This week the repugnant Donald Trump bragged to his adoring masses at a Florida rally* that he managed to get a $20m discount from a golf course he was purchasing, after he signed the contract. Trump simply told the seller he wasn’t paying and threatened to drag him through the courts for years after.
While I hope that company sellers never have to negotiate with an acquirer with Trumps’ lack of ethics, it does highlight an extreme example of what can go wrong.
You’ve found a buyer. The transaction is progressing well. The buyer is motivated, as they see real upside in your company. You sense that settlement is in sight, then they’ll be a few months of transition and then freedom!
Hang on. In my experience more MidMarket deals have the potential to undo at the latter negotiation and structuring phase than at any other time in the transaction.
The potholes on the road to settlement can be broadly summarised as: earn out and deferred payment clauses, transfer and incentivisation of employees, agreeing on the due diligence process, managing advisors, intellectual property considerations, non competes, managing working capital, and property and leases.
However, a successful transaction relies most on maintaining empathy for the buyers needs. There’s danger when the transaction timescales stretch out, and when potentially combative legal and financial professionals working for either party start to eat away at the goodwill built between the acquirer and seller.
Sometimes egos start to take control and imagined slights pervade the thinking of both the seller and buyer. With a recent acquisition, the buyer threatened on three separate occasions simply through exasperation with a highly detail oriented sellers solicitor.
Let’s look at the key points of negotiation when structuring a deal.
EARN OUT CLAUSES
Acquirers seek to guarantee future returns or reduce risk by deferring some of the payment for sale of the company. They can stage these payments over time or establish earn outs that are triggered by pre- agreed achievement criteria.
Earn out clauses are so fraught with challenges that I’ve heard some M&A professionals refer to them as unexpected bonuses rather than part of the deal. I consider this an exaggeration and believe that a decently drafted agreement, and monitored hands on post-completion commitment processes make earn outs an integral part of the deal making process.
Earns outs are one or a series of post completion payments. They are a contingent consideration payable to a seller based on the after-sale performance of the entity. This could be based on either a financial target or metric (EBITDA, revenue) or a milestone such as an external event.
For example, I have completed a deal that pays the seller 80% of the agreed amount upfront and the remaining 20% in four quarterly periods subject to maintenance and growth of quarterly profits. The seller is staying on and could over perform resulting in an increased earn out.
The parties agreed on EBITDA over revenue because it’s a much better indication of growing shareholder value than revenue. It encourages the business to only sell profitable products or services, and to keep operating costs down.
But using EBITDA over revenue also has its pitfalls. For example, it could encourage a short-term view of the business by reducing marketing spend or capital expenditure in order to keep such costs down. This failure to invest in growth can hurt long-term business prospects.
Written into this particular contract was a sub-section that dealt with a variety of circumstances where the seller would be protected if the circumstances changed in such a way that it made it more difficult for these EBITDA targets to be achieved.
These circumstances could include examples such as the sale of the business by the current buyer, a change in the job role for the seller, a change in the product portfolio impose by the buyer and a variety of other circumstances.
Furthermore the seller also has rights to inspect the financial records of the company and the right to veto any large expenses proposed by the buyer.
Even though the safeguards are there, even this is not an ideal situation. For example, it virtually removes the right of the buyer to do anything radical with the company and forces them to have to run the acquired business as a separate entity.
Importantly, in this instance the earn out period was short and the buyer was able to capped the upside payment to the seller at 120% of target. The seller also had an ongoing employment clause that was short enough that the buyer didn’t have to keep a malcontent on the books for too long.
As the seller was also going to stay employed within the new business, the earn out also comprised of 50% shares. This gave reassurance to the acquirer that the seller would be financial motivated to increase shareholder value.
There may be situations where the full amount has been agreed but payment is deferred.
One example is escrow. Generally, escrow is used where a part of the purchase price is set aside against adjustments or warranty claims. Such warranties are a guarantee against certain negative events not occurring else payment is deducted. They could include: incomplete litigation, contingent liabilities or asset valuations.
With one of my clients, the final purchase price was based on the assumption that a major local council customer of theirs would not cancel an ongoing contract within the next twelve months. Had the local council have done so, it would have had a detrimental effect on cash flow. So the agreement was that some of the payment would be held in a trust account until the condition was satisfied.
TRANSFER OF EMPLOYEES
One of way of ensuring that key employees transferred over and were motivated to continue performing is to grant options. Such loyalty payments, contractually paid after a specified period with pre-defined performance criteria are increasingly forming part of contracts.
The emotional buy in of the sellers’ key employees is absolutely essential to the ongoing success of the merged entity. However a challenge arises where the buyer knows before the transaction – or comes to realise after the transaction – that certain employees need to be retrenched.
Perhaps there are cost synergies such as duplication of function. Perhaps the anticipated ongoing profitability of the merged entity cannot be realised with a core of inefficient staff being removed. One of the key elements of a pre-contract negotiation may be which employees are coming over. This needs to be borne in mind considering that employee entitlements such as annual, long service and sick leave or redundancy entitlements will roll over.
Part Two: will complete this analysis covering topics such as agreeing on the due diligence process, managing advisors, intellectual property considerations, non competes, managing working capital and property and leases.
Mark Ostryn is director of Strategic Transactions & Valuations in Sydney, Australia. He can be contracted on firstname.lastname@example.org