Think hard about the question, “What am I buying?” Intellectual property, especially know-how, is becoming increasingly important even in businesses not primarily service in nature. The most important element of due diligence may be dividing the mindset of key employees; first you must figure out who they are and then read their minds.
Due diligence is a critical function. The statement seems obvious but due diligence is subtle and difficult. If it isn’t done thoroughly, the buyer is operating in the dark; if it is done thoroughly, the seller may be badly hurt. (Imagine an infestation of nematodes swarming through your business talking to your employees and examining your records.) Representations and warranties in the draft P&S Agreement are useful not only for the obvious reasons but also as an aid in discovering information about the seller and the target company. It is especially important for a potential buyer to examine inventory carefully, inasmuch as inventory is seldom completely clean. A ploy that sometimes helps is for the seller to retain the inventory and buyer to purchase it on an as-used basis.
Valuation is an important exercise but usually the value thus determined is not the purchase price. The business will be bought for whatever the seller will take for it. The challenge to the buyer is to figure out how to swallow the acquisition costs in spite of the business’s problems. The buyer should focus on what he can do with the business, especially whether the cash flow will be there to support the purchase price. Remember the buyer wants to make money for himself, not just support the seller in his old age. Given the earlier remarks about the importance of emotion, it is essential that the buyer remember that he has no cure for cancer; if the deal comes too easily, look out.
Critical mistakes
A critical negotiating mistake buyers sometimes make is to aim to “win” or to try to destroy the other side as in an adversarial legal matter. A paranoid mindset, “Am I being cheated?” takes over. The result will either be no deal at all or a lopsided deal. Lopsided deals end up in court. For example, the high profile sale of Rockerfeller Center to the Japanese and the recent breakdown of relations between the seller/mortgagee and the buyer which led to the filing of a bankruptcy petition. Unless the deal is balanced, beware!
Perhaps the most common mistake made by a buyer after it has acquired the business is to give inadequate attention to the financial aspects. The average entrepreneur considers himself a perfectly adequate CFO. He is wrong. If he is an adequate CFO, he probably isn’t an adequate entrepreneur. Access to strong financial capability and the use of those talents will save many situations which otherwise would fail. Parenthetically, the computerization of the manufacturing operation, especially a perpetual inventory, is becoming an essential tool for survival. No company will survive unless it knows its costs accurately and in real time.
Negotiating
In approaching a negotiation, the first problem is determining who the decision maker on the other side is. Lots of jaw bones have been worn out in pseudo-negotiations with the wrong person.
Once the decision maker has been identified, it is important to establish a rapport with him. Unless the head of the buying group and the decision maker on the seller’s side are able to work together, the consummation of a deal is highly unlikely. At some point, a social dinner including the seller’s spouse may be an ideal way of furthering the negotiation.
At some point in every transaction, usually fairly early, it is important that parties leave the meeting with some psychological bridge having been crossed, all sides wanting to make a deal. From there one, the negotiation will take on a life of its own and be much more likely to close. Nevertheless, each negotiator must always leave the impression that he is able to walk away from the acquisition if it does not go according to his wishes. Neither side can afford to let the other believe that it is desperate. Good guy/bad guy roles are useful when negotiating as a team. Also, it helps if the real decision maker on your team is not in the negotiating sessions.
The final transaction is usually couched in a fashion that it has many facets so that it is all but impossible to determine the “price.” It is almost true that the seller’s price can always be met if the buyer is allowed to set the terms of payment. For instance, a common provision is that the patriarch’s son will be employed by the business for several years or possibly the seller will be left with a 10% interest in the ownership. Usually this latter is accompanied with some sort of call provision residing in the buyer. Contingency earn-outs based on post-closing performance are the sources of much controversy; they seem to be useful mostly as a fall back device to break an impasse.
Other important points
• Be a student of the tax law. All acquisitions revolve around taking maximum advantage of the tax laws to benefit both buyer and seller.
• Knowledge is all powerful. Know not only the law but all you can about the target company and its owners.
• Negotiate on your own turf for psychological reasons.
• Be sure to control the drafting of the P&S Agreement and other documents. While it is customary for buyers to do the drafting, if the seller can seize that function, the seller will have an advantage.
• Keep the momentum going. Deals that drag don’t close. Energy and zeal are critically important.
• It is important that the buyer have enough money not only to make the acquisition, but to run the business thereafter. If he has only 100% of the funds available, the business will probably fail as a result of unforeseen needs. If he has 200%, he will probably be about right. If he has 1000% of the needed funds available to him, his chances of failure go up again because sloppiness will creep into the operation.
Advisors/professionals
The buyer should be sure he has the right lawyer. For instance, in Massachusetts, there are about 37,000 lawyers but perhaps fewer than 5,000 are experienced in doing M&A transactions. (The other 32,000 are not interested in telling you that they are not skilled in this field.)
The seller’s accountants always oppose the transaction. The buyer’s accountants normally favor the transaction, but think that the price should be about half of what it is being negotiated. Whichever side you are on, make sure your lawyer is a skilled business lawyer and that your accountant thinks that the Internal Revenue Code is the world’s most interesting reading.
One of the buyer’s best allies can be his banker. Bankers abhor surprises, so frequent and candid communication is essential. Establishing good working relationships with loan officers has become difficult in recent years as banks have become more bureaucratic and tend to look upon customers as adversaries, irrespective of claims made in the bank’s advertising. Banks love personal guarantees because the guarantees take the risk out of the deal for them. If a banker is too aggressive in looking for a personal guarantee, which after all is a statement by the banker that he doesn’t trust the deal, take a good look at your deal to see if it is too thin so that he must have your personal credit behind the deal. If the deal seems strong enough, resist executing unlimited personal guarantees. Limited personal guarantees may be all right to give the banker assurance of your commitment when things go wrong.
Corporate business appraisers can be very helpful, but as noted above, not necessarily for establishing the purchase price of the business. Appraisals tend to be on the low side of the final price. Because bargaining power of the parties vary so widely, the bargaining power tends to be more determinative of the acquisition price than the appraisal.
Final words
Buyers normally want to acquire assets and sellers want to sell stock. Tax considerations may cause these choices to be reverses. A seller’s insistence on a stock deal need not be a deal buster because there are other ways for a buyer to protect against unknown liabilities.
As a potential buyer, watch out for the “Life Monument Syndrome.” Many potential sellers find that talk of selling the business is an ego trip, sometimes a way of keeping an obstreperous employee-son-in-law in line. If the owner of the target company is totally inflexible, the potential buyer should be ready to abandon or postpone the acquisition project.
Inasmuch as the biggest deal breaker is usually the disparity of the price between the buyer and seller, and the negotiation is usually a colloquy to bridge the difference, one approach is for the buyer to say, “This is the way I see the valuation. What do you see?” Or the buyer may respond to the seller by saying, “I have trouble with your valuation, but if you will allow me to suggest flexible terms, we may be able to get together.” Be careful how you say to an owner that you have trouble with his valuation; nobody likes to be told his baby is ugly.
