Closing
How to Negotiate Terms and Finalize the Purchase Agreement: Best Practices for Search Fund Acquisitions
Negotiating the terms of an acquisition and finalizing the purchase agreement are two of the most critical steps in the search fund process. The right negotiation strategy can ensure that you acquire the business on favorable terms, minimize risks, and set the stage for a successful transition. In this guide, we’ll explore best practices for negotiating terms and finalizing the purchase agreement when acquiring a business through a search fund.
1. Start with the Letter of Intent (LOI)
The Letter of Intent (LOI) is the foundation for negotiation. It’s a non-binding document that outlines the main terms of the potential deal, such as the purchase price, financing terms, and exclusivity period for due diligence. A strong LOI sets the stage for smoother negotiations later.
Key Elements of an LOI:
Purchase Price: State the proposed price for the business, but leave room for adjustments after due diligence.
Deal Structure: Specify whether it will be a stock purchase or an asset purchase, as this impacts tax implications and liabilities.
Financing: Outline how the acquisition will be financed (e.g., cash, seller financing, debt financing, or earnouts).
Exclusivity Period: Define a period (usually 60-90 days) during which the seller agrees not to negotiate with other buyers while you complete due diligence.
Contingencies: Include any contingencies, such as obtaining financing or resolving specific legal or operational issues uncovered during due diligence.
Best Practices:
Keep it Simple: The LOI should be concise and to the point. Overloading it with details can bog down negotiations and complicate the process later.
Be Flexible: While you should clearly outline your key terms, be open to some flexibility. For example, you might adjust the purchase price or terms based on new information from due diligence.
Be Timely: Once both parties sign the LOI, move quickly to begin the due diligence process, as delays can derail the deal.
2. Due Diligence: Identify Key Points for Negotiation
Due diligence is your opportunity to thoroughly review the business’s financial, operational, legal, and market conditions. The findings from this process will often lead to key points for negotiation.
Financial Due Diligence: Verify the accuracy of the financial statements, assess cash flow, and evaluate the working capital requirements. Look for any discrepancies or hidden liabilities.
Operational Due Diligence: Evaluate the company’s processes, supply chains, technology, and human capital. Identify areas where you might need to invest post-acquisition, which can serve as leverage during negotiations.
Legal Due Diligence: Review contracts, litigation risks, regulatory compliance, and other legal liabilities. If you uncover any significant legal risks, you may need to adjust the deal terms or seek legal protections.
Customer and Market Due Diligence: Assess customer concentration and market trends. If the business is overly reliant on a small number of customers, this could be a risk that justifies price negotiations or earnouts.
Best Practices:
Be Thorough: Leave no stone unturned during due diligence. This is your last chance to uncover any red flags or potential deal-breakers.
Use Experts: Engage accountants, lawyers, and industry experts to assist with due diligence. They can help you identify issues that you might not catch on your own.
Document Everything: Keep detailed records of your findings. If something discovered during due diligence leads to price negotiations or changes to the deal structure, you’ll need a documented basis for the adjustment.
3. Negotiate the Purchase Price and Deal Structure
The purchase price is often the most contentious part of the negotiation. While the LOI sets a baseline, new information from due diligence often leads to adjustments. Beyond price, the structure of the deal (e.g., payment terms, seller financing, or earnouts) is just as important.
Adjust Based on Due Diligence: Use the findings from due diligence to support your position if you need to reduce the purchase price or change the deal structure. For example, if you uncover unexpected liabilities or future capital expenditures, it’s reasonable to ask for a price reduction or shift some of the payment to an earnout.
Seller Financing: Offering seller financing (where the seller agrees to receive part of the payment over time) can be an attractive option for both parties. It reduces your upfront capital needs and demonstrates the seller’s confidence in the business’s future performance.
Earnouts: An earnout is a performance-based payment structure, where part of the purchase price is contingent on the company hitting certain financial targets post-acquisition. This can be an effective way to bridge valuation gaps, as the seller is incentivized to ensure the business performs well.
Best Practices:
Be Data-Driven: When negotiating price reductions or adjustments, use data from due diligence to justify your position. This removes emotion from the negotiation and demonstrates that your requests are reasonable.
Find Win-Win Solutions: Structure the deal in a way that benefits both parties. For example, offering seller financing or an earnout can make the deal more attractive to a seller who is concerned about price reductions.
Stay Calm: Negotiations can get heated, especially when discussing price. Stay calm and focus on problem-solving rather than winning every point.
4. Address Key Contractual Terms
After the price and structure are agreed upon, it’s time to negotiate the key contractual terms of the purchase agreement. These terms protect both you and the seller and ensure a smooth transition.
Representations and Warranties: These are statements made by the seller about the condition of the business. They typically cover financial accuracy, compliance with laws, and ownership of assets. If any of these representations turn out to be false post-acquisition, you could seek compensation.
Indemnification: Indemnification clauses protect you from certain liabilities or losses that might arise after the deal closes. For example, if the seller failed to disclose a pending lawsuit, the indemnification clause would allow you to recover losses associated with that lawsuit.
Non-Compete Agreement: In many cases, you’ll want the seller to agree not to compete with the business for a certain period after the sale. This protects you from the risk of the seller starting a competing business or poaching customers.
Earnout and Seller Financing Terms: If you’re using an earnout or seller financing, clearly outline the payment terms, performance metrics, and timing. Ensure that both parties agree on how the earnout will be calculated and verified.
Best Practices:
Be Specific: Ensure that all representations, warranties, and indemnification clauses are clearly defined in the contract. Vague language can lead to disputes down the line.
Cap Indemnification: Negotiate limits on the seller’s liability (called “indemnification caps”) to avoid excessive exposure for the seller, while still providing you with protection from major issues.
Consider Escrow: If you’re concerned about the seller’s representations, consider placing part of the purchase price in escrow to cover any post-closing issues.
5. Focus on Transition Terms
The terms of the transition period are crucial to ensuring the business continues to operate smoothly after you take over. Depending on the complexity of the business and the seller’s role, you might need the seller’s help during the transition.
Transition Support: Define what role the seller will play post-sale. This could include staying on as a consultant for a certain period or providing training and introductions to key clients or employees.
Employee Retention: In many small businesses, the employees are critical to the ongoing success of the business. Discuss strategies with the seller for retaining key employees, such as offering retention bonuses or stock options.
Best Practices:
Plan for Knowledge Transfer: Ensure that you have access to key business information, from customer relationships to proprietary processes, during the transition period.
Set Clear Expectations: Clearly outline the seller’s role and responsibilities during the transition period in the purchase agreement to avoid misunderstandings.
6. Finalize the Purchase Agreement
Once you’ve negotiated all the terms, it’s time to finalize the purchase agreement. This legally binding document will govern the sale and transition of the business.
Work with Legal Experts: Have a lawyer with experience in mergers and acquisitions review the final agreement to ensure that all legal aspects are covered and that there are no loopholes that could create problems later.
Best Practices:
Review Thoroughly: Go through the agreement with a fine-tooth comb to ensure that it accurately reflects all the terms and conditions you’ve negotiated.
Be Timely: Aim to finalize the purchase agreement promptly after completing negotiations. Delays at this stage can lead to deal fatigue or give the seller time to reconsider the sale.
Conclusion
Negotiating terms and finalizing a purchase agreement is a complex but rewarding process that requires preparation, flexibility, and strong negotiation skills. By thoroughly conducting due diligence, negotiating with data-driven insights, and focusing on key contractual and transition terms, you can ensure a smooth and successful acquisition. Always remember to seek legal and financial advice from experts to avoid potential pitfalls and protect yourself throughout the deal. With these best practices in mind, you’ll be well-positioned to secure favorable terms and transition smoothly into your new role as the business owner.