This article addresses issues that a business owner and his or her team of advisors face in the process of negotiating with prospective buyers. It was written for the Topline Business Owners Workshop, an event hosted by Topline Valuation Group in conjunction with Kaulkin Ginsberg Company and Santos, Postal & Company, P.C., on Tuesday, May 12, 2015.
This is part two in a four-part series.
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.
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.