Negotiating Price & Terms When Selling A Business or Merging / Acquiring One: A Case Study
Business owners often underestimate what's involved in negotiating price (or, more specifically, 'deal terms'). Many think it's just about finding a price that works for both parties. Or worse - they think the negotiator is going in there to get them the "highest possible price".
Price is but a very small part of the equation! A typical negotiation for even a 'small' £2 million sale could be spread over several days and involve agreeing not one figure but dozens of them!
Introduction
In addition to 'negotiating price', there's also agreement to be reached on the amount of working capital and cash and debtors and stock and other assets to be left in the business on the day of transfer. Then there's the interest rate buyers will be paying on the deferred payments. There's the extent of VAT, corporation tax etc., that should be paid by the seller to the buyer to cover HMRC liabilities up to the date of sale.
Some Other Deal Terms
The headline price itself is meaningless when not accompanied by the rest of the deal's terms. Sometimes there are 50 - 100 such numbers to be negotiated! And they are often inter-related i.e., a lower figure in one place opens the opportunity to negotiate a higher figure elsewhere.
I explain "deal structure" in my article offering to buy your business today for double whatever valuation you've been given for it.
Apart from negotiating of numbers, there are various terms that need to be negotiated as well. There cover operational, employment, intellectual property, liability, collateral, indemnity and other issues.
A successful negotiation for the sale of a business ends with both parties having a clear idea on the various numbers and terms. This oral agreement is then drafted into a document called the Heads of Terms (HoT) for both parties to sign.
The draft HoT doesn't always have a smooth passage. It is often the case that further negotiation and clarification is required after parties have seen the draft HoT and done the necessary running of the draft past their accountant / tax adviser / lawyer. Once the HoT is signed, the buyer can instruct their lawyers and accountants to start the due diligence process (What is due diligence? Download a 200-point Due Diligence Checklist & Strategy Guide.)
To present a better idea of the kind of numbers involved in a typical negotiation, I provide below a case study of a four day negotiation I was involved in for the sale of a business that was worth, roughly £3.4 million.
And this was a relatively simple negotiation as negotiations go!
The Company: My clients were shareholders of a company, let's call it Acme Ltd, that was turning over circa £5m per year and generating a pre-tax profit of £850K. It was owned by Mr A and Mr B. The shareholders and I came to the conclusion that the asset base of the company (the net assets) was higher than that of similar companies and that this needed to be reflected in the deal.
Acme Ltd had no borrowings except for a £400K loan from one of the directors. There was also a high cash balance in the business of circa £750K as a result of shareholders not taking out large dividends in previous years.
Some points for negotiation that were identified early on
The headline price
The sellers were not fussed about headline price as they realised that these deals are about the terms of the whole package rather than a particular number.
The "cash" element
As with most sellers, Acme Ltd's shareholders had a preference for cash ie., they wanted 100% of the price to be paid into their bank account on the day of the transaction. But they realised that deals of this size are almost never all-cash, part of the price is always paid later.
Further, they appreciated that the larger the amount they were willing to defer, the higher the overall price they could expect. The sellers and I had extensive discussions around this point and the extent to which any cash sacrifice they made would need to be compensated for by a larger overall price.
So, for example, if buyers were able to pay £2m in cash, the sellers were willing to take a total price of £3.4m (with £2m in bank transfer on the day and £1.4 million deferred). If buyers were able to put up only £1.5 million in cash, the vendors were expecting a total price of £3.6 million (£1.5m in bank transfer on the day and a further £2.1 million in deferred payments), the additional price being a compensation for offering a larger deferred element.
The minimum cash component did also need to be agreed and the vendors in this case set a threshold of £1.2 million.
The non-cash element
If part of the price is being paid via shares in the acquiring company or other such not liquid asset, each form of such payment would need to be discussed individually with Acme Ltd's shareholders. There are various implications for taking such illiquid assets in payment and they would need advice on a case by case basis.
For example, if offered shares in a larger (unlisted) company Acme Ltd's shareholders would end up as minority shareholders in that company. They would likely have difficulty selling those shares if they ever wanted to convert them to cash. Shares in unlisted companies are not 'liquid' and there isn't a market for them.
Further, taking shares in an unlisted company requires a careful look into the strength of the company. One needs to get a valuation on that company (to know the value of the shares being offered). There would also need to be a shareholder agreement drawn up.
This protects A's and B's rights as minority shareholders in that larger company. All of this costs money - more than a grand or two on lawyers - and part of the negotiation would involve agreeing who'd pay these costs!
A and B preferred to sell to a large, well established company in their sector. They felt such a sale to a trade buyer would result in the highest value for the buyer and the highest value extraction for them.
However, the biggest acquirers, the large and well established companies that can pay the highest price, almost often prefer to pay part of the price using their own shares! So I advised A and B that they would need to expect part of the offer to be shares based.
The deferred payment
The size of the deferred payment would be affected by the above elements, but the terms of the deferred payment matter. The duration of the "loan" from seller to buyer, the interest rate on the loan, the format of repayment (whether payable in monthly installments or at a fixed future date) and other matters related to repayment were discussed between the sellers and me and thresholds were agreed.
Security for the deferred payment
Buyers typically require full control of the business from the day of the sale. This leaves sellers in a vulnerable position in that they have handed over 100% of the value but received only part of that value - the cash element (and/or acquiring company's shares) - in hand. The outstanding amount needs to be covered by adequate security.
Security in these situations can be 100% secure treasury bonds or a bank guarantee. That, however, is rare. Collateral could be in the form of a charge on fixed assets such as the buyer's family home. Buyers will resist this. There's also the buyers offering personal guarantees. Some buyers might attempt to offer a debenture on Acme Ltd itself as security.
I explained the flaws with some of these securities - such as the debenture - and got a feel for what level of security would be acceptable to the sellers. In the event, it turned out that they wanted at least 75% of the loan to be covered by very high quality security. They understood my explanation that if they require very high quality security, it limits what some buyers are able to offer. Not all are in a position to deliver security of that quality.
We also discussed that it's difficult to judge the value of security such as personal guarantees. Prior to accepting personal guarantees one needs to verify the quality of the party offering the guarantee. It would require a credit search on the individual/s at the very least.
And there is a cost to getting lawyers involved in drawing up the documents necessary for any such form of security. That's because whatever the security, from debentures to personal guarantees, one needs a properly drawn up contract when big monies are involved! The Heads of Terms, when drafted, would need to include clarity on who'd be paying these costs. This forms part of the negotiation.
Takeaway: Typically, the lower the value of the security being offered by buyers, the higher the risk the sellers are shouldering and the higher the price they can reasonably demand.
Debt Free Cash Free Deals (DFCF)
I explained DFCF to the vendors and the implications of a share sale vs asset sale (and there are various tax and other implications for choosing one over the other). We discussed what they'd prefer - it was a share sale - and how much of a "concession" a buyer would need to make if the buyer wanted my clients to agree to an asset sale instead.
Value extraction prior to sale
My clients wanted to know if they'd be able to extract all the surplus cash before selling the business. And whether they could reduce some of the debtors ie. call in those debts and withdraw that cash as well.
This is a tricky matter. While all the cash is not required in the business, in these situations the fact remains that you'll have given prospective buyers copies of your last accounts. And those accounts would have included this cash balance. Buyers would see that as a legitimate asset of the business and not money that belongs to you, the owners. Besides, a certain amount of cash, or "working capital" does always need to be retained to cover day to day expenses.
If the vendors do want to withdraw this case there are various implications. For one, there's the tax! I advised that they'd probably have to withdrawn the cash as dividends. But dividends attract dividend tax and, given the high cash balance here, they would be paying dividend tax at the highest marginal rates.
There is one advantage they have - the director loan account. As the company owes one of the directors £400K, that £400K could be drawn without any penalty or tax. Further it would not affect the net asset figure in the balance sheet which means buyers are generally not going to object to such a move.
However, extracting more than £400K would cause a problem as it makes the company less attractive to buyers. I discussed various options with my clients and gave them suggestions including a simple and common one involving getting full Entrepreneurs Relief on that cash (ER drastically cuts the Capital Gains Tax payable).
Some Others
- Whether the sale is to be an asset sale or share sale.
- If it's an asset sale, what assets? If it's a share sale, what shares? (All the shares? The share of the trading company or holding company?)
- What assets will be removed from the business prior to transfer?
- The amount of cash that sellers can extract via adding it to the sale price (more complicated than it looks as a buyer taking on that 'excess' cash can't draw it out of the business without paying dividend tax on it).
- The percentage of the sale price that will be in cash on completion.
- The terms of any deferred payment.
- Negotiation around the security the buyer is providing to cover those deferred payment.
- Working capital requirements of the business (ie what needs to be left for the buyer to enable him to continue running the business without a further cash injection).
- Sharing of risk - to what extent, and how, will the vendor/s share post-completion risk with the buyer?
- Discussions around clawbacks.
- Some initial discussions around warranties and reps (more detail will be trashed out by the lawyers when drafting the sale agreement).
- Whether to use locked box or completion accounts.
- Lots more.
Conclusion
The above is just a very small selection of the numbers and terms a business broker negotiates in a typical small business transaction and that transaction advisers negotiate in the larger deals.
If there's the possibility of an "earn out", that's a detailed discussion in itself, as is the future involvement of the owner (generally speaking, the longer the owners are willing to stay the higher the price they can expect).
Further research: These two free PDFs offer plenty of additional information: 1 | 2.
Need someone to negotiate a deal for you (either as buyer or seller)? Get in touch with me I can recommend some very competent negotiators.