Monday, April 25, 2016

How to Stop Your M&A Deal from Blowing up Late in the Process

New Article just published on Divestopedia

I believe one of the biggest reasons for M&A deals blowing up is a poorly worded letter of intent (LOI). The standard process to solicit offers from buyers in the form of an LOI includes terms and conditions that 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. Buyers Have the Advantage of Experience

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/her 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/her 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/her life's work. He/she 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/she thought he/she 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 to Even the Playing Field

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 LOI 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.

Sample Earnout Clause Within an LOI

Buyer's 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 retention by the BUYERs to be paid in two 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.

Seller's 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 four 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 TTM 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 one and $2,535,750 in year two. 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 million.

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 two years' revenues total $4.50 million - the resulting two-year payout would be $535,244.

Example 2 is the combined two years' revenues total $5.50 million - the resulting two-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.

Sample Working Capital Clause Within an LOI

Buyer's Proposal

This proposal assumes a debt free cash free (DFCF) balance sheet and a normalized level of working capital at closing.

Seller's 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 on cash equivalents. The balance sheet will be assumed by the buyer with a $0 net working capital balance.

Get the Specifics

The buyer's language is vague and 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 working capital levels retained at normal levels.

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.


Tuesday, April 12, 2016

How to Avoid Lowball Offers When Selling Your Company

My article was just published on Divestorpedia.

Takeaway: The only way to encourage buyers to make fair offers is to conduct a marketing campaign to industry buyers that have strategic reasons for making acquisitions.

We are in the middle of a merger and acquisition engagement representing a human resources consulting company. We had contacted several industry players and had received some good initial interest. Several buyers dropped out because their entire management team was comprised of family members. We asked our client to take their company off the market and to bring in at least one non-family executive that had the authority and the ability to run the company. They successfully implemented this change and asked us to take them back out to market.

Because their business is counter cyclical and actually grew during the recent economic downturn, they posted some pretty impressive growth and profit numbers. It was difficult to determine how much of the improvement was due to the addition of the new senior manager.

Avoid Buyers Who Use 'Fuzzy Math'

As we re-launched our marketing efforts, we identified several interested buyers. One buyer was particularly interested and, after signing the confidentiality agreement and reviewing the memorandum, contacted us almost daily with additional detailed information requests. Before long he started to grill us about selling price expectations. As we usually do, we deflected his requests and asked him to put together his letter of intent based on the value of the business to his company.

He started giving us a lecture about valuing service companies whose assets (meaning people) walked out the door every evening. He pointed out that their revenues were based on new sales each year and not “contractually recurring revenue.” We had our client put together for us a chart that showed the “historically recurring revenue” generated from their top 20 clients over the past five years. This was our way to demonstrate some consistency and predictability of revenues.

As we conversed further, my radar started buzzing loudly. This guy was getting ready to provide a lowball offer and was trying to sell me on all the reasons why I should go back to our client and pitch his offer. I politely listened to his well-practiced approach for a little while longer. Then he came up with the statement that I just could not let go. He said that last year’s revenues were an unusual upward spike and “I am just going to use the year prior to last year's revenues as my basis for my offer." Well, I just could not let that one go. I asked him how he would have made an offer if last year was unusually bad, but the prior five years were strong. He would not respond, but of course, the answer was that he would have made his offer based on the new trend.

Avoid Buyers Who View You as Just a Number

There are thousands of business buyers out there that are just like this guy. There is a famous residential real estate investor that has written a book and gives classes to help individuals become real estate moguls. I could sum up his book and his class in one sentence: Find 100 people with their homes for sale, then approach them aggressively and make a lowball offer and one of them will take it.

When I reviewed where our buyer had originated, I traced it back to a posting we had made on our business broker’s association website. As I think about it, these "Business-for-Sale" websites actually give these buyers a powerful tool to actively and aggressively contact their 100 potential sellers. As I thought about this, sure enough, I have seen this behavior repeated multiple times and the source was always a "Business-for-Sale" website.

So, we are always preaching to our prospective clients to get multiple buyers involved in the process. If they post their business on one of the "Business-for-Sale" websites, they may get multiple buyers interested, but they are those buyers that are contacting 100 sellers very efficiently through the power of the Internet in order to make their lowball offers.

Avoid Buyers with Lowball Offers By Making a Plan

But I digress. Let’s get back to our client. The good news is that we had six other industry buyers that we had contacted and they were looking for acquisitions that were based on acquiring new customers or adding another product offering, or leveraging their sales force or install base. In other words, their buyer motivation was not to buy a company with a lowball offer.

The only way we can encourage buyers to make fair offers is to conduct an outbound marketing campaign to industry buyers that have strategic reasons for making acquisitions. If we can get several involved, then the buyer that comes in and says that he/she is going to base his/her offer on the year prior to last year's performance, is easily eliminated from consideration. If a business seller is only going to attract these inbound, bargain-seeker buyers from websites or otherwise, he/she will only be getting lowball offers and wasting a lot of time.
