By: Andrew J. Sherman, Esq.
This article addresses issues that a business owner and his or her team of advisors will face in the process of negotiations with prospective buyers. It was written for the Topline Business Owner’s Workshop, an event hosted by Topline Valuation Group, Kaulkin Ginsberg Company, and Santos, Postal & Company, P.C., on Tuesday, May 12, 2015. To view the presentations from this event, visit Topline’s blogs.
I. Selecting a Team
The first step to prepare the company for an M&A transaction is to hire a team of professionals that at a minimum includes:
- An investment banker
- A certified public accountant (CPA)
- Legal counsel that is experienced M&A deal lawyers
These professionals will help you understand what you want as a seller, and tailor those wishes and desires to the reality of the company that will be sold in the context of a market.
A. Investment Banker
An investment banker advises the seller on issues relating to market dynamic, trends, potential targets, valuation, pricing, and deal structure. He or she is also responsible for assisting the company in drafting the confidential information memorandum, which is the main marketing document used by the investment banker to sell the company. Further, he or she assists the seller in understanding the market, identifying and contacting prospective buyers, and negotiating evaluating offers. Finally, in many cases, multiple offers may have divergent structures and economic consequences for the seller, so evaluation of each offer is conducted by the investment banker.
B. Certified Public Accounts (CPAs)
The account (a certified public accountant) assists the seller in preparing the financial statements and related reports that the buyer inevitably requests, which also serve as a valuation tool for the buyer and for the seller to know what to expect in terms of an offer.
C. Legal Counsel
The legal counsel, who should be experienced in M&A deals, is responsible for assisting the seller in a wide variety of duties, including (without limitation):
- Assisting the seller in setting up the company for sale by cleaning up corporate records, responding to buyer due diligence requests, developing strategies for dealing with dissident shareholders, arranging necessary consents from third parties or governmental entities in relation to the deal.
- Working with the investment banker in helping evaluation competing offers, and also focusing on those aspects of the offers that are not necessarily expressed in hard numbers but affect the attractiveness of the deal, such as indemnification-related provisions in the letter of intent.
- Assisting in the negotiation and drafting of the letter of intent and nondisclosure agreements, which should be signed by all potential buyers who are provided with the investment-banker-prepared confidential information or who otherwise have access to the seller’s book and records.
- Negotiating and drafting definitive purchase agreements with buyers’ attorneys.
- Assisting the seller with post-closing matters, such as working capital adjustments, problems with the payment of a buyer’s promissory note, and other matters.
D. Step Back for a Minute
A seller should understand from the outset that the team of professionals that will assist him or her, especially the investment banker and legal counsel, have different goals in the context of a deal and are sometimes at odds with each other. We are not suggesting that the process of selling entails mastering a potential conflict of responsibilities or even interests between different factors of so-called professionals, but a seller is definitely better off understanding them. This isn’t because the seller will want to play those factors against each other – quite the contrary – but to understand what each one deems to be in your best interest as seller.
The overarching goal that unites the team of professionals is to sell the company, as each was hired in the context of the transaction for that purpose. The investment banker wants to accomplish that goal and also maximize sales price – another goal that is highly related to the goal of selling the company. Sometimes this means that once the investment banker feels that the sell price has been agreed to – usually through a letter of intent from the buyer – ideally he or she would like to see a smooth negotiation process on the remaining points so as to minimize potential conflict and maximize the chances of sealing the deal. Ultimately, the investment banker only gets a positive return on his or her investment in the seller (opportunity costs) if the transaction closes because usually the investment banker gets paid a commission on the transaction. While the investment banker is also desirous of getting you the best deal possible, he or she will be less willing to take hard positions on certain issues, especially when it comes to taking risks even in the process of the negotiation of the letter of intent.
This sort of behavior sometimes may act against the best interests of the seller, and may seem at times that an investment banker may be negotiating against the interest of the seller, as one client told us recently. In a buyer’s market – and in a seller’s market as well, but to a lesser extent – the seller’s peak in negotiating leverage is usually at the stage of the negotiation of the letter of intent. If the investment banker is not keen on negotiating a certain point that may be important in the context of a transaction in the letter of intent, odds are that the seller has given up his or her chance to get the best deal on that certain point. In this instance, the seller can use the advice of legal counsel to weigh the risks and consider whether the point should be negotiated now or later.
Legal counsel who are experienced M&A lawyers also share in the overarching goal of selling the company at the best price possible, but in the context of creating the least risk possible for the seller. There is no point in receiving the maximum valuation possible for the company if eight months later the seller may be exposed to an indemnity obligation of 35 percent of the sales price. In order to achieve the least risk possible, the legal counsel in most cases will have to negotiate with the attorneys for the buyer. Although attorneys differ in terms of negotiating tactics (and those tactics matter), an attorney will sometimes touch upon points during a negotiation that may cause some considerable tension among buyer and seller. Companies that are for sale come in many varieties, and what may be important for one may not be for another.
For instance, there is not much to be gained for a seller to heavily negotiate the off-balance sheet arrangements representation and warranty when the company for sale does not have any. Yet, many attorneys negotiate points that are counterproductive to the goal of selling the company since those negotiations may only serve to irritate a buyer and create doubts in the back of the buyer’s mind about what he or she is proposing to buy without creating any value or benefit to the seller. In this instance, the seller can use the advice of the investment banker and the accountant to determine the importance of an issue in the context of the company, and assure legal counsel that there is not much to be gained from negotiating a certain point.
In relation to the investment banker and legal counsel, the seller should use them as resources that complement each other, but also as a source of competing ideas that should be thoroughly considered in order to reach the best solution. Circumstances among sellers can vary widely. An idea or suggested solution may work for one seller, but not for another. The shrewdest of sellers will put both the investment banker and the legal counsel on the same page to achieve the best deal possible given the circumstances.
E. Investment Banker and Legal Counsel: Who to Hire First?
If we were sellers, we would hire legal counsel that is composed of experienced M&A deal lawyers first. Legal counsel is usually paid on an hourly basis, and their engagement letters are fairly straightforward. Experienced M&A deal lawyers are an essential ingredient to the deal team – sort of like electricity to a plant. The more the seller uses experienced M&A deal lawyers, the more expensive they become, but usually the seller is much better off by their active participation.
One of the instances a seller can enormously benefit from an experienced M&A deal lawyer’s advice is in the negotiation of the engagement letter with the investment banker. Investment banker engagement letters pose a number of issues that the average seller, especially a seller who has never sold a company previous to the transaction in question, may not know about, and, as a consequence, may fail to pick up. For instance, the average investment banker letter has a seller paying a commission on the closing for a part of the purchase price that the seller may receive years after the closing, and – in the worst case scenario – may never receive. There are other issues in which assistance from experienced M&A deal lawyers may be helpful, if not essential.
II. The First Team Meeting
We suggest that the seller have a strategy meeting with all members of the team to understand the realities of the market at the time. Further, the meeting should cover the items described below in order to prepare the company for the sale:
A. Identify What the Seller is Seeking Financially and for the Company
Many sellers are not selling just to get a ton of cash up front, and sometimes receiving a ton of cash up front may not be likely or even possible. The investment banker, with the assistance of experienced M&A deal lawyers, should assist sellers in adjusting expectations to the reality of the market. Further, some sellers are interested in keeping a stake in the company after the sale and/or want to keep working for the company. Another point to consider is that many sellers want to position their company and employees through the sale to enhance the company’s growth prospects, and for other business and strategic reasons.
B. Develop a Plan of Attack and Timeframe
If the first meeting does not result in the development of a plan of attack, we would say that the meeting time was not used efficiently. The investment banker, accountant, and legal counsel should explain to seller the time commitment and the related diversion of company resources that result from the sale process. Nowadays, the sale process on average takes between six and eight months. Keep in mind, this time is comprised of deal-related work that will take away a lot of man hours from the company that could have otherwise been used to operate more efficiently and enhance growth prospects. A plan of attack should outline a timeline and expected completion dates, but it also may have to be flexible enough to take into account unexpected difficulties.
C. Understand the Current Market and the Potential Valuation of the Company
The investment banker, with the assistance of legal counsel, should assist the seller in understanding the market dynamics at the time that may affect the valuation range for the company. For valuation purposes, the seller may find it useful to know:
- Whether the market favors buyers or sellers
- Which sectors are in demand and support higher valuations
- The macroeconomic factors that may affect the sale and how
- The valuation techniques that are in vogue
- Other pertinent information
The valuation of the company is one of the most important business issues in a deal (if not the most important!). Valuation is not an exact science, and it’s based on objective and subjective factors as well as on mathematical methodologies. Valuation attempts to define the point at which a seller is willing to sell and a buyer is willing to buy. There are many valuation methodologies, including:
- Comparable company and comparable transaction analysis
- Asset valuation method
- Discounted cash flow valuation method
- Simple multiplication of a number such as 6 (depending on the valuation that the market at the time supports) to EBITDA.
The investment banker, with the assistance of legal c0unsel and accountants, can assists a seller in identifying which valuation methodologies are more appropriate given the market and the goal to maximize price. Furthermore, the investment banker is ultimately responsible for stirring the pot that creates a market of interested purchasers that is often essential to sell the company within the high end of the valuation range.
D. Discuss the Potential Classes of Buyers and Determine Which Makes More Sense for the Seller and the Company
Generally speaking, the market nowadays boasts a large array of buyers that range from private equity funds to strategic buyers. Many buyers are competing with each other to buy companies for sale, which benefits the seller. A key distinction between a private equity fund buyer and a strategic buyer is the former tends to be more flexible in the negotiation table as long as the numbers behind the story they are purchasing work. In contrast, strategic buyers usually have in-depth knowledge of what they are purchasing, and have goals different than company growth that may compromise their flexibility, making every point count a bit more. Regardless, sellers – especially in the current environment – should benefit from their presence in the market of buyers as more players tend to drive valuations higher.
A seller should use his or her investment banker to identify potential merger or acquisition candidates from all classes of buyers and organize them. Then, the seller and the investment banker should identify which classes of buyers would likely be more interested, and which classes would be ideal for seller’s goals. Afterward, the differentiation between prospective buyers is almost a self-selection process; prospective buyers presumably would be interested in reading the confidential information memorandum, and later express how serious their interest is after further conversations with the investment banker and management presentations of the company.
E. Outline of the Confidential Information Memorandum
The confidential information memorandum is the main marketing document used to sell the company to prospective buyers. It provides an opportunity to portray the company’s key characteristics, size and growth of the market, and potential profitability. However, the company must be presented accurately and fairly in all respects with a portrayal of the problems and challenges that the company faces. The confidential information memorandum should also employ a marketing strategy or “spin” to develop a profile of the ideal buyer, identifying how and when the buyer will be selected, and gathering a set of initial materials to be given to potential buyers and their advisors. Usually, the investment banker does most of the drafting with considerable assistance from the seller, as the investment banker needs relevant information relating to the company. The offering memorandum should include the following information:
- Executive Summary
- Market Opportunity
- Business Overview
- Products, Services, and Pricing
- Manufacturing and Distribution
- Sales, Marketing, and Growth Strategy
- Competitive Landscape
- Management Team and Organizational Overview
- Risks and Litigation
- Historical Financial Information
- Projected Financial Performance
- Supplemental Materials
F. Legal Audit and Cleanup Process
Another important feature of the preparation process is to get the company ready for buyer analysis and diligence investigation. We cannot emphasize enough that it is critical to identify and predict the problems that will be raised by the buyer and its counsel. A legal audit should be conducted in connection with corporate housekeeping and administrative matters, the status of the seller’s intellectual property, and key contracts (including issues regarding assignability, regulatory issues, and litigation). The goal is to remedy any problems to the extent feasible. Now may be the time to resolve any disputes with minority shareholders, complete the registration of copyrights and trademarks, deal with open issues in your stock option plan, or renew or extend your favorable commercial leases. Those problems that cannot be solved must not be hidden because they will prove rather self-defeating later in the process. The seller may lose negotiation leverage, or – even worse – a change in the structure of the consideration that is to be paid by buyer at the closing that is not proportional to the magnitude of the problem or a buyer walking out of the deal after all the time and energy that has been put to the process.
The legal audit should include an examination of certain key financial ratios, such as debt-to-equity, turnover, and profitability. The legal audit should also look carefully at the company’s cost controls, overhead management, and profit centers to ensure the most productive performance. The audit may uncover certain sloppy or self-interested business practices that should be changed before a seller sells the company. This strategic reengineering will help build value and remove unnecessary clutter from the financial statements and operations.
Even if the seller does not have the time, inclination, or resources to make such improvements, it will still be helpful to identify these areas and address how the company could be made more profitable to the buyer. Showing the potential for better long-term performance could earn the seller a higher selling price, as well as assist the buyer in raising capital needed to implement the transaction.
In the process of marketing the company, the seller will be asked many questions, and the overwhelming majority is fair game. Further, the company’s state of affairs will be subject to full review and scrutiny. The legal audit and the steps taken to remedy problems will be the key to answering questions and providing a favorable impression of the company to prospective buyers. Therefore, in addition to the legal audit, sellers with the assistance of legal counsel should develop a list of things that must be done in connection with corporate housekeeping matters, such as maintenance of regulatory filings and managing potential obstacles, to the sale from dissident minority owners of the company.
G. Discuss Potential Points that Make the Company Less Desirable to Prospective Buyers
The seller and his or her chosen team of professionals should discuss those features or issues associated with the company that will make it less attractive to buyers. During that time, a discussion should take place on how the company will be marketed in spite of those features or problems, and how to accurately disclose those issues or problems to buyers. Another key component of that discussion should be when and to who to disclose those features or problems, but in no event no later than the letter of intent stage. The answer as to who is usually those parties that are serious candidates who have expressed interest in issuing a letter of intent.
H. The Seller Should Assist the Professionals in Understanding the Company
The experienced M&A deal lawyers, with assistance from the investment banker, will be negotiating the transaction documents on the seller’s behalf. A lot of the negotiation relates to matters of fact, including representations and warranties that the buyer will want to obtain from the seller. The seller’s experienced M&A deal lawyers will be in a better position to negotiate representations and warranties that reflect the reality of the company of the seller facilitates the necessary information relating to the company. As a consequence, the need to disclose exceptions to the representations and warranties will be minimized, and, more importantly, the chances of a breach of a representation or warranty are reduced.
I. The Game Plan
Once the transaction preparation is complete, the process can be managed any number of ways. A major decision at this stage is in determining how closely the process should match a formal auction. A formal auction is typically based upon sending standardized company materials to a large audience, providing the targets with specific dates of management meetings and timing for which offers are due. This formal process can lead to very positive results; however, no buyer likes an auction. An auction ensures that the “winner” values the deal more than other auction participants, and as such, some companies refuse to participate in auctions, thus closing the door to potential buyers.
A less formal approach, however, can yield similar if not better results to an auction. In this approach, the investment banker coordinates more informally with identified buyers and ensures that all of the target buyers are contacted simultaneously. In addition, each of the targets is examined more closely for strategic fit, and often the communication and marketing materials are tailored to underscore the strategic rationale of the proposed transaction.
There are multiple benefits to this approach. First, each buyer is different, and providing a tailored message may be better received. A likely buyer may review a large number of potential deals (even if few are done), and helping the evaluator come to the proper conclusion can be best accomplished in more focused communication. Second, for each pairing of buyer and seller, there are different synergies to be had. If a seller truly wants to maximize the value obtained from the buyer, then understanding the synergies available is critical and necessary. Finally, investment bankers typically have interacted with many of the target buyers in the past. As such, a less structured process allows the investment banker the opportunity to solicit more candid, direct feedback about the proposed transaction—feedback that is typically not available when the process is more structured.
The last option for running a merger and acquisition process is to have the CEO of the company contact the targets directly. This is rarely the best option, largely due to the challenge of price negotiations. An intermediary can preserve the good working relationship between the CEOs, despite differences in price expectations. When two CEOs are working together directly, however, price can become an emotional and personal roadblock to productive discussions.
III. Common Preparation Mistakes
Once the seller has assembled his or her team, conducted an internal presale legal audit, and pulled together the "good, the bad, and the ugly" in a detailed confidential information memorandum, the seller is ready to start contacting potential buyers. To maximize the selling price, however, the seller must take certain strategic and reengineering steps in order to build value in the company and to avoid the common mistakes made by sellers, as discussed below. To properly reengineer and reposition the company for sale, hard decisions need to be made, and certain key financial ratios need to be analyzed in critical areas, such as cost management, inventory turnover, growth rates, profitability, and risk management techniques. The following are a few of the common preparation mistakes sellers make in getting ready to sell their company:
A. Being Impatient and Indecisive
Timing is everything. If the seller seems too anxious to sell, buyers will take advantage of his or her impatience. If you sit on the sidelines too long, the window of opportunity in the market cycle to obtain a top selling price may pass the seller by.
B. Telling Others at the Wrong Time
Again, timing is critical. If the seller tells key employees, vendors, or customers that he or she is considering a sale too early in the process, they may abandon the relationship with the seller in anticipation of losing their jobs, their customer or supplier, or from a general fear of the unknown. Key employees, fearful of losing their jobs, may not want to chance relying on an unknown buyer to honor their salaries or benefits. A related problem for companies that are closely-held (or if one person owns 100 percent of the shares) is how to reward and motivate key team members who may have contributed over time to the company’s success and will not be participating in the proceeds of the sale at closing. It is critical that their interests are aligned with the seller and that they work hard and stay focused on getting to the closing table. A bonus plan or liquidity event participation plan can be an effective way to bridge that gap and allow them to participate in the success and share in the proceeds at closing without owning equity in the seller’s company. Vendors and customers will want to protect their interests, too. Yet these key employees and strategic relationships may be items of value in the sale; the buyer may count on their being around after closing the deal. If the seller waits too long and discloses the news at the last minute, employees may feel resentment for being kept out of the loop and key customers or vendors may not have time to react and evaluate the impact of the transaction on their businesses – or, where applicable, provide their approvals.
C. Retaining Third-Party Transactions with People Related to the Seller
If there are relationships that will not carry over to the new owner, shed these ghost employees and family members. They should follow the seller out the door once the deal is secured.
D. Leaving Loose Ends
Purchase minority shareholder interests so that the new owner won’t have to contend with their demands after the sale. Very few buyers will want to own a company that still has remaining shareholders who may present legal or operational risks. It’s akin to the real estate developer who needs 100 percent of all of the lots in a development to agree to sell before proceeding with his or her plans—a lone straggler or two can break the deal.
E. Forgetting to Look in Your Own Backyard
In seeking out potential buyers, the seller should look for those who may have a vested interest in acquiring control of the company, such as key customers, employees, or vendors.
F. Deluding Yourself – or You Potential Buyers – About the Risks or Weaknesses of Your Company
The seller’s credibility is on the line—a loss of trust by the potential buyer usually means that he or she will walk away from the deal.
G. Trying to Save Legal Fees by Not Keeping Legal Counsel Informed
One of the main duties of the seller’s legal counsel is to negotiate the purchase documents, including the representations and warranties, and assist the seller in drafting disclosure schedules. If your legal counsel does not have all the information, he or she can only provide limited assistance. Given that most sellers do not fully understand the legal language in the representations and warranties of the purchase agreement, the effort to save legal fees by not keeping legal counsel informed may result in a breach of representation and warranty for a lack of disclosure, which usually means that the seller will be paying much more in indemnification payments than the dollars he or she saved in legal fees.
IV. Other Considerations of the Seller
A. The Importance of Recasting
Since privately-owned companies often tend to keep reported profits — and thus tax obligations — as low as possible, financial recasting is a crucial element in understanding the real earnings history and future profit potential of your business. Since buyers are interested in the real earnings of a business, recasting shows how the company would look if its philosophy matched that of a public corporation, in which earnings and profits are maximized. As part of the confidential information memorandum, a seller should recast the company’s financial statements for the preceding three years. For example, adjust the salaries and benefits to prevailing market levels, eliminate personal expenses (expensive car leases, country club dues, etc.) and exclude nonworking family members. Recasting presents the financial history of your business in a way that buyers can understand. It translates the company’s past into a valuable, saleable future, and it allows sophisticated buyers the opportunity for meaningful comparisons with other investment considerations.
B. Selling the Pro Forma
The price that a buyer may be willing to pay depends on the quality and reasonableness of the profit projections the seller is able to demonstrate and substantiate. The profit and loss statement, balance sheet, cash flow, and working capital requirements are developed and projected for each year over a five-year planning period. Using these documents, plus the enhanced value of your business at the end of five years, you can calculate the discounted value of the company’s future cash flow. This establishes the primary economic return to the buyer for his acquisition investment.
C. Prequalifying Your Buyer
It is critical to prequalify the potential buyers, especially if the seller contemplates a continuing business relationship after closing the deal. Thus, the buyer must demonstrate the ability to meet one or more pre-closing conditions, such as availability of financing, a viable business plan for post-closing operations (especially if the seller will be receiving part of its consideration in the form of an earn-out), or a demonstration that the post-closing efficiencies or synergies are bona fide. Take the time to understand each potential buyer’s post-closing business plan, especially in a roll-up or consolidation, where the seller’s upside will depend on the buyer’s ability to meet its business and growth plans.
The seller has decided to sell the company, and it is time to execute. The process of selling the company is energy and time-demanding. Why not ensure the seller’s success to the extent feasible by hiring an investment banker, an accountant, and legal counsel composed of experienced M&A deal lawyers to get the job done right? A shrewd seller will want to listen to the perspective of each of the professionals hired to weigh risks versus the goals of the transaction. The first team meeting should be used to develop an action plan including the confidential information memorandum drafting and identifying the seller’s goals in the context of market realities. Short cuts in the planning stages can be costly, and open flow of information among team members is key. Further, the temptation not to disclose negative information to the buyers with the strongest prospects should be avoided. The preparation stage that occurs after the first meeting is the time to clean up corporate matters and issues that may rear their ugly heads later. Finally, the seller should strive to avoid common preparation mistakes.
About the Author
Andrew J. Sherman is a partner in the Washington, D.C., office of Jones Day, with more than 2,600 attorneys worldwide. Mr. Sherman is a recognized international authority on the legal and strategic issues affecting small and growing companies. Mr. Sherman is an Adjunct Professor in the Masters of Business Administration (MBA)program at the University of Maryland and Georgetown University, where he has taught courses on business growth, capital formation, and entrepreneurship for more than 20 years. Mr. Sherman is the author of 23 books on the legal and strategic aspects of business growth and capital formation. Mr. Sherman can be reached at (202) 879-3686, or email firstname.lastname@example.org.
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