Buyers in the security industry purchase accounts they think will generate recurring monthly revenue (RMR) for more months than the multiple they pay. It’s simple math. To earn a return on investment on an acquisition priced at 36 times seller’s RMR, a buyer must keep the purchased accounts for 48, 60 or 72 months, or perhaps even longer, especially when you consider attrition and transaction costs. These numbers change based on the multiple, buyer’s targeted ROI and costs of funds, attrition, amount of the holdback and length of performance guaranty, among other things. The well-executed acquisition of an account base can be extraordinarily profitable, especially when compared to organic growth.
Generally speaking, the better the operator, the better the quality of contract, the more comfortable the buyer can feel about the purchase and the higher the purchase multiple. While detailed representations and warranties are crucial to acquisitions, nothing beats thorough due diligence. What a buyer fails to discover before closing may create significant problems after closing, when buyer’s recourse may be significantly limited (or barred) for any number of legal or practical reasons. Buyers should assemble its due diligence team early in the process. Sellers should complete their due diligence before even taking the company to market.
Here are contract due diligence issues to focus on–whether buying or selling accounts:
Monitoring Contracts: Prospective sellers should purchase form contracts from qualified industry counsel when getting started in business, not when they begin selling their company. Good contracts will pay dividends on exit. A generic central station contract almost never contains terms to protect your company against claims and certainly does not establish your company’s title to an account.
Assignment: While this provision may not be so important to the sales team, it is essential to sellers and buyers. Prohibit subscribers from assigning contracts to third parties. Permit your company to assign the contract to another without the subscriber’s consent. Without this clause, the account may not be assignable to the buyer, which, at best, will lead to additional work and possibly concessions on the seller’s part, or no account to sell.
Monthly Recurring Charges: Clearly set forth the monthly charge. You’d be surprised how often this comes up in a deal.
Services: List all services offered to rebut potential claims that you failed to offer additional protection. Contracts should also include written acknowledgment that additional protection is available at additional cost.
Term: The length of term (12, 36 or 60 months) should be pre-printed on the standard agreement. Never leave a blank for a salesperson to fill in later—terms accidentally left blank create issues for both buyers and sellers. Although contracts should renew automatically upon expiration of the initial term and each renewal term, buyers should determine the seller has complied with any applicable legal and regulatory requirements governing renewal. For example, many states require written notice that the contract will renew within a specific time absent the subscriber’s written notice of intention not to renew the agreement. Failure to comply renders the contract voidable by the subscriber. Can the seller prove compliance with the law? Many companies simply re-contract their accounts at the end of each term as a means of avoiding the applicable law. But buyers won’t and shouldn’t pay for expired contracts.
Three-Day Rescission: This legal requirement has two sources—rules promulgated by the Federal Trade Commission and similar (but not identical) state laws. The FTC rule applies to residential customers where some portion of the sale transaction takes place away from the seller’s place of business. This includes virtually every sale of a residential security system. State laws often apply in similar circumstances. (Determine which state laws apply and what they require.) The FTC rules require residential contracts to provide a subscriber notice of the subscriber’s right to cancel the agreement by written notice prior to midnight on the third business day after the date of the transaction. To comply with federal law, a seller must also provide the subscriber with a separate, pre-printed notice of cancellation and acknowledgement form. The subscriber signs this form to acknowledge its receipt and can sign the notice and put it in the mail within the three-day period in order to cancel the transaction. A buyer should confirm seller’s compliance with this requirement by reviewing at least a representative sampling of the seller’s subscriber files. Buyers should confirm seller’s compliance with applicable state laws, too. Failure to comply with these state or federal laws may make give the subscriber the right to void the contract and that right continues even after the buyer takes over the contract in an acquisition.
Right to Increase RMR: Include a provision permitting increases in monthly charges, at least on an annual basis. From a seller’s perspective, if the market (and your account base) will tolerate minimal increases in RMR every year or two (e.g., $1 a month), you should consider doing so. Over time, the difference will be material, particularly when each dollar of RMR is worth $30 to $40 in purchase price.
Monthly Electronic Funds Transfer or Credit Card Payment: Electronic payment is the way to go! Allow the subscriber the option of choosing a payment preference on the face of the agreement and offer a discount to induce subscribers to pay electronically.
Warranty: Contacts must include very specific language, presented in a very specific manner (e.g., location, type and size) to disclaim implied warranties. Avoid language implying any sort of “lifetime warranty” even where a trip charge may be included, otherwise, a buyer may allocate some portion of RMR to the service aspect of the warranty and pay for that portion of RMR at a reduced multiple. (Service contracts often trade at lower multiples than monitoring contracts.)
Exculpatory Clause: This clause, which protects against fault or liability even if the alarm provider was negligent, are not only enforceable, but provide significant protection. Sellers should include legally-enforceable versions of such clauses and buyers should confirm their existence.
Limitation of Liability Clause: Similar to the exculpatory clause, a limitation of liability clause limits an alarm provider’s liability to a subscriber—or even a third party—to a specified or determinable amount (e.g., fees paid to the provider). These clauses are enforceable and the greater the dollar amount of the limitation, the more likely a court will enforce it. (The $250 limitation of liability clause is an industry relic!)
Indemnity Provision: Indemnity requires one party (the subscriber) to pay the legal costs of another party (the alarm provider). This includes the obligation to pay any settlement or judgment entered against the alarm provider in litigation. This is an essential clause for both buyer and seller.
Waiver of Subrogation Clause: Subrogation permits an insurer to “step in the shoes” of an insured (such as a subscriber) and sue a third party for causing the loss the insurer covered. This clause waives any right a subscriber’s insurer has to seek damages where the provider’s wrongful conduct contributed to a subscriber’s loss. These clauses tend to be enforceable and will go far to keep insurers from suing you. Make sure to include this term.
Contractual Limitation on Action: Parties to a contract may shorten the time period in which one party (the subscriber) can assert a claim against the other (the alarm company). With some exceptions, this provision is generally enforceable and certainly worth including in a contract.
This list is not exhaustive and some issues are more important than others. Make sure you involve counsel in each acquisition. The single most important factor in any acquisition is knowledge about the seller’s account base. A seller should know everything it can about its account base before taking the sale to market. A buyer should learn everything it can about the seller’s account base before closing the deal. In an acquisition, knowledge really is power.
Eric Pritchard is a partner in Kleinbard Bell & Brecker LLP, Philadelphia, a commercial law firm with a national practice in the electronic security and life safety industries. This column does not constitute legal advice; contact an attorney with specific questions.