THE NEGOTIATION PROCESS

Since the sale of your business is extremely complex and involves consideration of so many issues, you must expect negotiations to have significant ups and downs. Even if negotiations appear to break down altogether, it is best not to burn your bridges as you may be able to restart them at a later date. Your objective during the period leading up to the agreement of a sale price is to manage negotiations as positively as possible by paying attention both to the project management of the process and also by actively attempting to build consensus between yourself and the purchaser as to what has been agreed so that the remaining items for discussion can be gradually overcome.

The keys to successfully managing the negotiation process are as follows.

Listen to the purchaser

It is important to understand the purchaser’s needs and wants and therefore their reasons for buying the business as well as the concerns that they need to address in order to feel comfortable in doing so. In particular, do not assume that the purchaser’s concerns have gone away just because they have not mentioned them for some time. However, once you have agreed with them that a concern has been addressed, you should avoid unnecessarily reopening this as an area for them to consider.

Whilst listening, attempt to identify any particular issues in how the purchaser wants to structure the deal that may present you with a serious problem, given your objectives in the sale (for example you want to retire immediately, whilst the purchaser is evidently going to want to negotiate that you stay on for a number of years in order to smooth the transition).

The key to achieving this is to let the purchaser talk so that they can disclose their attitude towards the items under discussion. By contrast, some sellers become so focused on the need to ‘sell’ during negotiations that they appear to wish to dominate the conversation rather than negotiate an agreement between two parties. This leads on to the following.

Keep focused on your objective

Your objective is to reach an agreement to sell the business for an acceptable price and on acceptable terms so that you then keep the proceeds. It is not to dominate the conversation and you should try to avoid becoming emotionally involved (which is one reason for leaving much of the basic price negotiation to professionals working on your behalf). The buyer will be doing their job by making their opening offer a low price, at which point some sellers become insulted or upset and attempt to break off negotiation.

Remember that price negotiation is a process, not an immediate event, that will require you to interact with the purchaser in order to attempt to seek a deal which is acceptable to both sides. Retain a clear focus on your priorities and your target of a walkaway price, avoid becoming bogged down in unnecessary details (although appreciate that all the details will need to be covered by way of the final agreement), and remember it is a process with a purpose. What is important is achieving the sale and not in retrospect the process that led you there. Therefore remain flexible so as to be able to work round any objections or problems arising, and consider and make alternative proposals as part of the negotiation process. In a negotiation you should not expect to win every single battle and therefore it is important to prioritise your objectives so that you are in a position to trade concessions on items of lesser importance to you in order to obtain concessions from the purchaser on items of critical importance to you.

Be flexible

Whilst being flexible, remember that any business sale is not simply about the headline price for the business, but is also about the terms on which the deal is done. So be prepared to trade items to do with price against the nature of payment.

Be positive

Be positive and cooperative in your approach to the negotiations as at all times you are looking to increase the buyer’s level of comfort and confidence in your business and in support of that, in you.

Be open and honest

Attempts to pull the wool over the purchaser’s eyes will undermine their confidence and therefore the price they are prepared to pay. Always remember that any price you negotiate and agree at this stage will be subject to their detailed due diligence and the effect of uncovering adverse information (particularly if it appears this has been deliberately withheld during initial negotiations) will have a more significant adverse affect on the final price agreed and paid (and may even cause the deal to collapse altogether) than if information had been made available during initial discussions so it could be taken into account in negotiating the basic price.

Don’t invent offers

Do not be tempted to create fictitious offers from non-existing alternative purchasers. If at this stage you are dealing with more than one prospective purchaser, it is appropriate to tell them and it is appropriate to put in place a sensible timetable during which to obtain offers from both interested parties. If you are in this position, you need to make clear to both parties how you are going to deal with considering such offers. You may consider getting each party to a position where you can conduct an auction (once one party has made an offer you go back to the second to see whether they will top it, before returning to the first to see whether they will increase their offer), which may seem a good way of increasing the offer price. However you will need to discuss this carefully with your professional advisors as unsurprisingly, many purchasers are unhappy at being placed in such a situation and the threat of such an auction may cause one or more to consider exiting the process.

If you attempt to use the prospect of a fictitious prospective purchaser to drive up the price of a real party you are negotiating with, you must expect that at some point the existence of this deception is likely to be discovered by the real purchaser, with potentially damaging consequences for the sale.

Don’t walk unless you mean it

Whilst you must have your drop-dead price and must not therefore be afraid to walk away from any negotiation if it does not seem to offer the prospect of achieving this, you should only threaten to do so if you really mean it and if you have explored every other opportunity and option to try to negotiate around the problem. You should never grandstand on points of pride or ego in this process.

Leave doors open

If you reach the stage where you need to withdraw from discussions because it appears a deal cannot be reached, you should always attempt to end on a positive note, express your regret for the fact that you do not appear to be able to be in a position to conclude a deal with the purchaser at the present time, emphasise the points on which you have managed to reach agreement and leave a channel open for the purchaser to come back to you should they be willing to reopen negotiations over the points which at the moment cannot be resolved.

Know when to stop

Once you have achieved your objectives, stop. Bear in mind that just as you will have your drop-dead price below which you are not prepared to sell, the purchaser will have their walkaway price above which they are not prepared to pay. If you have achieved your objectives, do not be tempted to over-negotiate, as while you might obtain extra funds, you might drive away a perfectly acceptable deal.

STRUCTURING THE DEAL

Whilst much of the detail of structuring the deal will be negotiated during the period of due diligence and drawing up of the final sales contract, some of the overall elements will need to be thrashed out in order to agree the basic price and shape of the sale for incorporation into a formal offer letter from the purchaser to you that sets out the main terms of the proposed deal (known as heads of terms, or heads of agreement discussed in more detail later in this chapter).

Negotiations at this point are therefore not simply about price, but will also be about the overall shape of the deal.

Some of the principal issues that will need to be dealt with at this stage are detailed below.

How is the sale to be structured?

Broadly speaking if your business is operated through a limited liability company you will have two alternatives. Either as the owner of the shares in the company you can sell to the purchaser your shares, so that they have ownership of the legal entity that is the company, together with all its assets, business and liabilities; or the company can sell them its business and assets in return for cash or other consideration which then belongs to the company under your control.

For tax reasons (see Chapter 13), as a business owner, you are likely to want to sell the purchaser your shares. However for accounting reasons, the purchaser is more likely to want to buy the business and assets, as they then have choices as to how they account for those in bringing them into their own books which will affect the amount of goodwill they have to account for within their own accounts which they are also, as a result of recent changes in taxation, now able to write off against tax.

Additionally, if the purchaser buys the shares of the company, they are acquiring the company’s liabilities as well as its assets. Whereas if they only buy the business and assets, other than some specific liabilities (such as the rights of employees which will be carried across and become rights against the new owner as the new employer under the Transfer of Undertakings, Protection of Employee Regulations, or TUPE), and any liabilities arising that relate directly to specific assets (such as the new owner takes over liability under the property or plant and equipment leases), the purchaser has limited their risk in the transaction as they will not be picking up any other liabilities the company may have.

If however the purchaser buys the shares, the company under their ownership continues to have all its own old liabilities. The worry for purchasers here is that there may be claims of which they are not aware that may subsequently arise and give them problems. For example, the company might have had some form of legal dispute which the owners quite reasonably feel can be defended or is unlikely to be pursued further by the other side. There is always the risk for the acquiring company, however, that the complainant may decide to take it further and may be successful. Alternatively the company may have supplied goods which have a warranty attached to them, and at the time of the sale there appears to be no problems with such goods in circulation, however at some point after the sale it transpires that problems have arisen that are covered by the warranty for which the company under its new ownership is now liable.

If a purchaser is to buy the shares of the business the seller must expect a more significant level of due diligence work to be undertaken in respect of potential liabilities so that the buyer can ensure they have avoided any of the above problems. Alternatively, if the buyer wishes to purchase only the business and assets, because of the adverse tax consequences for the seller, you may wish to seek a higher price from the purchaser to compensate you for the tax disadvantages of this method of sale.

How certain is payment going to be?

Many owner managers become so focused on the headline price of the sale, that they fail to take into account how this interacts with the terms of payment.

Leaving aside for a moment any payments made in respect of future profits above certain targets, consultancy after the sale, or interest on finance for the sale provided by the seller; the core of the deal will be a payment made by the purchaser to the seller for the business and assets or the shares in their company. This payment can either be made by way of cash or cash equivalent (within which I would include shares in the purchasing company where the shares are listed and readily tradable on a stock exchange, so that the seller can immediately convert some or all of the shares received into cash), or paper, by which I am referring to payment using instruments that are not immediately realisable by way of cash. Such paper instruments can include such things as:

• loan notes, whereby the purchasing company agrees to pay consideration over some period into the future
• options over the purchasing company’s shares which are not immediately exercisable
• or shares where there is no immediate market through which you can turn them into cash (for example where the company is private and therefore not listed on any stock exchange).

Some deals will be a mixture of the two. As illustrated in the chart in Figure 6, the greater the element of cash or near cash in a deal, the greater your certainty of payment. The more paper there is in the deal, the less certainty you have of eventual cash outcome, and therefore you will seek a higher price to compensate you for this extra risk.

Case study

An Internet start-up sold a percentage of its equity to new investors (also in e-business) in return for listed shares in those investors valued at £8m. By the time the company decided to sell these shares in order to raise cash, the technology market had gone into decline and the shares were eventually sold for £4m.

How much are you financing?

Aligned to the above, what degree of the financing for the purchase are you going to have to provide? If you are in the fortunate position of selling your business to a cash rich purchaser, this may not be relevant. However in the case of many business sales, such as for example, to a management team, the seller will end up financing part of the purchase price as the purchasers will not have enough cash available both to pay you for the purchase of the business, and to fund the working capital they will need going forwards to trade the business once they have bought it. If you are not prepared to provide some of the finance for the sale by way of giving them extended payment terms, you will in effect be reducing the amount of money they can afford to pay you for the business.

Payment to you for the business will come from money raised against the assets in the business, capital introduced by the purchasers, either from their existing cash reserves or by borrowing money against their personal assets, such as their houses, and finally, future trading. In order to maximise the amount of money available from the first two sources, it is important that the purchaser work with experienced asset finance brokers to raise the maximum amount of money that can be generated from both their personal and the corporate assets to be acquired. If the purchasers are not already in touch with such brokers, it can therefore be in your interests to ensure that they do so, try www.creativefinance.co.uk

Where you are helping to finance the sale by allowing the purchaser credit or agreeing to some form of payment over time by way of an earn-out, you do need to take precautions in order to reduce the risk you are taking.

If you do allow some deferred consideration, you should insist on having at least some of the consideration in cash so that the buyer has had to produce a significant down payment. You should ensure that the purchaser personally guarantees payment of the balance in addition to any contract signed by the purchaser’s company. Where you are selling assets and are still owed money, you should take security by way of a charge over the assets sold so that in the event of the purchaser defaulting on payment, you can appoint a receiver to take over the assets and sell them on your behalf so you can be repaid. However you should appreciate that such security may be difficult to obtain and enforce.

Obtain credit references and credit searches on the purchaser, insist on being provided with regular sets of accounts, and ensure you have the right to inspect the company’s books and records at any time.

Keep the period over which any extended period is to be paid to one that is reasonably short. However, equally importantly, allow a payment period to be sufficiently long to be practical. Having taken into account the likely sustainable profits to the business going forwards and the costs to the purchaser of servicing the rest of the debt they need to incur to buy the business from you, as well as funding working capital, ensure that the payments to be made to you leave enough in the business to provide both a cushion against any unexpected shocks and the purchaser with a decent living. Having the purchaser commit to such a high level of payments out of future income that the business either fails because it runs out of cash, or the purchaser decides to wind it up because they are not making any money out of it, are both self-defeating in the long term.

If you are providing finance for the deal by way of deferring payment terms, you should of course charge interest for the money you are effectively lending to the purchaser to buy your business. This is also high risk money as far as you are concerned (and you probably have no real wish to run a bank), and you also want to provide an incentive to the purchaser to find the money from other sources, be it finance companies, friends, or relatives. You should therefore charge a rate of interest that is significantly over the rates available for commercial loans at mainstream banks. If nothing else, this will also encourage the purchaser to pay off this money as soon as possible and therefore help to reduce your risk.

The best overall advice is generally to ensure that you obtain sufficient value up front in cash to meet your objectives and to treat deferred consideration as the icing on the cake!

How certain is the price?

The price you will achieve for your business will be largely determined by the confidence of the purchaser in the likely level of sustainable profits going forwards. Where there is any concern or dispute over the likely level of those profits, or the purchaser has difficulty in raising the full asking price by way of cash, use of an earn-out can be a way of bridging the gap between the price you are looking for and the upfront price the purchaser is either willing or able to pay.

An earn-out involves payment to you (in addition to the initial lump sum paid to you at the date of transfer) out of future trading profits.

The purchaser may also want to use an earn-out arrangement as a way of motivating you should you be staying on after a sale in order to help ensure the business achieves and beats the forecast profits.

The earn-out will usually be based on payment of either a specific percentage of profits or a percentage of profits over a specific target agreed between you and the purchaser.

An earn-out will usually last either one or two years. You may want to include within the contract a clause stating that in the event that the purchaser is able to sell on the business during this period for significantly more than they have paid you for it, you would also see a share of this profit (a non-embarrassment clause).

Be very careful about going into any earn-out arrangement however. Things will change in the business significantly over one or two years following a business sale and however tightly drafted, an earn-out agreement cannot realistically be expected to cater for all the changes of circumstance that may arise. There is therefore often significant potential for disputes arising between the buyer and seller over how the earn-out is worked and you should only therefore go into it if you are very confident of your ability to manage the ongoing relationship with the purchaser following the sale.

Any arrangements for an earn-out need also to cover a number of specific points so as to minimise areas of dispute. If you are going to be rewarded out of future profits, then you will need to agree with the purchaser how certain items are going to be managed so as to ensure that profits do not meet expectations for reasons outside your control. These include the impact of any accounting policies that the purchaser wishes to use that differ from the existing ones upon which the forecasts have been based; any cross-charges that the purchaser is intending to make to the business (for example by way of group ‘management charges’); how any financing costs that are either cross-charged from elsewhere in the group or have been incurred by the purchaser to buy the business impact upon your forecasts of achievable profits; and commitments that the purchaser will make in investments (for example in plant and machinery, or maintaining or increasing advertising expenditure), upon which the forecast profits and targets have been based.

Obviously, if you are going to be rewarded by the profits generated from the business over a specific period, you are going to want to maintain control of the business during that period and so you may well need to have written in to the contract that you will be retained as managing director throughout the period of the earn-out.

If you are considering some form of earn-out based on your forecasts as to how the business is likely to perform following the sale, if possible undertake some research into businesses previously acquired by the purchaser to see how well they have managed previous acquisitions. One thing you must expect as the result of any sale is that how your business is operated will change. The purchaser will have different ideas about how things are to be done and to be managed and if it is an established group, will have its own operating rules and procedures. Insofar as you are able to do so, the more you can find out about how acquisition by this purchaser has impacted on prior businesses they have bought, the better you can judge the likely impact of the sale on the prospects for your business and therefore on your earn-out.

How much support is the buyer going to need after completion of the sale?

Will the buyer need you to stay on for a month or two to allow you to train them in running your business? May they need you to stay on for one or two years in order to ensure a smooth handover of contacts, relationships and clients?

What restrictions will the purchaser place on you as part of the sale?

Almost every sales contract is likely to include some form of noncompetition covenant whereby you undertake not to set up a new business in competition with the one you have just sold within a specified time or area. Obviously your own circumstances and objectives in achieving the sale will have a significant impact on how strong or far reaching a covenant you are going to be able to live with. If, for example, you are simply looking to retire, then the effect of such a covenant may be completely irrelevant to you. If however you are looking to cease trading your own particular business but may be interested in doing say, consultancy in this area in the future, then you are going to need to think very carefully about what wordings for such a covenant will be acceptable to you.

HEADS OF TERMS

By the end of this process you should reach the point where you have agreed the basic price and terms of the sale with the buyer, and you will be in position to agree heads of terms or heads of agreement.

This usually takes the form of a formal letter from the purchaser to you confirming the general outline of the purchaser’s offer which you have agreed to accept, subject to contract.

As such you will expect the heads of terms to set out broadly:

• The price, either by way of a specific number (£Xm), or by way of some kind of formula (X% of profit over the next three years paid annually three months after the end of the year).
• The deal structure, either a sale of shares or a sale of business and assets (in which case if there are any assets which are to be specifically excluded, for example land or property or debtors, these should be noted).
• Specific description of the purchaser’s requirements from you, such as your staying on for a specified period as an employee or under a consultancy agreement, and details of the proposed noncompetition covenant.
• Conditions attached to the offer such as the need for audit and due diligence (in which case there needs to be some indication as to the scope of work required and how the process is to be managed, particularly in respect of access to staff, papers and maintenance of confidentiality).
• Exclusivity. Having reached this point the purchaser can now expect to start to incur significant professional costs as they will need to instruct their professional advisors to undertake formal due diligence and the detailed negotiations of the sales contract. Since the purchaser knows that they are going to have to spend money on this activity, not unreasonably most purchasers want to ensure that they are not wasting their time doing so and will therefore demand that you agree for a limited period of time to deal exclusively with them in order to give them a fair chance of completing the transaction. Whilst unless there are particular circumstances it is not unusual to agree to such a condition, it is important to ensure that this period is limited to a specific period sufficient to allow due diligence to take place and a contract to be agreed (say 45 to 90 days), otherwise you are simply giving the prospective purchaser an exclusive option over your business from now until such time as they might decide to exercise it or not. In addition, by placing a time limit you focus their minds on the need to complete the deal before other parties can become involved again.
• The offer may also give specific conditions that have to be met in order for the deal to proceed (such as the net worth remaining over a specified sum or regulatory approval, or the purchaser’s raising funds) or set out events that will cause the deal to fail (such as the loss of specified key customers or issues in respect of financial assistance).

It is important to stress that the heads of terms is essentially a letter of intent to complete a deal and is not the contract for sale itself. It is important however, for a number of reasons, as:

• It marks the stage at which you have an offer that you have negotiated and agreed with the purchaser.
• It does have legal implications (and therefore you should take legal advice about accepting it) in that, for example, you are comfortable with the terms under which you are agreeing to any period or form of exclusivity to the purchaser.
• It provides a degree of moral commitment on the part of the purchaser to move towards completing a deal.
• The granted period of exclusivity clears the decks for the purchaser to commit to what is for them the most expensive part of the process leading up to a sale.
• It provides written evidence of the structure of the deal and terms you have agreed with the purchaser.

However it is important to realise that the purchaser has made this offer before carrying out detailed due diligence. It is therefore an offer made based on the information you have provided (on which the purchaser is relying at this stage). Once the purchaser’s advisors gain access to your books and records to conduct their proper due diligence, if significant issues arise they will obviously have a serious impact on the price that is finally agreed for the sale.

SAMPLE DOCUMENT – A TYPICAL HEADS OF TERMS AGREEMENT

The following is an example of the format that heads of terms will take showing how, subject to contract, due diligence, maintaining or achieving certain specified performance benchmarks and negotiation of the detailed terms, the basic outline of the sale agreement is summarised and the purchaser is given access and a period of exclusivity within which to seek to close the sale.

Text supplied by Horwath Corporate Finance