Now is an opportune time for owners to sell their companies.
Valuations through the third quarter of 2016 are at the highest level since at least 2010. Private equity dry powder is at record levels and PE firms are under pressure to invest. Many recent auction processes have been highly competitive, and in some cases preempted. These dynamics combine to put sellers in a strong position.
But that advantage can easily be squandered. What follows are five points that we believe sellers may want to keep in mind to preserve leverage, and to maximize deal proceeds and favourable deal terms.
1. Not prioritizing objectives
Many sellers are keen to bring their businesses to market as quickly as possible. However, the desire for speed must be tempered against the need for thorough exit preparation.
A seller and its advisers should, at the outset of the sales process, take the time to develop a clear hierarchy of deal objectives. Maximizing price, deal certainty and limiting post-closing exposure will almost always be paramount. But sellers should take this analysis to a more granular level, methodically think through their “must-haves” and “nice-to-haves,” and ascribe them relative priorities.
For example, a private equity seller may not have the capacity or desire, following the closing, to keep carriage of legacy litigations at the target company. Accordingly, the seller should instruct its lawyers not to spend time and resources negotiating for control of third-party claims.
While it’s often tempting to “kick the can down the road” when it comes to establishing the second and third tier of deal objectives, doing so can easily become a recipe for inefficiency.
2. Not anticipating bottlenecks
Sellers should carefully think about allocating transaction-related responsibilities.
Understandably, sellers often lean towards keeping the knowledge group as small as possible so to avoid distraction, attrition and the risk of leakage.
But sellers should consider just how much incremental work can be taken on by a small group of key employees who, in addition to preparing the company for the deal, have day-to-day responsibilities to discharge. This is particularly important in exit processes that are expected to be lengthy or that entail time-consuming work streams, such as the preparation of disclosure schedules that require tabulating vast amounts of information.
Identifying potential bottlenecks before they become clogged can go a long way towards preventing buyer frustration and deal-fatigue.
3. Underestimating the importance of sell-side due diligence
Sellers’ natural inclination is to minimize third-party costs in connection with an exit. However, a seller’s failure to dedicate sufficient resources to sell-side due diligence can be a costly mistake.
This is particularly true in sales processes involving “non-core” assets, where legacy issues and contingent exposures may not have received much of management’s consideration. Where a purchaser is first to unearth a diligence issue, the seller frequently finds itself on the defensive. Further, a single adverse discovery may result in buyer losing faith in the quality of the process.
In contrast, sellers who expend the time and resources to comprehensively identify diligence issues prior to launching the process have a two-fold advantage: the opportunity to clean up smaller issues (such as errors in title reports) and the ability to properly position larger ones.
For example, where a target is subject to material litigation, the seller should consider posting a memo to the data room with details on the claim, the procedural status, the potential exposure, to what extent the exposure is covered by insurance, as well as a proposed risk allocation as between seller and buyer. Doing so will demonstrate thoroughness and thoughtfulness on seller’s part and may help defuse buyer’s reaction.
4. Not giving consideration to insurance
Representation and warranty (R&W) insurance has become ubiquitous on mid-market deals in the United States. R&W insurance allows transaction participants to offload certain unknown exposures to third-party insurers, typically for a premium equal to 3 percent to 4 percent of the amount insured.
Many sellers now “staple” buy-side policies to their auction draft purchase and sale agreements, both to underscore that the purchase of such a policy is a key deal consideration from seller’s perspective and to speed up the underwriting process.
Contrary to public perception, R&W insurance policies often leave sellers with some residual exposure for claims related to the breach of their reps and warranties. For example, sellers and buyers often share the retention (deductible) that applies to the insurance. Sellers who have carefully considered exactly what risk-sharing they are comfortable with will almost always enjoy a negotiation advantage.
5. Waiting to scrub working capital issues
Provisions relating to price and particularly working capital adjustments are especially prone to disputes in private company M&A.
Beginning early in the transaction process, sellers should utilize their access to management at the target company to unpack the intricacies of a target’s working capital profile with a view to anticipating issues that could be contentious. Ideally, a seller would present buyers with a well-thought out proposal as to both working capital target and methodology (as well as an illustrative example working capital calculation) when serving up the auction draft purchase and sale agreement.
Doing so allows a seller to bring focus to this key deal point early in the process and may avoid costly and time-consuming post-closing entanglements.
This article and others published as part of Torys LLP‘s Torys Quarterly can be viewed here.
Stefan Stauder is a partner at Torys LLP with a broad transactional practice that includes M&A and private equity. He wrote this article in collaboration with Katherine Spenner, a senior associate who advises corporate clients, private equity funds and commercial banks on M&A and investments.
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