The Anatomy of the Deal – The Ligaments

In the previous Blog entry, we investigated the skeleton for a done deal – good data gathering and good connecting-up of that information for the buyer. We also briefly touched on putting the skin onto the skeleton – the process of Due Diligence (DD), carried out – and paid for, by the prospective purchaser of a company. Deals need administrative structure when in process, but they also need transactional structure at the very end. Bones without ligaments just rattle!

Matters for negotiation do not always impact the price

Issues raised at DD will almost certainly become matters for negotiation. Matters for negotiation do not always impact the price, but they will certainly affect the formal deal structure and the important part of the ‘small print’, the warranties. If we all connect the right terms and conditions to the right issues raised by DD and stored in the Data Room, we get a skeleton that can dance.

For example, DD may draw attention to an aging management team but younger active shareholders. How is that risk to be managed? How are skills going to be shared? Do they need to be transferred? How much will it cost to sort out? At this point, the owners may be planning to ride off into the sunset. But a buyer will start demanding three-year consultancy commitment from them or a three year ‘Earn-Out’, or even stage payments over the three years. Another possibility is a reduced offer on the company to reflect recruitment and salary for replacements, either of the managers or the shareholders. What concerns them is risk.

The more you are perceived to participate in the handling of risk to the buyer, the more you will get for your business

Now, in the real world, the average period that outgoing shareholders stay is 15 months (source: Office of National Statistics). When I worked buy-side, my biggest acquisitive clients always told me either that they wanted rid of all shareholders in a year – or immediately! In other words, they only asked for long commitments either to flush out issues or out of fear. The overall intention was a clean break and a fresh start. Inexperienced buyers will tend to ask for such terms automatically, though. They do it because handbooks on buying companies tell them to. Or they do it because their own advisors push them to, to make themselves look like good risk managers. They do it because they think it will leave them with a ‘handle’ on the original shareholders if things go sour. Both experienced and inexperienced acquirers may do it as a trading tool, of course. Some feel that you may compromise on the price or warranties to escape an onerous period of ‘servitude’!

However, the above has to be balanced by another fact. It is a proven fact that the most a shareholder will ever get for their shares is from a well-structured period where they do remain – temporarily – tied to the business. This mechanism is called an ‘Earn Out’, because it is a ratchet where better results give more per share, over an agreed period of time. One or more of those younger shareholders staying could alter the total moneys received substantially upwards.

The most a shareholder will ever get for their shares is from a well-structured period where they do remain – temporarily – tied to the business.

There is a single very simple rule here. “Think it out beforehand” – during the ‘Preparation for Market’ phase. DD should never bring surprises, just known issues where pre-prepared solutions can be immediately proposed, solutions that could work equally well for both parties.

In the next Blog, we will be looking at the heart of a deal, the people who can make or break a transaction, and how this happens. Please do, in the meantime, feel free to contact us to discuss in greater detail any matter raised above.

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