Business Sellers: Run a Good Process and Don’t Settle for “Market” Terms

December 2024

A Sub-Optimal Sale Process Can Lead to a Disappointing Outcome

After decades of helping lower-middle-market (LMM) business owners raise capital or sell their companies, we are usually impressed with the expertise, service and value experienced lawyers, CPAs, investment bankers and other advisors provide their clients. Too often, however, business owners are surprised and disappointed by a sale process that fails to achieve an optimal outcome. This is especially true for LLM businesses in the $20 million (and less) to $100 million enterprise value range.

There are many reasons for this, including:

1. The owners’ failure to:

(a) develop their (i) business (improvements, risk-management, growth and succession), (ii) personal (retirement and “third act”) and financial (lifestyle and retirement) transaction goals;

(b) engage experienced lawyers (letter of intent and purchase agreement negotiation and risk mitigation), CPAs (accounting, tax and purchase price adjustments), financial (brokers or investment bankers, and personal financial planners) and other professional advisors who can make the transaction a top priority;

(c) clearly and openly communicate their goals, concerns and the business’ strengths and weaknesses, and their advisory team role expectations early in the process.

2. The owners’, financial adviser’s or lead lawyer’s failure to coordinate key management and advisory team involvement early in the process; and

3. The advisers’ failure to:

(a) adequately educate the owners about the process, range of potential outcomes, and “market” for typical deal terms and issues; and

(b) negotiate the most favorable valuation and terms and run an efficient and effective sale process.

How an LLM Company M&A Process Differs from Smaller and Larger Deals

Smaller businesses can often achieve a good result with a business broker and their regular small business advisors because the sale transaction is relatively simple. Larger companies have armies of long-time professional advisers and deal experience. LLM business owners have unique challenges:

1. Compared to a small business sale, the transaction is usually more complicated than for a small business;

2. Their advisors often don’t have extensive M&A experience;

3. An M&A process is a major distraction from the owner’s and management’s day jobs and more work than they usually expect; and

4. Compared to a larger company, the process is more personal and emotional for company owners.

A poorly planned and executed sale process can dramatically impact the price, terms, seller risks and management of a sale process – all of which ultimately drive the value of the deal to the sellers. So, it’s critical to go to market with the transaction goals and parameters set and with the sellers and their advisory team prepared and in sync. The sellers’ leverage decreases as the process evolves from the non-disclosure agreement (NDA) and confidential information memorandum (CIM), through initial buyer indications of interest, to a letter of intent (LOI) with the winning buyer, and through due diligence, negotiation of the purchase agreement and closing. Conducting a deliberate and organized process with a calendar of tasks and milestones is critical to an optimal outcome and avoiding an “ambush at the finish line”.

Focus on the Process, and Verify and Trust Your Advisors, to Achieve a Good Result

Lawyers, CPAs, investment bankers and other advisors with the experience, expertise, creativity, bedside manner, time and capacity to run the process are obviously key. Although they work in different firms, they should be team players who together can run an efficient and effective process for the sellers. The investment banker and/or lead lawyer should usually be the “quarterback” of the advisory team and “coach” to the sellers or “owners”. Advisors should be researched and selected carefully to confirm they are a good fit for the company and its owners (and old ones should be supplemented or replaced if they don’t have adequate deal experience).

A good process and result also require that the owners and their management, and the buyer and their advisors, do their part (and the sellers’ advisers should help make this happen by outlining the process and what’s expected from all of the players). The management and advisory teams should expect a lot of work and constantly focus on telling the “best story” for the company (honestly and with full disclosure, including how to address company weaknesses and risk factors) and preserving as much optionality (e.g., delaying exclusivity, preserving “walk-away” rights) and leverage with the buyer (e.g., adequately detailed LOI and required completion dates for legal documents and due diligence) as possible. The teams’ process should always be directed toward getting the owners their bargained-for price, and mitigating the risks of business interruption, buyer re-trading, post-closing buyer legal claims, and a “busted deal”. This is the advisors’ job and, if well done, should make their fees more than reasonable for the value ultimately obtained by the sellers.

A good team should know that, especially in the LMM, every business, owner, buyer and transaction is unique and should be tailored toward a win-win for all parties. It follows that LLM company sellers should expect transaction terms that are tailored to their business and goals, and not a “suit-off-the-rack” that might be more “common” in most deals or “the way” the buyer “usually does deals”. So, when confronted with buyer statements that a particular valuation or terms are “market” or how they do things, the sellers and their advisory team should always be prepared to respond “so?” or to demonstrate why they should not settle for what’s “market”. In our experience, many material seller pushbacks are successful, and we all know that you never get what you don’t ask for. Most important, running an efficient and effective sale process, getting the key terms in the LOI before going exclusive with one buyer, and anticipating negotiations around what’s “market” can greatly reduce the risk of late-process surprises.

Knowing the “Market” and Seeking Seller-Favorable Terms (at the LOI Stage)

Once you’ve engaged the right team and planned and prepared for a well-run sale process, you and your advisors should be prepared to not settle for a buyer’s claims that certain terms are “market” or “the way they usually do deals”. To do this, your advisors should know the “market” and position your business to negotiate the most seller-favorable terms. SRS Acquiom, a leading provider of M&A transaction statistics and trends, just released its 2024 M&A Deal Terms Special Report on Lower Middle Market Deals.1 Interestingly, the report focused on deals with closing payments of $50 million or less, indicating that these smaller LLM deals make up more than 40% of reported deal volume. Below, we use some of the highlights of this report to illustrate the deal negotiation areas in which we have been successful in getting some seller-favorable terms for our clients despite opinions that they may not be “market” for a smaller-sized deal or company. A selling company’s advisors need to be familiar with these so that they can anticipate and negotiate around any statistics or trends that are not applicable to, or are unfavorable to, the sellers.

Too many LLM companies are advised that, because size matters (i.e., buyers view small businesses as more risky), the smaller the company, the less favorable deal terms they will get. We don’t believe the advisors should approach negotiations with this mindset. In fact, in our experience, the smaller the deal, the more complicated it may be in that the terms of smaller deals vary widely and are often not consistent with “normal” or “market” terms. The deal term areas below all impact the sellers’ ability to get their agreed-to price while minimizing risks, so they are as important as the initial valuation.

1. LLM Deals Have More and Larger Earnouts. Earnouts (and for that matter seller financing and even retained or rollover equity) are often negotiated to close a seller-buyer valuation gap and to reduce the buyer’s required cash to close. LLM deal earnouts have been on the rise and can range from 20% to 50% of the total deal consideration. Of course, they also reduce the sellers’ cash received at closing, so present more risk. If the sellers are forced to agree to an earnout in addition to closing cash and any retained equity stake, they should, first, press to minimize the earnout and, then, negotiate one that is revenue and not EBITDA-based, as achieving EBITDA milestones or projections will depend in large part on the buyer’s operation of the business after closing. If the sellers have to agree to an EBITDA metric, it should account for reasonable adjustments to fairly “normalize” company earnings by providing for classic addbacks. Especially for LLM companies that do not have audited financial statements, revenue or EBITDA based on “generally accepted accounting principles” should be avoided or at least adjusted or modified to more fairly reflect the business’ historical accounting practices and financial statements (e.g., revenue recognition, expense accruals, non-recurring items and capital expenditures).

The sellers should also demand ongoing buyer reports on the earnout progress calculation during the earnout period and a reasonable opportunity to dispute any calculations or nonpayment of the earnout. And they should attempt to have the buyer commit to certain post-closing operating conditions to protect the earnout (e.g., limited overhead allocations, providing adequate personnel and capital, and separate financial records). All of these are typically difficult asks of the buyer, and they will usually push back, but sellers should be prepared to request, and their advisors should negotiate for, adequate protections to maximize their opportunity to actually receive the earnout payments. The earnout terms should be reasonably detailed in the LOI and not left to future negotiations after the seller gives the buyer the exclusive right to negotiate for the sale as is usually required by the LOI.

2. Working Capital and Other Purchase Price Adjustments. Almost every deal will have a purchase price adjustment which allows the buyer to recheck (within some period of time after the closing) the company’s net working capital (accounts receivable and other current assets less accounts payable and other current liabilities) and compare it to an agreed normal level of (or “target”) working capital appropriate for the business. This will result in a post-closing cash payment to the sellers or to the buyers. Most valuations and deals are on a “cash-free, debt-free” basis (meaning that the sellers often get to withdraw or receive credit for the company’s cash and any company debt is paid off from the closing cash otherwise going to the sellers).

But the buyer does usually insist on a normal level of working capital adequate to operate the business in the short term. Increasingly, the buyer also has the right to double check the amount of transaction expenses and company indebtedness that existed and were not paid off at closing. Here, it is critical that the sellers get carefully defined terms for calculating working capital and that the calculation is not based entirely or merely on “generally accepted accounting principles”, but rather on some agreed calculation methodology that is more consistent with the company’s historical accounting practices and financial statements. Like any earnout, any purchase price adjustments should be reasonably spelled out in the LOI.

3. Seller Indemnification Obligations and Buyer Due Diligence. Buyer due diligence is now more intense than it was a decade ago. And “market” surveys suggest that buyers are increasingly pushing for more buyer-favorable indemnification protection. Indemnification is basically the sellers’ agreement to return or forfeit a portion of the purchase price in the event that it breaches any of the many representations and warranties in the purchase agreement. Despite “market” reports and buyer negotiations to the contrary, we have worked with even smaller LMM sellers in negotiating for buyer representations and warranties insurance (“RWI”, even though the market statistics suggest that only between 10% and 49% of deals, depending on size, include RWI) and limited seller liability for future claims. Too many advisors assume that small LLM deals will require the sellers to agree to a substantial purchase price escrow or “holdback” for some period of time following the closing when in fact many buyers can be convinced to give the sellers a better deal. Like minimizing any earnout or purchase price adjustment, this can significantly increase the cash paid to the sellers at closing.

4. Post-Closing Disputes Over Indemnification, Price Adjustments and Earnouts. Sellers should always be aware of the possibility and risk of post-closing claims by the buyer for breaches of purchase agreement representations and warranties, working capital purchase price adjustments and failure to achieve any earnout payments. As mentioned above, the terms of the indemnification and any earnout can be negotiated in a way that significantly reduces the sellers’ post-closing deal risk. But it is helpful for sellers to understand the frequency of post-closing disputes. SRS Acquiom also released its 2024 M&A Claims Insights Report2 on the frequency of buyer indemnification claims and earnout achievement. While the report revealed that 28% of private-target M&A deals resulted in an indemnification claim (most of those related to tax and undisclosed liability issues), that has not been our experience. We suspect that many of those claims might have been avoided with better seller “self-due diligence” and due diligence responses and disclosures to the buyer.

The report also showed that only about half of agreed earnouts were ultimately earned or paid, suggesting that either the sellers did not negotiate for reasonably achievable earnouts or their advisors did not negotiate for adequate calculation protections and “guardrails”. Post-closing disputes over purchase price adjustments have been more prevalent than indemnification claims. The sellers internal and outside accounting advisors should be intimately involved in the negotiation of working capital and other purchase price adjustments. And the sellers’ tax advisors should have input into tax representations and terms relating to pre-closing and post-closing tax matters. Claims relating to customer contracts and intellectual property issues tended to be higher than other claims, making the lawyer’s review of contracts and IP matters, as well as purchase agreement representations about these, important.

Stage Your Business and Negotiate Like You Don’t Have to Sell

Too many LLM businesses fail to demand reasonable seller-favorable terms, often because their advisors don’t educate them about all of the available options or they just assume that they won’t be able to get better-than “market” terms. “Market” deal statistics can be misleading insofar as they don’t always apply to a particular company, buyer or industry. Buyers routinely use them to their own advantage. The real value of an M&A transaction, like any “investment”, will ultimately be reflected not only in the purchase price net of taxes, transaction expenses and company debt, but also in the transaction terms relating to closing purchase price adjustments, post-closing consideration (e.g., indemnification escrows or “holdbacks”, earnouts, seller financing or notes, and retained or “rollover” equity), and the sellers’ post-closing exposure to buyer indemnification claims.

We encourage you and all sellers to engage good advisors, prepare your management team, and lead by example through an intense sale process so you can actually achieve your business, personal, financial and other goals and objectives. Business valuation, EBITDA and valuation multiples are only the beginning. The buyer selection, LOI, agreement negotiation, due diligence and closing process can dramatically improve ultimate deal value and owner returns. So, position your company to differentiate it from others and be prepared to ask for your own terms. Your advisors can argue why buyer-favorable “market” terms should not apply. The worst the buyer can do is say no, and they won’t likely walk away just because you had the self respect and confidence to ask.

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1 ? SRS Acquiom Inc. All rights reserved..

2 ? SRS Acquiom Inc. All rights reserved.