You’ve established your company, made it through the hard years of building the business, developing your product, taking on staff, and raising capital from investors, and now you have a buyer interested. Assuming you have some interest in selling (and most business owners will sell if the price is right), what happens next?
The m&a process can seem strange and unnecessarily complicated to those who haven’t been through it before. This guide talks you through the initial stages of that process. Our second guide in this series, tech company m&a – closing the deal, discusses what happens between signing the letter of intent and completing the sale of your business.
Because tech m&a transactions are more commonly structured as sales of the business and assets of a company, rather than the shares in a company, this guide focusses on the first steps in an asset sale process. However, the steps we describe will apply generally to share sales, although the detail at the pointy end of the transaction (the sale and purchase agreement) will differ.
We have written this guide from a seller’s point of view, since sellers are often m&a first timers, whereas acquirers usually have some prior m&a experience.
the first date
The first thing you need to work out is whether the buyer is serious about acquiring your business.
If your potential buyer (or buyers) are on the hook as a result of a sales process run by your investment bankers, it will be pretty obvious. But if the buyer has approached you, you will want to find out if that buyer has a genuine interest in your business, and, what sort of offer they are looking at. There is no point wasting time and effort with a buyer if you wouldn’t be interested in selling on their terms. Even worse, you do not want to provide sensitive commercial information to a tyre-kicker or possible competitor who may be using the process to obtain those details.
Find out from a buyer who has approached you:
- why that buyer is interested in buying your business
- how it would fund a purchase
- any assumption it has made about your business
- if they are offering cash or another in-kind offer for the business (e.g. shares in their company)
- whether any earn-out is proposed (where payment of part of the proposed purchase price is deferred and linked to the business meeting pre-agreed targets over time).
This information will help you get a feel for whether the interest is genuine and the offer may be attractive to you (and your other shareholders).
If an earn-out is being requested, think carefully about whether you can work for the proposed buyer. Often sellers’ of tech companies have been their own boss for many years. The transition to being just an employee or a small cog in a larger (possibly international) corporate wheel, can be unappealing.
If you are interested in the proposed offer, you’ll need to provide some high level information to your potential buyer. Before you do this, make sure the buyer signs a confidentiality agreement (or NDA) to protect your confidential information. Our template NDA can be used for this. At this stage, the buyer will normally want to see your financial statements together with other financial, commercial and market information that generally describes your business.
If the buyer still wants to proceed after testing its initial views about the value of the business, it will often propose in more detail the terms on which it is willing to purchase the business. There is no particular form for this, but it is often set out in a letter of intent. The purpose of that letter is to frame the offer and set out the proposed structure and key commercial terms of the offer. The buyer proposes the first draft of these terms but bear in mind that they will be the buyer’s first shot, you can and should negotiate those terms to ensure you’re happy with the deal.
While the letter of intent is not legally binding, it is very difficult in practice to change things agreed in that letter. So it’s a good idea to run the letter of intent past your advisors or get them involved in the negotiations, because the key terms and value of the deal will be set out in that letter.
The letter of intent sets out the price (and how it will be paid), any assumption made in calculating the price, and the conditions required to complete the transaction (e.g. shareholder approvals, consents to the assignment of key contracts).
While the key thing you will be interested in is the price, this is not the end of the story. A lot of value in the deal rests on how the price will be paid. It’s a good idea to agree the payment structure early on in the process.
cash v equity
Tech company buyers sometimes offer equity (shares) in their own business, or a combination of cash and equity, rather than straight cash to buy a business. This is particularly the case where the buyer is a listed company or is undertaking a roll-up acquisition with a view to a listing in the near-term. In either case, before accepting shares instead of cash, you need to carry out your own due diligence on the buyer, i.e. to make sure you understand the value of the buyer’s business. Clearly, this can be a risky option because you are reliant on the future performance of the buyer (over which you will have no control) to get full value for the sale of your business.
Because tech companies are often selling a story about on-going growth, tech businesses are often valued on their projected growth, not on historical performance. The more your price is based on projected growth, the more likely it is that the purchase price will be determined and paid based on the future performance of the business.
An earn-out is a mechanism used where part of the purchase price is dependent, and is calculated based, on the performance of the business after completion. That part of the price is paid-out over a period (often 2 years) only if certain pre-agreed performance targets are achieved.
Earn-outs have many advantages for a buyer, including delaying the payment of some of the purchase price, ensuring on-going seller involvement in the business, and usually most importantly, protecting the buyer against the business not performing as projected. Earn-outs are also a helpful way for a buyer to transition a very founder-dependent business to the new owners. It ensures that the founder remains with the business, and remains motivated to perform, while the new owner’s team learns the ropes and forms relationships with key customers and suppliers.
However, earn-outs are notoriously difficult to achieve, largely because of the seller’s lack of control over the business after completion. Once the business has been sold, operational and structural changes are likely (e.g. day to day operations, cost structures, management, and priorities). The objectives of the new owners may be different to yours, and it can be a real struggle to keep the business on track to meet earn-out thresholds.
Ideally, a seller should not agree to an earn-out but, in reality, if your value is based on future growth, it will be difficult to avoid an earn-out.
Some lawyers like to address caps on the seller’s liability in the letter of intent, in order to limit the negotiation later on (particularly if a key driver of the seller is minimising its liability risk). However, in our experience, it’s better not to discuss liability caps at this stage because it:
- draws the focus away from the positive value of the deal by dwelling on the more negative aspects of seller protection
- may give the impression that you have concerns about issues in the business.
Also, this is one aspect of the letter of intent that lawyers always have no hesitation in renegotiating – so any victory may be pyrrhic .
are we exclusive?
Buyers usually want to be granted exclusivity in the letter of intent. This means that, for a pre-agreed period of time, the seller cannot enter into sale discussions with another party. The rationale for exclusivity is that a buyer will spend considerable time and money investigating the business and will be reluctant to do this if they can be gazumped.
The exclusivity period is usually set at the period of time the parties expect it will take to reach a signed sale and purchase agreement – so it differs from deal to deal, depending on complexity and momentum. As a seller, you will want the period to be as short as possible, both to drive the deal forward and to ensure that, if that deal falls through, you have not wasted too much time before you can negotiate with others.
Of course, as a seller, one of the best ways to optimise the price (and deal terms) is to create competitive tension, whether real or imagined. The opportunity to do this is limited if exclusivity has been granted or if the time period agreed is lengthy. So, if you can avoid exclusivity, or agree a short period, push hard to do this. A short period is particularly important because a buyer can get nervous when exclusivity is about to expire – a situation you can use to your advantage to impose deadlines and resolve issues.
It is Murphy’s law that once it looks like you are off the market, other suitors come out of the woodwork. If that happens during exclusivity, it can leave you in a difficult position if the other potential buyers look like a better option. A helpful way to deal with this is to enable the buyer to break exclusivity by paying a fee to the original prospective buyer (a break fee). This break fee can be substantial, as it is usually set at an estimate of the buyer’s costs relating to investigating and negotiating the transaction. Including a break-fee, though, can mean that you can still sell the business to a third party if a higher offer comes along. In effect, the cost of the break fee is borne by the new buyer.
Check out our second guide in this series where we discuss closing the deal.