In a Business Sale, the Buyer Has the Upper Hand (Part 3)

Divestopedia just published my article. https://www.divestopedia.com/2/7801/sale-process/negotiation/in-a-business-sale-the-buyer-has-the-upper-hand-part-3

Takeaway: This is part three of a three-part series that identifies the natural advantages that business buyers bring to the table before the transaction process even starts.

In parts one and two of this article series, we discussed the natural experiential advantages that a business buyer's team would bring to the table in a business sale transaction; identified buyer attacks on the transaction value during the negotiation and LOI process; and offered approaches you can use to hold your ground against this formidable opponent in regards to the working capital adjustment, benchmarks and earnouts. In this article, we continue to view this negotiation process like a fencing match; buyer thrust, seller parry.

The Due Diligence Surprise

Thrust - "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."

Okay, 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.

Unreasonable Reps and Warranties

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 misinformation in the due diligence process, the economics remain the same."

As for the scary reps and warranties, holdbacks 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/her advisor to work them out with the buyer. By this stage, these final points are settled constructively.

Delayed Closing Date

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 30, 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."

Stalemate

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/her business as opposed to just running his/her 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 recommend our client execute a very detailed-, formula- and example-driven LOI.
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 view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Business Buyers are Savvy Shoppers

The business sale process is a complex battle for leverage. A seller wants to invite many qualified buyers to the table and position his company to produce strategic value. The experienced professional business buyer has his own arsenal of tools to move the balance of power in his favor. This article examines how Private Equity Groups approach the process and try to stack the odds in their favor.

We preach to our business seller clients the benefits of testing the markets and inviting many qualified buyers to participate in the process. The ultimate goal is to get two or more buyers that recognize the tremendous synergies that the combined companies could realize and produce offers that are not based on a financial multiple, but on a strategic value premium. A financial multiple would be a purchase value something like 4 X EBITDA (basically cash flow) or 70% of annual revenue. 

What would produce strategic value? The good news is that this can be created in a number of different ways.  The evil "Wall Street stereotype" is to eliminate duplicate functions and save a tremendous amount in payroll expenses. I am not a big fan of this as the reason for doing an M&A deal. Somehow tearing something apart does not represent any particular management imagination or skill. Identifying ways to build value by creating the sum of the parts that far exceeds the inputs is real visionary management. 

This strategic value can be created by acquiring a complementary product line that can be added to a strong sales and distribution network.  Acquisition targets can provide superior systems, business models, product technology, and  management talent that can be leveraged by the new combined company to produce revenues and profits that far exceed the two separate companies. 

This sounds easy on paper and makes a lot of sense, but the truth is that most acquisitions fall short of expectations because, integrating all the systems, personnel, culture, locations, customers, etc. is complex. This makes buyers cautious. When buyers get cautious, they revert back to the conservative financial multiple which basically provides a safety net to their investment if the post acquisition synergies are not realized.

We subscribe to a private equity group database which helps us identify likely buyers of our sellers based on searching their investing criteria and identifying their portfolio companies. A surprising discovery I made is that in this particular universe of the largest 3500 private equity groups, they owned a combined 46,000 companies. If you wanted to draw any conclusions about business buyer behavior, this would be your group of target subjects.

First conclusion is these guys want to win. Sure it's money, but it is the game and the competition and thrill of the conquest that also drives these serial business acquirers. They think they are the smartest guys in the room (hey check their educational, and job history background) and on paper  they may just be. But you only need to have one failed $20 million acquisition to instill some real rigor and financial conservatism into your process.  They want to stack the deck to put as much as they can in their favor to make these investments winners.

The first thing they do is look for Warren Buffet type businesses. You know the ones that have a durable competitive advantage, positive cash flow, steady growth rate, loyal customers…… They want to draft Payton Manning coming out of Tennessee - Great start.

The next tenant of their success formula is to take advantage of the large company valuation premium. This is how it works. Their first acquisition into a market space is generally a bigger company, say $25 million in revenue. Let's say that this valve and pump company sells for a 6.1 X EBITDA multiple. They then attempt to make a series of tuck-in acquisitions of a $5 million valve company here and a $4 million pump company there. These smaller companies command a smaller valuation multiple than the large company, say 4 X EBITDA. The day the acquisition is completed, the PEG has already won because the acquired company is now valued at the higher EBITDA multiple of its new parent. They make a series of these investments, grow the company organically as well for 7 years and then sell their $150 million in revenue company to a strategic buyer at an EBITDA multiple of 7.8 X.

These sophisticated buyers are very disciplined in their acquisition process and very seldom stray from the strict EBITDA multiple offer.  In order to stick to that discipline, they have to look at a lot of deals. We normally ask our buyers that have signed NDA's and looked at our client, and then withdrew, why they dropped out. We get a lot of different answers, but the top answer is that they were in another deal and would not be able to process both at the same time. Most of these firms invite 50 - 100 potential acquisitions into the top of the funnel for each one that they complete.

So, what they are doing is creating the counterbalance of the leverage we are trying to create by getting lots of potential buyers involved.  They have multiple options, so if the price gets too high, they go for easier prey. If the sellers are difficult, they move on. If the financial reporting is shaky and unclear they find a company where it is transparent.

Please don't let me give you the impression that this process is totally by the numbers. There are great companies that will command a premium, but just like buying a luxury automobile, they are still shopping.

 


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 view our lists of buyers and sellers click to visit our Web Site MidMarket Capital