Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How an Anti-Sandbagging Clause Cost a Buyer $30 Million
Transcript
- Lucas: So we've covered a lot of M&A traps on this show—earnouts, non-competes, working capital pegs—but there's one clause that flies under the radar for a lot of first-time sellers and even some experienced buyers: the anti-sandbagging clause. Luna: Anti-sandbagging? That sounds like something you'd find in a hiking gear catalog, not a purchase agreement. Lucas: Right? But it's deadly serious. Essentially, it determines whether a buyer can sue a seller after closing for a breach of representation or warranty that the buyer knew about—or should have known about—before the deal closed. Luna: So it's about who bears the risk when the buyer had a hunch something was off but didn't follow through. Lucas: Exactly. There are two flavors: a pro-buyer clause, sometimes called a 'sandbagging' clause, lets the buyer sue even if they knew about the breach before closing. A pro-seller clause—the anti-sandbagging clause—bars the buyer from bringing claims for any facts they actually knew or reasonably should have discovered. Luna: And which one is more common in the middle market? I've seen both, but I think the pro-seller version has been gaining ground. Lucas: You're right. In the mid-market, it's now standard for sellers to push for an anti-sandbagging clause. The logic is: if you as the buyer found a red flag, you should either price it in or walk away—not close and then come back with a lawsuit. Luna: But it can be a real trap for a buyer who skimps on due diligence. Let's talk about the OmniCorp acquisition of DataStream Analytics. I heard that one went south. Lucas: Yeah, that's the case I wanted to walk through. OmniCorp bought DataStream for $150 million in 2023. During due diligence, OmniCorp's finance team noticed some odd revenue recognition patterns—DataStream was booking multi-year contracts as upfront revenue. The team flagged it internally but the CEO decided it was 'aggressive' but not fraudulent. Luna: So they knew, or at least had constructive knowledge. Lucas: Right. They signed the deal without a specific indemnity for that issue. The purchase agreement included a strong anti-sandbagging clause, drafted by DataStream's law firm. It said OmniCorp couldn't bring a claim for any breach of reps based on facts it 'knew or, with reasonable inquiry, should have known' before closing. Luna: And after closing, what happened? Lucas: Within six months, DataStream's largest customer canceled its contract, citing non-performance. Turns out that revenue had been recognized prematurely to hit quarterly targets. OmniCorp had to restate a full year of financials and took a $20 million write-down. Luna: Ouch. So they tried to sue DataStream's shareholders, I assume? Lucas: They did. But the court pointed to the anti-sandbagging clause. OmniCorp's own internal emails showed they had raised questions about the revenue recognition before closing. The judge ruled that OmniCorp 'should have known' about the issue and dismissed the claim. They walked away with nothing from the seller. Luna: That's a brutal lesson. And it's not just about knowledge—it's about the level of inquiry required. Some clauses say 'actual knowledge,' others say 'constructive knowledge,' and the standard can be really hard to define. Lucas: Exactly. That's where the negotiation gets delicate. A buyer might try to limit the anti-sandbagging to 'actual knowledge' only, meaning the seller has to prove the buyer actually knew. But sellers will often push for the broader standard, including what the buyer should have discovered with reasonable diligence. Luna: And there's another twist: 'knowledge scraping.' Some agreements try to scrape off the buyer's knowledge by saying only the knowledge of certain deal-team members counts, not the whole company. That can become a huge fight. Lucas: Right. In OmniCorp's case, the clause covered anyone 'involved in the transaction.' The emails that killed them were from a junior analyst to the CFO. So the entire deal team's knowledge was imputed. Luna: So what's the takeaway for a buyer going into a negotiation? How do you protect yourself? Lucas: First, decide if you want anti-sandbagging at all. If you're a buyer, you want to preserve the right to sue for breaches you discover post-closing, even if you had some suspicion. You might accept a 'pro-seller' clause but insist it only applies to information actually known to specific individuals—narrow the knowledge pool. Luna: And also put a carveout for fraud. No court is going to let a seller hide fraud behind an anti-sandbagging clause, but you need to write that in explicitly. Lucas: Absolutely. For sellers, it's the opposite: you want the broadest possible anti-sandbagging, covering constructive knowledge, and you want to define the knowledge group broadly—anyone who had access to the due diligence materials. Luna: It's one of those clauses where spending a little on good legal advice upfront can save millions. And that's really the philosophy behind this show—we try to give you that good advice for free every week. Lucas: If these conversations have helped you in your work, a couple dollars a month at buy me a coffee dot com slash fexingo genuinely helps keep it going. It's listener support that keeps this show ad-free and independent. Luna: Yeah, even a small amount makes a real difference for us. We appreciate everyone who chips in. Lucas: Back to the clause: one more thing to watch is the 'materiality scrape' often bundled with anti-sandbagging. Some agreements say that for purposes of determining whether a breach occurred, you ignore materiality qualifiers in the reps. That can trick buyers into thinking they have a claim when they don't. Luna: Materiality scrape means that if the rep says 'no material undisclosed liabilities,' you treat 'material' as if it's not there, so any undisclosed liability—even a small one—counts as a breach. But then the anti-sandbagging might still bar the claim if you knew about it. Lucas: Exactly. So the interaction between these provisions is critical. In OmniCorp's case, even if they could have scraped materiality, the anti-sandbagging killed them on knowledge. Luna: Bottom line: don't let the boilerplate fool you. Anti-sandbagging is a major risk allocation tool that deserves careful thought, not just 'our standard form.' Lucas: And that's the takeaway. Next time we'll look at another clause that's often misunderstood—the 'bring-down' condition and how it can force a renegotiation at closing.