The execution of a letter of intent with the buyer is a critical step in the sale of a company. The LOI typically grants the buyer exclusivity to complete its due diligence, negotiate the purchase agreement, arrange financing and close the deal. The due diligence process is the fulcrum on which everything else depends; if it proceeds smoothly, then everything else usually falls into place.
My partners and I encounter buyers with two distinct due diligence mentalities — those focused on confirming the confidential information memorandum’s facts and the viability of the business so a closing can proceed, and those focused on playing “Gotcha!” in order to reduce the price.
Those buyers whose mentality in due diligence is to support a closing look to the underlying reasons for what due diligence uncovers.
- The seller missed its forecast due to a shipping delay? These buyers are comforted that the delayed shipment went out the door in early January … after the blizzard had cleared.
- A customer cancelled a big order? These buyers are relieved to learn that a new customer made a comparable big order.
- A critical machine tool broke down? These buyers are impressed that the seller successfully outsourced the machining while the equipment was repaired.
Such a buyer rightly insists on a price reduction if there is no good explanation for or balancing factor to a due diligence finding, but keeps an open mind while hearing the explanation.
Buyers with a gotcha mentality try to reduce the purchase price, underlying reasons be damned.
- Some inventory has been on the books for more than one year? That it is still usable and being sold regularly at a 50 percent gross margin is irrelevant. “Deduct the inventory from the purchase price.”
- A promised insurance recovery was delayed for four months? That it was paid in full is irrelevant. “Deduct the amount from the purchase price. Better yet, seven times the amount because the price is seven times EBITDA.”
- The cost of developing a new product was 50 percent over budget? That orders for the new product are 100 percent ahead of forecast is irrelevant. “Deduct seven times the overage from the purchase price.”
- Last year’s profitability was compressed by higher than anticipated raw material costs? That the raw material costs have dropped is irrelevant. “Reduce the purchase price.”
- Many of the seller’s customers are having troubles of their own? That this was stated clearly in the CIM and the management presentation is irrelevant. “The price must come down.”
Buyers with a gotcha mentality win some due diligence battles, but they often lose the due diligence war. This is because sellers, along with their investment bankers and lawyers, fight back aggressively with the balancing factors. The inevitable tension frequently drives the seller into another buyer’s arms. Even if a compromise is made, the seller will typically now fight twice as hard on unrelated points.
I can assure you that it gets around who those gotcha mentality buyers are. As a result, they see fewer acquisition opportunities and face sellers who are on guard when dealing with them.
Mark A. Filippell is managing director at Citizens Capital Markets and author of “Mergers & Acquisitions Playbook: Lessons from the Middle-market Trenches,” published by John Wiley & Sons, Inc. Reach him at [email protected].