I believe one of the biggest reasons for M&A deals blowing up is a poorly worded Letter of Intent. The standard process is to solicit offers from buyers in the form of Letters of Intent (LOI). The terms and conditions are negotiated until one winner emerges and the seller and buyer dual sign the LOI which is non-binding. This basically gives either party an out should something be discovered in the due diligence process that is not to their liking or is not as presented in the initial materials.
When I say
poorly worded, what I really should have said is that it is worded much to the
advantage of the buyer and gives them a lot of wiggle room in how the letter is
interpreted and translated into the definitive purchase agreement. The best
comparison I can make is a lease agreement for an apartment. It is so one-sided
in favor of the landlord and protects him from every conceivable problem with
the renter.
Business
buyers are usually very experienced and the sellers are generally first time
sellers. The buyers have probably learned some important and costly lessons
from past deals and vow never to let that happen again. This is often reflected
in their LOI. They also count on several dynamics from the process that are in
their favor. Their deal team is experienced and is at the ready to claim that
"this is a standard deal practice" or "this is the calculation
according to GAAP accounting rules". They count on the seller suffering
from deal fatigue after the numerous conference calls, corporate visits, and
the arduous production of due diligence information.
When the LOI
is then translated into the Definitive Purchase Agreement by the buyer's team,
any term that is open for interpretation will be interpreted in favor of the
buyer and conversely to the detriment of the seller. The seller can try to
fight each point, and usually there are several attacks on the original value
detailed in the dual signed LOI that took the seller off the market for 45-60
days. The buyer and his team of experts
will fight each deal term from the dispassionate standpoint on one evaluating
several deals simultaneously. The seller, on the other hand, is fully emotionally committed to the
result of his life's work. He is at a decided negotiating disadvantage.
The
unfortunate result of this process is that the seller usually caves on most
items and sacrifices a significant portion of the value that he thought he
would realize from the sale. More often
than not, however, the seller interprets
this activity by the buyer as acting in bad faith and simply blows up the deal,
only to return to the market as damaged goods. The implied message when we
reconnect with previous interested buyers after going into due diligence is
that the buyers found some dirty laundry in the process. These previously
interested buyers may jump back in, but they generally jump back in at a
transaction value lower than what they were originally willing to pay.
How do we
stop this unfortunate buyer advantage and subsequent bad behavior? The first
and most important thing we can do is to convey the message that there are
several interested and qualified buyers that are very close in the process. If
we are doing our job properly, we will be conveying an accurate version of the
reality of the deal. The message is that we have many good options and if you
try to behave badly, we will simply cut you off and reach out to our next best
choices. The second thing we can do is to negotiate the wording in the Letter
of Intent to be very precise and not allow room for interpretation that can
attack the value and terms we originally intended. We will show a couple
examples of LOI deal points as written by the buyer (with lots of room for
interpretation) and we will counter those with examples of precise language
that protects the seller.
Buyer's
Earnout Language:
The amount
will be paid using the following formula:
-75% of the
value will be paid at closing
-The
remaining 25% will be held as retention by the BUYERs to be paid in 2 equal
installments at the 12 month and 24 month anniversaries, based on the following
formula and with the goal of retaining at least 95% of the TTM revenue. In case
at the 12 and 24 month anniversaries the TTM revenue falls below 95%, the
retention amount will be adjusted based on the percentage retained. For
example, if 90% of the TTM revenue is retained at 12 months, the retention
value will be adjusted to 90% of the original value. In case the revenue
retention falls at or below 80%, the retention value will be adjusted to $0.
Earnout
Language Seller Counter Proposal
The amount will be
paid using the following formula:
-75% of the value
will be paid at closing
-The remaining 25%
will be held as Earnout by the BUYERs to be paid in 4 equal installments at the
6, 12, 18 and 24 months anniversaries, based on the following formula:
We will set a 5% per
year revenue growth target for two years as a way for Sellers to receive 100%
of their Earnout (categorized as "additional transaction value" for
contract and tax purposes).
So, for example, the
trailing 12 months revenues for the period above for purposes of this example
are $2,355,000. For a 5% growth rate in year one, the resulting target is
$2,415,000 for year 1 and $2,535,750 in year 2. The combined revenue target for
the two years post acquisition is $4,950,750.
Based on a purchase
price of $2,355,430, the 25% earnout would be valued at par at $588,857. We can
simply back into an earnout payout rate by dividing the par value target of
$588,857 by the total targeted revenues of $4.95 MM.
The result is a
payout rate of 11.89% of the first two years' revenue. If SELLER falls
short of the target they fall short in the payout, if
they exceed the amount, they earn a payout premium. Below are two examples of
performance:
Example 1 is the
combined 2 years' revenues total $4.50 MM - the resulting 2 year payout would
be $535,244.
Example 2 is the
combined 2 years' revenues total $5.50 MM - the resulting 2 year payout would
be $654,187.
Comparison
and Comments: The buyer's language contained a severe penalty if revenues
dropped below 80% of prior levels, the earnout payment goes to $0. Also they
have only a penalty for falling short and no corresponding reward for exceeding
expectations. The seller's counter proposal is very specific, formula driven
and uses examples. It will be very hard to misinterpret this language. The
seller's language accounts for the punishment of a shortfall with the upside
reward of exceeding growth projections. The principle of both proposals is the
same - to protect and grow revenue, but the results for the seller are far
superior with the counter proposal language.
Buyer's
Working Capital Example:
This
proposal assumes a cash free, debt free balance sheet and a normalized level of
working capital at closing.
Seller's
Working Capital Counter Proposal:
At or
around closing the respective accounting teams will do an analysis of accounts
payable and accounts receivable. The seller will retain all receivables in
excess of payables plus all cash and cash equivalents. The balance sheet will
be assumed by the buyer with a $0 net working capital balance.
Comparison
and Comments: The buyer's language is vague and not specific and is a problem
waiting to happen. So for example, if the buyer's experts decide that a
"normalized level of working capital at closing is a surplus of $400,000,
the value of the transaction to the seller dropped by $400,000 compared to the
seller's counter proposal language. The objective in seller negotiations is to
truly understand the value of the various offers before countersigning the
LOI. For example, an offer for cash at
closing of $4,000,000 with the seller retaining all excess net working capital
when the normal level is $800,000 is superior to an offer for $4.4 million with
a net working capital requirement "at normal levels". i.e.$800,000.
These are
two very important deal terms and they can move the effective transaction value
by large amounts if they are allowed to be
loosely worded in the letter of intent and then interpreted to the
buyer's advantage in translation to the definitive purchase agreement. Why not
just cut off that option with very precise and specific language in the LOI
with formulas and examples prior to execution by the seller. The chances of the
deal going through to closing will rise dramatically with this relatively easy
to execute negotiation element.
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To learn more about our services for technology business sellers click to visit our Web Site MidMarket Capital
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