For most CEOs of entrepreneurial companies, selling the company is one of the most important and critical events in their lives. Most are not as experienced as potential buyers are. Many CEOs in this situation, and especially in companies that may sell in the $5MM to $50MM range, believe that there is an essential symmetry between buyer and seller than can be managed. They also may have expectations about other aspects of the process that underlie their actions in managing the transaction.
In reality, selling a private company to a (usually) much larger and better-financed buyer is unbalanced and most often heavily weighted on the side of the buyer. If the selling CEO relies on the belief that the process is inherently fair and symmetrical, they do so at their peril.
The reality – as opposed to the beliefs and assumptions - of the way the process actually works can be very expensive tuition for sellers without deep experience in selling companies.
CEOs think that if their business is valuable enough, (this might include factors like being in a hot industry, fast growth, good earnings, and so forth), these factors will greatly contribute to establishing and maintaining symmetry between buyer and seller.
They also often have an expectation of essential fairness in the process.
These factors – symmetry and fairness - lead to an expectation that they can manage the transaction and produce a good outcome, and therefore the process itself becomes relatively less important.
Some CEOs think that the factors that help establish this symmetry and fairness include:
1. The existence of a set of valuation rules of thumb that are more or less available and set brackets around expected values for sale of their company in an industry.
I know before I begin what the expected returns are, and therefore the need for getting more than one solid offer isn’t really necessary.
2. A fairly robust set of buyers ranging from “strategic acquirers” in adjacent industries (in a variety of sizes) to financial acquirers, some of who are rolling up companies in the industry and most of whom are ready for this transaction.
I can pick and choose my potential candidates based on factors I perceive they have and are important to me. (i.e., location, price and terms, ongoing control, etc.)
3. A set of reasons why the entrepreneur’s particular company is obviously worth top of market multiples based on a set of obvious, if non-quantifiable, factors.
After I have selected my preferred acquirer I can talk the price up to what I want it to be. And based on my rules of thumb, I already know what it will likely be.
4. A belief in the basic fairness of the process itself. This sometimes includes assumptions about boundaries, truthfulness, integrity, and so forth.
I know this is a big boy game. However, acquirers won’t deceive me, or use “unfair” tactics because they want a future relationship with me, and if they did I’d just go back and find someone else on my preferred list.
5. The existence of a finite, but large, group of alternatives that will prevent the entrepreneur form having to accept less than “good” terms and conditions in a transaction.
I am sure I could generate more cash from investors if this doesn’t meet my requirements.
6. The belief that although the CEO has a “fixed number” in his head (from #3), he can successfully resist revealing it. Other parts of the process are apparent and therefore intermediaries are costly and often unnecessary.
I can run this process myself, be at the negotiations, and because we have symmetry and fairness an intermediary won’t add much value.
7. A worry that talking to “too many” people or considering very many alternatives can somehow lead to a less than good outcome.
I will limit the number of acquirer candidates to those I pick but won’t tell them I’m doing it. I can always generate more if I really need to – but if they meet my number I won’t have to. And anyway I always have more alternatives.
What buyers know:
1. Buyers have run the process many more times than sellers. They recognize many of these signs.
2. The buyers also know the basic rules of thumb, and most certainly have more information about the details than the seller does.
3. Time is the seller’s enemy but the buyer’s friend as few sellers have the cash to survive a long, convoluted process. Running the clock is an important strategy. Buyers can:
- Impose long diligence processes that distract employees, take time, and potentially destabilize the company.
- Build relationships that apparently are sincere and in the process apologize for the bureaucratic process.
4. Getting the seller’s number is an important, even critical, need.
5. Making an initial bid higher than the seller’s number may lead to negotiating leverage for exclusive negotiating periods or other types of in-process agreements.
6. Disconnecting the seller from his board or advisors through a variety of methods always works to the buyer’s advantage.
7. A seller with a lawyer who has conflicted feelings about whether he represents the CEO individually or the selling company is a gift to the buyer of great value.
8. If the seller has an intermediary, and if it is someone whom the buyer knows, it is a benefit to the buyer. They’ve seen the intermediary work before and know generally what to expect. This includes how hard they’ll work, whether they are easy to disconnect, and how much business the buyer has done or will do with them over time.
9. If the seller has no intermediary, many of the common buyer tactics will work better because they’ll probably be new to the seller.
10. The buyer knows what other companies are selling and how well managed they are. This gives the buyer more leverage in that he knows what other companies might sell for and which he could get for a bargain based on poor cash management on their part. He can generate “competing” opportunities to force the seller to make price concessions.
10. The buyer knows that If the CEO and his team wish to stay, the buyer can make side offers to management that disproportionately pays the proceeds to them. This may include after sale bonuses, options, and other forms of incentives.
Of course, it is true that there are cases where the seller beliefs hold true. If it is a very hot, competitive market and the selling company is the most attractive available, or in the group of best companies in the sector; if buyers waive their diligence discipline in favor of getting a deal done; and if they pay, on the basis of comparables, very top dollar. But it is not very often.
In a more typical narrative, the buyer has decided that his company wants to acquire a leading company in the sector and has targeted the seller’s company. However, the buyer would like to pay a lower than market price and get risk reducing favorable terms. In some situations the buyer is an employee and his economic incentive is not connected to long-term success, but rather to short term deal outcome measurements.
One of the first things a buyer wants is to eliminate other potential buyers and add time to the completion of the deal to be able to gain more control over the transaction.
This control allows the buyer to work the price down and impose new terms as seller’s options are reduced and the process imposes difficulties on the company, often in the form of diligence requirements.
This elimination of competition may take several forms. Buyers have more perfect knowledge of their competition and what they may be doing. They see many offering memorandums from sellers, have years long connections in competitor firms, know many industry analysts and see trends and strategies in their industry every day. They will know which competitors might also be potential buyers and will work to minimize their impact through exclusive negotiating period requests, joint development agreements, and the like.
One common method to keep other buyers from entering the process is to offer a top of market price and then ask for an exclusive negotiating period of many months.
When this happens, the buyer then begins a diligence process that is time consuming and expensive.
As it plays out, the seller’s company can get into cash trouble, especially if financial statements are made available to the buyer, giving them knowledge of how long to stall. During this period, if the buyer can gain information about the seller’s other alternatives, and more detail about selling stockholders interests, this leads to price adjustments unfavorable to the seller. And all the while other potential buyers have been eliminated by agreement!
Can The Seller Get More Financing? Do They Need It?
Another factor buyers consider is the need for and probable availability of new capital for the company. More cash enhances seller alternatives and diminishes buyer power.
Buyers know the venture firms in an industry and have very good access to current trends. (Some may be limited partners in some of those venture firms!) They understand how important a single company's performance is to the current investors. They will know if the seller's venture investors are raising a new fund and desire to maximize exits in the near term.
They will seek information about the seller’s stockholders and try and assess their appetite for more investment. As part of this process, they’ll look at cap tables, stockholder agreements, the timing of any redemption rights, and any signs or signals of seller stockholder dissatisfaction. If they believe that new capital is a potential problem they will proceed very aggressively in their price and terms discussions.
Using Time to Work The Price Down
When sellers have agreed to a price in exchange for an exclusive negotiating period, buyers use the time to find items in the diligence process to adjust the price downwards. This can include updating financial performance, introducing new terms based on discovery in the diligence process, using knowledge of the CEO’s number to threaten to walk away and so forth. This is almost a universal occurrence in the transactions I’ve seen.
The Joint Development/Engineering/Research Agreement
In some situations, the buyer offers some sort of joint development agreement, which promises to provide cash and expertise, as a first step toward completing an acquisition. In every instance it includes provisions about “jointly developed” intellectual property and products. These provisions present hugely onerous future economic barriers to selling company independence and usually have the effect of capping the eventual selling price. They also give the buyer a long look at the company and transfer risk from the buyer to the seller with no economic reward.
Buyers will try and sell these to the target company with cash payments, promises of access to markets, and so forth. At the same time, the buyer may ask for a buy-sell agreement that amounts to an upside cap.
(I recently was told about a company discussing a joint development agreement with a large potential acquirer. The terms amounted to a sale of the company, since the entanglements proposed included control over jointly developed IP, market distribution exclusives, carve outs and other terms that would make it impossible to remain independent. I heard they walked away from the deal and are doing just fine.)
As buyers try and force the price down, they sometimes offer additional milestone payments as a way to pay less at closing. These milestones mean that future payments to sellers are not guaranteed and are contingent upon achievement of certain goals.
In some industries this is standard and well known. Often buyers count milestone payments when describing selling prices and inexperienced sellers will also. The reality is, of course, that they aren’t guaranteed and are a way to transfer risk to the seller.
In addition, if milestone payments are divorced from rewards to the management team that is staying, and if the metrics underlying them are (almost always) controlled by the acquirer, they often are never going to be paid.
(These are common when selling companies that are development stage, such as in medical devices or pharmaceuticals where they feel more justifiable and are backed by long industry precedent.)
In any variation of these, the buyer is working to force the price down and transfer future risk back to the seller.
Splitting management from stockholders
If management wants to work for the company after the acquisition, and if the buyer wants them, the buyer may try and allocate some of those proceeds to the manager/entrepreneur disproportionately for the selling stockholders.
Without canny intermediaries some buyers may choose to try and hide these from selling stockholders not associated with management of the company. See footnote for an example.
Disconnecting Intermediaries and Advisors
Some buyers will try and open a direct channel to the seller and disconnect intermediaries or advisors or force them into a minor role. Inexperienced entrepreneurs can be drawn into this trap easily. It is an ego boost, of course, and they can feel as though they are in control. It is much better, in my opinion, if the CEO adopts a position in which whomever is talking to the buyer, even on those occasions when it is the entrepreneur, explicitly communicates that there is an other overseer somewhere who has to be consulted for decision-making. This may be a board, other investors, etc.
Buyers who believe that they can talk directly to the decision maker will attempt to gain concessions in real time conversations and use these in subsequent negotiations to work the price and terms to where they want them.
A buyer may perceive that the CEO’s attorney really represents the CEO first and the company second. Given this opening, it is much easier for buyers to propose “side deals” that favors the management team disproportionately to their ownership interest. Any disagreements between management and stockholders caused by this tactic simply bolster the buyer’s position.
So What To Do?
When the seller finds himself in this corner, the only alternative left is often to just say NO. But most of us resist that because it’s disagreeable and works against the relationship we think we’ve built with the buyer. It’s much better not to get there in the first place.
- Use an intermediary. Expert intermediaries should have very good knowledge of the market and be able to identify buyers and their appetites and risk profiles as well as their typical deal terms. They make money by getting better prices and terms for sellers. One major component of their process is to bring multiple buyers to the table and add their expertise to help balance the relationship between buyer and seller.
- Have an alternative financing method before you begin the process. Easy to say and sometimes hard to do. If you want to applaud you need two hands because the sound of one hand clapping is ineffective. So to here. If you must enter into the transaction process needing to sell, make sure you have experts who know the process – and listen to them.
- Plan for diligence. Know in advance what you will need; be as over-prepared as possible. Don’t be afraid to draw a line about what you will and will not do in the diligence process, especially if you have alternatives – real ones, not bluffs – that you can fall back to.
- Don’t get overcommitted. Use a group of trusted advisors not limited to your lawyer – to reality check your process and your situation. Continue to keep in mind that the buyer does want to buy and that it may be hard to resist some of these tactics, but in the end it’s a transaction first and a (possible) relationship second.
- Have the courage to allow yourself to believe that what appears to be negotiating tactics really are. Act on your knowledge.
All of this underscores the probability that the expectation of symmetry and fairness in most seller situations is a myth. Symmetry can be achieved but only through deep experience in a process that is inherently one-sided and unbalanced.
The ultimate balance between buyer and seller is to not have to sell and be able to have good, confirmed walk away alternatives. This is usually not an easy position to get to but it pays great rewards to sellers who have the discipline and savvy to achieve it.
 (Let’s look at an example. Irene owns 35% of her company and is planning to sell her company to Bigco. Her number is $25MM and she’s communicated that to them. They have worked it down to $19MM with $3MM in milestones. This is cash of $6.7MM to Irene and $12.3MM to selling stockholders. They have proposed holding back 10% of the proceeds for three years to assure against undisclosed contingencies. This results in a cash payment to selling stockholders of $11 MM, with a holdback of 1.3MM.
Now, they have decided they need Irene for three years. They now propose to pay $17.5MM with $3MM in milestones but no holdback. (“We like you and your company and think this is fairer to your sellers,” etc.) This increases selling stockholder cash to $11.4MM at closing.
They then construct a salary and bonus program for Irene that pays her proceeds of $6.1MM 75% cash 25% in their stock, and a post closing bonus equal to $2.5MM as well as full participation in the milestones.
If you assume no milestones are paid, Irene receives 6.125MM, with a 35% opportunity for growth in Bigco stock, and an additional $2.5MM. This is a total payment of $8.625MM which is very close to her original number of $25MM at 35%.
Selling stockholders, meanwhile, receive $11.4MM for their 65% which implies a price of $17.5MM for the company.
With milestone payments, Irene’s dollar value rises to $9.6MM implying an exit value of $27.5MM. Selling stockholders receive $13.4MM and an implied price of $20.6MM.
None of this includes her appreciation rights in Bigco stock, nor the tax deferral status of that portion of her proceeds characterized as a stock swap, deferring a tax payment for her of $500,000.)