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

Earnouts Tips and Tricks - Seller Earnouts in a Technology Business Sale

Quick Summary Explainer Video which covers the basics of this much misunderstood tool that can be quite effective in completing technology business sales.

Earnout Explainer Video

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

Buyers and Investors In Pre - Revenue Companies are an Endangered Specie

Before you dismiss my premise and label me as one who is out of step with the highly publicized social media mega deals, I am excluding them from my population. I am excluding them because they have a very important characteristic of value and that is broad customer acceptance. That acceptance was generally accomplished virally and very inexpensively. The owner of that technology will, the wisdom goes, eventually figure out a way to monetize all of those valuable users.

For purposes of this article I am limiting my population to technology based products and businesses that are aimed at the B2B marketplace. A good example might be application software. I may need a little help from Charles Darwin here with his theory of natural selection or may borrow from the saying that there are old pilots and there are bold pilots but very few old bold pilots.

Technology companies that buy other companies or professional investors that buy technology based companies generally have a first gate that all acquisitions have to pass in order to be considered as an acquisition candidate. Those targets must have real paying customers producing revenues, not necessarily profits, but that also is an often used helpful gate. 

Another gate is the level of revenues. We have small software companies approach us and say that Microsoft or Google or Apple should buy them. They have $5 million in revenue. Unless they are in the massive user base category or have a quantum leap technology, there is no chance. The corporate development people in those organizations are under instructions to only consider move the needle opportunities. It takes as much resource to complete a $300 million acquisition as it does a $5 million acquisition. Where do you think these giants are focusing their resources?

In working with entrepreneurs we see several recurring themes. They are wonderfully optimistic. With the odds of succeeding  in a start-up business not in their favor they must employ emotional blinders in order to press on. They believe their product compares very favorably on a feature/functionality basis with the leading competitive solutions on the market. Their estimate of both the TAM (total addressable market) and their eventual share of that market are highly aggressive. They under estimate the difficulty of reaching a critical mass of paying customers. And most importantly, they believe in their mission and deliver their message with the passion and commitment of a Billy Graham sermon.

We know from first-hand experience having represented several of these promising companies over the years. With this arsenal of optimism, these entrepreneurs have been pitching the corporate development departments, angel investors, venture capital funds, individual investors, friends and family, etc. You know what the buyers and investors all found out (even the super stars from Silicon Valley fail on 8 out of 10) was that they were not particularly good at picking the winners pre-revenue or pre- critical mass revenue.

Getting back to my Charles Darwin reference, the survivors evolved. They developed a characteristic that has enabled them to prosper. They no longer try to predict the winners pre-revenue. They let the market do it for them. No guru, no survey, no analytics is ever going to match the predictive power of the wisdom of crowds casting their economic vote to identify the winner. 

The second gate, the size of revenue also performs a very important function especially when it comes to information technology or emerging technology. A large company will often expend as much internal resource in integrating a new product into their organization and rolling it out to their sales channel as they originally spent for the company acquisition. Given that backdrop, they want to eliminate or reduce as much as possible, the technology risk. In other words, does the stuff work and will it stand up to the rigors of thousands of users. A product that has achieved a critical mass of users has been subjected to the quality control of paying and renewing customers with other choices. The major bugs have been worked out and the product has gone through a continual feedback loop of improvement.

The company buyers/investors survivors recognized that it was too difficult to predict the winners pre-revenue, even with the smartest guys in the room, without a natural market vetting process. The economic vote of a critical mass of customers has proven to be the best of all predictors of success. When a technology entrepreneur hits this gate with his targeted buyer and gets quickly dismissed, it doesn't mean that he has a bad product, it means that he has one more step to take before the money starts to flow. Focus your resources on generating sales.

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

Bridging the Valuation Gap between Business Seller and Business Buyer

Statistics show that a surprisingly low percentage of businesses for sale actually sell during their first attempt. The major reason for that is the valuation gap between the buyers and the seller. This post discusses how that gap can be breached resulting in completed business sale transactions.

In an earlier article we discussed a survey that we did with the Business Broker and the Merger and Acquisition profession. 68.9% of respondents felt that their top challenge was dealing with their seller client's valuation expectations. This is the number one reason that, as one national Investment Banking firm estimates only 10% of businesses that are for sale will actually close within 3 years of going to market. That is a 90% failure rate.

As we look to improve the performance of our practice, we looked for ways to judge the valuation expectations and reasonableness of our potential client. A Mergers and Acquisitions firm that fails to complete the sale of a client, even if they charged an up-front or monthly fees, suffers a financial loss along with their client. Those fees are not enough to cover the amount of work devoted to these projects. We determined that having clients with reasonable value expectations was a key success factor.

We explored a number of options including preparing a mock letter of intent to present to the client after analyzing his business. This mock LOI included not only transaction value, but also the amount of cash at closing, earn outs, seller notes and any other factors we felt would be components of a market buyer offer. If you can believe it, that mock LOI was generally not well received. For example, one client was a service business and had no recurring revenue contracts in place. In other words, their next year's revenues had to be sold and delivered next year. Their assets were their people and their people walked out the door every night.

Our mock LOI included a deal structure that proposed 70% of transaction value would be based on a percentage of the next four years of revenue performance as an earn out payment. Our client was adamant that this structure would be a non-starter. Fast forward 9 months and 30 buyers that had signed Confidentiality Agreements and reviewed the Memorandum withdrew from the buying process. It was only after that level of market feedback was he willing to consider the message of the market.

We decided to eliminate this approach because the effect was to put us sideways with our client early in the Mergers and Acquisitions process. The clients viewed our attempted dose of reality as not being on their side. No one likes to hear that you have an ugly baby. We found the reaction from our clients almost that pronounced.

We tried probing into our clients' rationale for their valuation expectations and we would hear such comments as, "This is how much we need in order to retire and maintain our lifestyle," or, "I heard that Acme Consulting sold for 1 X revenues," or, "We invested $3 million in developing this product, so we should get at least $4.5 million."

My unspoken reaction to these comments is that the market doesn't care what you need to retire. It doesn't care how much you invested in the product. The market does care about valuation multiples, but timing, company characteristics and circumstances are all unique and different, when our client brings us an example of IBM bought XYZ Software Company for 2 X revenues so we should get 2X revenues.

It is simply not appropriate to draw a conclusion about your value when compared to an IBM acquired company. You have revenues of $6 million and they had $300 million in revenue, were in business for 28 years, had 2,000 installed customers, were cash flowing $85 million annually and are a recognized brand name. Larger companies carry a valuation premium compared to small companies.

When I say my unspoken reaction, please refer to my success with the mock LOI discussed earlier. So now we are on to Plan C in how to deal with this valuation gap between our seller clients and the buyers that we present. Plan C turned out to be a bust also. Our clients did not respond very favorable when in response to their statement of value expectations we asked, "Are you kidding me?" or "What are you smoking?"

This issue becomes even more difficult when the business is heavily based on intellectual property such as a software or information technology firm. There is much broader interpretation by the market than for more traditional bricks and mortar firms. With the asset based businesses we can present comparables that provide us and our clients a range of possibilities. If a business is to sell outside of the usual parameters, there must be some compelling value creator like a coveted customer list, proprietary intellectual property, unusual profitability, rapid growth, significant barriers to entry, or something that is not easily duplicated.

For an information technology, computer technology, or healthcare company, comparables are helpful and are appropriate for gift and estate valuations, key man insurance, and for a starting point for a company sale. However, because the market often values these kinds of companies very generously in a competitive bid process, we recommend just that when trying to determine value in a company sale. The value is significantly impacted by the professional Mergers and Acquisitions process. In these companies where there can be broad interpretation of its value by the market it is essential to conduct the right process to unlock all of the value.

So you might be thinking, how do we handle value expectations in these technology based company situations? Now we are on to Plan D and I must admit it is a big improvement over Plan C (are you kidding)? The good news is that Plan D has the highest success rate. The bad news is that Plan D is the most difficult. We have determined that we as Mergers and Acquisitions professionals are not the right authority on our client's value, the market is.

After years of what are some of the most emotionally charged events in a business owner's life, we have determined that we must earn our credibility to fully gain his trust. If the client feels like his broker or investment banker is just trying to get him to accept the first deal so that the representative can earn his success fee, there will be no trust and probably no deal.

If the client sees his representatives bring multiple, qualified buyers to the table, present the opportunity intelligently and strategically, fight for value creation, and provide buyer feedback, that process creates credibility and trust. The client may not be totally satisfied with the value the market is communicating, but he should be totally satisfied that we have brought him the market. If we can get to that point, the likelihood of a completed transaction increases dramatically.

The client is now faced with a very difficult decision and a test of reasonableness. Can he interpret the market feedback, balance that against the potential disappointment resulting from his preconceived value expectations and complete a transaction?

Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of lower middle market companies. For more information about exit planning and selling a business, click to subscribe to our free newsletter The Exit Strategist