Preparing for an Actual Increase in Purchase Price During Due Diligence
If the price can go down during the due diligence process, then the price should also be able to go up.
One of the things I like best about representing small business owners as an M&A advisor is that no two days are the same. Yes, deals have common elements, but it is those unique details at the margin that must be handled on the fly that can mean the difference between success and failure. To prepare our clients for those 80% deal elements in common, we have written articles on each stage of the process and we review those articles with our client prior to the stage. So, for example, we will review the most commonly asked questions from buyers on conference calls and we will role play with our clients on answering these questions.
If the client knows what to expect prior to the stage, any bump in the road does not turn into a deal-threatening event. We try to manage and control what we can, but, more often than not, something new surfaces that is new to our experience. How those surprises are handled often can be the difference between closing and the deal blowing up. In a recent transaction that we completed, we had one of those first-time surprises. Luckily, we were able to get past it and improve our preparation for the next deal and, as an added bonus, resulted in this article.
Last Minute Threat to Closing and Purchase Price
Due diligence was coming to a satisfactory close, and the definitive purchase agreements, seller notes and employment contracts were moving through the process without a hitch. We were set to close on April 30 and, 10 days prior to closing, the buyer said, "We just want to see your closing numbers through April, so let's move the closing back five days." What were we going to do - tell them no? I said, "Well, you have already completed due diligence. Are you concerned about the April numbers?" He said, "No, we just want to make sure everything is on track."
My radar went off and I thought about all of the events external to our deal that could cause the deal not to close. How many deals failed to close, for example, that were on the table during the stock market crash of 1987? The second part of my radar said that we needed to be prepared to defend transaction value one final time. I suggested he bring in his outside accountant to help us analyze such things as sales versus projections, gross margins, deal pipeline, revenue run rate, etc. We were going to be prepared. We knew that if things looked worse, the buyer was going to request an adjustment.
An Unexpected Twist
Now here comes the surprise. The outside accountant discovered that there was a revenue recognition issue and our client had actually understated profitability by a meaningful amount. This was discovered after the originally scheduled closing date and it meant that the buyer had based his purchase price on an EBITDA number that was too low. Easy deal, right? We just take his transaction value for the original deal and the EBITDA number he used and calculate an EBITDA multiple. We then applied that multiple to our new EBITDA and we get our new and improved purchase price.
I knew that this would not be well received by our buyer and counseled our client accordingly. He instructed me to raise our price. The good news is that we had a very good relationship with the buyer and he did not end discussions. He reminded us that he had earlier given in to a concession that we had asked for and we added a couple of other favorable deal points, but he did not move his purchase number.
We huddled with our client and had a serious pros and cons discussion. He did recognize that we had fought hard to improve his transaction. He also recognized that the buyer had drawn his line in the sand and would walk away. The risk that we discussed with our client was that if we returned to market, that would delay his payday by a minimum of 90 days. Also, we pointed out that the market does not care why a deal blows up. When you return to the market, the stigma is that some negative surprise happened during due diligence and the new potential buyers will apply that risk discount to their offers. Our client did agree to do the deal and was very optimistic about the company moving forward with a great partner.
Preparing for Next Time
In a post-deal debrief with our client, I told him that had I to do it again, what I should have said when the buyer requested the delayed closing is, "We know that if you find something negative, you are going to ask for a price adjustment. If we discover something positive, will we be able to get a correspondingly positive adjustment?" What is he going to say to that?
In reflecting on this situation, I wanted to use my learning to improve our process and I believe that I had come up with the strategy. And in our very next deal, I got the opportunity to incorporate this new strategy. We got several offers with transaction value, cash-at-close, earnout, seller note and net working capital defined. In our counter proposals we are now proposing the following language:
We propose to pay a multiple of 4.43 times the trailing twelve months (ending in the last full month prior to the month of closing) adjusted EBITDA; which, using full year [insert immediate past year], is an adjusted EBITDA of approximately $1,000,000, results in a valuation of $4,430,000. Adjusted EBITDA for the purposes of this determination will be defined as net income plus any one-time professional fees associated with this business sale (currently, $42,000 for investment banker fees, additional legal and accounting services).
Evening the Playing Field for Sellers
What we are accomplishing with this language is that if the price can go down during the due diligence process, then the price can go up during the process. Why not formalize it? Because we know that in 99 times out of 100, if the company performance goes down from where it was when the bid was submitted, an adjustment will be applied by the buyer. If the seller does not relent, the buyer will walk away. The unwritten buyer's rule is that the price can only go down during due diligence. We are out to change that one-sided approach and even the playing field for our sell-side clients.