It is common practice in a standard Merger & Acquisition transaction for a sophisticated buyer to request that the potential seller agree to a period of exclusivity or exclusive dealings at the front end of the potential transaction.
What is not commonly understood, however, are the true consequences to the seller for agreeing to exclusivity too early in the process.
This practice – the practice of obtaining exclusivity without giving anything in return - is so engrained into the expectations of a selling company, that even sophisticated companies that should know better get sucked into this trap. And they not only go along willingly, but happily . . .
Most sellers get excited when a sophisticated buyer asks for the seller to agree to a period of exclusivity or exclusive dealings. What very few buyers realize however, is that this is the single-most effective tool an institutional buyer can use to lower the purchase price for a prospective target company. And savvy institutional buyers generally get it for the low, low price of merely asking for it.
In fact, most sellers don’t even realize that they have given anything up by agreeing to an exclusivity period. They don’t realize that with a single request, the buyer has fixed the ceiling on the purchase price for the company without effectively promising anything of value in return (or if there is anything actually promised in return, it is nothing that will protect the seller from erosion of the purchase price for his or her business).
Somehow, when a buyer receives a request for exclusive dealings with an institutional buyer, the emotional translation is “We just made a deal for exclusive negotiations with a highly motivated buyer!” - when what the buyer ought to be thinking is more along the lines of “Oh my Gosh, we just asked the fox to close the door behind himself on the way into the henhouse!”
I am not saying that there are never situations in which granting a period of exclusive dealings to a potential buyer is appropriate. That discussion, however, is beyond the scope of this article. What I am saying is that granting a right to exclusivity to a potential buyer should never be done casually, should only be done at the appropriate juncture in the transaction, and should not be done without an exchange of actual value from the buyer if at all possible.
Institutional buyers have multiple advantages over sellers.
An “institutional buyer” earns the title in the first place by having done multiple transactions. It is not a question of whether an institutional buyer has integrity or not, it is simply the fact that institutional buyers have become very good at setting the stage for a favorable outcome - in their favor.
They tend to be very good at getting the best value out of a transaction. Sellers on the other hand, typically only sell a single business or two in their lifetime and do not have the benefit of trial and error.
Most buyers believe that hiring a competent M&A attorney to negotiate and/or document the transaction will protect their interests. What sellers do not realize, however, is that there is a very large distinction between protecting “legal interests” and protecting “business interests” – and most M&A attorneys – even very competent ones, do not consider it their role to optimize the purchase price or the ultimate value to the seller. This is generally considered something that falls squarely within the “business decision” category to be worked out by the seller and his other financial advisors – and not to be second-guessed by the attorney.
While it is true that many sophisticated sellers have a very sound understanding of how to strike the best business deal, the vast majority of business owners faced with selling their businesses do not have either the experience or the expertise in their corner to craft value-optimizing outcomes.
Even the best financial advice will benefit from a solid understanding of the junctures in a transaction where the purchase price is potentially driven down and how to counterbalance the equation for the benefit of the seller.
Unfortunately, most M&A attorneys do not make it their business to protect the client’s larger picture business interests, as well as their legal interests. There is a profound difference between crafting legally competent documents to document the transaction (clearly enumerating the parties’ respective responsibilities and liabilities in a manner to avoid confusion and conflict), and managing the transaction in a manner that optimizes the value to the seller.
While we will need to cover this topic at greater length in another article, the point can be illustrated quite simply by the fact that a deal that closes for $5MM dollars may be just as “legally” sound as the same deal that closes for $8MM dollars – in fact you could even use the exact same transaction documents.
But I doubt the $5MM seller would feel like his interests were actually protected if he ever realized that he could have received $8MM for the same assets, and that how the transaction was structured and managed could have made the difference.
Institutional buyers are keenly aware of every juncture in a transaction that allows them to set a ceiling on the purchase price, and to hard-wire future reductions into the process – where sellers on the other hand only realize that they must go through each of the transaction phases in order to come out the back end. How those junctures are pro-actively managed, however, has everything to do with what comes out the back end, and ultimately, how much value is actually retained by the seller.
In the Merger & Acquisition game, however, the process itself is generally stacked against the seller because each phase of the transaction is designed to lower the purchase price. So, unless Seller’s counsel is as keenly aware of those same transaction junctures as the buyer and is allowed to manage those junctures proactively, the seller will essentially be relegated to accepting (or rejecting) whatever the institutional buyer is willing to pay for her business – after cutting off all other options (after the seller has willingly handed over “rights of exclusive dealing”).
And the whole process of boiling the frog starts with a request for exclusivity which is seldom even questioned before whole-heartedly given by a willing victim. (I employ a degree of hyperbole here mainly because it is a fun way to write, but the truth of the matter is that there might be less hyperbole than you would expect – and thus the importance of providing resources for unwitting sellers considering the sale of his or her most valuable possession.)
Institutional buyers know the value of closing the door to the negotiations behind them. If a sophisticated buyer can close off all discussions with other potential purchasers (which might very likely result in a bidding war or other market forces driving the purchase price up), they are much better off. Conversely, if locked in the henhouse with only the fox to negotiate with, a seller confronted with all of the reasons why the purchase price should be reduced, does not have access to any outside market forces counterbalancing the equation. The effect is both mathematical and psychological.
There are many M&A firms that can competently protect a seller’s legal interests in a Merger & Acquisition transaction, but there are very few that even contemplate protecting the value in your business by proactively advising you how to avoid the valuation traps set by a sophisticated buyer.
Ask your attorney how to best protect your bottom line in a sale of your business or reach out to the Rose Law Firm with the same question. Our focus is to – PROTECT – MAXIMIZE – REALIZE – RETAIN ® - the value you have created in your business, regardless of the transaction or legal matter that you find yourself faced with.