In part one 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. The seller is usually embarking on their first business sale, whereas the buyer has often completed dozens of prior transactions. So, from the start, the seller is subject to a process that greatly favors the business buyer. This article will identify in the negotiation and LOI process, buyer attacks on the transaction value and approaches you can use to hold your ground against this formidable opponent. Several subtle and seemingly harmless clauses in the LOI can result in swings in actual transaction value of hundreds of thousands of dollars. It may be helpful to look at this negotiation like a fencing match; buyer thrust, seller parry.
Thrust and Parry
Thrust - a buyer getting you off the market with a loosely worded LOI that allows him/her to "interpret the terms" in his/her favor deep into the due diligence process. This is the number one seller error in the process and results in either the deal blowing up or the seller taking an unnecessary hair cut.
Parry - a seller not counter-signing the LOI until terms are defined. There are several key terms of the LOI, so we will give each one their own "Thrust" and "Parry."
Working Capital Adjustment
Thrust - A buyer-attempted treatment of working capital. Most buyers attempt initial language for working capital in the LOI that looks something like this:
Working Capital Adjustment: There shall be a typical working capital adjustment to accommodate for changes to the working capital balance, including cash, accounts receivable and accounts payable, as of the day of closing. During due diligence, the purchaser will set a working capital target by determining a normal and customary level of current assets, including a positive cash balance. There shall be sufficient working capital, including a cash balance which shall be sufficient to operate the business on an ongoing day-to-day basis and the buyer will not need to fund working capital simply to operate the business immediately after the transaction.
Parry - Not so fast, Zorro! This seems like a perfectly reasonable treatment and, unfortunately, many unsuspecting sellers will counter-sign an LOI with this language in place. The result of this is either he/she is going to get taken to the cleaners on the level the buyer decides on, deep into the due diligence process, or the seller will blow up the deal deep into the process. Neither a good result, and the sad part is that it could easily be prevented. The first rule of LOIs is to not take your company off the market with a very important term not defined up front. This language enables their team of experts to calculate their own opinion of "reasonable and customary" while you have no negotiating leverage. You have already taken your company off the market as a buyer requirement to enable due diligence with a no-shop clause.
The second very important mistake is that by leaving that term undefined, you have not really benchmarked the proposed transaction value against other bids. We had a client that kept a net working capital surplus far greater than what was normally required to run the business. Let's say that they kept a surplus of $400,000 when their normal monthly business expenses were $100,000. So, the level could be set as a surplus of $100,000.
Now the buyers bring in their experts and look at your last 12 months' balance sheets and proclaim that your historical level of $400,000 is what they need, then you may have just sacrificed $300,000 of transaction value. If you have one buyer that bids $3,000,000 for your company with a net working capital surplus requirement of $100,000 and you close with $400,000 surplus, $300,000 is returned to you as transaction value. This makes the total transaction value $3,300,000. If the undefined working capital surplus buyer bids $3,100,000 and calculates, after the LOI, that his requirement is $400,000, then his transaction value is short the other bid by $200,000!
This can all be prevented by the seller insisting that the LOI include a net working capital level commitment with the calculation methodology spelled out. Each buyer may have their own opinion of what that number should be, but this exercise will allow you to equalize the bids and determine which one is truly superior. Unfortunately, the buyers try to leave this vague in their LOI so that 90 days into the due diligence process, they render their buyer favorable opinion and count on the seller suffering from deal fatigue and just caving in on this meaningful loss in value. The buyers know that they do damage to your future chances if you put your company back on the market with the stigma of the previous deal blowing up during due diligence. It usually results in a market discount being applied to your company the second time around.
The 'All or Nothing' Earnout Clause
Thrust - An earnout clause with punitive "all or nothing" language. In the realm of SMB mergers and acquisitions, an earnout is a common practice and a perfectly reasonable component of a business sale transaction. It is often an effective way to bridge the valuation gap between the buyer and seller, and to align the interests of the buyer and seller for post-acquisition business performance. But like other components here, there is good earnout language and there is earnout language that is one-sided in favor of the buyer.
An example of earnout language from a buyer LOI is: The total earnout shall be paid over three years. The total possible payout amount is $1.5 million, based on growing EBITDA by 5% per year over last year's rate of $1,250,000.
The target EBITDA in year one is $1,312,500, year two is $1,378,125, and year three is $1,447,031. If the target is hit, the payout will be $500,000 for the year. If the achievement is between 85% - 99% of the target, the payout will be that percentage attainment X $500,000. If the attainment is less than 85% of the target, no earnout payment will be made.
Parry - In general, we recommend that earnouts be based on a number that cannot be easily manipulated by the buying company. So measures like net profit and EBITDA are less favorable. Here they can insert some expense items like "corporate overhead," which are out of your control. We prefer tying earnouts to measures such as total sales or gross profit margin; far more difficult to leave up to interpretation.
Next, we never recommend an "all or nothing" earnout clause. Normally, earnouts are a meaningful percentage of the overall transaction value and, if an unforeseen event takes you below their cut-off target, you have sacrificed some serious value. Our argument is that if there is a big shortfall, the percent of that shortfall in their earnout payment is enough to keep buyer and seller interests aligned post-acquisition.
If there is a downside adjustment in the earnout calculation (there always is) then we like to have the corresponding upside for surpassing target performance. In other words, if you miss your target by 10% then you only receive 90% of that year's earnout payment target. If you hit 110% of your target, your earnout payment should be 110% of that target.
We also recommend that the earnout be formula-driven and include an example calculation as shown here. The earnout total would be $1,500,000 and be paid in the first three years after the closing within 30 days of the anniversary date. The earnout would be based on the trailing twelve months' revenues and a target to grow those revenues by 5% per year over the first three years following closing. So, the target for year one (again using the prior year end as the example) would be $5,000,000 X 1.05 = $5,250,000. For year two, another 5% growth would result in a target of $5,512,500. And for year three, another 5% growth would result in a target of $5,788,125, for a three-year total of $15,550,625. Dividing this by the total earnout payment at target ($1,500,000) results in an earnout payment of 9.06% of revenues for the first three years. The payment would be made annually within 30 days of closing of the company's books for 12, 24 and 36 months following closing.
For each year's earnout payment, the actual payout amount would be calculated by applying the payout percentage rate of 9.06% X the actual revenues. As an example, if the revenue for year three came in at $5,000,000 that would be multiplied by 9.06% and result in an earnout payment of $453,000. If the year three revenues came in at $6,000,000, the earnout payment would be $546,600.
Great, we have handled each thrust with our skillful parry. Match over, right? Keep that face protector on, the match is just heating up. Continue reading part three here.