“Far too many owners obsess over price at the expense of terms,” says Giff Constable, former investment banker, CEO through 3 exits, and currently VP of Product at Axial. “It’s absolute insanity to think about maximizing valuation at the expense of terms. This is true whether you’re taking a minority investment or selling.”
Terms determine what is actually cash that you can count on keeping after a sale vs. not. Imagine someone buying your house for $1 million dollars… but having the right to stick you with the bill if it burns down a year later. It may sound crazy, but in M&A such setups aren’t unheard of.
We talked to Giff about what factors besides price sellers should focus on when evaluating a potential deal.
This refers to the way in which you and other shareholders will get paid, i.e., cash vs. stock. “If you get stock, it’s quite vulnerable to shifting. It not only matters when the number of shares for the deal is calculated, it matters what happens to the stock once the deal is done. You could see your value evaporate,” says Giff.
Your decision will in large part depend on your transaction goals. “Let’s say you’re thinking about retiring and want to make sure you have money in the bank — in this case, you might prefer buyers paying cash, even at a lower valuation.” Your consideration preferences may also depend on the buyer profile — for example, you may be willing to take stock from established Fortune 200 companies but only cash from all other parties.
When you receive stock, you want to think about a collar agreement to protect from movement while the transaction closes. It is also not unheard of for buyers to try to insert language capping how high the stock can rise within a certain time period after the deal. You might consider putting in a “floor” which protects you from the stock dropping too far.
“This happened to me with the first company I sold,” says Giff. “It was a small all-stock deal, only $8 million, and it happened before the dot-com bubble crash.” Giff knew the acquirer planned to go public, which was one of the reasons he and his team chose them among their suitors. “We were confident the currency was going to become liquid. If you take private company stock, there’s always a risk you’ll never be able to sell.
“While I suspected the market might crash at some point, I thought we were far enough along to get out. I did put a floor in place, so that if the stock fell they would have to give me more. That is what happened when the bubble burst, but in retrospect, I should have done the deal in cash instead and locked in my returns.”
Earnouts are a common way to bridge the gap between a seller’s expectation of value and a buyer’s willingness to pay. “It’s a way to get the price up when the buyer’s struggling to justify your price expectations, but you have to consider whether the earnout is worth the risk,” says Giff.
Even if you’re staying on after the sale, there’s no way to predict how much control you’ll have over your ability to hit agreed-upon numbers. “Your plan to hit that earnout could get totally blown out of the window by a restructuring, new management, different strategic initiatives, or any of a number of other what-ifs.”
Bad behavior on the part of the buyer isn’t uncommon. In a panel at last year’s Axial Concord conference, Scott Hakala, Principal at ValueScope Inc., told a story of an exited owner with a 3-year earnout who watched from afar as the “buyer changed gears six months in and basically tanked the company.” He’s also seen roll-ups in which buyers deliberately credited the wrong business with sales in order to avoid paying an earnout.
“The buyer is going to want as much flexibility as possible, but you want as many guarantees as possible,” says Giff. “Furthermore, earnouts can cause real rifts between owners and employees because incentives get misaligned and trust can break down.”
Reps and Warranties
Reps and warranties refers to the “assertions that a buyer and/or seller makes in a purchase and sale agreement” (Divestopedia).
As a seller, “the buyer will try to stick as many guarantees on you as possible — it’s your job, with your lawyer and banker’s help, to fight them off,” says Giff. Make sure to hire an experienced transactional lawyer for this purpose.
Keep in mind potential concerns like new lawsuits (do you have to foot the bill for future litigation and for how long?), environmental issues (a particular concern for companies with physical installations), and employee retention (can they claw back money if key employees leave?).
“Think about what possible surprises might come up if you sell within the next 6-12 months,” Giff advises. “Is there a lurking group of unhappy customers who might churn? Do you have situations with key employees that might become problematic? There’s no need to disclose hypotheticals, but you should discuss each potential issue with your lawyer and banker, as they’ll affect how hard you fight for specific terms in certain areas.”