is an old saying that a person who uses himself for his attorney has
a fool for counsel. Likewise, a selling owner who uses himself as
his financial consultant in negotiating an acquisition has a fool
for an advisor. There is no way that a typical selling owner/entrepreneur
could have an accurate knowledge of the company’s value or a
remote grasp of how the representations, warranties and indemnifications
must be creatively structured to minimize risk.
The pricing of middle-market acquisitions is rarely announced. The
few that are made public are only announced in detailed SEC filings,
which are usually reviewed only by sophisticated acquisition consultants/investment
bankers. The seller’s accountant or law firm doesn’t have
expertise with the overall pricing and pricing trends of middle-market
deals by industry. In addition, almost all attorneys accept the prevailing
norms that sellers should be responsible for events occurring prior
to the closing date. Therefore, the selling owner, who is not advised
by an acquisition consultant with an aggressive philosophy predicated
on equitable treatment of the little guy, is forced to rely on the
validity of the following types of comments for guidance in deal pricing:
||“That is the normal way
transactions are done”, acquirers often state to defend
||The boasts of prior sellers about
the transaction price their company commanded.
It should be obvious that an individual
who sold his or her company has a strong emotional self-interest in
exaggerating its selling price. In addition, strategic acquirers can
have any number of motivating, and possibly conflicting, self-interests
that cause them to distort their actual purchase prices for prior
deals and their overall pricing philosophies. Any prudent person should
recognize that the conflicts in these situations make it unlikely
that it will be an accurate source for deal pricing.
The Impact of Timing on Deal Prices.
There is a significant consolidation taking place in many industries.
Many deals in the “consolidation-type” industries are
happening fast and apparently painlessly for selling owners. Unfortunately,
this is usually a sure sign that a company is being sold at a discount
price with the seller often having significant post-closing exposure
in the non-financial areas.
My Firm represented a heating and air conditioning equipment distributor
on the Pacific Coast. An aggressive but realistic price of $11 million
was established for the seller. A major strategic acquirer in this
industry made an offer of $9.5 million. As I discussed the offer and
justified the validity of our price, I pointed out that the acquirer
could make a very attractive return on investment at my transaction
price. The acquirer’s CFO stated that his company could buy
many companies at a much lesser price. He further stated it had consummated
eight deals during the past year and that none had been consummated
at my multiple of earnings level. When I inquired as to how these
sellers were advised, the CFO said that five were not advised by a
financial advisor and three had used their local CPA firm in that
capacity. Later that year, I sold the distributor at its target price
of $11 million in an all-cash deal. The point is that sellers who
are not properly advised almost always sell at a vastly discounted
Usually, fully-priced, adequately secured deals do not move quickly,
unless the seller has substantial leverage. These deals usually move
at a moderate pace with considerable negotiating obstacles. This reflects
the fact that acquirers typically do not initially make their best
offer. An actual sale illustrates this point.
A plumbing distributor was approached by a major public company. The
potential seller retained my firm, and a target price of $13.5 million
was established. The acquiring company adamantly maintained that its
best price was $11 million. We terminated discussions. Two years later,
the same plumbing distributor decided to actively pursue the sale
of his company. At that time, his earnings had slightly decreased
from the prior level. In spite of this, the public company that had
approached the distributor originally, now raised its offer to $12.25
million. I indicated that was not adequate. Two weeks later, it raised
its offer to $14.25 million. That offer was also rejected. Two months
later, a sale was consummated with another public company for $14.5
million, which was at the upper end of our price range.
The point is clear. The initial acquirer was attempting to steal the
company. A selling owner must be patient to get the price he or she
deserves. It is necessary to have expert negotiating skills to obtain
the leverage necessary to produce a realistic premium price.
Letter of Intent Discussion Points.
It is my Firm’s unique philosophy that a general discussion
of all issues should occur at the Letter of Intent stage, before the
likely potential acquirer is selected. The pricing of the deal is
only one facet of the transaction. The representations, warranties
and indemnifications are just as important and should also be generally
discussed at this preliminary stage. As this approach is unique, if
not done properly by a sophisticated and expert negotiator, it could
“blow the deal”. The advantage of a preliminary discussion
of these issues is that you obtain an understanding of the acquirer’s
position on all key issues at an early stage of negotiations. If the
acquirer is unreasonable in the non-financial areas, a prudent selling
owner must break the deal to assure his future security. However,
if the acquirer’s position in these areas appears reasonable,
it is likely that the deal will be successfully consummated. This
reduces the risk of an unsuccessful deal, before an acquirer begins
its comprehensive due diligence process. This is important as that
process at times can be disruptive to the seller’s company.
The Critical Financial Impact of Non-Financial Issues.
When an acquirer buys a middle-market company (transaction price from
$2 million to $250 million), a smaller company is typically being
sold to a much larger acquirer. The acquirer usually has done numerous
deals and has sophisticated professionals on staff that know how to
structure deals that work to the acquirer’s advantage. If a
selling owner would only stop and reflect, he or she would realize
that in any transaction where one party is much larger and more familiar
with a process than the other, it is usually that party who obtains
the better deal. This is never truer than in acquisitions. This unfortunate
situation has become the “norm” in the industry.
Correspondingly, most attorneys are used to structuring deals with
representations, warranties and indemnifications that conform to the
norm. However, there are a few sophisticated acquisition consulting
firms, who are seriously concerned about their client’s financial
interests, that find these norm terms offensive. Norm terms put selling
owners in extreme jeopardy after the deal is done. In a best-case
scenario, they open the door for selling owners to have their price
chopped by 5-10% due to post-closing issues. In a worst-case scenario,
if the representations, warranties and indemnifications are not properly
structured and limited in scope and duration, the impact on a seller
can be catastrophic. The seller can lose an amount up to or exceeding
the total deal price due to post-closing events that the seller was
unaware of when the deal was closed. In middle-market acquisitions,
that is the norm. It is up to your financial advisor to stop the acquirer
from getting that opportunity. If there are unforeseen rewards that
an acquirer realizes from the deal, they probably were developing
before the sale. In these situations, the acquirer theoretically bought
the company at a discount price. Unanticipated gains are never shared
with the seller. Correspondingly, why should the acquirer demand that
the unsuspecting seller absorb the full burden of negative surprises?
Furthermore, regardless of the amount the acquirer collects from the
seller under the indemnification provisions, the selling owner’s
covenant-not-to-compete will still be in effect. Correspondingly,
a selling owner could lose up to or in excess of his total deal proceeds
due to the post-closing discovery of unknown liabilities, and he would
be unable to work in his industry to earn a living due to the restrictions
in his covenant-not-to-compete. A seller willing to accept the norm
representations, warranties and indemnifications has placed himself
in this precarious position, whether he knows it or not. That is not
a risk a seller should have to bear.
The following are some, but certainly only a portion, of the issues
that can trigger a seller’s post-closing exposure.
Unknown liabilities – These include
product liability, contract and employee claims. Included in this
area are many issues that have occurred or will occur that an innocent
seller acting in good faith will not have any knowledge of at closing.
In spite of this, if the norm representations, warranties and indemnifications
are accepted, the seller could have post-closing exposure up to or
exceeding the deal price. If the seller is not able to shift the liability
for these issues to an acquirer or significantly limit his exposure,
he retains full responsibility for these issues, potentially for many
years after the acquisition is completed. The seller is not only responsible
to the acquirer as an indemnified party, but also potentially to the
claimant. In many situations, latent employee dissatisfaction can
be triggered by an acquirer’s conduct after a closing. Although
the events creating the claim might have occurred before the closing,
they would not have become an issue except for the acquirer’s
actions. Consequently, a liability that did not exist at the time
of closing becomes a post-closing liability for the seller.
Similar types of issues exist in the area of product liability. Often,
claims due to damage caused by equipment sold years before the acquisition
do not arise until after a sale. The seller’s exposure for these
claims depends on the negotiated representations, warranties and indemnifications,
along with other protections that the seller should put in-place.
It is my Firm’s philosophy that the only liabilities the seller
should be responsible for are those of which he is aware. Other liabilities
should be the responsibility of the acquirer. The financial implications
in this area are enormous to a selling owner.
Environmental claims – Environmental
problems found on a seller’s property might have been caused
by others, whether a previous occupant or by disposal or drainage
from another company. If the acquirer receives a clean report from
either a Phase I or a more detailed Phase II environmental audit,
the seller should use this as justification to restrict any post-closing
liability that he has to an acquirer. A satisfactory environmental
audit should be all the security that acquirers need to adequately
assure themselves that the property/properties are clean.
– Often, and especially in “consolidation-type”
industries, an acquirer feels that the collection of prior receivables
should be the responsibility, either directly or indirectly, of the
seller. This is pure hogwash. A sophisticated acquirer can determine
its exposure for bad accounts receivable before closing during the
due diligence process. If it has any significant collection exposure,
this should be negotiated as a deal price reduction before closing.
A sophisticated seller should not accept any liability for the acquirer’s
subsequent collection of receivables. This removes any pressure from
acquirers to use reasonable efforts to collect receivables.
Inventory – Acquirers often expect the
seller to be directly or indirectly responsible for inventory that
is not sold within a normal period. It seems inherent in this assumption
that the acquirer has only good inventory. Obviously, this is not
the case, so why should the seller be held to this standard? During
the due diligence process, the acquirer should evaluate the seller’s
inventory, inventory controls and inventory levels. If there is an
excessive amount of damaged, slow-moving or obsolete merchandise,
it should be addressed prior to the closing in the form of a reduced
transaction price. Once a deal is closed, the inventory should be
solely the acquirer’s responsibility. To do otherwise is to
give the acquirer a blank check. Many acquirers will gladly take advantage
of this loophole.
As a seller evaluates the importance of the representation, warranty
and indemnification issues, he should remember that negative developments
from poorly structured deals could place him in jeopardy for an amount
in excess of the transaction price. After the deal is consummated,
except to the extent the acquirer might benefit from the seller’s
personal goodwill, the seller often is of limited utility to an acquirer.
Any money that can be claimed against the seller will reduce the transaction
price for the company and increase the acquirer’s return on
investment. If that sounds cynical, you are not familiar with the
reality of corporate acquisitions. This is one area in which a seller
doesn’t want to get educated the hard way. The consequences
are too grave. In what is probably the largest financial battle of
your career, make sure that you are advised by a knowledgeable professional
capable of forcefully negotiating with a larger acquirer to structure
a deal that eliminates or severely limits your exposure to post-closing