Mergers and Acquisitions For Dummies (97 page)

Calling the Seller's Employeeswithout Permission

Unfortunately, Buyers have been known to pick up the phone and call a Seller's employees prior to the deal closing. Sometimes, Buyer even lets slip that he's buying the company and that the employees will soon have a new boss.

Although the cause of this behavior is usually not malicious (in their excitement about doing a deal, would-be Buyers jump the gun and start calling employees as if they've already closed the deal), this conduct is still wholly unacceptable and really just poor form. Tipping off an unsuspecting employee about a deal can cause untold havoc in Seller's business, much like breaking confidentiality can (see the preceding section). Buyers should always follow the chain of command and only speak with those people who know about the deal and to whom the Seller explicitly agrees you can contact. Make sure you go through the proper channels.

Contacting a Seller's Customers or Vendors without Authorization

Another huge no-no for Buyers! Customers are the most important relationship for a Seller, and a Buyer who carelessly contacts a customer and informs her about the pending deal may cause that customer to find a new vendor. This kind of breach can quickly scuttle the deal, as well as harm the Seller.

In most cases, this breach is caused by an overzealous Buyer trying to conduct due diligence. Although determining the strength of the relationship with customers is important, this situation is delicate, and Buyers should tread carefully.

Buyers should refrain from contacting Seller's vendors without permission for the same reasons.

Chapter 21

Ten Possible Ways to Solve Valuation Differences

In This Chapter

Exploring ideas for earn-outs

Looking at ways to provide consideration other than cash at closing

V
aluation is always the million-dollar question — well, often the multimillion-dollar question. The stereotypical negotiation impasse has Seller asking for a high price and Buyer offering a low price, with each side digging in their heels and insisting that the other side totally capitulate to their demands. But that strategy rarely results in a closed deal.

In the spirit of getting deals done, in this chapter I provide a few ideas on ways Buyers and Sellers can settle valuation disagreements and move forward to a closing.

Payments over Time

If Seller wants a certain price for the company, Buyer may be willing to pay that price over a period of time. Buyer has the benefit of the
time value
of money (today's dollars are worth more than tomorrow's dollars, so paying today's debts with tomorrow's dollars is a benefit to Buyer), and Seller gets to tell everyone that he was able to get the valuation he wanted.

If Seller agrees to accept payments over time, I suggest using a note to officially and legally document Buyer's obligation to Seller just in case the arrangement comes into question later.

Earn-Out Based on Revenues

The venerable earn-out (see Chapter 12) is a favorite deal component for Buyers because it allows the Seller to prove the company's profitability. If the company achieves the goals Buyer and Seller agree to, Seller gets the earn-out. Keeping the earn-out metric simple and easy to measure reduces the chances of a dispute down the line. Basing the earn-out on revenues is usually the most straightforward approach.

Earn-outs shouldn't be an all-or-nothing proposition. If the company falls short of the earnings goal, perhaps the Seller is still eligible for some of the earn-out. A dollar-for-dollar reduction in the earn-out based on how far short of the projection the company falls is often the solution. Say the earn-out was worth $2 million if the company achieved a certain revenue goal. If the revenue was $1.5 million short of that goal but the earn-out didn't require all-or-nothing success, Seller still receives $500,000 ($2 million minus $1.5 million).

Earn-Out Based on Earnings

This option is a cousin to the earn-out based on revenue (see the preceding section). It functions exactly the same, except that the metric for the earn-out is based on some measurement of earnings. Both sides need to very precisely determine how they'll measure earnings (EBITDA, net income, and so on).

Sellers should be wary of Buyers applying some overhead from the parent company's books to the acquired company's books. This accounting treatment may artificially lower the acquired company's earnings (because now expenses the company didn't incur are eating up its profits), thus reducing or eliminating the Seller's earn-out.

Earn-Out Based on Gross Profit

Another metric for an earn-out is to base the earn-out on the business's
gross profit,
or its profit after deducting the cost of sales but before deducting operating expenses. This method can be a great way to settle a valuation difference in an environment where pricing is falling (thus resulting in lower revenue) and the cost of sales is falling, too. And because the earn-out takes the profit before operating expenses, this technique eliminates the risk of Buyer adding applied overhead to the company's operating expenses, a trick I note in the preceding section.

Valuation Based on a Future Year

A multiyear earn-out may result in Seller not earning all the available money in some of the years. Basing the final valuation on a future year and provid-ing Seller with advances against that future-year valuation helps eliminate that occurrence. Effectively, this strategy gives Seller a make-up clause. If the company falls short of its goals in the early years, Seller can still get 100 percent of the earn-out as long as the company achieves the goals in the final year.

Sellers, make sure the purchase agreement defines all advance payments as nonrefundable. Doing so prevents Buyer from trying to reclaim some of the advance payments if the company falls short of the final goal of the earn-out.

Partial Buyout

If a Buyer and Seller can't agree on a valuation for a full buyout, a
partial buyout
is often the solution. Seller retains an ownership interest and can sell her remaining shares at some future date and hopefully at a higher valuation. In M&A lingo, this later sale is called a
second bite of the apple.

Most Buyers want a control stake in the business, meaning they acquire more than 50 percent of the company's equity. Depending on the situation (and how the purchase agreement is written), however, Buyer may be amenable to buying a minority position.

Sellers who retain a minority position should make sure a
put option
is part of the deal so that they can sell the remaining equity to Buyer at some future date at some future calculation. If Buyer ends up taking a minority position, Buyer should make sure the deal contains a
call option;
in other words, Buyer can buy the remaining equity from Seller at some future date at some future calculation.

Stock and Stock Options

Stock can be a great way for a Buyer to help finance an acquisition. If Buyer and Seller disagree over valuation, Seller may be receptive to taking stock in the parent company. The situation is often win-win: Buyer has to lay out less cash at closing, and Seller has the upside potential of stock appreciating in value.

Buyer should carefully consider the
dilutive effect
(owning less of the company) that comes as a result of providing equity to Seller. Also, Seller should consider the marketability of that stock; in other words, does the stock trade on a public exchange, and is the average daily volume sufficient enough to allow Seller to unload his position? Flip to Chapter 12 for more on stock deal considerations.