The initial dollar figure presented as a purchase price for a business, whether written on a napkin over coffee, or floated in a conversation, is not a binding offer. Any potential acquirer will need to conduct a due diligence investigation before they can enter into a definitive agreement to buy your business. Initial indications can be tactically inflated to ensure the acquirer gains access to your confidential information after which this price is systematically reduced, citing negative findings during due diligence – also known as “The Due Diligence Grind”. The most effective antidotes are preparation and competitive tension. Let's take a closer look at how a prospective buyer can grind down the purchase price.
Due Diligence becomes a Reactive Process for the Seller
Whether you have received a preliminary proposal from a single party who approached you or you’ve received several non-binding bids through a structured auction process, the nature of the process changes from proactive to reactive as due diligence progresses. Ultimately, each bidder will have different due diligence requirements and the onus is on the seller to satisfy those requirements (or not). The due diligence stage is the acquirer’s opportunity to investigate the business from top to bottom. Although difficult, it is essential to maintain control of the process, despite your reactive position during this phase of the process.
How Due Diligence Increases Transaction Risk and Impacts Valuation
The purpose of due diligence is for the acquirer to conduct his or her own assessment of the value of your business and to confirm their initial assumptions. As you submit information about your business to a potential acquirer, they will investigate potential risks, including validating information that may have been presented to them earlier in the process. Due diligence is an essential step for the acquirer to make a binding commitment to a price and to inform the negotiation of the definitive agreement. However, savvy acquirers are skillful at gaming this process to their advantage.
Potential acquirers can by cynical. A key due diligence objective is lowering the price of the business by focusing on its flaws – Imagine a customer listing a litany of complaints or deficiencies about your product or service as you are presenting your case for a routine pricing increase. Potential acquirers may attempt to reduce the value of the business either explicitly, by reducing the headline price, or indirectly, by revealing transaction terms that erode the value you receive.
Headline Price Adjustments via Valuation Metrics
Private businesses are routinely valued as a multiple of a particular financial metric. One of the more commonly used metrics is Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Adjustments are commonly applied to normalize EBITDA for what it would be in the hands of the new owner. These metrics are reported as part of the preliminary documentation and are scrutinized heavily during the due diligence process. The acquirer will typically seek to expose weaknesses in the information and rationale for the normalization adjustments to make a case that the metric is inflated. A few examples include:
- Accounting Policies: Suggesting accounting policies, such as revenue recognition, allowance for doubtful accounts or capitalization policy are too aggressive.
- Normalization Adjustments: Suggesting that non-recurring normalization adjustments really are normal-course business, that market value of the owner’s compensation is understated, that certain expense savings really are buyer synergies that are not appropriate for stand-alone valuation.
- Budgets and Forecasts: Often the valuation is based on a forward metric, such as forecast EBITDA. The seller’s forecast assumptions may be deemed too optimistic, or as we Canadians like to describe it, a “hockey stick forecast”, where projected growth is out of line with historical growth.
Given that the headline value is simply the product of the valuation metric and the valuation multiple, a reduction in the metric will have a proportionate impact on the headline price.
Headline Price Adjustments via the Multiple
Though less common that a negative revision to the metric, a bidder may suggest they have justification to reduce the multiple they have applied in their initial valuation assumptions because of newly identified/revised risks that they claim they were not aware of earlier. There are generally four reasons the valuation multiple may be reduced, the first three of which are specific to the business:
- Greater business risk, such as poor quality of earnings;
- Lower expected growth as a result of improperly supported growth forecasts;
- Reduced free cash flow conversion expectations, such as higher than expected capital expenditure or working capital requirements; or
- Deterioration in market conditions, such as a drop in capital markets valuations or tightening credit
Adjustments to the Transaction Terms
Negative revisions can also manifest in the deal terms. This can be more difficult to control because such details are usually ignored as part of the “business deal” and left for the lawyers. The acquirer may claim due diligence findings that require terms that either erode the value of the headline price or significantly shift risk to the seller. Examples include:
- Shifting Risk to the Seller: Out-of-market representations and warranties, indemnities or hold-backs. For example, an acquirer may agree on the ‘price tag’ of the deal, but add a condition that if the seller misses the five-year forecast by one dollar, the price paid will be reduced by 50%.
- Changing the form of Consideration: That firm cash price may become payable in IOU’s and store coupons. A portion of the price may become contingent on performance of the business post-closing, i.e. as an earnout.
- Working Capital: This one is a favorite! Instead of delivering the business with a level of working capital appropriate to operate the business in the normal course, you are presented with a convoluted adjustment mechanism that suggests the business should be delivered with more working capital than needed, resulting in a negative price revision for you post-closing. Or the most egregious of working capital manipulation, the cash dam.
- Effective Date: Seems innocent enough. Let’s make the effective date at the beginning of this year. The problem is that all of that free cash flow from the effective date until closing now belongs to the acquirer. Another effective reduction in the purchase price.
For more discussion on strategies for taking control of the due diligence process and negating the due diligence grind click here.