Dr. Earl R. Smith II

Dr. Earl R. Smith II
DrSmith@Dr-Smith.com
www.Dr-Smith.com

The balance of power in the M&A market is constantly shifting. It tends to swing back and forth between the extremes – now favoring sellers and later buyers. It is widely recognized that we are in a period when the pendulum has swung far over to the buyers’ side. There are a number of reasons for this – bad past investment decisions that have come back to haunt them and they are now much more cautious, uncertainty in the financial markets that make estimates of the terms of financing (and sometimes its very availability) hard to predict and a general uncertainty about the future are three worth mentioning. One of the most important advantages that buyers have in this environment is to be able to demand and receive exclusivity in negotiation.

It is always in the seller’s interest to conduct multiple negotiations. They seek to play one buyer off against another and improve the terms of the eventual deal. When buyers and financing were easy to come by, sellers and sell-side M&A advisers generally try to conduct auctions. They canvass the range of possible buyers, send out queries and select the best deal terms on offer before accepting a letter of intent and entering exclusive negotiations with a single party. When the power balance is excessively in favor of the seller, they are able to insist on terms that will allow other potential buyers to better the negotiated terms – so called go-shop provisions.

However, during times when the buyers have much power, many buyers are unwilling to enter into auction negotiations. Sellers face a difficult choice. With so few aggressive buyers out there they run the risk of losing any options if they insist that the will not enter into exclusive negotiations. Buyers have become cautious. They are sensitive to two categories of risk. The first centers on the company being acquired. The rather more casual approach to diligence so prevalent in the mid-to-late 90s – as well as the hectic pace – has been replaced by a much slower, much more methodical and extensive one. Sellers are now being subjected to scrutiny across a much broader range – and diligence goes much deeper into the workings of their company. The second is the financing risk. With uncertainty in the financial markets comes the tendency of buyers to lay off that risk – transfer it to the sellers.

The two risks combine to produce an environment that adversely affects the interests of sellers. The risk of a failed or abandoned process is much greater than before. Deals may not close because of the inability of buyer and seller to reach agreement – but they also may not close because of developments outside of the control of either. Terms may shift because of developments beyond either’s control but in today’s environment, one thing is certain – the seller pays the related costs.

The basic rule in M&A is that the seller’s power is at its height the second before they sign the binding letter of intent. This remains true today with two modifications. The level of seller advantage before the signing is much lower than it was a couple of decades ago and the erosion of that power following the signing is much more severe. A buy-side M&A advisor recently told me, “We sign the letter of intent (LOI) and then the real negotiations begin. In the past, we might have a dozen people involved in the diligence process. Now we have several dozen. We are looking for any lever to use to improve the deal – and they are always there. Diligence is cost-effective in improving the terms and lowering the price”. I have seen this close up. A friend recently sold his company to a strategic buyer. At the time of sale, the company had a few million in annual revenue. The buyer deployed forty professionals in the diligence process. Their marching orders were clear – find us ammunition that will help improve the deal.

For CEOs who are thinking of selling their company, this description may sound like a journey into illogic. After all, a valuation is supposed to be based on the financial performance and financial strength of their company. That may be true when the power pendulum is closer to the center of its swing. However, when it favors the buyer sellers are not just sellers – they are prey. Moreover, buyers are the big cats in the jungle. I met a friend who runs a private equity fund active in buying companies. I asked him about his approach to negotiations. “Its all about getting the best deal – the best terms – the most advantage. Sellers who think that there is some ‘truth’ that will establish a valuation for their company are in for a real shock. At the end of the day, it is the amount that I am willing to pay that matters and, if they don’t like it they can leave the table. I make more money walking away from deals that don’t give me that kind of advantage and waiting for the ones that do. The cost of diligence is a fraction of the gains. I don’t have to buy anything – this is no longer a ‘must have’ market. A deal is just a deal.”

Current conditions tend to separate out the sellers that need to sell from those who are considering selling. As sellers reassess and re-balance their priorities, the pool of active sellers tends to shrink. Many are simply not willing to enter into negotiations when the party on the other side of the table holds so many more cards. For those who decide to brave the process, price is still going to be critical, but speed of execution, confidentiality, certainty of financing and locking down a deal have become important.

One thing is clear. Current conditions will pressure sellers to deal exclusively with one party much earlier in the process. If a potential buyer approaches them, certain actions – such as early attempts to organize an auction – may simply drive the buyer away Rejection of a request for exclusive negations may have the same effect. Sellers also need to remain flexible after the LOI is signed. Buyers may press them hard and they need to be ready to accommodate or break off negotiations as their own best interests dictate.

Some advantages do remain for the seller. If they are willing to entertain exclusivity, they might be able to negotiate a lower break fee. They may also be able to get a limited go-shop provision that will allow them to solicit a higher price for a limited time after signing. Never the less, this is not the early 90s – sellers beware!!!

© Dr. Earl R. Smith II

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• Exit Strategies Under Current Conditions
• Exit Strategies Under Current Conditions – Part 2
• Attitudes, Agendas, Interventions and Compromises
• Four Mistakes Entrepreneurs Make When Buying a Business
• Gap Analysis
• Turbo-Charging Business Development

Dr. Smith is a proven senior executive, successful entrepreneur, published author and public speaker. He serves on boards of directors and advisory boards or as a strategic adviser to CEOs. Dr. Smith specializes in turnaround management, strategic planning, leadership development and executive coaching. He also works as an executive and/or life coach in the areas of personal growth and spirituality. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.

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