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HOW TO AVOID THE 10 MOST COMMON M&A DEAL TRAPS

By Ryan Kuhn. A Harvard MBA, Ryan founded M&A advisor Kuhn Capital 35 years ago. Since then, the firm’s principals have initiated hundreds of high-IP mid-market M&A transactions together worth more than $3 billion.

Congratulations. Your investment banker has reeled in a particularly promising M&A counterparty. But negotiations have been testy and now you fear the deal may blow up.

Below I’ve listed 10 of the biggest challenges — the most treacherous negotiation traps — that buyers and target companies encounter during the M&A process and how to resolve them before they ruin your day.

1. Valuation

The Conflict

Valuation disagreements win first place both in how frequently they occur and their lethality. Sure, sellers predictably go high and potential buyers low, but theValuation seller who goes too high can very quickly persuade buyers that the future will be a conga line of unrealistic expectations. (For other M&A mistakes sellers make, see my Top 5 Ways Business Owners Kill M&A Deals.

Even assuming that the sellers’ “ask” isn’t outlandish, both parties have legitimate reasons for disagreement over value. Sellers weight current and projected future performance more heavily, while buyers look to the past in an effort to reduce risk.

And many founders are emotionally attached to their “baby” and unconsciously seek compensation for having to say goodbye.

Some Solutions

A. Get a third-party valuation before going to market. Retain an investment banker, M&A advisor or valuation specialist with relevant experience. “Relevant” experience isn’t a tax or estate planning valuation, nor is it earning a CPA. You’re also not getting one done as “proof” of value. You’re making a good faith effort to explain the reasons for your value.

B. Negotiate over what period of time to base the valuation. Example: for a growing company, the buyer annualizes the most recent six months rather than the prior calendar year which closed long ago.

C. Use an earn-out that makes part of the purchase price contingent on future performance. If you as seller are convinced that the future looks bright, put money on it – yours.

(But know that creating an earn-out formula can lead to secondary conflicts. For example, no sellers like earn-outs based on pre-tax profit when they have no control over corporate overhead charges. Solution: base the earn-out on a measure of profit that excludes imposed expenditures.)

2. Purchase Price Adjustments

The Conflict

Target financials change between when the parties strike a deal and when it closes. Even before then, values on the target’s balance sheet may be either more or less than what’s needed to operate the business.

To make these adjustments, the parties must agree on formulas that modify what the buyer ultimately pays and what the seller can extract from the business before close.

Failing to do that successfully may be the second most common deal killer. Mostly to blame are complicated net working capital calculations. For detail, see Smith Gambrell Russell’s article.Purchase adjustments

Sellers could see buyer adjustments as attempts to renege on a settled price. Buyers see them as safeguards against paying for the target twice – once at close, then again to cover cash flow shortfalls after close. They’re after a one-and-done deal.

Some Solutions

A. Create the ideal formula: one that’s transparent (no gotchas), reasonable, settled well in advance, and vetted by your M&A advisor. The goal is fairness and predictability.

B. Set caps and floors. Limit how high and how low a value can be to reduce uncertainty.

C. When adjustments are substantial, establish an escrow permitting quick access to adjustment cash.

3. Due Diligence

The Conflict

Buyers need comprehensive due diligence (DD) on the seller to proceed with confidence. But some sellers may rightfully find the that duplicative, a threat to confidentiality, or irrelevant. Worse, sellers often have limited resources with which to respond to exhaustive due diligence demands.Due Diligence

So we see DD conflicts as the third most common deal killer. (For more bad buyer behavior see my Avoid the 7 Most Common Ways Buyers Kill M&A Deals.)

Some Solutions

A. Before DD begins, the parties negotiate a tightly efficient “to do” list. It names each task, completion date, progress notes, who’s to manage it and their contact info, etc. Only unexpected findings add to the list.

B. Release sensitive information in the virtual data room (VDR) as mutual trust and interest builds. Examples of such staged releases are client lists and employee files.

C. Create a seller-centric NDA and periodically confirm the buyer is honoring it.

4. Representations and Warranties

The Conflict

Buyers seek from business owners reps (statements of fact) about the business and guarantees (warranties) that they’re true. For more detail seeRepresentations and warranties CRI’s article. Predictably, buyers want more expansive reps and warranties; sellers want limited and fewer. (Sellers seek buyer reps and warranties too but they’re minor.)

Some Solutions

It’s tedious and multi-layered, but both the buyer and seller must closely attend to drafting reps and warranties language:

A. Sellers want to limit their liability only to “material” issues while Buyers want “materiality scrapes” to relax or eliminate those limits. You need experienced M&A counsel to parse these terms. Let them negotiate among themselves before returning to you with recommendations.

B. In negotiating the scope and duration of reps and warranties, the buyer should concentrate only on where substantial value is at stake to reduce the seller’s burden.

C. Use an escrow to hold back part of the buyer’s purchase price in the event of a seller reps and warranties breach.

5. Indemnification

The Conflict

A purchase agreement’s indemnification clause defines seller liability when breaching reps and warranties terms post-close.

Buyers predictably propose broad indemnification coverage (both by kinds of breaches and by amounts) while sellers want less.

Some Solutions

A. Buyer and seller agree to caps and baskets. (Caps are maximum indemnification amounts and baskets are threshold amounts for multiple reps before indemnification obligations kick in.)

B. They can also compromise on survival periods — long indemnification obligations remain in effect.

C. Last, they can define specific versus general claims that narrow liability to subjects unique to the seller like a former employee’s lawsuit. In any case, seller’s total liability should never approach transaction value.

6. Employment and Management Continuity

The Conflict

Sellers typically want job security for their staff. But buyers may wish to increase profit by cutting overpaid, ineffective or strategically irrelevant positions.

Some Solutions

Some sellers don’t understand that obstructing buyer’s plans for the company post-close may reduce what buyers will pay for it. The solutions below assume that the seller understands this trade-off:Retention agreement

A. Grant a few key employees golden parachutes in the event they’re fired within a certain time period following close. (Actually, there an even more compelling reason to do this: you need their cooperation during DD.)

B. Then allow the buyer to negotiate post-close employee retention agreements with them before close. If those discussions fail, attempt to mediate a resolution.

In many cases, buyers are already quite interested in a defined transition period during which the current management team (and particularly the CEO) assists with a handover. In fact, private equity firms often require it.

7. Transition & Integration Terms

The Conflict

The operating period following close can be contentious for three reasons: 1)M&A Integration The owner/CEO wants out but the buyer wants him/her to stick around to reduce risk. 2) The buyer wants some controls over the seller’s CEO who isn’t used to any. 3) Company cultures clash, common when the buyer is a strategic.

Some Solutions

A. A mistake buyers often make is neglecting to create together with the seller a detailed transition plan to be managed by a joint integration team. It includes milestones, responsibilities and timelines.

B. It also contemplates a phased integration to allow for adjustments along the way.

C. In cases where the seller is divesting a business unit, it may sign a transition services agreement (TSA) to support the buyer till integration completes. Example: a TSA allows the buyer to use seller’s accounting system for six months.

8. Non-Compete Agreements

The Conflict

Non-competes protect the buyer from principals of the target going into business against them post-close. Sellers can regard these agreements as unfairly hampering their ability to make a living.

Some Solutions

A. Negotiate reasonable, specific terms. Limit the geographic scope, duration, industries and roles covered to protect buyer’s necessary interests without unduly restricting seller’s senior executives.Non-compete agreement

B. Offer them compensation (like a consulting contract) that recognizes their potential loss of future opportunities.

Note that a number of states snow restrict the use of non-competes and California — ever the pioneer – renders them entirely unenforceable.

9. Closing Conditions

The Conflict

Closing conditions are requirements that must be met before finalizing theClosing Conditions transaction. Examples: regulatory approvals; third-party consents; financing conditions; resolving certain seller liabilities, asset values or other financial statement items; confirmation of intellectual property (IP) licenses; etc. Buyers and sellers can disagree over the feasibility, timing, and responsibility for meeting these conditions.

Some Solutions

A. Set down responsibilities and deadlines for each condition.

B. Agree to break-up fees (penalties should a deal crater due to a party’s failure to meet a condition).

C. Develop contingency plans for when specific closing conditions aren’t met. Examples: extend deadline, redefine condition, etc.

10. Escrow Arrangements

The Conflict

Escrows hold in a bank a portion of the buyer’s purchase price till reps and warranties terms are met. No surprise, sellers want smaller escrows held for shorter times.

Some Solutions

A. Proactively engage in discussions to agree on an escrowed amount and duration based on buyer’s perceived risks and how long it will take to resolve them.

B. Appoint a neutral third party to manage the escrow account.

C. Implement step-down provisions, where portions of the escrow funds are released in stages as milestones are met.

D. Establish separate escrow accounts for specific types of potential liabilities, such as tax claims, legal disputes, and environmental liabilities.

Conclusion

Recapping the 10 most common M&A transaction conflicts and their resolutions:

ConflictSome Solutions
1. ValuationA. Get an experiences valuator
B. If at loggerheads, bridge the valuation gap with an earn-out
2. Purchase Price AdjustmentsA. Create explicable formulas
B. Use caps and floors
C. Disburse fund from an escrow as adjustments are finalized
3. Due DiligenceA. Set up a DD plan and project management team
B. Seller discloses sensitive information in stages
C. Negotiate seller-friendly NDAs
4. Reps and WarrantiesA. Meet in the middle
B. Negotiate what’s covered and for how long
C. Disburse funds from an escrow as reps expire
5. IndemnificationA. Caps and baskets
B. Negotiate survival periods.
C. Restrict indemnification to seller-specific claims
6. Employment and Management ContinuityA. Golden parachutes
B. Seller mediates pre-close on buyers’ proposed employment agreements
7. Transition & Integration TermsA. Detailed plan
B. Phased integration
C. Transition services agreement (TSA)
8. Non-Compete AgreementsA. Let’s be reasonable
B. Executive comp if necessary
C. Limit constraints to circumstances unique to seller’s execs
9. Closing ConditionsA. Clear timelines and responsibilities
B. The nuclear option: break-up fees
C. Contingency planning
10. Escrow ArrangementsA. Negotiated escrow terms
B. Third-party escrow manager
C. Step-down provisions
D. Divide and conquer: create escrows to match seller’s situations

Parting Shots

Deal closing success requires compromise, attention to detail, maybe a little bit of bravado, and flexible — even creative — horse trading.

That means giving up something of lesser value to get something of greater value. As they say, value is in the eye of the beholder.


© 2024 Kuhn Capital, Inc. All Rights Reserved

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Ryan Kuhn

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06/24/24

Ryan Kuhn is the founder of Kuhn Capital (bio). This article is not the product of AI. AI is a product of this article.