Mergers and Acquisitions: the current environment

For 18 months or so acquisition activity has been dormant as shareholders have been reluctant to sell on the basis of valuations that reflect the current economic climate, believing whether rightly or wrongly that shareholder value will return in the ensuing upswing. While it is important to note that the upswing is only just beginning and that there are very real risks that there may be further pain to come if the press talk us into a 'double dip', some purchasers are now entering the market. However, the days of setting a price and paying it at completion are for the time being things of the past. Indeed the valuation process is now part of the consideration process with the purchaser utilising consideration tools in a transparent manner that were previously part of the hidden process of valuation and that places the risk of underlying asset valuation together with goodwill on the seller. For instance, a purchase price can be a mix of : -

1. Cash payment up front (which will normally be a much smaller amount than previously);

2. Underlying (non-goodwill) assets paid after completion based on agreed completion accounts;

3. Quasi-Goodwill payments calculated by way of earnout (particularly relevant in an owner managed business) subject to maximum period and payment.

The process of creation of the Heads of Terms it a much longer process than it was. Purchasers are now specific about the calculation of the amount that they are prepared to pay to the seller for the company and its business. Moreover, the seller will try to fight their corner to ensure that they get best value for the work that they have put in over the years to create what is being sold.

The difficulty with a calculation of the underlying assets is the basis upon which the agreed form will take such as management accounts versus UK GAAP. The solicitors and accountants may have little control over the production of the Heads of Terms and therefore are left with a document that informs the legal documents and leaves the seller exposed to greater risks based on a lack of understanding. Whilst this is of little concern in most cases the introduction of the wrong word into the Heads of Terms can prove extremely costly as it may extend the negotiation thereby increasing the negotiations involved or indeed leading to a collapse of the acquisition process. Additionally, simple items such as debt provision where a business owner could quite correctly apply a process of bad debt provision in the knowledge that those debts greater than 90 days will still get paid (and need not be provided for) and provide for others less than 90 days that certainly won't get paid. This may be at odds with the Purchasers process where they may wish to calculate bad debt provisions on 90 days plus. In this case, the negotiations may have to focus on individual debts which leads to protracted discussions.
As regards Earnout, a wordy description in the Head of Terms is sometimes unhelpful. Almost invariably this can only really be described by way of a spreadsheet setting out certain scenarios. The Seller is taking a risk in following an original draft because it will often be wrong. The Seller should have protections by way of a right to be passed full and detailed information on process and perhaps even involvement on an ongoing basis with the Company's Customers. This is often acheieved by a short term conultancy agreement which in most cases is to the benefit of the Purchaser as there is a seamless hand over in respect of the business processes. Quite often the Seller is seen as integral to the business by its customers and where that person disappears from the scene this can have a negative effect on the trading position of the Company and its business.
Taken together the seller and purchaser are best advised to take advice on the Heads of Terms prior to them being signed to ensure that any grey area in the HOTs is expanded upon so that the process of agreement drafting doesn't become a continuing negotiation.

In the current market the Seller is taking some of the risk of the future performance of the Company and its business but in the current climate this is only to be expected. To ensure that the Seller and Purchaser know what they are transacting it is essential that they take the appropriate legal and accountancy advice.

In the next blog I will explain the process of Due Diligence, Warranties and Disclosure.