Making offers quickly and often in your search is critical to buying a business. As in sports, taking frequent “shots on goal” is always better than waiting for the “perfect” opening. After all, the offer is the first step on the path to “closing” on the business you acquire! When it comes to making offers, the keywords are practice, practice, practice.
If you are not making at least 2-3 offers a month, then there is a problem with your search. You are either too risk averse, being too selective or just fearful of making a decision without sufficient information. It may also be that your prospecting campaign is not serving up enough businesses.
Difference between IOI and LOI
There is a significant difference between an IOI (Indication of Interest) and an LOI (Letter of Intent), especially in the mind of the seller. The IOI is basically a simple term sheet, outlining the offer details, written in plain language. A single page in length that helps the seller see what cash they will get at closing and what is deferred, the expectations of their involvement with the business going forward and what may be excluded (real estate assets) or specifically included (receivables, payables, inventory). The seller perceives it and successive revisions as part of a series of protracted negotiations.
The LOI looks more like a legal document and formalizes many of the details that will be present in the final Purchase and Sale Agreement. The LOI is signed by the seller after the earlier rounds of IOI’s are complete and they agree to an “exclusivity period.” Its purpose is to “lock in” the business owner and take their company off the “market” so you can initiate solicitation of bank terms and assessing investor appetite before spending scarce funds on a Quality of Earnings (See QofE blog post) and moving into due diligence (see Due Diligence blog post). A searcher explained its use, “The seller needs to really understand the implication of their subordination to your bank loan and other specific bank requirements. This will avoid their re-trading farther down the line when the legal documents arrive.”
Another searcher found that the LOI process, “Allowed us to build initial trust with the seller and gain access to more detailed financial and customer information, which in turn gave us greater leverage in re-negotiating some additional terms.” The signed LOI gives you and the business owner “closure” after the very challenging negotiation process. 60% of what a searcher learns during search occurs during finalization of the LOI and the closing which averages 5.6 months and is often fraught with failure in 69% of the time! (See Blog Post Getting to Closing)
While the informality of the IOI is better suited to the early stage of negotiations, the LOI can confuse or even scare the seller. But it is worth the time and effort to spell out in writing as many of the specific terms as can be agreed upon before moving into toward closing that might otherwise be taken up with legal wrangling and lengthy discussions with the seller’s accountants and advisors. As one searcher points out, “My IOI’s were pretty extensive in detail. The LOI’s reached even deeper into things like specific balance sheet line items to be excluded from the Working Capital Adjustment. I didn’t use these documents as a means to push for progress, instead as markers for progress.”
Move quickly to get your offer on the table
Getting the basic framework of your offer and terms of the transaction in front of the owner should happen as quickly as possible. Don’t spend your own or your interns valuable time digging deeply into the company or industry. Instead, it is crucial to get a sense of whether the seller is serious about moving forward with the basic structure of your proposal.
You don’t even need financial statements. Instead on the first call with a seller, you can lay out your assumptions of their revenue and cash flow and make an offer. This will set the stage for continued dialog around firming up the terms and asking for detailed financial historical statements. In fact, it may reveal both size and profitability hurdles that are below your criteria. Of course, with a brokered, deal, the CIM (Confidential Information Memo) should contain all you need to make your initial offer.
Besides price, you want to clarify what is included(receivables and inventory) and excluded (cash) from the purchase. You will want to explain the concept of a seller note so the owner does not expect an all-cash closing. The business owner will also want to know their expected role going forward and for how long they will be expected to remain after closing. Finally, it is important to identify a preliminary timeline for completion of main items needed to close, including the next step of a signed LOI. Richard Parker, has written some practical advice on this process.
Most businesses won’t have an EBITDA breakdown to base an offer upon, you will have to estimate it. The key here is developing the “add backs” to Net Income that identify the cash flow value of the company once you own it. These develop from discussions with the owner about non-recurring expenses like personal travel, auto leases for family members, country/athletic club memberships, and a myriad of others. One searcher mistakenly classified owner “distributions” of profits as an add-back, when it was never on the income statement as an expense – a 3.5x multiple quickly turned into an unattractive 5.5x!
Where to start your offer
Early in your search, you want to start off with low anchor points. You can’t afford to overpay for the business you buy and need to gain experience for what your investors will finance and what to expect from sellers. You would rather have a good business at a great price than a great business that you are overpaying for. Avoid the tendency to focus too much on what the seller is “asking for”. Instead, offer a below-market valuation that will be the beginning of a negotiation. ^, searcher/CEO at Arden Bay warns, “Know what you’re able to offer. Have clear expectations with the investors, bankers, accountants, and others you work with, to understand what all of those who are supporting/financing your search are comfortable with, before you box yourself into a position with the sellers.”
“Anchor” your offer low on total valuation and high (50%) on the seller note. This is the start of a protracted dialog with the seller, who probably has never experienced selling their business before, but has had a lot more practice than you at complicated negotiations. Be prepared for many rounds and much time between each round. Searchers report hating this “dance” of back and forth negotiations. “Practice is key. The best way by far to hone judgement is through repetitions of your offers”, observes one searcher.
Depending on the industry and strength of historical performance, offering 1-2x multiple below industry “going rates” is a good place to start. Your search effort should yield sellers who have a special affinity for you, allowing them to justify a reduced multiple. If they exist, point out the reasons for being lower than market such as high customer concentration, low margins and hiring/retention issues, all of which are important for the seller to hear.
Set a fixed price rather than a multiple of EBITDA. In fact, never even verbalize a multiple to the seller! Too many deals die with a change in the TTM (trailing twelve months) EBITDA as closing approaches. When earnings trend upward as you near closing the seller will expect a higher price. This wreaks havoc on the capital raise from banks and investors. On the flip side, when earnings drop, sellers have a hard time swallowing a downward price adjustment. A fixed-price offer supports the sellers’ natural fixation on what they will receive at closing.
Be sure to build in a “cushion” that you are comfortable with for the inevitable “surprises” you find during due diligence. “Re-pricing” or “Re-trading” while under LOI is one of the best ways to destroy trust with your seller. You can expect to find discrepancies that may justify a price adjustment, but doing so puts the transaction at risk. Having a 5% margin of error will avoid the seller losing confidence in you. Best to leave the seller with the impression that you are committed to the terms in the LOI.
Also, avoid quoting a price range. With a range, you are thinking the low end and the owner is out discussing a sale at the high end with friends, advisors, and significant others. If and when you start to drive down to the lower end of the range, you risk seller disappointment and mistrust. Don’t set yourself up for these emotional reactions that may damage trust.
You may be tempted to bridge a “valuation gap” with an earn-out. The seller does not deserve to reap the rewards of your efforts in the future, you are compensating the owner for what they have done, and not what you will be doing with the business.
Generally, earn-outs end up creating conflict with sellers. Once you own the business, you control expenditure levels and the accounting statements. The seller may complain and perhaps bring legal action over how earnings are reported. If the seller is your landlord and visible in the local community, this can get messy. Many banks prohibit seller payouts in many cases for 2 years and are not anxious to support variable payments to ex-owners.
Similarly, avoid re-engaging the seller by rolling some of their valuation into equity. Research shows that the relationship between sellers and searchers typically erodes over the years. Sellers develop remorse or there is a disagreement with post-close business decisions. Avoid thinking your case will somehow be different.
Enhance the total value
While most sellers understand the time value of money, they will fixate on the total value of the IOI. Simply state the elements of the value.
Total Consideration of $x,xxx,xxx: Cash at Closing. Escrow for Working Capital and other adjustments paid 12 months after closing. Seller Note – interest rate(5-7%), first payment after 2 years and balloon date, 5 to 10 year amortization schedule. Seller Non-compete/Non-solicitation payments over 5-7 years. Seller Consulting fees
Build flexibility into the seller note structure by starting high, in the 50% range. Typical seller notes range from 20% to as high as 60% of purchase price, and discussing this with the seller early on is important. Securing interest and principal “holidays” up front will help ease early cash flow requirements. SBA lenders require no payments to the seller for 25 months.
Once the business is running well, you may be able to replace seller financing with lender financing, so be sure to stipulate in the LOI that there are no prepayment penalties. Paying principal on a 10-year amortization schedule with a balloon payment in 5-7 years allows you to back load your cash flow. This element of your IOI Term sheet is very negotiable, so give yourself plenty of room.
Assigning value to Non-compete/non-solicitation allows tax-deductible payments to the owner and inflates the total price. These payments can also be variably structured over a 5-7 year time frame to allow for less cash flow impact early on in your ownership.
Terms are as important as valuation
The terms of your offer can be critical to your success running the business later on. The purpose of additional terms is to prevent misunderstandings that get in the way later, to speed the process along.
Additional non-financial terms: Purchasing assets, excluding cash, not stock. Excluding debt, obsolete inventory and 90+ day old receivables. Leasing building/property with option to purchase. Compensating seller after closing for advice and support. Escrow for Working Capital adjustments and Reps and Warranties
Over-communicate exact inclusions and exclusions. Most sellers have an incomplete understanding of working capital. While they expect to keep the cash they have in the business they are emotionally attached to their receivables, arguing that they did all the work to create them and therefore should keep them. Being reminded that you are purchasing their “on-going” business and that they keep the cash sounds rational but is rarely accepted by the seller without extensive dialogue. Conversely, being intentionally vague about obsolete inventory and older receivables raises the opportunity for a discussion about accounting practices and disputes or expectations of selling off old supplies as further negotiation rounds.
If real estate is involved, letting the owner keep the real estate is a good way to reduce debt obligations early on and as long as there is an option for purchase in the 5th year or so. The seller will appreciate the extra security and value from the lease and eventual sale of the property. It would be reasonable to include the lease payments in the financial terms of the IOI with an option to purchase at “market”. You will likely need the wisdom and support of the owner after closing. Paying a daily consulting rate allows the seller to feel valued while giving you the flexibility to engage the seller as needed.
Always put an expiration date on your offer, with a short 2-3 day fuse, emphasizing that you will be buying a single business and cannot afford to take too much time. Be, reasonable and willing to extend, but start with early dates. This is about “getting to no, fast” so you can move on to then next prospect.
This is a two-sided negotiation, as much as you will hate it
Be prepared to negotiate with the seller. As you are buying only one business, it is critical that you not overpay for it. If the terms you end up with are too favorable to the seller, your investors and/or bankers will push back on you. In my own first LOI, I was devastated when my banker told me they would not provide the financing because they felt I was paying too much, despite my spreadsheets that showed how I could make it work; but they held the purse strings!
I typically hear, especially from searchers early in their process, that the “back and forth” negotiation of the IOI is draining, fraught with uncertainty and leaves them feeling exhausted and sometimes taken advantage of. Remember, this is just part of the process and owners have been negotiating with customers, bankers, vendors and employees for years. In fact, one searcher said, “I felt like I was swimming with sharks while trying to negotiate with the owners of a scrap metals business whose livelihood depended on their ability to drive hard bargains.” Avoid the “this is my best and final offer” game and be prepared for multiple cycles.
The seller may need time to reflect one of the more important decisions in their life. They will want to thoroughly understand the IOI. They have to absorb the reality that “discounts” taken for high customer concentration, low margins, seasonality, cyclicality, competitive pressures, transition issues, uneven quality, delivery, or service levels are all reasonable factors in your valuation. Seller disagreement sets you up to ask for factual data to justify increasing your offer. Zack Belzberg, says, “An IOI merely serves as a guide for what I was willing to pay and on what terms assuming what the seller has told me is in fact true and tool to getting more information. I would inevitably learn more about a given business over time and adjust the valuation and terms accordingly. In short, make offers early and often.”
It may even allow you to adjust the terms in your favor, extending the payment holiday or reducing the interest on the seller note. Since your financing will be almost exclusively based on historical results, avoid dialog around the seller’s future expectations for the business. You are not paying for future earnings, just their historical results. Additionally, as Mike Donovan of East Range Partners points out, “Keep probing, and don’t let the dance, lunches, and coffees carry on for too long without getting at least a ballpark understanding of why is now the time to sell and why not a few years from now?”
Put your offers in writing, regardless of the outcome
Never leave one of these challenging “offer” discussions without immediately reducing your offer to writing. Sellers are often confused by the terms and language and my need time to see the details in a form they can print, contemplate, pass along to their advisors or simply move to their Trash! It should clearly state your assumptions and have an expiration date of less than a week. One searcher believes “Verbal offers mean nothing – create it in a PDF document on your search entity letterhead in their hands immediately. Don’t forget to set an expiration date of a 5 days hence; time is of the essence as they say in Real Estate.”
Having it written down adds another dimension according to ^, searcher/CEO at Arden Bay, “When written, it shows your seriousness and will get the sellers socializing the deal with whoever they need to on their end, which is significant for them. I think its most important function is getting the price and terms in front of the owner to see if you’re in the same ballpark.”
Of course, the seller may always reject your proposal. However, the adage that businesses are only worth what someone is willing to pay for it rings true. It may be a long wait before the business owner may see another proposal. Consider it a “gift” you are making to future searchers in setting a realistic valuation “bar” for the owner.
No does not mean no, follow-up is critical
Hearing “no” from the seller should only be treated as “no for now”. Remember that the seller may not yet be comfortable with the reality of selling their business, or with seeing a valuation price put on their decades of work. These rejected offers should be revisited with prospects on regular 30-day/monthly follow-ups. Your message should be scripted as a continuing strong interest on your part, respect that they rejected it, an affirmation that they have created a valuable business, and recognition that they may need more time to think about this big decision but that now may be the right time to resurrect the discussions.
Searchers are sometimes hesitant to be this assertive with prospects and share that they don’t want to be viewed as spammers, stalkers or desperate to find a business. However, at least a third of closed search transactions come from “re-opened” dialog with early prospects. You are not a “loser”, this is simply a good sales prospecting technique utilizing a gentle, but persistent monthly reminder that may pay off. ^, Searcher/CEO at King Sales Group, urges “If they told me to never contact them again, I respected that. Otherwise, I followed up every 3-5 weeks. Many did change their minds.”
Business owners undergo life changes, their other offers fall apart, or they simply become more comfortable about selling their business. However, when a “resurrected prospect” calls, take a deep breath and prepare them for a lower offer, with statements such as “market conditions have changed, and I have been moving forward with many other interesting opportunities.” Remember, they are getting back in touch with you for a reason and this is the start of another negotiation!
Since it takes a while for your proprietary search campaign to yield results, early on in your search you can start with CIMs (Confidential Information Memo) from brokers to gain experience. Often times these broker sourced opportunities do not make it through to closing and often return to the market.
Understand and develop seller confidence during the process
Each occasion to dialog with an owner is an opportunity to build trust. Make small commitments and follow through on them. Continually ask and probe the seller about their motivations for selling, their plans afterwards, and concerns about specific customers, vendors and employees. Speak 1/3 of the time and listen 2/3’s. The more sellers are able to share these with you, the more comfort they develop with the process of selling…just because they have said they are interested, does not necessarily not mean they will make it all the way to closing day with you.
Give the owner some time to review the offer before a face-to-face dialog or meeting. Be prepared for the butterflies in your stomach that will happen every time you click “send.” The feeling that this “could be the one” is exhilarating and terrifying at the same time! It does get easier with time, practice, patience, perseverance and courage. On visits, ^, CEO at Dodds Doors in Canada, cautions, “A typical early mistake is taking a meeting a few hours drive away just to find out that the seller has a business that is either too small or has unrealistic value expectations. Ask for an introductory phone call in advance of a visit an probe with the seller to learn how many employees they have, if they have considered selling before. This will save a lot of time and heartache!”
You also want to subtly communicate that there are other prospects that you have put on hold to focus on this. While you should not have two signed LOI’s, managing multiple IOI’s at the same is reasonable and customary. Beware of being shielded too long or too often by an intermediary. It generally means the seller is looking for the “highest” price for their business, and not resonating with other considerations that make searchers so attractive by appealing to their “legacy”, continuity with employees, along with minimal impact on the community, customers and vendors. Let someone else with deeper pockets buy them instead and move on.
Stay fixated on the search, not the deal
It is not unusual for a searcher to have a half dozen IOI negotiations ongoing at any given time. Avoid fixating on a single transaction. Allocate 40% of your time to prospecting activities. Avoid the natural tendency to dig deeper into the target company’s market, industry or financials, since about 80% of these will not turn into LOI’s.
You will learn more with each “shot on goal.” The skills you develop early on in the process pay off handsomely by the time you reach mid-way in your search. Sellers will sense the confidence you have developed to provide flexible solutions to the issues that make each search transaction unique.
Feel free to share some of your own best practices or experiences in dealing with these issues in the blog comments. I encourage comments and dialog, allowing all in the community to learn from both my views and the views of others – a virtuous learning cycle. Jump right in! I frequently update individual blog posts, add to the Reference section and Search tips, so visit the www.jimsteinsharpe.com website regularly.