The seemingly hard part is over. You have selected a buyer, agreed to a price, and outlined the structure of a deal. Now all that remains is the buyer’s due diligence and final documentation to close the deal. You are relieved. You feel as though you are there – “Safe & Sound.”
Be forewarned, many deals fall apart during the next phase. This article alerts you to a number of recurring themes which you should know.
Report of Sales & Earnings Below Forecast
Based on our several decades of experience, the biggest impediment to a deal’s closing occurs when the business reports lower sales or earnings relative to management’s forecasts. During this crucial pre-closing phase, buyers generally want to pay the agreed price. The buyer reasonably wants to confirm the business they agreed to buy will be delivered without change. Sales and earnings are always under close scrutiny. Failure to meet forecast dents confidence in the business and questions management’s ability to lead. The result may cause a price renegotiation and, at worst, the buyer may walk away from a transaction.
During this important phase, management must be certain that forecasts are robust and achievable. We have seen too many owners take their eyes off the ball once a Letter of Intent (proposal) has been accepted. After signing the Letter of Intent, more than ever the entire management team must remain completely focused on the continuing operations of the business.
In addition to advising clients to meet or exceed “robust” forecasts, C.V. Lemmon & Co. works with clients to implement a process of good news management. This process causes the buyer to retain confidence in the business through the closing phase.
There are many mines in this field. The most common mine primed to explode occurs when the business is heavily reliant on managers and/or shareholders, who desire to exit following a sale.
A buyer will look closely at the role of all shareholders in the business. How reliant is the business on those individuals? Who controls the key customer relationships? If those shareholders are deemed critical to the business, this perception (correct or not) may well impact the business. A buyer may reasonably request that the important shareholders remain with the business and accept partial payment by way of deferred terms, thus tying them going forward and making payment contingent on their mutual success of the business. C.V. Lemmon & Co. works with clients to anticipate this problem with forward planning and remedial action. For the stability of the business in your absence, you too should put in place a management team capable of running the business.
Another potential mine primed to explode relates to a passive minority shareholder(s). We have seen situations whereby minority shareholders could not be found! This certainly presents a problem when the buyer wants to acquire 100% of the business. Another primed mine occurs when the minority shareholder(s) object to any terms in progress including price, structure, identity of the buyer, or even consent to sell under any terms! C.V. Lemmon & Co. advises that all shareholders be located and informed. Some majority shareholders may want to keep the sale process confidential even from minority shareholders rationalizing, “They will go along with anything I do” or “They are so small their votes don’t count.” This is flawed reasoning. Open communications and cooperation among shareholders is imperative to avoid a late term mine explosion.
Customer and Vendor Issues
A considerable portion of the business’ value frequently lies in the strength and quality of its customer and vendor relationships. Even if customer and vendor contracts have been previously signed, they invariably include a “Change of Control” clause, which means the contract may be terminated if business ownership should change. During the due diligence process you can reasonably expect that the buyer will request to meet with key customers and vendors to confirm the anticipated continuity of these relationships. You would also want to confirm customer / vendor relationships if you were buying the business. These meetings / conversations reinforce the buyer’s perception of business stability, quality of service, and future prospects. It will be a problem if customer relationships are personal and not entirely business. Be prepared for this potential problem and take advance remedial action.
Due Diligence Issues
It is likely that the buyer will retain a third party firm to conduct the due diligence of your business. The final reports will provide details on the financial health of your business, your commercial position in the marketplace, and your advantages / disadvantages among competitors. The due diligence process may seem intrusive. It will touch on a variety of legal issues including, but not limited to, real property, personal property (equipment), intangibles, asset quality, liens, financial reporting systems, contracts, employment terms, and many other matters material to a thorough understanding of your business prior to a closing.
C.V. Lemmon & Co. advises clients not to allow difficult issues or problems be discovered during due diligence; instead, bring them out for discussion early in the process. C.V. Lemmon & Co. prefers to disclose potential fatal flaws in the Confidential Investment Memorandum. Prepare in advance a comprehensive assembly and scanning on a DVD of all documents likely to be requested by a buyer. In this way the documents are assembled on your time schedule rather than a buyer’s, confidentiality can be maintained, and any additional required documents do not impose an undue time burden. Remember, management must remain focused on the company’s ongoing operations to meet sales and earnings goals. The distribution of documents on DVDs makes it easy to control who gets which documents at what time.
C.V. Lemmon & Co. suggests that you assign the document gathering responsibilities to one senior person who has access to the information and knows your company is soon to close a major transaction. The due diligence process is greatly facilitated and expedited when all anticipated documents are promptly shared on DVD with the buyer and his advisors including attorneys, accountants, and due diligence team. C.V. Lemmon & Co. requires that the buyer sign a Receipt of Information form confirming possession of the due diligence DVD. The buyer is directly responsible for the actions of his advisors, who may also receive the same information.
If you have a defined benefit plan which has a deficit, then this fact will undoubtedly cause challenges. It is likely that the buyer will want to analyze the deficit and reasonably require that it be made whole prior to a final closing. This may very well involve trustees of the pension fund and a detailed debate regarding the assumptions used in calculating the amount of the deficit. This will all involve time and negotiations. With the assistance of your financial advisor this matter should be addressed early in the offering process – specifically in the Confidential Investment Memorandum first provided to a buyer after signing a Confidentiality Agreement.
Representations & Warranties
As a seller you will reasonably be expected to provide representations and warranties in respect to the business. These are customary and necessary so the buyer can be satisfied he is receiving what he thinks he is getting, and if that proves not to be the case, then he can take financial recourse. On the surface these representations and warranties can appear quite frightening. Make sure your legal counsel talks with you about what will be expected at an early stage so these reps & warrants do not come as a shock.
C.V. Lemmon & Co. advises clients to retain an attorney who specializes in mergers & acquisitions. Specialists are advised because they recognize nuances and can suggest alternatives for seeming deal breakers.
You have to be prepared as a seller to adopt a co-operative approach. The due diligence process will throw up numerous issues which require debate and careful negotiation. A blanket “I am not agreeing or accepting that approach” might appear appropriate, but it is not likely to get the deal done. Put yourself in the shoes of the buyer. Is his request reasonable? Can you find a mutually acceptable way forward?
Listen to your investment banker and attorneys. Put your emotion aside and suggest or accept an alternate structure to meet your needs while moving forward. A deal that falters in the run up to completion is rarely good news for anyone. The passage of time after signing the Letter of Intent and closing rarely makes for a better deal.
C.V. Lemmon & Co. provides comprehensive advisory services to our clients. Part of our skill set is to listen and understand each client’s unique opportunity, anticipate problems, and solicit advance alternatives to resolve issues. Work with us so your closing occurs with as few exploding mines as possible.
Charles Lemmon is President of C.V. Lemmon & Co., Inc., a private investment banking firm and an AICA member in Dallas, Texas. Charles Lemmon can be contacted by telephone at (214) 692-2748, ext. 106 or by E-mail at CVLemmon@CVLemmon.com.