As prepared as a business owner may be for negotiating an M&A or other exit transaction, Murphy’s Law promises that things will go wrong when they can. Therefore, sellers must understand and adopt relevant, appropriate negotiation strategies to achieve a favorable result and mitigate unexpected challenges.
Keys Points of Negotiation
The key aspects of the negotiation process include transaction structure, earnout protections, non-compete obligations, reps and warranties, and indemnification.
Transaction structure. The transaction structure can significantly impact the tax impact on sellers and buyers. For example, let’s say you are the seller (of a C corporation) and have been holding your shares for less than the five-year qualified small business stock (QSBS) holding period. If the deal is structured correctly, you may benefit from QSBS treatment concerning buyer stock you receive by tacking on the holding period. As another example, a buyer might want to do an asset sale, which can be tax disadvantageous to the seller; the selling company may have to pay tax at both the entity and the shareholder levels. But if the selling company has enough net operating losses, the entity-level tax might not matter.
Earnout protections. Many M&A transactions involve some form of “earnout,” where a portion of the deal consideration is contingent upon achieving specific targets or milestones. This can be revenue-based or development milestone-based. Sellers must negotiate protections based on their ability to achieve earnouts. For example, what if the seller or sellers get terminated during the earnout period?
The broader the representation and warranties are, the more likely sellers will face liability in the future.
Non-compete obligations. Founders, CFOs, and other key personnel might be required to sign a non-compete agreement. To preserve their ability to find other employment or to retain the flexibility to start a new company, sellers should seek a short non-compete period and narrow the agreement’s scope.
Reps and warranties. Sellers are typically asked to make various representations and warranties about the company, usually negotiated heavily. The broader the representation and warranties are, the more likely sellers will face liability in the future.
Indemnification. In private M&A transactions, sellers are usually asked to indemnify the buyer for losses, most typically from breaches of reps and warranties. The scope of indemnification obligations, how long those obligations last, and caps on liability are some of the many areas that can be negotiated. Absent an informed negotiating strategy and position, a seller might end up jeopardizing all of the money received in the exit transaction.
Info the Seller Should Have
A seller would be wise to identify a BATNA — the best alternative to a negotiated agreement, also defined as the position it will fall back on if the negotiation proves unsuccessful. A BATNA provides leverage and bargaining power throughout a negotiation. This is critical in the event the negotiation fails.
Additionally, a seller benefits from having intelligence on how the buyer has treated any prior acquisition targets. For example, is it likely to sue for indemnification, or does it tend to be judicious? How do they treat the seller’s employees that go work for the buyer?
The seller should also understand what liabilities the company may face. This is important for negotiating reps and warranties and indemnification obligations.
M&A transactions often involve continuing obligations, and sellers do not want a continuing obligation to an unreasonable party.
Finally, sellers need to understand what provisions are currently market standard, so they can be more credible negotiators.
Attention to Red Flags
While strong negotiation tactics are critical, so is paying attention to any red flags that may arise.
First, if one side in a deal insists on non-market terms — at least without explaining what makes the deal unique — it indicates they may be unreasonable. M&A transactions often involve continuing obligations, and sellers do not want a continuing obligation to an unreasonable party.
Second, an unwillingness to share reasonable amounts of information can mean that a party is hiding something or lacks respect for the process.
Finally, sellers should be wary if the buyer is unwilling to do reasonable diligence. For example, a buyer might want to conduct customer interviews. The seller often requests this to be the last diligence item, as it can be destructive for customers to know a seller might be exiting. However, if a buyer is unreasonable about such requests, it may indicate it has ulterior motives and has no intention of buying the company.
Fair and Reasonable Requests
First, sellers can request a structure that minimizes their tax burdens. Tax-friendly structures usually aren’t particularly burdensome on the buyer.
Second, sellers can request reasonable narrowing of representations and warranties, particularly in light of the industry or the stage of the company. Broad representations and warranties increase the deal's price for the seller due to higher legal fees and create greater potential liability. If the seller is an early-stage company, a buyer should be reasonable about the risks it faces in buying the company.
Finally, sellers may benefit by requesting reasonable caps on indemnification. It is also fair to share liabilities with the buyer, given the buyer is not sharing the profits (beyond the purchase price).
During a negotiation, expect the unexpected, understand the intricacies, and keep your eye on the end goal: to get the deal done.