Negotiating a purchase of a business is one of the key stages of the business buying process. Negotiation involves crafting a deal that focuses on the common goals between parties in order to find a desired outcome.
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Five Key Factors of Negotiation
Once you get to the phase where you have determined a valuation range and it is time to negotiate the purchase price, you want to be as prepared as possible. In this article, we will cover five key factors to keep in mind as you go into a negotiation, as well as some of the key parts of the deal structure that can be negotiated.
Below are five key factors to keep in mind when crafting a win-win scenario between yourself and the seller of a business.
Know Your Numbers
One of the first things you should understand before going into a negotiation is knowing your numbers! You want to make sure that you have all of the information you need to negotiate effectively. Collecting the information below from the seller will help you better understand how to offer a valuation range.
- Balance sheet, income statement, cash flow statement
- Profit margins
- Sales projections
- Financial ratios
- Tax returns!
The more information you collect about the underlying performance of the company including its finances, and how it operates, will help you craft a win-win scenario for you and the seller!
Understand What You Want
“If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.” – Sun Tzu’
It’s not only important to know what the seller wants out of the transaction, but it’s just as important, if not more important, for you to understand what you want. If you don’t have a clear idea of what you’re looking for you’ll likely end up with something less than what you wanted. Before you begin the actual search phase for a business to buy, it is important to have an established set of criteria for what the ideal business will look like. For example, you will not buy a business for more than 6X EBITDA in the pet food industry. Buy knowing what you can do in the first place will make you more confident in your negotiation ability.
Active Listening/Building Rapport
Active listening is essential skill when negotiating a business acquisition. Active listening skills are just as important if not more important when talking in a negotiation. By active listening you are able to ensure all information gets exchanged and understood correctly and can build rapport with the seller.
Active listening can help you shift tensions and enhance progress in negotiations. It’s also one of the most effective way to develop strong relationships and reach successful outcomes. Active listening also signals to the other party that you’re putting your own agenda aside and taking the opportunity to consider theirs.
Many people think that active listening is just “listening” and nodding your head when the speaker is talking. This could not be further from the truth.
Here are some tips to active listening during negotiations:
Mirror: Mirroring someone is when you repeat what they have just said, or more specifically the last three words. The power of this is that it shows you are listening and taking an interest in what the other side is saying. Not only can mirroring be an effective way to build rapport but can allow the other party to digress more on a subject or issue allowing you to obtain more information that could be critical to the deal.
Ask questions: To empathize, you need to accurately understand the message the other person is trying to convey. By posing questions to the seller, it shows your interest in understanding the other party’s viewpoint and allows you to be open to exploring both sides of an issue.
Also, try to limit the number of close-ended questions you ask. If you want the seller to expand upon a subject matter, try to ask open-ended questions like “what” or “how” questions. An example of some open-ended questions would be “how long has this been a problem?” or “what experience are you missing to grow the company?”
By active listening and establishing rapport, you can identify what the pain points of the seller’s business and what he hopes to gain out of the transaction.
Know What The Business Seller Wants
“‘Everyone has his price’-this is not true. But there surely exists for everyone a bait he cannot help taking.” -Friedrich Nietzsche
Understanding what the business owner wants out of the transaction is arguably one of the most important things to understand during the negotiation process. If you don’t know what the sellers’ goals are with the sale of his/her business, you will have trouble crafting the deal structure.
Maybe the seller isn’t looking for someone who will come in and buy and flip the business, maybe the owner wants someone who will focus on creating long-term value and steward the legacy of the company he created.
The seller may not be looking for a complete buyout, maybe he wants to seller finance a portion of the business, so he can defer capital gains tax.
Every business owner is different, make sure not to treat them all the same.
Figure Out Industry Comps
When it comes to negotiating the value of a business, it will be to your advantage to bring up industry deal comps of similar companies that have sold. For example, if you are in negotiations with a target company to acquire their business and you determine that you should offer X amount to the seller, but through your research, you discover similar companies like this are being acquired for X number of EBITDA, that can be used to your benefit when giving your valuation range. An example resource where you can find similar deal comps would be BVR. DueDilio has a great article on calculating business comparables valuations.
Key Parts of Deal Structure to Negotiate
So far, we have covered some of the key factors to keep in mind when negotiating a business, that can help you in the initial stages of the negotiation process. In this section, we will cover submitting an LOI (Letter of Intent) and some of the key terms/contingencies that are most commonly used/negotiated when crafting a deal structure.
LOI (Letter of Intent)
Once the buyer and seller have agreed to a suitable valuation, it is now time to lock up the deal under an LOI. Letters of Intent (LOI) are used to document the mutual understandings of a buyer and seller concerning the economic terms and often most non-economic terms of a transaction.
A letter of intent (LOI) is a non-binding agreement between a buyer and a seller indicating mutual interest in entering into a transaction. In general, a letter of intent is not considered a legal offer; rather, it serves as a framework for negotiations. An LOI may include/outline key parts of how the deal will be structured, covering financial details such as a proposed purchase price, financing arrangements, payment schedules, and other key contingencies. The provisions in the LOI that are usually binding are exclusivity, confidentiality, due diligence, earnest money, and expenses.
A letter of intent shows that both parties are serious about moving forward and the seller agrees to the terms laid out in the proposal.
Financing Contingency Clause
One of the key clauses you can negotiate when buying a business is a financing contingency clause. A financing contingency means is a clause that states that the offer is contingent upon the buyer obtaining financing for the property. Financing contingencies provide buyers with protection against possible legal repercussions if they fail to secure financing. Having a financing contingency can help you back out of the deal in case you are unable to raise the financing for the business.
An earnout, also known as contingent consideration, is an agreement where a company agrees to make additional payments if certain performance criteria are met. In return, the acquirer promises to pay the seller a sum of money based on those performance criteria. The goal is to bridge the gap between what a target wants in total consideration and what the buyer is willing to pay for it.
For example, if the seller wants $5 million of his/her business, but you are only willing to offer $ 4 million. You could structure an earn-out to pay the additional $ 1 million that the seller wants in the form of additional payments at a later date once certain financial or non-financial milestones are met.
Seller financing is where the seller of the business will carry a note on a portion of the business purchase price. The seller in a sense will act as a bank and provide you financing. The business itself and/or significant business assets, serve as the primary collateral for these loans. A lien on a property is filed with the Secretary of State’s Office, so the world at large knows that it exists. Should you fail to repay the loan, the lender would be the first in line should the borrower default.
Seller financing is advantageous to the seller and the buyer for many reasons. It benefits both parties because it allows the seller to continue to have a stream of income over an extended period and allows the seller to save in capital gains tax savings over time. Seller financing also shows that the seller still believes in the long-term success of the company. The benefit to the buyer is that it allows him to minimize the amount of capital he needs to put down, and he will also be able to have more flexibility in negotiating the interest rate on the promissory note.
Holdback and Escrow
A holdback is an amount of money that the buyer holds back from the purchase of the company for a set period in case there are any problems with the business. The holdback amount is held in an escrow account and is usually paid within the first year of close.
An example of when you might want to negotiate a holdback provision is if you are concerned about the true profitability of the company. Sometimes the concern is whether the representation and warranty claims made by the seller are true.
For example, let’s say you are acquiring a biotech company that is still awaiting FDA approval for one of its key pipeline therapies. You can negotiate to hold back a portion of the purchase price until the FDA gives final approval.
You can also negotiate how much money will be placed in escrow. Most money placed in escrow is 10% of the target company’s purchase price. But if you as the buyer believe there is a fair amount of liabilities that could arise post-close you should seek to negotiate as high an escrow amount as possible to cover any purchase price adjustment and determining liabilities.
One of the hardest parts of buying a business can be negotiating the deal. In this article, you learned some of the key factors to consider when negotiating a business purchase and how to figure out what the seller wants. We also covered some of the key clauses and contingencies that you can negotiate to craft a win-win deal.
When it comes to buying a business everything and anything can be negotiated. One of the keys to negotiating is to not be attached to the outcome of the deal. If you as a buyer become too attached to the outcome of the deal, you could potentially buy a bad deal. One way to become less attached to the outcome of a deal is to be looking at multiple businesses instead of one deal at a time. That is why having access to quality deal flow and investment partners is highly important.