Unless your company is one of those must have, breakthrough, technology companies with buyers crawling all over you, you are subject to a process that greatly favors the business buyer. This presentation will identify these attacks on transaction value and approaches you can use to hold your ground against this formidable opponent. It may be helpful to look at it like a fencing match; buyer thrust, seller parry.
Thrust – Buyer experience. If the buyer is a private equity group, they buy companies for a living. They will have acquired dozens of companies prior to entering the competition for your business. If it is an industry buyer, they likely have an individual or department whose sole function is to look for business acquisitions. For most business sellers this is their first and only rodeo. What you don’t know will definitely hurt you, or at least cost you.
Parry – Do not go it alone. Hire an experienced M&A advisor to help you, not only for the packaging and marketing of your company, but for defending the value you thought you were going to receive at closing. Make sure you get an experienced deal attorney at the contract stage to counter act the incredibly one-sided agreement that the buyer’s team will present.
Thrust – Buyer choices. I know this will come as a shock, but yours is not the only business the buyer is seriously evaluating for acquisition. For private equity buyers, they generally look at about 100 companies for each one they buy. They will have several deals in the queue along with yours to give them plenty of options, to leverage one against the others, and to reduce emotional attachment to any one deal.
Parry – Seller choices. If the seller tries to sell his company on his own, he can usually only process one buyer at a time in a serial process because of all his other duties running the company. If a buyer knows he is the only buyer, count on bad behavior – inability to tie him down on a firm offer, missed time commitments, delays, endless information requests, and on and on. If, however you have been able to attract multiple buyers, your negotiating position is strengthened and you can offset these buyer tactics.
Thrust – Buyer controlling the negotiating dialogue. It is not uncommon to hear something like this from an experienced buyer, “Well last year you had a spike in profitability, I am just going to use the average of the last three years as the basis for my offer.”
Parry- Seller response via Advisor. It makes no sense to try to negotiate at this level. We just say, “Feel free to slice it any way that works for you. At the end of the day, if that approach makes your offer not competitive, you will eliminate yourself from the competition.”
Thrust – Buyer getting you off the market with a loosely worded LOI that allows him to “interpret the terms” in his favor deep into the due diligence process.
Parry – Seller not counter signing the LOI until terms are defined. There are several key terms of the LOI, so we will give each one their own Thrust and Parry.
Thrust – Buyer attempted treatment of Working Capital. Most buyers attempt initial language for Working Capital in the LOI that looks something like this: Working Capital Adjustment: There shall be a typical working capital adjustment to accommodate for changes to the working capital balance, (including cash. accounts receivable and accounts payable) as of the day of closing. During due diligence the Purchaser will set a working capital target by determining a normal and customary level of current assets including a positive cash balance. There shall be sufficient working capital, including a cash balance which shall be sufficient to operate the business on an ongoing day to today basis and the buyer will not need to fund working capital simply to operate the business immediately after the transaction.
Parry – Not so fast Zorro! This seems like a perfectly reasonable treatment and unfortunately many unsuspecting sellers will counter sign an LOI with this language in place. The result of this is either he is going to get taken to the cleaners on the level the buyer decides on, deep into the due diligence process, or the seller will blow up the deal deep into the process. Neither a good result and the sad part is that it could easily be prevented. The first rule of LOI’s is do not take your company off the market with a very important term not defined up front. This language enables their team of experts to calculate their own opinion of “reasonable and customary” while you have no negotiating leverage. You have already taken your company off the market as a buyer requirement to enable due diligence with a no shop clause.
The second very important mistake is that by leaving that term undefined, you have not really benchmarked the proposed transaction value against other bids. We had a client that kept a net working capital surplus far greater than what was normally required to run the business. Let’s say that they kept a surplus of $400,000 when their normal monthly business expenses were $100,000. So the level could be set as a surplus of $100,000. Now the buyers bring in their experts and look at your last 12 months’ balance sheets and proclaim that your historical level of $400,000 is what they need, then you may have just sacrificed $300,000 of transaction value. If you have one buyer that bids $3,000,000 for your company with a net working capital surplus requirement of $100,000 and you close with $400,000 surplus, $300,000 is returned to you as transaction value. This makes the total transaction value $3,300,000.
If the undefined working capital surplus buyer bids $3,100,000 and calculates, after the LOI, that his requirement is $400,000, then his transaction value is short the other bid by $200,000!
This can all be prevented by the seller insisting that the LOI include a net working capital level commitment with the calculation methodology spelled out. Each buyer may have their own opinion of what that number should be, but this exercise will allow you to equalize the bids and determine which one is truly superior. Unfortunately, the buyers try to leave this vague in their LOI so that ninety days into the due diligence process they render their buyer favorable opinion and count on the seller suffering from deal fatigue and just caving in on this meaningful loss in value. The buyers know that they do damage to your future chances if you put your company back on the market with the stigma of the previous deal blowing up during due diligence. It usually results in a market discount being applied to your company the second time around.
Thrust – An earnout clause with punitive “all or none” language. In the realm of SMB mergers and acquisitions, an earnout is a common practice and a perfectly reasonable component of a business sale transaction. It is often an effective way to bridge the valuation gap between buyer and seller and to align the interests of buyer and seller for post acquisition business performance. But like other components here, there is good earnout language and there is earnout language that is one-sided in favor of the buyer. An example of earnout language from a buyer LOI is: The total earnout shall be paid over three years. The total possible payout amount $1.5 million based on growing EBITDA by 5% per year over last year’s rate of $1,250,000.
The target EBITDA in year one is $1,312,500, year 2 is $1,378,125, and year 3 is $1,447,031. If the target is hit, the payout will be $500,000 for the year. If the achievement is between 85% – 99% of target, the payout will be that percentage attainment X $500,000. If the attainment is less than 85% of target, no earnout payment will be made.
Parry – In general we recommend that earnouts be based on a number that cannot be easily manipulated by the buying company. So measures like net profit and EBITDA are less favorable. Here they can insert some expense items like “corporate overhead” which are out of your control. We prefer tying earnouts to measures such as total sales or Gross Profit Margin; far more difficult to leave up to interpretation. Next, we never recommend an all or nothing earnout clause. Normally earnouts are a meaningful percentage of the overall transaction value and if an unforeseen event takes you below their cut-off target, you have sacrificed some serious value. Our argument is that if there is a big shortfall, the % of that shortfall in their earnout payment is enough to keep buyer and seller interests aligned post acquisition.
If there is a downside adjustment in the earnout calculation (there always is) then we like to have the corresponding upside for surpassing target performance. In other words, if you miss your target by 10% than you only receive 90% of that year’s earnout payment target. If you hit 110% of your target, your earnout payment should be 110% of that target.
We also recommend that the earnout be formula driven and include an example calculation as shown here. The earnout would total $1,500,000 and be paid in the first three years after the closing within 30 days of the anniversary date. The earnout would be based on the trailing twelve months revenues and a target to grow those revenues by 5% per year over the first 3 years following closing. So the target for year one (again using the prior year end as the example) would be $5,000,000 X 1.05 = $5,250,000. For year 2 another 5% growth would result in a target of $5,512,500. And for year 3 another 5% growth would result in a target of $5,788,125, for a three year total of $15,550,625. Dividing this by the total earnout payment at target ($1,500,000) results in an earnout payment of 9.06% of revenues for the first three years. The payment would be made annually within 30 days of closing of the company’s books for 12, 24, and 36 months following closing.
For each year’s earnout payment, the actual payout amount would be the calculated by applying the Payout percentage rate of 9.06% times the actual revenues. As an example, if the revenue for year three came in at $5,000,000 that would be multiplied by 9.06% and result in an earnout payment of $453,000. If the year three revenues came in at $6,000,000, the earnout payment would be $546,600.
Great, we have handled each thrust with our skillful parry. Match over, right? Keep that face protector on, the match is just heating up.
Thrust – the due diligence surprise. We noticed that your average billing per customer is smaller than our average billing rate, we are going to have to adjust our value.
Parry – What about the memorandum, the detailed customer lists, the monthly billing report that you reviewed prior to executing the LOI didn’t you understand? Our price is firm. If you want to adjust, we are cancelling the LOI and we are back on the market.
Thrust – we noticed that you had a spike in this particular type of revenue which is unusually profitable. We do not believe that this is sustainable and are going to have to adjust our bid to account for that.
Parry – If you analyze it correctly, last year was pretty much the norm for this type of revenue. The year prior was actually the outlier and much lower than average. Secondly, if you truly allocated corporate overhead to this income category, you would find it about the same level of profitability as our other lines of business. No adjustment is warranted.
OK – we held our own during that round. Now it is just a formality to get the purchase agreements signed and provide our wire transfer instructions. Not yet, pick up your sword.
Thrust – You receive the definitive purchase agreement from the buyer’s attorney and it looks like you have to rep and warranty your first born in order to get the deal signed. All of a sudden you see escrows and holdbacks, and guarantees that were not mentioned in the LOI. Much of that is pretty standard stuff although it will be very slanted to the benefit of the buyer.
Parry- no material changes to the deal economics allowed. We signed the LOI and provided you a no shop in order to allow you to perform due diligence. We were very detailed in our LOI in order to compare your bid with others that were very close. Without any legitimate finding of mis information in the due diligence process, the economics remain the same.
As for the scary reps and warranties, hold backs and escrows we let our lawyers talk with their lawyers. It is almost like they have the lawyers secret pinky handshake and they carve through this language with clarity and precision. What it usually boils down to is what is reasonable and customary in transactions that are similar to this one. If there are any remaining issues they identify them and ask the seller and his advisor to work them out with the buyer. By this stage, these final points are settled constructively.
Thrust – Oh, just one more thing, you are going to throw in the floor mats and the undercoating at no charge. We tell our clients to expect this because it is just the nature of the buyers. Here is how it is manifested in a business sale transaction. The closing date is set for September 30th, month end. We want to move the closing date back to October 7 so we can take a look at your month end numbers. Do you have any concerns? No we just want to make sure things are on track.
Parry – Not much we can do about this one but try to anticipate what they may be looking at for that final attack on value and to prepare our counter attack. This one is a little trickier, however, because in prior attacks we had the luxury of time in order to strategize and craft our response. This one is usually real time where emotions are on the jagged edge. We ask our client to prepare a response to our anticipated last minute objection and then we, as their advisors, take the first attack. We want to have the client stay above the fray and preserve their relationship for the upcoming partnership together. If that effort is not accepted and the buyer insists on an adjustment based on “it looks like you are not tracking to hit your first year earnout target.” We prepare the seller with, “You know that we put in the earnout in order to align your interests with ours going forward. I have a good deal of transaction value tied to hitting our targets and I would not have signed this agreement unless I was fully confident that I would collect every dollar of that earnout.”
Unfortunately, in spite of my best efforts I view a stalemate as the best outcome we can hope for once we are off the market. As you can see the leverage totally shifts to the buyer. The price is never increased during due diligence and contract negotiation. There is pressure to even keep the business flat during this process because a good deal of the owner’s attention and emotions are going to be focused on the process of selling his business as opposed to just running his business. So our process is to make it evident that there are several qualified buyers that are very close in their offers to the winning offer. If there is buyer bad behavior we can simply plug in the next best bidder. The other major strategy we employ is to be very detailed, formula and example driven in the LOI that we recommend our client execute.
Dave Kauppi is the editor of The Exit Strategist Newsletter and a Merger and Acquisition Advisor and President with MidMarket Capital, Inc. MMC is a private investment banking, merger & acquisition firm specializing in providing corporate finance and intermediary services to entrepreneurs and middle market corporate clients in information technology, software, high tech, and a variety of industries. Dave began his Merger and Acquisition practice after a twenty-year career within the information technology industry. His varied background includes positions in hardware sales, IT Services (IBM’s Service Bureau Corp. and Comdisco Disaster Recovery), Software Sales, computer leasing, datacom, and Internet. The firm counsels clients in the areas of merger and acquisition and divestitures, achieving strategic value, deal structure and terms, competitive negotiations, and “smart equity” capital raises. Dave is a Certified Business Intermediary (CBI), is a registered financial services advisor representative and securities agent with a Series 63 license. Dave graduated with a degree in finance from the Wharton School of Business, University of Pennsylvania. For more information or a free consultation please contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page http://www.midmarkcap.com