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 and 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:
1."That is the normal way transactions are done", acquirers often state to defend their proposals.
2.Prior sellers' boasts about the transaction price their company commanded.
It should be obvious that an individual who sold his 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 they will be a source for actual deal pricing.
The Impact of Timing on Deal Prices
There is an incredible consolidation taking place in many industries. The quantity and pace of the acquisition frenzy is unlike any in the past 20 years. 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.
In 1996, my firm represented a heating and air conditioning equipment distributor on the West 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 their offer and justified the validity of our price, I stated they could make a very attractive return on investment at my transaction price. The acquirer's cfo stated that they could buy many companies at a much lesser price. He further stated they 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. Subsequently, in late1996, this distributor was sold 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 price.
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.
In 1994, 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 acquirer adamantly maintained that his best price was $11 million. We terminated discussions. In 1996, the same plumbing distributor decided to actively pursue the sale of the company. At that time, its earnings were less than in 1994. In spite of this, the public company that had approached them originally now raised its offer to $12.25 million. I indicated that was not adequate.
Two weeks later they raised their 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 deserves. It is necessary to have expert negotiating skill on the selling owner's side, if he wants the leverage necessary to produce a realistic premium price.
Letter of Intent Discussion Points
It is my firm's 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 every bit 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 to be reasonable, it is likely that the deal will be successfully consummated. This reduces the risk of an uncompleted deal, before an acquirer begins their comprehensive due diligence process. This is important as that process often disrupts the seller's company.
The Critical Financial Impact of Non-Financial Issues
When a middle market company (transaction price up to $100 million) is bought by an acquirer, 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 utmost advantage. If a selling owner would only stop to reflect, he 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 that 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 structure deals with representations, warranties and indemnifications that conform to the "norm." However there are sophisticated acquisitions 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 knew nothing about when the deal was closed. In middle market acquisitions, that is the "norm."
This violates the overriding principle of capitalism, which is "those who take the risks get the rewards." The principle is not supposed to be "those who get the rewards don't accept any risks." In most mid-sized acquisitions the latter statement is how an acquirer wants it to be, and it is what they are used to getting. It is up to your financial advisor to stop them. 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. The acquirer never shares unanticipated gains 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. Likewise, a selling owner could lose up to or in excess of the total deal proceeds due to the post-closing discovery of unknown liabilities and he would be unable to work in the 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" reps, warranties and indemnifications are agreed to, 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/her exposure, they retain full responsibility for these issues potentially for many years after the acquisition is completed. The seller is not only responsible to the claimant but also to the acquirer as an indemnified party.
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 product liability area. 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 reps, warranties and indemnifications, along with other protections that the seller should put in place. The only liabilities which the seller should be responsible for are those of which they are 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 they have to an acquirer. A satisfactory environmental audit should be all the security that an acquirer needs to adequately assure themselves that the property(s) are clean.
Accounts receivable: 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 his exposure for bad accounts receivable during the due diligence process before closing. If he has any significant collection exposure, it should be negotiated as a deal price reduction before closing. In no case should a sophisticated seller 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, this 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, they should remember that negative developments from poorly-structured deals can place them 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 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 liability.
George Spilka, who has written previously for ID Access, is president of George Spilka and Associates, a Pittsburgh-based merger and acquisition consulting firm that specializes in middle market, closely-held corporations. His website is located at www.georgespilka.com