The great deal risk balancing act

The great deal risk balancing act

Perhaps the most important concept to understand in a deal negotiation is that the buyer and the seller have diametrically opposing interests. Put simply, a great deal for one is a poor deal for the other, and vice versa.

This tug-of-war is why the mergers and acquisitions industry exists in the first place. Financial experts help the parties agree on a valuation and legal experts bash out the clauses that will govern the terms of the deal. There are many other parties involved along the way as well, ranging from accountants to tax and sometimes exchange control advisors.

Deal strategy is everything. To help you understand some of the focus areas of the negotiations in real-world deals, we’ve laid out three methods that investors use to help reduce their risk in the deal.

1 – Not overpaying on entry

This sounds really obvious, yet there are so many buyers who get hot for the deal and end up paying too much. Savvy investors know that the money is truly made on entry, not on exit. This can drive a tough negotiation around the deal value.

Parties battle it out over somewhat objective matters like forecast profits, as well as subjective issues like the appropriate discount rate for the company. Those who understand the sensitivities in these valuation models are in the best possible negotiating position. They know where to give room and where to fight harder.

For example, the discount rate for future cash flows is often a far more important variable in a valuation than the cash flows themselves. It all depends on the timing of those cash flows.

Long story short: the best way for a buyer to swing the balance in their favour is to bring the entry price down.

companys profits

2 – Paying the seller with the company’s profits over time

Ever heard the term “other people’s money”? It’s a beautiful thing and a concept that many capitalists have used to try and capture the upside without carrying all the downside risk.

In an acquisition, the way this works in practice is deferred payments. This might include an earn-out, in which case there are milestones like profit targets, or simply a structure that spreads out the payments with no regard to future milestones.

Buyers love earn-outs, as this takes the profits promised by the buyer and amends the purchase price if they aren’t achieved. For sellers, earn-outs are terribly dangerous yet often unavoidable.

If buyers can’t negotiate earn-outs, they will almost always try and spread the payments out over a couple of years anyway. Aside from the benefit of time value of money, this creates a scenario where much of the purchase price is funded by the profits generated by the company itself. Again, this puts the seller at significant risk, as the buyer may not be able to meet the future payment obligations.

For sellers, tools to fight back include putting an imputed interest charge on the deferred payments and obtaining guarantees from the buyer that give the seller legal recourse to assets that sit outside of the company being sold.

gradual exit

3 – Gradual exit

A technique commonly seen when listed companies buying private companies is the use of a staggered transaction. This achieves a gradual exit for the seller, in which an initial smaller stake is sold (sometimes a minority stake and sometimes control), with the rest of the business sold to the same buyer over time.

The benefit to the buyer is that this creates a handover period in which the seller is incentivised to keep the business going. For sellers, there is often a net benefit here as well in terms of a higher selling price (buyers are more comfortable with higher prices when the risk is reduced) and the likelihood of leaving a legacy rather than just handing over the keys to the business.

For sellers who are only interested in a clean break with no handover period, this type of deal isn’t possible. This severely weakens the seller’s hand, which is why the best strategy for a seller is to look a few years ahead and start planning an exit well ahead of the intended “walk-away” date.