Caption: When Selling Your Business, Negotiation Strategy is Everything
If you’re contemplating selling your business, you’re likely primarily concerned with the form and amount of compensation you’ll receive. The purchaser might offer you a combination of cash, debt, stock, or other incentives (the “seller consideration” or “purchase price”). The challenge is to identify—and negotiate—the right combination of financial incentives that would motivate you to move forward with the deal (and allow you to take a well-deserved vacation after the closing).
In any M&A transaction, the negotiations can often be likened to a strategy-based game like poker, in that the purchase price (the “pot”) can be subject to future risks (“odds”), variance, and long-term versus short-term results. Once you and the buyer agree to a compensation amount (usually by signing a letter of intent), you should thereafter consider the purchase price to be “aspirational” in the mind of the buyer. In other words, a shrewd buyer will exploit the remaining sales process in an effort to ratchet down the final purchase price to be paid at closing. Here are some strategies that competent purchasers regularly employ to do so.
Caption: Minimize Any Risk to Your Purchase Price
Replacing Guaranteed Cash with Stock, Notes, or Earn-Outs
Different forms of seller consideration can pose varying risks. On the closing date of the sale, a seller would ideally like to have the buyer transmit an all-cash payment directly to his or her bank account. This would put the seller consideration at the least risk because cash is highly liquid, and having it deposited in the seller’s bank account immediately establishes possession and control. Conversely, the purchaser would ideally want to avoid delivering any cash whatsoever at the closing and have the entire purchase price subject to uncertainty or pre-conditions.
One popular buyer strategy is to offer the seller a portion of the purchase price in the form of stock rather than cash. These shares can represent an ownership interest in either the target company, the buyer entity, or some other buyer affiliate. This option can be problematic since the shares’ worth would be subject to unpredictable fluctuations in the issuer’s future value. The shares could also be subject to redemption or restrictions on transfer.
A buyer might also offer a portion of the purchase price in the form of a promissory note, which allows the purchaser to withhold some of their payment until a later date.
Another popular buyer strategy would be to offer you future payments (referred to as “earn-outs”) based on the company’s future performance. You and the buyer would negotiate financial targets for the earn-outs (often based on EBITDA), which could include conditions under which you would still receive a portion of an earn-out, even if the company fails to achieve 100% of the targets. Earn-outs usually compel one or more members of senior management to remain as employees or consultants for the company (for a minimum period of time) so that the business can continue to benefit from their expertise, influence, and institutional knowledge.
The Due Diligence Process
Conscientious, risk-averse buyers will insist on conducting a thorough “due diligence” review of all of your company’s documents, financials, and other information. This is so that the buyer can identify any potential liabilities that it might end up assuming following the closing. If the due diligence investigation reveals a potential or existing liability, it is likely that the buyer will either seek a reduction of the purchase price (usually dollar-for-dollar) or address the matter in the indemnification provisions of the purchase agreement (the “indemnities”), as further discussed below.
Always keep in mind that you and your management should be forthright, efficient, and thorough in providing answers and materials so that the company discloses all potential liabilities to the purchaser as early as possible in the process. When the closing date is imminent, and all parties are at peak motivation to conclude the grueling sale process, then an eleventh-hour revelation exposed by the diligence investigation can give the buyer optimal leverage to strongarm you into lowering the purchase price.
Breaches of Representations, Warranties, and Pre-Closing Covenants
The sale contract you negotiate with the purchaser will likely include representations and warranties (the “reps”), which are declarative statements from the seller that relate to multiple aspects of the business. If there is an intended lag time between the signing of the purchase contract and the closing of the sale, then the contract will usually also include pre-closing covenants. These are promises by the seller to take (or abstain from taking) certain actions between the signing and the closing. Whether as a result of the due diligence process or otherwise, if the purchaser discovers that any of the reps are incorrect or that a covenant has been breached, then it might seek compensation through the indemnities.
Indemnification is how a buyer gets compensated in the event it experiences some unexpected loss due to a liability that the seller has either misrepresented, overlooked, or failed to disclose. The indemnification provisions in the purchase agreement are deliberately structured to put your purchase price at risk. You and your business attorney should carefully review all of the terms of the sale agreement, particularly how the indemnities work hand-in-hand with the reps. Furthermore, note that a buyer might want some of the purchase price to be placed in escrow in order to satisfy any future indemnification claims (clearly you should try to avoid this, if at all possible).
Exploiting Closing Delays
Sale transactions rarely close on the target closing date, for reasons outside either party’s control. Keep in mind that the buyer might claim that any delays are being caused by you and your team (either because of a sluggish due diligence process or your management’s failure to timely assemble the documents to be delivered at closing). Purchasers can use delays—regardless of fault—to invoke their escalating costs, usually in the form of attorney’s fees, and then pressure you into accepting a downward adjustment to the purchase price as their recourse.