Sellers often focus on the purchase price when considering a sale. Most sellers aim to maximize the proceeds realized through the sale of their business. This mindset makes total sense. They are monetizing their life’s work. Many have lived frugally, diverting money into rather than out of business. As such, the sale of the company truly is the time to monetize a lifetime of effort.
Buyers who have been stretched to a valuation beyond their comfort level may be motivated to recapture some of that “excess purchase price” during the deal. Their approach to minimizing their outlay can take on several forms. In this article, I will cover a few of the most common methods used by buyers to “normalize” their outlay.
Let’s first look into the mindsets of the parties to a transaction. Sellers tend to be driven by equal parts emotion and pragmatism. While they are generally competent business people, they also contemplate exiting a business they care very deeply about. They want to protect their people. They want to ensure that this business and its legacy are entrusted to a buyer who will be a thoughtful caretaker. Buyers, by contrast, tend to be ruthlessly pragmatic when it comes to a transaction. Whether investing out of their funds or those of others, every decision must be justified. There must be a business case for each decision. They measure in terms of Internal Rate of Return (IRR), Return on Investment (ROI), and Multiple on Invested Capital (MOIC)- also known as Cash on Cash Return. They cannot and will not let emotion drive decision-making as they will have to justify each critical decision. The juxtaposition of these two disparate mindsets and the resulting decision-making approaches often are the root cause of issues in a deal.
I mentioned above that buyers who have been stretched out of their comfort zone would generally look for opportunities to retrade the deal. This can be overt, in the form of a purchase price reduction, or surreptitious by perhaps an artificially high Net Working Capital target. Let us explore the former first. A retrade occurs when one on the parties to a transaction, generally the buyer, attempts to change components of the deal that were already contemplated and agreed to in the Letter of Intent. Often, that retrade comes in the form of a purchase price reduction though it may also be presented as a change in the deal structure, from, say a stock deal to an asset deal. In other cases, cash at closing is shifted to a contingent payment or seller note. Buyers will make the case that their offer price wasn’t supported during their due diligence investigation. Perhaps they will find during their Quality of Earnings (QoE) that the EBITDA is 20% lower than expected. If they expressed their offer as a multiple of EBITDA, they would generally apply the exact multiple to the new, lower EBITDA to determine a new purchase price. Some buyers will suggest the business has been undercapitalized and that they will be forced to infuse the business with capital to make up for the CapEx deferred by the current ownership. Often they will conflate CapEx for maintenance with CapEx for growth. The latter is their obligation, and the seller should never be saddled with that responsibility. The overarching point is, that because the buyer was stretched on valuation, they will be looking for ways to claw back deal value. They will be on alert and more likely to pounce on any abnormality. Sellers would be wise to be on their toes. A capable sell-side advisor can provide tremendous value on this front.
Retrades can take on more subtle forms. One classic method for buyers to reduce sale proceeds to the seller is manipulating the Net Working Capital (NWC) target or PEG. Net Working Capital is a measure of a business’s liquidity and solvency. The formula is simple. Current Assets (generally excluding cash) minus Current Liabilities. The critical line items tend to be Accounts Receivable, Inventory, and Accounts Payable. Rather than simply turning over the balance sheet to the buyer on closing as-is, buyers require that a “normalized level” of NWC be left in the business. Why is that? If the balance sheet were to be assumed as-is at closing, the seller would have the incentive to delay the payment of payables and accelerate the collection of receivables. The seller could offer a 10 or even 20% discount to customers if they pay within 5 days rather than the customary 30. In that case, the buyer may inherit an inverted balance sheet. To avoid that, we review monthly balance sheets over time to determine a target level of NWC. How much NWC should this business have to operate as it had? Buyers do their analysis. Sellers do theirs, and a target is negotiated. Once the target is established, a few days prior to closing, both sides will analyze the estimated balance sheet at closing and compare the NWC to the target. If the actual NWC is less than the target, the purchase price is reduced dollar for dollar by the shortfall. If the actual NWC is higher than the target, there is a gross-up of the purchase price. You can see here just how meaningful that target is. The buyer has the motivation to set the target as high as possible and the seller as low as possible. I’ve seen $15MM deals where the buyer’s proposed target varied from ours by millions of dollars. A seller, without proper representation, can see a significant erosion of sale proceeds simply because they were outgunned in the NWC negotiation.
Most sellers want to maximize their purchase price. They’ve poured a lifetime of blood, sweat, and tears into their business, and they want to know that that work has value. However, when buyers are stretched beyond their comfort level, they will often look for ways to claw back some excess spending. A seller, without proper representation, may find themselves overmatched by a professional buyer. We highlighted above a few of the specific ways a buyer may retrade the deal. Their approach may be overt or covert. The key takeaway is to be on the lookout and be sure to engage transaction professionals adroit at combatting these buyer strategies.
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Benchmark International’s global offices provide business owners in the middle market and lower middle market with creative, value-maximizing solutions for growing and exiting their businesses. To date, Benchmark International has handled engagements in excess of $8.25B across various industries worldwide. With decades of global M&A experience, Benchmark International’s deal teams, working from 14 offices across the world, have assisted thousands of owners with achieving their personal objectives and ensuring the continued growth of their businesses.