Unless you are one of the rare companies that is viewed as a valuable strategic acquisition by a company with high-valued stock as their currency, your selling price is going to closely approximate your industry's valuation metrics. For an eCommerce Website, it could be a multiple of annual net profit; for an IT-managed services provider, it is a multiple of monthly recurring revenue (MRR); and for a distributor of medical supplies, it is a multiple of EBITDA.
What Is Re-Trading?
Wikipedia defines a re-trade as the practice of renegotiating the purchase price of real property by the buyer after initially agreeing to purchase at a higher price. Typically this occurs after the buyer gets the property under contract and during the period that it is performing due diligence. The buyer may raise a due diligence issue and demand a purchase price adjustment to a lower re-trade price. The seller can be left in a bad situation where it must either accept the lower price or lose the sale and re-market the property.
How Can I Protect My Business Sale?
Set It Up Right
To illustrate why trying to re-trade mid-deal can hurt both the seller and the buyer, I’m going to share an example deal involving a private equity group (PEG) and an IT-managed services provider I was representing at the time. We had a great deal of buyer interest and multiple buyers involved. We started taking bids and negotiating letters of intent (LOI). Because we know that the due diligence process can stretch out (sometimes as a buyer's way to make late-inning price adjustments), we wanted to provide a price adjustment mechanism that was fair to both buyer and seller. Normally, because the process favors the buyer, the price can only go down between LOI execution and closing. It almost never goes up (if you don't believe me, read on and you will see how true that is). We wanted to accomplish two things with our approach: One — encourage the buyers to complete the process in a reasonable period of time; and, two — provide for both price increases and decreases with a performance measurement that would be based on the prior 12 months to the month of closing.
Use the Best Valuation Method for Your Business
As we started getting our offers, our counter offers converted the purchase price into a multiple of EBITDA and then incorporated language that would base the final purchase price on the actual EBITDA for the prior 12 months to closing. The language looked like this:
BUYER will pay SELLER purchase price of $4,350,000 (four million three hundred fifty thousand US dollars) for 100% of debt-free assets of the company, goodwill, non-compete and non-solicit agreements. For illustration purposes, the valuation is based on 4.35 times EBITDA of the trailing 12 months (TTM) to the month prior to the execution of this letter, as provided by the business broker. At the present time and using available information, the TTM EBITDA from October 2014 to end of September 2015 is calculated to be approximately $1,000,000. The purchase price at closing will be based on an EBITDA multiple of 4.35 X the actual EBITDA for the 12 month period preceding the month of closing.
Again, the main purpose of this language is to level the playing field between buyer and seller. Normally the buyers deluge the seller with voluminous data requests, and in smaller, privately held companies it is usually the owner that is in charge of responding. Often the performance of the business suffers, and the buyers then make their adjustment to the purchase price based on that downturn. If you do not formalize and document the corresponding upside for the seller, and should the business’ performance improve, the buyers never raise their price. They have had you off of the market for six months and they can play a more aggressive game and threaten to walk on the deal rather than raise their price. However, you box the buyer into a corner with this language by proactively documenting what you know they will do already. Once documented, it is pretty hard to argue that you, the seller, shouldn't be provided the same protections. It is the same principal as a mutual non-disclosure agreement.
So, in a competitive bidding situation, we get the best terms and conditions from our buyers by including the variable purchase price calculation at closing and fixing the amount and the formula for calculating the net working capital level.We hammer out a couple of additional details, including the calculation of the earnout, with the ultimate winner and we dual-sign the letter of intent.
Doing Your (Reverse) Due Diligence
So in this example, the due diligence was exhaustive with the private equity group buyer. They assigned a junior analyst to be the coordinator and another analyst to focus on populating the data room. They already owned a platform in this industry and they decided to involve that company's CEO in our weekly status calls. As the months passed — yes, months — the seller's performance continued to improve and we were sending monthly financial updates. It was becoming evident to all involved that the purchase price was going up … remember what I said earlier: for the buyer, the price almost never goes up.
Four months into the process, the buyer produces a term sheet which basically fixes the purchase price to the original place holder level and overrides several key points that we had earlier negotiated on in a competitive bid process. Our client was very upset, but we had done our reverse due diligence and we pointed out to the buyer that we were not going to accept new terms after we had been off of the market for four months. We reminded them that they had agreed to these terms in a competitive situation, and I even sent them our email threads of our hard-fought negotiations as a reminder. I also sent them our deal comparison worksheet to show all of the other bids that we had received (buyer identities blanked out, of course). Because of our extreme negative reaction, they did not pursue any agreement on the term sheet.
So, we returned to the due diligence process. The PEG hired a human resources consulting firm, adding to the due diligence burden and often duplicating requests already completed. They also hired an independent third party CPA firm to go over our client’s information and produce a quality of earnings report, but not before yet another exhaustive round of data gathering — again, much of it duplicated.
Recognize the Warning Signs of a Re-Trade
We received a detailed report with several attacks on EBITDA and value, but one of the highlights was: "to recruit and maintain quality employees, the Company may have to step up its contribution to the cost of health insurance and also add to the benefits package. The costs of such upgrades could easily run $50K-$100K per year." This was completely speculative and not backed by any facts (not even after requesting a quote from their insurance carrier, just to see costs). We also pointed out that retroactively applying anticipated future adjustments to historical EBITDA was a real stretch on industry practices.
Another gem in the report was: "the company will need to add resources in the administrative function at a cost that might be estimated on the low side at perhaps $100k annually." This is after we have already discussed eliminating the seller's CFO with the platform company at a savings of $50,000.
Another quality of earnings report finding: "the relatively low margin on product sales combined with the fact that they are generally not recurring except over multi-year replacement and upgrade cycles means that the product component of the business should be valued using a separate, lower multiple of revenue and/or earnings than the service revenue, which is recurring." Well, the division of product revenue was clearly stated in all materials the PEG had when negotiating their offer. The offer against 11 other qualified bidders was a single EBITDA multiple. Again, the bid was set in a competitive process and did not include any dual multiple component.
All in all, they presented $332,000 in EBITDA adjustments as their starting point to reopen the price negotiations almost five months into the process. We refuted every one of their unsupported and arbitrary adjustments.
When Enough Is Enough
As nerves were frayed and the deal was on the edge of blowing up, I got an email from one of the partners at the PEG saying, “thanks for the note, Dave. Clearly we are just going to keep talking past each other if we focus on EBITDA. I think we can agree to disagree. (For clarity this won’t change the approach to employees, they will still be offered our company's benefit package at closing). MRR is clearly the value driver of this and all MSP businesses." He claimed that the information they were provided and were using for their LOI showed a different revenue breakdown between product sales and monthly recurring revenue than what the seller was currently doing. "That issue notwithstanding, the average TTM MRR at that time was 239k and the purchase price in our signed term sheet was $4.35M or 18.2x MRR. The average TTM MMR has indeed grown since April (by 7.2%), applying an 18.2x multiple to that MRR $256k brings you to $4.66M, we are willing to round up to $4.7M. That represents a $250k increase in enterprise value since the term sheet was signed." However, the actual measurement that the LOI called for was based on 4.35 X the latest TTM EBITDA of $1.2 M which put the value at $5.22 M.
At this point the PEG counted on us caving in, but there had been so much erosion of goodwill that our sellers walked away. This was a very expensive outcome for all involved.
My take away from this is, first, that I am really angry at this unfortunate practice of re-trading that some PEGs use as their acquisition model. Secondly, it occurred to me that had the buyer set their purchase price to the metric that was most important to them in setting value, they would have made sure to completely understand what the MRR was in this case prior to negotiating a LOI. If the due diligence process showed an unexpected surprise or variance in MRR, they would have been protected. Also, the seller would have accepted any legitimate price adjustment because the rules were clearly spelled out. They, instead, bid on a multiple of EBITDA and, despite their best efforts to carve it up in due diligence, could not find one defensible, legitimate adjustment. When the price went against them and they attempted to change the metric to give them the answer they wanted, they destroyed the seller's trust and killed the deal.