Following up on our last post, we thought it would be instructional to give some insights into how we evaluate and negotiate an LOI. Now, we can’t give away all of our tactics – that’s why you hire us, but we wanted to provide a broad overview of what we do and why.
The first thing we do when we receive an LOI (as a sell-side advisor) is do a “walk through” with our client. Unless the proposal is exactly what the seller was looking for (in terms of headline number and other key terms), there is always a sense of disappointment. Again – this might be the first time that an entrepreneur really gets a sense of what their business is worth and everyone always has a twinge of hope for an over the top bid.
During the walk through, we review with our clients the key business terms, including value and terms of consideration, structure (e.g. asset vs share sale), due diligence requirements, and timeline. There are often a lot of assumptions (implied or explicit) outlined in the LOI so we take note of those and compile a list of clarification questions that we will go back to the buyer with.
The second thing we do with the buyer is evaluate their “BATNA”, or Best Alternative To a Negotiated Agreement. Now that’s a very MBAish term, so we don’t actually say that out loud to our clients, but we want to establish whether the deal as proposed is “workable” or whether the deal is soo far out of line of expectations that we just politely turn it down. To establish our BATNA we look at a few items. First, we look at whether our client needs to do a deal at any cost (usually this is because of creditor pressure, ownership death or divorce that makes running the business long term impossible or a partnership break up). The greatest leverage an entrepreneur has when selling their business is the ability to “just say no” and retain the business. Assuming this is not a distressed sale, we then look at the merits of retaining the business and running it versus a full sale. We establish what the minimum value a client is willing to accept and on what terms. This may take a few conversations and a bit of soul searching on the part of the entrepreneur, especially if the deal is primarily based on asset value (as opposed to earnings) and the buyer and seller have a different perspective on asset value. We look at precedent comparables for earnings based businesses and local auction house values for asset based sales.
Once we have completed that analysis, we do a “side by side” analysis of all of the proposals and try to weigh the merits of each and establish the broad parameters of what we would be willing to accept for a transaction. While there may be a “clear” leader, we don’t want to make that declaration until we are absolutely sure we understand all the facets of a proposal. At this point, we will go back to potential buyers to clarify their proposal(s). We like to do this so that we are not making any assumptions on the proposal that can cause us grief later on in negotiations.
When making this call (and it should always be a call and not an email response), we always start with “I am not here to negotiate today, I just want to make sure I fully understand and appreciate your proposal”. This does a few things. First, it sets an expectation that today is not the day to negotiate, but that we are genuinely interested in their offer and are giving the potential buyer a chance to clarify important aspects of their proposal. Sophisticated buyers will generally ask for a call prior to sending over their proposal to do a walk through of their own – we always accept those calls as its just polite, and we can always learn something, but often they focus on what the buyer wants us to remember. These follow-up calls allow us to set the agenda in terms of what we want clarified. Second – by making that statement, it somewhat disarms the counter-party. They are more likely to be open and less guarded with their responses. As stated in a prior post, we always try to negotiate to a “fair” deal and by asking a lot of clarification questions, we make sure that both sides understand all the broad assumptions and terms of a proposal. Too many deals (others we hear about – not our own) fall apart because a buyer or seller made an incorrect assumption about a key term, but by inserting this step, we do our best to tease out motivations, expectations and other key points that a proposal was built upon.
Once we start reviewing the terms, we seek to clarify the value and ask questions about the methodology for arriving at that value, we discuss the terms of any deferred compensation and earn-outs and we start to begin to manage expectations about what our counter-proposal may look like. For example, recently I had a discussion with a potential buyer about an earn-out structure they were proposing (both the buyer and their advisor were on the call). Through the course of our discussions, I was able to clarify that they had expectations that the earn-out they were proposing had in their estimation, a six year payout! Now, I would seldom advise a client to lock into a six year earn-out (ok, I never have, but I don’t want to say never). I was able to highlight to the buyer that it was an unreasonable ask of anyone and that it we were going to come back with something more market on this point (I don’t think the other advisor had done the math as we did, so the buyer was somewhat annoyed at their advisor and this extremely off-market ask). What’s great about this is we were able to tease out an important deal term in a non-confrontational way and guide our buyer to expect something more market based. There was no negotiation at this point, just clarification, but it served an important purpose to setting up the actual negotiations. I also always ask about valuation methodology. This is usually where I can get a sense as to whether this buyer really knows this industry sector or whether this was a “shot in the dark” to see what our response is. Shot in the dark’s to the low side are generally easier to manage as you can quickly manage value expectations up based on precedents or comparables. High, but uninformed bids are harder to manage as you don’t want to scare off a buyer if their proposal is genuine, but we are always concerned that a buyer once more engaged in the process may try to re-trade on value once they do more work on the sector. By having a value conversation up front, we can begin to get a sense of how real a bid is and what protection mechanisms (e.g. non-refundable deposits have a tendency to sharpen the mind) we may need to build into a LOI to insulate our client from a future re-trade.
Once we complete this call, we let the buyer know that we are still evaluating our various proposals and that we will get back to them shortly with next steps. I then report back on the conversation to our seller and we again walk through all the terms and confirm our previous side-by-side analysis. This is the point when the seller then gives the “Go- No Go” on whether they want to continue the discussion with one or more parties. Our next blog post will outline a bit more about negotiating an LOI.