be asserted (and then whether all damages may be recovered or just those in excess of the agreed amount),
- the total amount of damages for which a seller may be liable,
- the types of damages (or whether consequential or punitive damages are excluded or modified in some ways),
- whether damages are calculated before or after the tax effect thereof, and
- the procedure for controlling third-party claims and handling the disputes between the parties.
