Mergers and acquisitions (M&A) are definitely starting to come back to life. In fact, we’ve recently been retained on a couple of new sell-side, middle-market M&A transactions. Accordingly, I thought I’d briefly share with you the five biggest mistakes I’ve seen entrepreneurs make in connection with selling their company, based on my 16+ years of M&A experience.
Mistake #1: Not Creating a Competitive Environment. A lot of entrepreneurs make the huge mistake of talking to just one potential buyer (usually a competitor, a vendor or some other company they have a relationship with) and then negotiating the terms of the sale. Indeed, there is nothing that will give an entrepreneur more leverage in connection with the sale of their business than a competitive bidding process (or the perception of one). Bidders can be played-off of each other and, as a result, the entrepreneur will be able to strike the best possible deal.
This was recently demonstrated in spades in connection with the sale of 3PAR Inc., as a bidding war ensued between titans Hewlett-Packard and Dell. H-P eventually won the battle with a $2.1 billion offer ($1 billion more than the original agreement between 3PAR and Dell). Needless to say, 3PAR’s investment banker, Frank Quattrone, did an extraordinary job playing H-P and Dell off each other.
This is why I often recommend to entrepreneurs that they retain a strong investment banker to help them sell their company. Most entrepreneurs don’t have the skill set or experience to play buyers off of each other; and even though investment bankers can be expensive, it’s well worth it if they can help negotiate the best deal for the entrepreneur and otherwise add value to the process.
Mistake #2: Not Negotiating the Material Terms of the Sale in the Letter of Intent. Entrepreneurs must understand that their strongest leverage as a seller is prior to the execution of the letter of intent (LOI). This is the time-frame when bidders must be played off of each other. Not negotiating the material terms of the deal in the LOI is the most common mistake I see from the sell-side.
Once the LOI is executed, all of the entrepreneur’s leverage is gone because he generally won’t be able to shop his company around to any other potential buyers for a period of 60-90 days due to what’s called a “no-shop provision.” So prior to executing the LOI is when the seller wants to create a competitive environment (or the perception of one) and have the prospective buyers compete on price and terms.
One buyer, for example, may offer a higher purchase price, but require that part of the purchase price be put into escrow and/or a “cap” on liability (which I discuss below) equal to the purchase price; another buyer may offer less, but not require an escrow and accept a 10% cap on liability. Accordingly, prior to choosing a buyer, the seller should negotiate and weigh all of the material terms of the offer, and the LOI should reflect those terms.
Mistake #3: Selling Assets Instead of Stock. Entrepreneurs should structure the sale of their company as a stock sale, not the sale of the assets, for three major reasons: (i) tax savings if the company is a “C” corporation (i.e., to avoid “double-taxation”); (ii) to pass the company’s undisclosed liabilities onto the buyer (subject, of course, to the indemnification provisions); and (iii) to keep it simpler and cleaner – i.e., it generally requires less documentation (including obtaining consents) selling stock and thus less time to close (which means less legal fees).
Clearly, every deal must be structured with the assistance of experienced tax counsel; however, as a seller, you should always be thinking about selling stock, not assets.
Mistake #4: Not Running the Negotiations Through the Lawyers. This may sound a bit self-serving, but entrepreneurs should leave the negotiating to a strong corporate lawyer. Entrepreneurs are generally no match for sophisticated private equity guys or corporate development guys who do deals for a living.
Accordingly, a smart entrepreneur will stay above the fray and let his corporate lawyer run the deal. I used to represent private equity guys and hedge fund guys in NYC, and they sometimes would do an end-run around the target’s lawyers (and even criticize them) and try to negotiate key issues without lawyers. Entrepreneurs must thus be aware of this game and try to avoid “side-bar” negotiations with the principal(s) on the other side.
This approach is particularly important where the entrepreneur will be staying-on after the closing; the goal is not to poison the relationship with testy, acrimonious negotiations (i.e., let the lawyers fight it out).
Mistake #5: Not Capping the Seller’s Potential Liability. Obviously, an entrepreneur wants to sleep well after he sells his company (and enjoy the fruits of his labor). Accordingly, it is critical that certain key provisions be inserted into the acquisition agreement to protect him post-closing. One such provision is a cap on liability, which, as noted above, should ideally be negotiated in the LOI.
A cap basically means that if something goes wrong post-closing and it turns out, for example, that the seller has breached a representation and warranty in the agreement, the buyer can only recover up to a certain amount.
Sellers should strive for a cap of 10-20% of the purchase price and should also try to minimize any buyer carve-outs. The message to the buyer is simple: inherent in any business are certain ongoing risks; thus, once the business is sold, the buyer should only be able to recover a limited amount of the sale proceeds (absent fraud).
I hope the foregoing is helpful. Selling a business can be a very difficult and emotional experience, particularly for first-time entrepreneurs. If you can avoid the five mistakes above, I am confident that the sales process will be a lot more productive and beneficial to you. Please call me if you have any questions (415-979-9998). Thanks, Scott