Thursday, January 19, 2012

Thinking About Selling in 2012? Be Prepared to Show Buyer Why your Business is Worth What You’re Asking

For many of our entrepreneurial clients, the sale of the business he or she founded is the most obvious exit strategy when the entrepreneur no longer wants or is able to continue actively running the business and the entrepreneur’s children have not inherited his or her “entrepreneurial spirit.”

While a few of those entrepreneurs have been through a sale transaction before with other businesses they owned or when employed in other capacities before becoming an entrepreneur, for most of them a sale of the business he or she founded is a once-in-a-lifetime event. Having never participated in an M&A transaction before, it is hard to know what to expect or what is “normal.” 

One way we help entrepreneurs evaluate what is “normal” in their negotiations is by reviewing the results of various published studies, including the Mergers & Acquisitions Committee of the American Bar Association Business Law Section’s Private Target Mergers & Acquisitions Deal Points Study. The most recent iteration of this study was released in December 2011 and analyzes the frequency of certain material legal terms in 100 acquisitions of private companies completed in 2010. Of the transactions reviewed by this committee in 2011, almost half involved entrepreneurial sellers, so we know these results are relevant to what our entrepreneurial clients can expect in sales of their businesses.

I thought it would be interesting to compare the results of the 2011 study with those of the 2007 study, which analyzed acquisitions of private companies completed in 2006, well before most of us knew that we would soon be facing an economic crisis. 

When comparing the results, I expected that certain deal terms reflecting heightened buyer apprehension would be more common in the 2011 study than the 2007 study. Specifically, I expected that buyers would be demanding more post-closing remedies against sellers in the event of breaches of purchase agreements by the sellers. Certainly, it has felt to me that buyers have been more conservative than they used to be and less willing to take the risks that are inherent in any acquisition. What I found was that some of the most highly-negotiated indemnification provisions were almost the same in the two studies, but that there was a substantial increase in the use of certain provisions that arguably bear a more direct relationship to the bottom line.

Buyers in the 2011 study certainly seemed to be more concerned about overpaying for the target company than they were in the 2007 study. Post-closing working capital adjustments (usually requiring a target company to have some minimum amount of working capital delivered to the buyer at closing) were included in 68% of the transactions in the 2007 study and 82% of the transactions in the 2011 study. Additionally, the use of earnouts (additional purchase price to be paid to the seller upon the business achieving certain performance goals after the closing) to bridge a valuation gap between what buyers were willing to pay and sellers were willing to accept for their businesses increased from 19% of transactions in the 2007 study to 38% of transactions in the 2011 study.

By contrast, the primary contractual provisions that provide remedies to the buyer after closing were almost unchanged between the 2007 study and the 2011 study. There was no significant change in the period of time after closing during which a buyer was entitled to assert indemnification claims against the seller for breaches of the seller’s representations and warranties. In both the 2007 and 2011 studies, the most common survival period was 18 months, followed by 12 months and then 24 months (each appearing with similar frequency in both studies).   

Similarly, there was no significant change in (a) the amount of the purchase price held in escrow or held back by the buyer for some period after closing, (b) the percentage of transactions for which the escrow or holdback was the buyer’s exclusive remedy after closing, or (c) the cap amount for the seller’s general indemnification obligations as a percentage of transaction value. In both studies, more than half of the transactions had an escrow or holdback amount in the range of 7-15% of the transaction value and just over half of the transactions had the escrow or holdback as the buyer’s exclusive remedy. In the 2011 study there were actually a higher percentage of transactions in the lowest category of cap amounts, but overall the cap values were similarly distributed in both studies.

These few data points are, of course, just a small sample of the results of these studies, but they serve as a good reminder of something attorneys are prone to forget: the dollars and cents of a transaction matter most. Legal points and risk management are important, certainly, but favorable indemnification terms alone don’t make a financially unsound transaction suddenly attractive. My advice to entrepreneurs looking to sell their businesses is this: be prepared to show your buyer why your business is worth the price you are askingwhether it’s based on current financials or future potential. If you’ve done that, negotiating the legal and risk allocation points is likely to lead to similar results in any economic environment.

A Post by Alyssa Hirschfeld, Guest Blogger

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