Acquisitions: NEGOTIATING THE DEAL

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Dr. John Psarouthakis, Founder and former CEO, JPIndusries,Inc., a Fortune 500 industrial corporation. .
Currently, Distiguished Visiting Fellow / Professor, University of Edinburgh, Scotland. Heis the Executive Editor of www.BusinessThinker.com

Successfully negotiating the deal requires a clear understanding
of the negotiation process.  This article presents a view of the negotiating process which will help you to be a more effective negotiator.  Negotiation needs to be viewed as a problem-solving process.
  Your goal should be to establish a positive atmosphere of communication and trust.  Such an approach is likely to increase the odds that you actually close the deal and develop a sound business relationship with the seller after closing.  To be successful,  you must be well informed–about both the company you plan to purchase and the industry.  You should also understand a seller’s motives for selling, but don’t waste too much energy on fancy techniques designed to psyche out the seller. Further, you must avoid romanticizing or “falling in love with”  any one deal. Being a good negotiator does not require fancy tricks, “bamboozling” or bluffing the other side or reading tiny signals of body language.  It requires that you, as the buyer be as informed as possible about the situation–the seller’s motives and details about his or her company and the industry.  Finally, good negotiation also requires that you know exactly when you are going to walk away from the deal and when the seller is likely to do so.  When you have that clarity, you can be a tough negotiator.

Negotiations begin with the first phone call to the broker or seller and continues through closing. Different aspects of negotiation are usually covered at different stages or steps in the acquisition process. This chapter also reviews some of the more common reasons that sellers sell.  An understanding of the seller’s motives is likely to assist you in structuring a deal successfully.  This chapter closes with some other tips that will help you to be a more effective negotiator.

                                      Negotiation A Problem Solving Process

Negotiation is a problem-solving process by which two parties converge on the same solution.   In the acquisition process, the buyer and seller must concur on a variety of terms expressed in the purchase agreement that documents the sale.  Looked at in this way, negotiation requires the identification of issues and problems that need to be resolved.  The buyer and seller must work out acceptable solutions to these issues and problems.  To accomplish this task, various arguments may be set forth, proposals made and individuals persuaded until all parties involved in the sale arrive at an agreed point of view.

In short, in the final analysis, negotiation is a process that involves resolving business issues that result in financial payment to the seller in some form, whether it be cash, notes, or stock, for buying the company’s assets and operating activities.

 

Know the company and industry well

Successful negotiation depends, first and foremost, on thoroughly knowing and understanding the company and industry with which you are dealing.  Accurately estimating value, and foreseeing potential problems and opportunities require a thorough understanding of the company you are planning to acquire and the industry it operates in. If you lack direct work experience in this particular industry, you may need to do extra homework at the library and to talk with others in the industry.

Depending upon the industry you are investigating, information might be available through a trade association, or other published resources at the library, such as Standard and Poor’s Industry Survey.  Predicast, Value Line Industry Reports and on-line business publication databases are other possible resources.  Your local university or public library reference librarian should be informed about materials available to you. It is remarkable how much printed material is available for most of the major industries.

If you are investigating a relatively new or small industry, you might find less available in print.  However, trade associations often have valuable reports and publications even for relatively specialized industries.  You may talk to typical customers if the company services other businesses, or to manufacturers’ representatives.  Typically, previous work experience in a particular industry is also a very valuable way to learn who you can contact for more information.

Learn the seller’s motives

To be a successful negotiator, you should also have a thorough understanding of the seller–his or her motives for selling and his or her fears about selling or the selling process. This is such an important area, we will explore this area in detail later in the chapter.

Maintain control of business decisions

Don’t let your consultants manage you or the negotiation process.  Successful negotiation also requires the effective management of parties other than buyer and seller.  Although attorneys are needed to work out many legal aspects of the purchase agreement, they should not serve as the negotiators for business related issues that are not strictly legal in nature.  Similarly, you must keep the accountant’s role in proper perspective.  Although various accounting details need to be resolved, in the end, the buyer and seller must develop a deal that is comfortable to them.

Establish a positive atmosphere with the seller

It is important that you maintain an atmosphere of open communication and trust with the seller throughout the negotiation process.  To assure that you reach a closing, it becomes essential that a positive atmosphere is developed in which the buyer and seller view negotiation as a process for finding solutions to issues, and not as a means to create an adversarial atmosphere.  Certain support people, especially attorneys, may need to be managed carefully because their involvement can often lead to a more adversarial atmosphere. On the other hand, it is probably better to be dealing with a well-versed, competent attorney than to be delayed indefinitely by a first time seller who does not know what he is doing.

Build rapport with the seller Successful negotiation and consummation of a sale often requires a certain chemistry between buyer and seller, especially if the company is privately owned. The typical seller may have spent many years building his or her company and may have ambivalent feelings toward its sale.  He or she often has an attachment and obligation to long-time employees and may be reluctant to sell the company unless he or she feels it will be taken care of properly.  The importance of comfort and trust between buyer and seller should not be underestimated.

Don’t try to “psyche out” or bluff the seller Some treatments of negotiation devote too much attention to adversarial tactics such as bluffing or “psyching out” your opponent. Do not concentrate too heavily on this aspect of negotiation or you will miss the main point of negotiation.  It is helpful to know how the other side thinks, what the seller’s priorities are, their concerns, and style of negotiating.  Consider also whether or not they are prone to bluffing, are argumentative or prefer a rationale based on facts and numbers.  But the critical aspect of negotiation is that you want to keep the momentum of discussion moving to keep the process moving forward–not spending all your time determining an opponent’s body language!

Narrow the gap in how buyer and seller perceive the target company

Much of negotiation is really a matter of balancing the perceptions the buyer and seller each has of the value attached to different parts of the business.  Typically, the seller tends to pay more attention to the positive aspects of the business and may be less willing to accept the problems that a buyer might identify, especially those problems that may significantly devalue the worth of the company. Acknowledgement of such problems is necessary, however, to come to terms with adjustments to a finally agreed upon price and terms.

Say for instance, that as a result of your preliminary due diligence you offer ten million dollars in your letter of intent.  But then during the formal due diligence process you begin to uncover facts of which you were not previously aware.  Perhaps you uncover a pollution problem requiring expensive clean-up or liabilities for a pension fund that had not been properly accrued.  You have to convince the seller first of all, that these problems exist, and that secondly, they should reduce the overall price of the company by two million dollars.  A good negotiator is able to persuade the seller that this point of view is valid and to convince the seller to accept the new price or at least some price in between the old and the new one.  However, if there is a lack of trust between buyer and seller, this is much more difficult to accomplish.  Some frequently negotiated topics relate to inventory value, pollution problems and negotiation of other reserves.

Differences in perception in inventory value Inventory valuation is a common area that often requires renegotiation of price.  A seller might perceive his inventory to be perfectly good but when the buyer evaluates it, he or she might find that a part of the inventory only moves once in every three years, or may be altogether obsolescent.  There is no fixed formula to devalue slow moving inventory.  Thus, when inventory is a significant proportion of the total assets, it usually becomes an issue for negotiation.

Pollution problems: Another negotiation topic The cost of environmental clean-up is another problem, the cost of which may not be precisely pinpointed in advance, unless the seller agrees to take care of the problem before closing, although this is not always feasible or the pollution problem might be a pending future threat (i.e., slow moving ground water that has been polluted by factory waste). Negotiation involves not only the agreement of a final price but also the amount of reserves that will be held in escrow for a period of time for these possible “future” liabilities.

Negotiation of other reserves Other reserves typically cover Workers’ Compensation claims, bad receivables and deferred taxes.  In each case, the seller and buyer must agree on how much each issue or problem impacts the prices or the amount of the reserve.  The buyer or the seller are  not necessarily trying to bluff or take advantage of the other side.  It is usually more a matter that each side has different perceptions of the situation. Perhaps the seller feels it is only necessary to put $2000 in reserve.  But you have done your own investigating and determined that $10,000 is a more appropriate reserve for a pollution problem.  This is where the development of trust between buyer and seller can be quite helpful because you, as the buyer must persuade the seller that you are not trying to squeeze him on price but that the pollution clean-up will likely cost about $10,000.  This is only one example of dozens of issues that might crop up prior to closing.

How to convince the seller to accept a variance to the agreed upon price Following the rational model laid out thus far, convincing the seller to accept a lower price or a higher reserve amount requires your accurate understanding of experience by other businesses in your industry.  For instance, you need to research what reserves are typical in that type of business.  You might obtain a balance sheet from another company and share it with the seller.  Or you might share other knowledge obtained from work experience in the same industry.

If you do not know what your peers are doing, then you should be able to rely on your accountants or auditors, who will often know.  Thus, if you reach an impasse with the seller, you might suggest that the two accountants get together to work things out.  With proper guidance, the accounting firms can often come up with a good compromise.  They will review the details and history of the company.  For instance, if the dispute involves Workers’ Compensation reserves, the accountants can review the seller’s workers’ compensation experience.  They might note that a recent spike in costs is not typical of historical data and come back with a more likely scenario of future costs.  However, you will need to understand what changed in the business to cause the recent increase.  In a case of slow-moving inventory, you have to work with the seller to convince him or her that it is not your role as buyer to cover the seller’s bad business calls (in a tactful manner, of course). Sometimes when you really reach an impasse, you may simply agree to split the difference, or change the terms of the deal in some other manner, such as how much is paid in cash at the closing date.

                                          Timing and the Negotiation Process

Unlike some of the other aspects of the purchasing process, such as preliminary or formal due diligence, negotiation begins with the first call to your broker and continues until closing.  However, certain aspects of negotiation tend to take place at different times.

Negotiation and price

Most of the price negotiation is typically done prior to signing the letter of intent. Although neither party is legally bound by the price agreed to in the letter of intent, it is advisable to be as accurate as possible, given the information available to you.  Otherwise, you run the risk that the seller might change his or her mind about selling later on after you have spent more time and money during the formal due diligence period.

On the other hand, if information surfaces during the formal due diligence which has a major effect on your valuation of the target company, clearly you need to negotiate more acceptable price terms with the seller.  Pollution clean-up costs, unreported liabilities for a pension fund, or pending law suits from a former employee or customer might affect the price.  However, contingencies, such as a threatened law suit, or possible clean-up are treated differently than costs that are known.  These uncertainties may be handled differently in the contract by negotiating an escrow amount

Using the purchase agreement to surface problems 

Negotiation of the purchase agreement is an extremely helpful tool in surfacing problems you may not learn about otherwise.  That is why we recommend that you begin work on the purchase agreement as early in the formal due diligence process as possible.

The purchase agreement is the first legally binding document in which the seller maintains that he or she has fairly and openly represented the company accurately.  The consequence of hiding information is straightforward.  The selling owner is bound to reimburse the buyer for costs that the buyer can prove were intentionally hidden, i.e., that the seller knew about but chose not to reveal.  The buyer’s attorney or other legal representative may point this out explicitly to the seller early in the development of the final purchase agreement. Surprisingly, this reminder frequently surfaces new and important information affecting the valuation and pricing of the company.

Negotiation of escrow amounts

In the course of investigating the target company, you may learn of potential problems that are not yet resolved, such as a threatened law suit or possible pollution problem.  Rather than adjust the price, sellers and buyers may negotiate terms in the purchase agreement to set a certain amount of money in escrow for a set period of time until such an issue is resolved.  This type of negotiation usually takes place after the letter of intent is signed, as such issues surface during a more formal due diligence process.

                                                       Meeting with the Seller

An efficient acquisition search depends upon a clear understanding of your seller. You want to find out as early as possible in the acquisition process, first of all, whether or not you are dealing with a willing seller and secondly, whether or not the seller is a reasonable individual. Just as the seller expects you to be a credible buyer, you need to be concerned about whether or not the seller is credible.  You don’t want to waste your time with an individual who is not serious about selling or who is going to be unreasonable throughout the negotiation process.

Reasons for a sale

It will help you in the negotiation process to understand why the seller is selling his or her company.  He may not always come right out and tell you at first, and the initial reason given may not be the primary or accurate one.  But if you are able to build rapport with the seller, and spend enough time communicating with him or her, eventually you will figure out the true reasons.

A seller may have of several legitimate reasons for selling a business.  This section presents some of the more common reasons.

Setting the family estate In our experience, the most common one for a private owner is the need to settle a family estate.  Based on current tax laws, capital gains are generally taxed at a much lower rate than an inherited estate.

A need to “smell the roses” Another commonly given reason is that the owner does not want to take risks any more.  He or she wants to “smell the roses,” so to speak.   Interestingly, in our own experience, the most likely time that most people who sell for that reason, other than for an estate, are between 50 and 65 years of age. Over 65, although of course there are exceptions, typically the owner does not sell.  Either the estate issue is not relevant–perhaps the heirs are already well taken care of– and/or the seller has reached the point where he or she hasn’t developed any outside interests or hobbies.  The company itself is the hobby so the owner

doesn’t sell.  It is often much tougher to buy a company from a healthy 75 year old than from a 50 year old owner!            

Overwhelming challenges    An owner may also decide to sell when some change in the business or industry which makes it difficult for the owner to continue to manage effectively.  These changes may have left the company short of capital, too large to manage or in a poor market position to compete given the company’s current resources and available management skills.  These are all legitimate reasons for selling.  But depending upon your own skills and access to resources, you need to carefully evaluate your ability to take over such a company and run it successfully.

Lack of strategic fit    Large, publicly held companies have other motivations to sell than does the private owner.  Typically, the divestiture of a particular unit takes place because it does not fit strategically with the rest of the company, the parent company decides that the market is too small, or the division is not as profitable or growing as quickly as the parent company desires. Such divisions can also be a good opportunity, depending upon your own background and ability.

The owner is burned out You should be especially cautious of purchasing a company which is run by an owner who has lost the drive to compete.  Such a company may have already fallen into such disarray, from the standpoint of facilities upkeep, employee morale, or customer reputation, that it may not be worth purchasing. Watch out for repeated comments by the owner about the competition.  If your prospect is a manufacturer, you want to explore how recently the company has developed a new product.

Why you should learn about the seller’s motives

You have several negotiating advantages if you can learn the seller’s motives for selling.

Gauging whether the seller might back out of the deal First of all, the strength of the owner’s motivation to sell will give you a guideline as to how hard you should push for concessions or compromise to your point of view.  Especially among smaller companies not represented by an investment banker, the owner may be ambivalent toward the sale.  It is not uncommon for a seller to cool toward the idea part way through the sale and change his or her mind.  Even when the seller has signed a penalty clause in which you recoup formal due diligence expenses, you can never recoup the lost time that could have been spent on a sale that would have been consummated.  If you learn that a seller is not very motivated, you may be well advised to drop the lead and consider a different prospect.

Gauging which compromises might be appealing or likely Secondly, the seller’s motives may guide you in the types of compromises to negotiate during the acquisition negotiation process.  For instance, if the sale is motivated by estate reasons, then you are likely to assume that tax considerations, especially tax savings might be a valuable bargaining chip for the seller.  Timing of the closing, for instance, might affect the year in which taxes are due. This may be more important to the seller than to you as the buyer

Gauging the likelihood of serious problems Finally, the seller’s motives might reflect knowledge about pending changes in the competitive structure of his or her industry. A large competitor might be moving into his or her territory. Or a major customer may have cancelled a long standing order.  Although such issues should surface during due diligence, it is important to learn of serious problems threatening the business early on in negotiation so you can evaluate whether you are prepared to deal with them.

                                                  Don’t Romanticize the Deal

One of the most important aspects of being a tough negotiator, i.e., of negotiating to your best advantage, is to know exactly when you would walk away from the deal.  It also requires that you realize that you should be ready to walk away from any deal, regardless of how much money you might have sunk into it up to that point.  Don’t make a deal just because you have spent a lot of time and money on it, unless the deal really makes sense.  This phenomenon, the perceived need to pursue a course of action solely because of the time and effort already expended, is referred by management experts as escalating commitment.  Even experienced managers  fall into this trap from time to time.

In short, regardless of the money spent, if at a particular point it is clear that the purchase would be a mistake, or the price has simply become too expensive, you must remember that there are always alternatives out there.  Critical to your negotiating strength is the maintenance of a lead flow throughout negotiation, and clear thinking, all the up to the closing of the deal.  Don’t stop looking once you have signed a letter of intent or even when you have completed formal due diligence.

                                                 Summary                                                                       

Perhaps too much has been written about elaborate or indirect negotiating techniques in business situations.  At least in the case of acquisitions, we espouse a direct, problem-solving oriented approach. This builds trust between buyer and seller and allows for resolution of key issues.

Thorough understanding of the seller’s motives and details about his or her company and industry will aid your negotiating ability.  You should thoroughly understand the prospective company, including the likely risks and potential problems you might encounter if you take over ownership.  Further, you should be able to present such concerns in a way that the seller will find believable and will be able to accept.

You may run into a seller whose perception of the company is too different from your own to resolve in negotiation or in some other way becomes unreasonable.  For this reason, it is always critical that you keep your lead flow going. This may necessitate having a cash reserve or going back to investors for more money so that you can investigate other leads.  Be cautious about holding all your “eggs” in one basket.  Keeping your leads flowing will also reduce the chance that you romanticize any one deal.  Also keep in mind that there are always other “fish in the sea”.  You want to guard against escalating commitment, the phenomenon that you become more strongly committed to the deal just because you have invested more time and money in it.  No deal is perfect, but if you really uncover a major concern, it is never too late to back out of a deal prior to closing.  It is better to lose $30,000 or even $100,000 than to pay $500,000 or more for a business that is headed for serious trouble.

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Reference: “How to Acquire the Right Business”

John Psarouthakis & Lorraine Uhlaner

Published by Xlibris, 2009

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RECOMMENDEDREADINGSFOR CHAPTER 12

1.”The rule of the four P’s in Tuller, Lawrence,  Buying In: A complete guide to acquiring a business or professional practice, Liberty Hall Press, 1990. pp107-111

This short reading describes the four P’s: People, planning, perception and patience.

2. “Why Sellers Sell” in How you can buy a business without overpaying by Merfeld, Eugene and Schine, Gary L,New York: The Consultant Press, 1991, pp.15-20.

This reading goes into more detail about the reasons for selling, including retirement, the owner is bored or fed up with the business, the need for a regular peacock, a good offer comes up, family life changes, spouse job change, business owner gets job offer, future growth limited by management abilities, and need for investment capital.

3. “Seller Perspective versus Buyer perspective, in How you can buy a business without overpaying by Merfeld, Eugene and Schine, Gary L,New York: The Consultant Press, 1991,pp. 21-22.

This reading describes in more detail the theme of the emotional attachment to the business by the small company owner, seller optimism, potential mistrust between buyer and seller, and the notion that some sellers think that no one else can run their business.

4. “Chapter 13: Negotiating the Purchase”, in How to buy a business by Joseph, Richard, et al,Enterprise,Dearborn, 1993, pp. 198-208.This chapter has several suggestions for negotiating, including some common traps and suggested guidelines.

 

 

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