Chapter 3

In the first step of the Proactive Sale Strategy, we collected a wealth of information about the company, sales in its industry and about the owner.  At the end of that collection process, the prospective seller has an opinion of value and marketability and, based on the seller’s answers to the questions in our Sale Readiness Assessment, we have an idea about his or her goals, potential opportunities and threats.
At this point we meet to discuss what we’ve learned, to clarify the reasons for the range of value we assigned to the company and to probe the likelihood of getting one sale price versus another.

This usually very candid discussion gives the owner information necessary to decide whether to pursue or postpone a sale, and it gives me an opportunity to gauge an owner’s personality, habits, likes and dislikes.  All of these traits are important if we choose to work together toward a sale and, if all other parts are in place, will be hugely important should we be able to pursue the Outrageous Price.  (Please see Chapter Eight for a discussion of the characteristics of an Outrageous Owner.)

Let me insert here a brief comment about the relationship between the range of value and the owner’s decision to sell or not sell.  Suppose I tell an owner that I can sell his company for $10M with 100 percent certainty, or for $100M with 10 percent certainty.  The owner has a decision to make:  where along that continuum is he or she willing to sell?

The range I typically provide is rarely so broad—unless there’s a possibility that there’s a buyer who is willing to pay twice that of all other buyers (a/k/a the Outrageous Buyer).  Normally, I provide prospective sellers the bottom of the price range and am comfortable extending that range by one multiple.  For example, I may be able to fix the bottom purchase price at a 4x multiple and the upper limit at the 5x multiple.

If the owner decides to purse a sale within these parameters, it is time to dissect all of the information we collected and analyzed in Step One of the Proactive Sale Strategy.  The company’s financial information and owner’s answers in our Sale Readiness Assessment guide us as we put the company under a microscope during Step Two: Pre-Sale Due Diligence, to see if both can withstand the scrutiny of a buyer’s due diligence.

DUE DILIGENCE
Due diligence as a concept is simple:  buyers despise risk and will do all they can to reduce it.  So, during due diligence a buyer will ask for every document that it deems necessary to assure itself that the acquisition it is considering is worth what the seller represents it to be.  To achieve that end, buyers look for any malfeasance or undisclosed material risk such as fraud on the part of the seller or its managers.  They look for items or issues the seller isn’t disclosing, such as unpaid taxes, pending or threatened litigation, or technical obsolescence of the company’s equipment, processes, product or service.  Finally, buyers use due diligence to search for areas in which they can make immediate improvements (thus earning additional revenue) such as inefficiencies, unnoticed opportunities, waste and mismanagement.
In this search buyers request hard evidence for every claim that sellers make: from who owns the company to how many widgets it produces; from who owns the real estate on which it operates to who its customers are; from where it is licensed to do business to whether it is in compliance with all applicable regulations.  If a buyer intends to arrive at the closing table with cash, the seller can be assured that on the way to the table, the buyer will press the seller through its due diligence grinder.
 And that’s where the simplicity ends because on the other end of this due diligence process are sellers—men and women who have put everything into their successful companies, and are now involved in not only the most important financial transaction of their lives, but also one of the most emotional.

 All sellers experience some anxiety about due diligence for one or more of several reasons:
1.  The process of collecting and organizing data is a daunting task that many owners undertake on their own because they wish to keep confidential the prospect of a sale.
2.  Most sellers do not understand the reasons for due diligence, so their assumptions about process take a significant emotional toll.
3.  There are unscrupulous buyers who, with no intention of closing the deal, use due diligence to gather competitive intelligence about sellers.
4.  For various reasons, the due diligence process has evolved into an enormous beast.

Before discussing how sellers can address each of these anxiety-inducing issues, let’s examine them in greater detail.

Owners and Data
Most owners of mid-size companies no longer create their own financial statements, organize and file every contract, bank statement and license.  They don’t maintain or update their corporate documents, write all the checks, constantly update their lists of machinery, equipment office furniture and fixtures, keep a diary of all pending and past litigation, manage all regulatory compliance issues, keep track of every customer that has left or consistently update the company’s organizational chart (complete with up-to-date salaries, benefits, and job descriptions).  Owners employ people who perform these tasks and can organize these items (and the many, many more listed on the due diligence Appendices B and C).  But once owners engage in negotiations with buyers, they must find, copy, organize, and often analyze all of these items:

• Without help from their employees. (Owners often decide to keep a transaction confidential until a closing is likely.)
• On a deadline. (Time favors buyers so producing documents quickly is critical for sellers.)
• While continuing to operate their companies at peak performance.  (Of course, there’s no ideal time to experience a drop in revenues, but the period during which one is negotiating a sale is perhaps the least optimal.)

Realistically, owners working alone cannot collect all of the information on these lists.  They must rely on, at a minimum, their CFOs for help. We prefer to work with sellers to craft Stay Bonus Plans for those employees who will help with pre-sale due diligence before the process begins. (See Chapter Two for more details about these Plans.)  Once employees sign Stay Bonus Plans, owners have greater assurance that these employees will not work toward, not against a sale. 

Emotional Toll
At the risk of understating the point, owners don’t like the due diligence process.  Their reasons vary from the rational (collecting and organizing a small boatload of data demands time and energy that they could spend on their companies, their families, their hobbies, etc.) to the irrational:  “This buyer wants all this documentation because it doubts my integrity!”

A number of years ago, I represented a seller of an office equipment company, let’s call him Liam O’Malley.  We were on the eve of closing when the buyer in this transaction made a very minor last-minute request that sent Liam into orbit. “That’s it! No more!  I’ve given in time and time again.  Now they want me to pay the overnight shipping charges on documents they could have requested weeks ago!  Forget it.  I’m done.”

The history of this deal was like most:  the buyer had asked for small concessions at every stage of the process.  It was the cumulative effect of having to consider each request that aggravated Liam.  Liam’s anger had far more to do with the frequency of the requests than it did with their legitimacy.  As we reviewed each request, it was clear that this buyer had been very reasonable, and had stayed in the deal despite the fact that we had denied most of its requests. When I pointed out that pattern to Liam, his emotional energy began to dissipate.  Liam’s fatigue stemmed from the emotion of the constant exchange, not from the quality of the deal.

Generally, integrity has little to do with a buyer’s requests unless it discovers in its review of a seller’s documents something that gives it cause.  But keep in mind that buyers ask for all these documents before knowing anything about a seller.  What a buyer considers to be reasonable requests designed to decrease its risk, sellers often consider to be onerous and all-out attacks on their good character.

To bridge this huge gap of misunderstanding, we do two things with selling owners before the buyer’s due diligence process even begins.  First, we conduct a pre-sale due diligence process to give sellers a small taste of what they will endure later in the process.  In essence, we use pre-sale due diligence like a vaccine.  By injecting a small amount of the germ into healthy patients, we inoculate them against the disease.

Second, we remind owners that if they expect a buyer to arrive at the closing table with a large check for a company it really knows nothing about, they’d also better expect that buyer to do everything it can to reduce its risk of losing that cash.  Ultimately, sellers have a choice about how they manage a buyer’s due diligence.  Sellers can prepare for it, understand the reasons behind it (reducing the buyer’s perception of risk) and pocket a sizeable amount of cash at closing.  Or, sellers can resist or refuse buyers’ reasonable requests and subsequently pocket much smaller amounts of cash at the closing table—if they even get that far.

It is a transaction truism that buyers who are not confident in a seller’s representations or who cannot verify the seller’s claims bring less cash to closing.  They may (or may not) pay the same amount as a confident buyer, but wary buyers shift much of the purchase price into earn outs.  The lower the confidence level the greater the earn outs and the amount of time that must elapse before they expire.  (Please see page ___ for more information about earn outs and how they work.)
           
Unfortunately, sellers often ignore my reminders, warnings and explanations as did Joseph Ritter (a fictional name for a real seller). 

I met Ritter in May of 2010 to represent him in the sale of his $25M hunting goods wholesale company.  At our second or third meeting, I told Joe that the documents I needed to prepare the Deal Book for his company and to conduct pre-sale due diligence would pale in comparison to what the buyer would ask for when it conducted its due diligence.  Joe assured me that this wasn’t his first rodeo and he’d do just fine.  When I tried to share the same insights into due diligence that I do in this Chapter, I could see Joe had tuned me out, so we moved on.

Six months after that conversation, I learned that Joe’s previous “rodeo experience” of selling several homes didn’t prepare him for the buyer’s multiple requests for documents or for the size of his attorney’s bills (reflecting the amount of time spent collecting and organizing those documents). Having expected the sale process to resemble a sale of real estate, Joe interpreted each buyer request as an attack on his integrity.  He grew so agitated and obsessed with the process that while his wife threatened divorce, his son in the business quit.  At Joe’s Thanksgiving dinner that year, there was tension in the air and several empty chairs at the table.

Competitive Intelligence Gathering
            While most buyers use due diligence to reduce their risk, and there are indeed some who use it to methodically chip away at the purchase price, sellers worry most about those rare few who use due diligence to gather competitive intelligence with no intention of closing the deal.  Sellers are so anxious about this possibility that at some point, almost every seller I’ve worked with suspects that their buyer is negotiating in bad faith.  If a buyer postpones a scheduled meeting, asks for additional data, or sends an unexpected representative to a meeting, sellers often interpret those actions as proof of the buyer’s nefarious intentions.

            If sellers allow paranoia about a buyer’s intentions to take root and to color all of their decisions, their resulting behavior will drive the buyer away from the transaction.  If they are not careful, sellers can easily create self-fulfilling prophecies.

            Years ago an owner retained me to sell his company.  When we discussed possible buyers, he named one company that he demanded be struck from the list.  Given that this buyer was much larger, active in the marketplace, deep pocketed and had reason to acquire this seller’s company, I asked him for his reasons.

            He had two strongly held convictions.  First, the owner knew that this buyer only paid for its acquisitions in shares of stock.  Second, the buyer’s CEO cheated at golf.  While I respected this owner’s wishes and pursued other buyers, this buyer fit our target buyer profile so well that I decided to test the owner’s beliefs.

            Within a few weeks I played golf with the “cheating CEO.”  During the round I learned that this gentleman did not cheat at golf.  While playing casual rounds like ours, he did take free lifts out of the rough, but only after asking if I minded and only when there was no bet on the hole. I also learned that this CEO had recently changed his company’s acquisition policy from paying for acquisitions in stock to paying for acquisitions in cash.

            Had I let this owner’s beliefs about this CEO and his company color his judgment we would never have sold this company to the “forbidden buyer” for top dollar.

Buyers entering into negotiations as a cover for collecting competitive intelligence is a rare phenomenon, but it does happen and it is your investment banker’s job to protect you from these unscrupulous buyers.
In my practice, we protect sellers by releasing information to buyers in carefully considered and measured doses.  We continually test the buyer’s intent and sincerity, often requiring the buyer to spend money and to meet tight deadlines in order to stay involved in the transaction.  As we release increasingly sensitive data to the buyer, we may require it to agree to financial penalties if it fails to close.

Most importantly, we watch the buyer’s behavior.  Is it continuing to commit additional funds to the process and is it meeting deadlines. If it is, perhaps the seller’s paranoia is misplaced.  Of course, we routinely remove sensitive information from documents (such as customer names, or gross margin data) and use creative ways for buyers to access the information they need without jeopardizing the seller’s confidentiality (such as allowing a buyer to use a third party to interview the seller’s customers). Still, if something just doesn’t feel right, we can create a specific and separate non-disclosure agreement for a particular document or set of documents.

Constantly, but less formally, before we release any document to a buyer we think about how we can prove that this buyer received the information.  We imagine the buyer testifying that she couldn’t have used the information at issue because she didn’t know it.  For that reason, my firm uses elaborate systems to ensure that we can prove the buyer has received exactly what we have provided it. For a more complete discussion of confidentiality, please see Chapter Ten.

The Due Diligence Beast
Let’s consider the current weight and heft of the due diligence beast. I urge you to review the Legal and Financial Due Diligence List and the Management System Due Diligence List (Appendix B and Appendix C, respectively). Until early 2010 we did not see lists of this size in the middle-market range. At about that time we entered a buyers’ market, and buyers began to take advantage of their leverage to ask for more complex and larger-than-ever amount of data.

During the boom days of the M&A cycle, (2004 - 2007) buyers were in a frenzy to close deals.  Many failed to think about, much less carefully analyze economic cycles, or predict integration issues.    As a result, many big buyers were burned at least once, and some were burned quite severely.  With that not-so-distant experience in the back of buyers’ minds, sellers who are lucky enough to attract a buyer without its own battle scars, should expect that buyers are quite familiar with one or more stories of “Good Deals Gone Bad.”

Another fuel feeding the growth of the due diligence beast is the new economic reality for law firms.  As companies bring more legal work in house or use contract employees for specific projects, or employ sophisticated software to sort and analyze mountains of documents, law firms now operate in a contracting and highly competitive environment.  While many have responded by reducing the number of new hires and steadily lowering salaries for new associates, firm demand more and more billable hours from those associates.  (According to the Yale Law School Career Development Office, the demand for billable hours ranges from 1700 to 2300 hours per year.)  What better project to amass billable hours than to create new and more complex requests for due diligence documents?  More altruistically, attorneys can (and do) argue that their increasingly complex due diligence requests are designed to help their clients avoid “bad deals” and ultimately, save their clients more than they spend.
Law firms aren’t the only professionals at the due diligence table.  Buyers use accounting firms to request, review and analyze all of a seller’s financial documents. (See Appendix B for a list of financial documents.) But the newest players in the due diligence game are management consulting firms.  Buyers retain these experts to analyze all of the operational data of a company. Under the operations umbrella we find:  human resources (recruitment, training, benefits, overtime hours, etc.), customer retention and warranties, supplier/vendor selection, contracts and rebates, sales and marketing, manufacturing capabilities, shipping, pricing strategies, market surveys and environmental issues.
For all these reasons, today sellers negotiate with buyers who accept nothing at face value, and who have legions of motivated experts to help them turn over and look under every rock.  Today, buyers often demand documentation to the invoice level and are willing to pay handsomely for the assurance doing so offers.

In a recent $15M transaction, I estimate that the buyer paid at least $500,000 to its team of due diligence experts. While that dollar amount may give you an idea of the scope of the due diligence project, consider also the firepower of the buyer’s representatives.  Its due diligence team was made up of a Big Four accounting firm, a Wall Street management consulting firm, and one of the biggest law firms in the country.

With players of that caliber across the table, we do everything possible—before starting the sale process—to ready a seller’s company and to prepare its owners for an extensive due diligence process.
The buyer’s cost for conducting due diligence illustrates how buyers also incur expense if they fail to close a transaction.  Buyers often part with significant amounts of cash to pay the fees of their high-power due diligence teams. This level of financial commitment can indicate a buyer’s seriousness of purpose, and may mean that it is less likely to walk from the deal.  This may be small consolation to the harried seller on the receiving end of these due diligence lists, but if sellers step back a bit to see the big picture, there is some comfort in negotiating with a buyer who comes to the table having spent money to get there.

If this description of the due diligence beast does not keep you up at night, consider one additional recent development.

You, Too, Can Help Launch Your Buyer!
Armed with leverage and a battalion of experts, buyers’ due diligence requests no longer simply reflect the buyers’ need for documentation.  With greater frequency, we see buyer requests that indicate a desire to involve sellers in launching the new enterprises.   Buyers are asking sellers to lend their expertise to integrating the two enterprises, or to initiating the process by which the buyer intends to make more money than the seller ever did.

In one buyer’s attempt to pick a seller’s brain about how it (the buyer) could make more money, the buyer made the following request:  “Estimate the equipment costs necessary to start manufacturing in house those products that are currently outsourced.”

While you might be tempted to categorize this request as over-the-top, first realize that to buyers, there are no over-the-top requests.  In their minds, everything they do during due diligence is designed to minimize risk.   Second, in making this request, the buyer has offered us an insight into its post-closing strategy.  This buyer is looking for ways to combine its manufacturing capability with the seller’s, or thinks it can, through this acquisition, reduce its overhead.  That’s a critical piece of information that an investment banker can use to resist a buyer’s efforts to gain concessions from the seller.

            In other transactions, a buyer may seek to reduce duplicate personnel expense so it will likely ask detailed questions about people in management positions, their experience, duties, strengths, salaries, and benefits.

            The key question here is how do we navigate the very thin line between reasonable requests—those that reflect what a buyer needs to know—and less-than-reasonable requests—those that reflect what a buyer wants to know.  If you work with a skilled investment banker, he or she should be able to distinguish between the two types of requests.  We’ll talk more about this distinction in Chapter Nine.

THE CASE FOR PRESALE DUE DILIGENCE
            If the arguments on the last few pages about the emotional side of due diligence haven’t already convinced you of the value of pre-sale due diligence, let me make my case for the measurable benefits of pre-sale due diligence.  As a non-negotiable part of the Proactive Sale Strategy, I guide my clients through this dress rehearsal for due diligence for several reasons:

• Before entering the marketplace, I want to know if the seller’s company harbors any outright deal killers or deal cripplers that will lead to seller concessions.
• Collecting and organizing the data a buyer will ask for in advance of the sale process saves the seller time during the process.   Once the sale process begins, time favors the buyer and I want to minimize the buyer’s advantage.
• In addition to minimizing the risk of not closing and maximizing sale price, the pre-sale due diligence process provides a great opportunity for both me and for the owner to see how the other operates. 

Deal Cripplers and Killers
            Deal killers are issues that make your company un-saleable.  Deal cripplers make it un-saleable at its maximum price.  Killers can be the process you’ve used for years to account for inventory or your company’s dependency on a single or unstable customer.  A killer might be one significant environmental issue or your company’s participation in a wounded industry.  (As I write this book, the homebuilding industry comes to mind.)

            Some of these killers might be downgraded to cripplers if we can negotiate adequate safeguards for the buyer.  Buyers generally equate “adequate safeguards” with significantly lower purchase prices, but occasionally (depending on the nature of the deal crippler) buyers will demand other concessions, including that more cash be put into escrow.

Seller Concessions
At this point, let’s pause for a moment to talk about the types of concessions buyers will demand in their quest for certainty about the quality of their acquisitions.  Using the due diligence process, buyers solicit every possible morsel or chunk of information that they believe will minimize their risk in buying companies they know little about.  Sellers want to protect information and get maximum prices for their companies.  Between these two positions is a great deal of room for negotiation.

            So, let’s assume that, through due diligence, a buyer learns that your company is dependent upon three major customers for 75 percent of its sales.  Is this issue a deal killer (end of the transaction), a deal crippler (reason for the buyer to reduce its offer) or can it be handled so that the buyer stays at the negotiating table with the same offer?  In this case (and many others like it) my task is to assuage the buyer’s fears using several negotiating tools.

            First, to manage a buyer’s concerns, we might negotiate a form of deferred payment:  a promissory note (held by the seller), an earn out, or some sort of royalty.  Depending on the circumstances (the needs of both seller and buyer and the issue at hand), we may agree to convert a part of the purchase price from cash to a promissory note—guaranteed or un-guaranteed—payable to the seller as certain conditions are met.  The conditions of the note and all of its terms (payments, dates, interest rate, etc.) are negotiable as well.

            Second, we could construct earn outs that are payments that a buyer makes to a seller if the company meets predetermined performance goals after the closing.  Generally, earn outs relate to certain sales or profit levels and are used when the seller predicts (but hasn’t yet experienced) relatively new or significant growth.

            Third, we might choose to use royalties to give a buyer more confidence in seller’s estimates of its company’s future performance.  If a seller’s Profit and Loss statements do not clearly or satisfactorily illustrate to a seller how it makes its profits, a buyer may prefer to pay the seller a royalty on each widget it sells after closing than to dissect each line of the seller’s P&L.

            Finally, we might offer to put a negotiated portion of the purchase price into an escrow account held by a neutral third party (usually a bank).  We would negotiate each term of the escrow agreement until we reached an agreement both seller and buyer judge to be fair and reasonable.

            Each technique (deferred payments, earn outs, royalties and escrow agreements) is simply a tool we use to bridge the gap between the seller’s desire for a fair purchase price and the buyer’s desire to get what it paid for.   And each tool is subject to extensive negotiation between the two parties.
When we give an owner a range of possible purchase prices early in the Proactive Sale Strategy, the owner decides whether or not to pursue a sale.   During the due diligence process, the owner again decides whether and how to comply with the buyer’s requests for information.  While many owners expect that the sale process will be difficult, if not impossible to control, understand that with a cool head and the assistance of a skilled investment banker, you can retain control of the transaction.

Time Favors The Buyer
            Another transaction truism is that time favors buyers.  The more time sellers give buyers to perform due diligence, the more time they’ll gladly take, the more documents they’ll request and the more issues they are likely to uncover.  In conducting pre-sale due diligence, we not only collect and organize many of the documents that the buyer will request, but we have an opportunity to address the issues that we uncover.  For example, if agreements with vendors or customers are not up to date, we can fix that.  If a lease does not allow a buyer to assume the lease, we may be able to renegotiate new terms.  If key employees haven’t signed employment agreements or covenants not to compete (if applicable and enforceable in the seller’s state), we can see that those are created and signed. 

            If sellers wait to perform these tasks (and many others like them) until due diligence begins, the process slows to a snail’s pace.  It helps to recall that the buyer’s due diligence process does not commence until the terms of the sale  (including purchase price) are set and that purchase prices are upward inelastic.  No buyer increases its offer based on what it finds in due diligence, but many, many buyers reduce their offers.

Retrading
            So many buyers use the data that they uncover during due diligence to reduce the purchase price that we have a name for the process:  re-trading.  Operating under this strategy, buyers use their high-powered magnifying glasses to locate as many issues as they can that, they contend, reduce the value of the company.  Typically, the buyer says something along the lines of, “This is so, so unfortunate, but we just discovered that your biggest customer doesn’t tie his shoes correctly.”  (Okay, I admit that this is an exaggeration—but not a large one.)

After emphasizing how distressed they are to learn of this devastating flaw, they reassure the seller that because they are such good guys they are willing to stay in the deal, but they (regretfully) are forced to reduce either their purchase offer or to reduce the amount of cash they’ll pay at closing (allocating more to post-closing earn outs).  From this moment on, buyers opportunistically chip away at the purchase price and secure better terms from owners who have already dreamed about how they’ll use the original purchase price.

Here’s how one owner faced a buyer who engaged in aggressive re-trading.
Siegfreid Applebaum owned a mid-size fruit and vegetable processing plant in South Carolina.  He’d inherited the business from his father, but his sons had left the business for careers in opera and sports so Siegfried decided to sell.

Siegfried and his investment banker had engaged as a buyer, one of the country’s largest frozen and canned food producers.  The buyer’s representatives had tendered a Letter of Intent offering Siegfried five times EBITDA for his $2M company.  One week after happily accepting this offer, Siegfried’s stop-shop agreement took effect as the buyer dove into the due diligence process.

And that’s when the phone calls started.  The first had to do with Siegfried’s contracts with his growers.  The buyer decided that because they were “too loose” it would pay x% of the purchase price as an earn-out payable to the seller one harvest after closing—if the growers continued to work with the new owner.

The second call came from the buyer’s accountants:  unfortunately, they’d discovered that Siegfried’s company’s financials were not in compliance with GAAP (Generally Accepted Accounting Principles).  They had restated Siegfreid’s company’s earnings according to GAAP and the newly calculated earnings were significantly lower than those Applebaum’s accountants had provided.  Of course, the buyer would “correspondingly adjust” its purchase price.

The next call was related to Siegfried’s three key employees:  without employment contracts and covenants not to compete, the buyer couldn’t be assured that these three would stay with the company once it took the reins.  The buyer was willing to stick with the adjusted purchase price, and rather than walk from the deal, it would settle for allotting another percentage of the purchase price to an earn out payable to Siegfried one year and two years after closing—assuming, of course, that the key employees stayed with the new company.

Siegfried’s investment banker was in over his head.  Had he done his research, he would have known that this re-trading tactic was a favorite of the chlorophyll colossus.  Since he hadn’t conducted pre-sale due diligence, he allowed a buyer to take his client by surprise and had lost considerable negotiating leverage.  In the end, these avoidable mistakes cost Siegfried a third of his purchase price.

Sellers should expect every experienced buyer to set the stage for re-trading.  But before you think that if you reach the closing table without a reduction in purchase price you have won the war, let’s talk about a strategy buyers use to reduce the price after closing.

Post-Closing Adjustments
Before negotiations begin, some buyers set up price-reduction strategies that kick in only after closing.  In order to fly under the seller’s radar, a buyer must understand the seller’s financials better than the seller does. It is not rare or unusual for buyers to outsmart sellers in this way.

A buyer who plans to execute a post-closing adjustment strategy will enter the transaction with a highball offer in its Expression of Interest (or even in its Letter of Intent) confident that it can recoup the portion of its purchase offer that exceeds what it wanted to pay.

            Let’s look at how one buyer used a post-closing adjustment strategy against a seller.
Sandy Simms owned a chain of three popular barbecue restaurants with an EBITDA of $1 million. One day an intermediary representing a well-known hospitality group expressed interest in buying all three locations and asked to see Sandy’s financials. Two weeks after their first meeting, the buyer sent Sandy an Expression of Interest offering four times EBITDA (an attractive multiple in the restaurant business) and Sandy was confident she could get full value for her life’s work.   She pursued negotiations without the guidance of an investment banker and without paying much attention to the last phrase in the buyer’s offer, “Four times EBITDA as defined by GAAP (Generally Accepted Accounting Procedures.”

What Sandy didn’t know, but the buyer did, was that her company’s EBITDA was not $1 million, but rather $500,000. After closing, the buyer successfully argued that Sandy’s EBITDA was $500,00 and, in the end, Sandy received the promised 4x multiple but only on $500,000 instead of $1 million.  Had Sandy known that she’d end up with “half a slab,” she never would have entered negotiations.

In another common post-closing adjustment strategy, buyers who understand that sellers’ earnings are overstated will insert language into the definitive Purchase Agreement that can be, and is, often overlooked.  The hidden landmine reads something like, “If during the post-closing adjustment period the Company’s earnings fall short of Seller’s representations, Seller will pay Buyer $5 for every $1 of degradation.”

Is it hard to believe that a buyer would have the chutzpah to attempt to slip this kind of language by a seller?  It happens all the time.  Professional buyers know that even attorneys don’t always read the fine print carefully.  When buyers plan to use this or any post-closing adjustment strategy, they often employ Big Four accounting firms so that there is no question about the CPA’s credibility.  They know that few sellers have Big Four accounting firms in their corners.

In either post-closing adjustment strategy, the buyer knows more than the seller about the seller’s business and lies in wait until after closing to take its pound of flesh.  When re-trading, buyers rely on the stop-shop agreements that prevent sellers from negotiating with other buyers for the leverage they need to begin whittling away at the price.  When this happens, the seller’s only means to halt the downward purchase price spiral is to withdraw from the deal entirely.

An experienced investment banker can help sellers to avoid or limit the impact of stop-shop agreements. (See Chapter Ten for a more complete discussion of these agreements.)   If a seller’s company is in high demand, the investment banker may negotiate a stop-shop out of the deal completely.  But in most transactions, buyers demand—and receive—stop shops so the investment banker must limit the seller’s vulnerability.  While there are a number of ways to do so, perhaps the most effective technique is to insert a number of carefully placed hurdles into the agreement.  These hurdles can take the form of a date by which a task must be accomplished or additional funds that the buyer must commit to the transaction.

The most rigorous hurdle states that if the buyer attempts to change the terms outlined it its Letter of Intent, the stop-shop agreement ceases to exist.  This strategy is only effective, however, if the buyer believes that there are other buyers at the table.  If the seller has not retained an investment banker, buyers know that there are no other buyers.

More common hurdles are those that hold the buyer’s performance to a schedule.  For example, once the stop shop agreement becomes effective, the buyer has three weeks to draft its Definitive Purchase Agreement.  Three weeks after that date, it must provide to the seller a Financing Commitment Letter and three weeks after that it agrees to have completed, or to waive, due diligence.  Motivated buyers do not want to miss these dates if they think they are competing against other buyers.

Again, use your investment banker to help you navigate the stop-shop agreement, but also to steer clear of the common and completely legal and (in the M&A world) ethical) re-trading strategies.

A Preview of Behavior
            When we work with owners during the pre-sale due diligence part of the Proactive Sale Strategy, we gain important insight into how responsive they are, how they manage numerous, distracting demands, how they maintain objectivity, and most importantly, how well they maintain their cool.
            If a seller cannot organize the documents required for pre-sale due diligence or the documents are in disarray, we have three options.  Option One:  if the issues in the documents indicate that this transaction will likely fail to close, I will candidly tell the seller exactly that and we part amicably.  In Option Two, we dig deeper into the company’s records.  We bring in the company’s CPA to clean up the worst messes so we can begin to anticipate where and how a prospective buyer will attempt to blow holes in the seller’s financials.

            In a hot M&A market, we have a third option.  That is to clean up what we can today, enter the market and, knowing that the market for this company is active, deal with the issues later in the transaction.  If this is the strategy we recommend, we do so only with the full knowledge and consent of the owner.

            From the sellers’ perspective, pre-sale due diligence offers them the opportunity to evaluate how organized and creative I am (and my firm is), the quality of my associates, the issues I handle and those I ask associates to handle, and, most importantly, how I prioritize and separate the wheat from the chaff.  While we cannot predict with 100 percent certainty exactly what will be important to a specific buyer on a particular day, we can (based on years of experience and significant research into a buyer’s motives and deal-making history) distinguish between those issues that will prevent a closing, from those that will reduce a purchase price, from those that can be neutralized.

 I strongly encourage you to work with an investment banker who knows how to read between the lines of a buyer’s due diligence list to understand what plans the buyer may have for the company and what it perceives as its greatest areas of risk.  Remember our discussion about buyers using due diligence to involve the seller (and his or her expertise) in launching the new venture?  Well, a good investment banker will have a wealth of experience in distinguishing among those issues that will derail a transaction from those that will cause the buyer reduce its purchase offer from those that can be neutralized or managed.  There are no transaction truisms that govern the thin and ever-changing line between each type of issue so sellers are dependent upon the expertise and negotiating abilities of their investment bankers.

Taming the Due Diligence Beast
Pre-sale due diligence is the best way to:
1.  Identify, and address a company’s problems before buyers take the opportunity to use those problems to gain concessions from the seller.
2. Introduce potential sellers to the much, much more rigorous process they will undergo once a buyer is engaged.
3.  Maintain deal momentum in favor of the seller once the transaction process begins.
4.  Remove some of the heat from a process that, for most sellers, is emotionally fraught with misunderstanding.   Sellers who understand why buyers request the information they do are better prepared to survive the process, arrive at the closing table, and take home a maximum amount of cash (rather than sit waiting for the new owner to pay earn outs based on performance under its ownership).

We take sellers through the pre-sale due diligence process before we proceed to Step Three of the Proactive Sale Strategy: Identifying and Preparing Buyers.

Prescription for Sanity
            Appendices B and C are two generic due diligence lists: the first is a hybrid of legal, financial and tax matters and the second covers management issues.  If you haven’t done so already, I encourage you to take a look at each and—as difficult as it may be—to continue to breathe normally as you do so.  Keep in mind:
1. These lists are generic.  A professional buyer will ask you these questions and more related specifically to companies in your industry.
2.  There are no “as is” sales.  Buyers don’t buy companies “as is” and yours is no exception.
3. As a rule of thumb, a buyer who is purchasing the stock of your company will be more thorough in its due diligence than will be a buyer acquiring only assets.  But that’s only a rule of thumb.
4.  Every item and every clause of every item on a due diligence list is negotiable.  It is critically important to hire an investment banker, an accounting firm and a law firm that know how to clear away the unnecessary clutter and negotiate paths through this maze of requests.
5.  If you hire the right advisors, you are not helpless in the face of these due diligence requests.  The skilled investment banker will be an expert in the art of how to disclose and when to disclose information.