Even after a buyer and seller have agreed on a valuation, it can take months for an acquisition to close. The reason? Often it's tense negotiations over the purchase agreement, in which the deal's nuances--working capital, warranties and representations, survival periods, earnouts--get ironed out.
While purchase agreements seldom make headlines (those are usually reserved for the deal's public price tag), they can provide a gauge through which you can assess the mergers-and-acquisitions climate. For example, the terms of purchase agreements--and the tenor of the negotiations--can indicate whether it's a buyer's or seller's market.
A new survey of CEOs and CFOs at small and midsized companies shines a fascinating light on how purchase agreements have (and haven't) changed in the last 12 months. Specifically, the 190 executives and financial advisors polled by national law firm Dykema Gossett PLLC in its annual Mergers & Acquisitions Survey were asked: Which of the following provisions in purchase agreements have you found to be the subject of increased negotiations during the past 12 months? Here were their top three answers:
1. Working capital purchase price adjustments (51.40%). It sounds complicated. But it's easy to grasp what it means once you define "working capital" in an acquisitions context. Valuations expert John Warrillow defines it as "the money that your business needs in the bank the day you hand over the keys to the acquirer."
Dykema's Thomas S. Vaughn says that of all the provisions in purchase agreements, the firm generally spends the most time negotiating this one. "It's less sensitive to market ups and downs than the others," he adds.
Why is it hard to find an agreed-upon value for working capital? Several reasons. Say you're a seasonal business. You might need less working capital around the holidays than you do in the summer (or vice versa). Then there's accounts receivable. Can the acquirer realistically expect to collect on invoices more than 90 days overdue? "You might know [the overdue customer] is good for it, but the buyer might not believe it," explains Dykema.
And that's just the start. Inventory and expenses are also large pieces of the working capital negotiation. While you'll never be able to sidestep this provision, you can minimize it depending on your pricing model, notes Warrillow. "If your business just spits out cash because you've got a subscription model or you charge a big chunk of what you do up front, the acquirer's gonna come along and say, 'Hey, we don't need to inject any working capital in this business, therefore we're happy to write a bigger check to the owner,'" he writes.
2. Rep/warranty survival periods (44.13%). The representations and warranties in question here are, essentially, the written promises that the buyer and seller make about themselves to each other.
If either party breaches a promise (or is thought to have breached one) then the other party, of course, can bring a claim. So in a purchase agreement, the provision to be negotiated is this: For how long a period of time--after the sale is final--can one party bring a claim against the other?
The usual period of time--a.k.a. survival period--is between 12 and 18 months. "The sellers want it short," explains Vaughn. In a seller's market, he adds, sellers have more leverage to seek shorter survival periods. "They can say, If you want this deal, [the survival period is] only going to be 12 months, take it or leave it."
Why are survival periods challenging to negotiate? Mainly because, as a general rule, the buyer and seller are coming from opposite perspectives. Both want protection. But one party achieves it with a shorter survival period, the other with a longer one.
Moreover, some representations and warranties require their own particular side negotiations. For example, if you're acquiring a business whose environmental track record is potentially troublesome, you might be a stickler for a longer-than-18-month survival period when it comes to strictly environmental claims. Negotiating the lengths of these specific survival periods only lengthens the already significant distance to-be-bridged between buyer and seller.
3. Earnouts (36.31%). An earnout is a way for a buyer to mitigate risk. Instead of buying a business valued at $1 million for $1 million in flat-out cash, the buyer agrees to pay the seller (say) $500,000 in cash. The rest of the money comes during an agreed-upon period of time, and the sum is based on agreed-upon profitability targets.
What should those profitability or EBITDA targets be? How long should the time period of the earnout be? These are the thorny subjects of negotiation.
Interestingly, it's become a little less thorny in recent years, according to Dykema's survey respondents. In 2012, a whopping 46% of them indicated that earnouts were the subject of increased negotiation in purchase agreements. In 2013, that number was down to 41%. And this year, it's all the way down to 36.31%. "Which is consistent with a market that's heating up," says Vaughn.
Which makes perfect sense. The hotter the market for sellers, the easier it is for sellers to demand a majority-cash deal with a minimal earnout. Recently, Vaughn has even observed a company for sale at auction exert enough leverage to insist on all-cash bids. The lone buyer who proposed an earnout "didn't get to the next round" of bidding, he says.
Of course, most deals are still going to include earnout provisions from one to five years, depending on your leverage. Your takeaway, as a seller, should be a newly informed mindset about the timing of your sale. If you want to completely exit your business in six years, you should consider selling it in two years, on the assumption that the sale itself will take one year--and your earnout period will be three years long.
"Typically when you sell a company you've got to stay on--on average for three years," notes Warrillow. "And so, for most people they've got to move up their sell-by date by at least four years. If for example you say, 'By age 50, I wanna be on the beach,' you really need to actually start selling your company at age 46."