In the mergers and acquisitions (M&A) world, there are few terms as dreaded as the “re-trade.” The continued market uncertainty, coupled with increased buyer scrutiny and diligence, likely increases the possibility of ”˜re-trades”™ for the coming year. However, proactive business owners can mitigate this risk.
The most critical stage of any M&A process is the point at which the seller selects the ultimate buyer/investor by executing a letter of intent (LOI) and agrees to provide “exclusivity,” prohibiting them from talking to other bidders. While it is each party”™s stated intention (not obligation) to close the deal exactly following the terms outlined in the LOI, it is important to note that the LOI, by definition, is non-binding and subject to further due diligence.
A re-trade happens when the buyer lowers the valuation and/or changes the structure. Reactions to the re-trade depend upon one”™s perspective:
Seller”™s perspective: “I would never have agreed to sell my business on this new valuation and structure had it been offered in the first place.”
Buyer”™s perspective: “I would never have offered that valuation and structure if the Seller had provided me with the information I now have.”
Both sides think they are right. And they may be.
Bait and Switch or Justified Change?
In M&A, there is no such thing as a good surprise. In today”™s M&A market, the buyer due diligence process is becoming increasingly exhaustive and lengthy. When this detailed and disciplined process reveals something unexpected (a surprise), buyers will try to use this new information to renegotiate the terms, price and structure. Generally, justifiable surprises come from:
Missed financial performance
Different assessment of operating risks
Changing industry dynamics
Financing contingencies
While issues may surface during the diligence process that justify a revised offer, re-trades can also be part of a buyer”™s negotiating strategy: Give the seller what they want in order to get exclusivity, then trade down to a lower price using ”˜new”™ information based on their due diligence. This strategy is especially effective with inexperienced and/or over-zealous sellers.
Regardless of strategy, the re-trade usually comes at the worst possible time ”” right before the closing when there are limited options for the seller.
How to Protect Against a Re-trade
There are a number of steps sellers should take to help protect against a re-trade. Overall, sellers should be realistic and look at the company through the investor lens.
Be fully transparent: There should never be a ”˜buyer-beware”™ mentality as the buyer will always find the bad news (which will inevitably lead to a re-trade). Being fully transparent about both the strengths of the business and its weaknesses is the best possible way to avoid a re-trade. The fact that a weakness exists is not an issue if it is positioned correctly (as an opportunity) and disclosed in advance. Buyers cannot claim a ”˜surprise”™ in due diligence if they knew about it before they make an offer.
Conduct a sell-side Quality of Earnings (QoE) report: We always recommend hiring an experienced accounting firm to conduct a QoE report prior to going to market. This exercise will proactively uncover meaningful issues influencing valuation (EBITDA normalizations, margin analyses, net working capital trends, etc.) and reduce the likelihood of future disagreements with the buyer”™s QoE findings during the diligence process.
Understand the buyer: Knowing the motivations and experience of the buyer/investor is critical to predict the possibility of a re-trade. Do they have a history of re-trades or earnouts? Do they know the industry well and have experience investing in competitive companies? Do you trust them?
Understand the basis of the valuation: Receiving a premium valuation is the dream of all sellers, but it is critical to understand the basis for that valuation. What are the buyer”™s assumptions behind the initial valuation (typically, historical EBITDA, growth rates, profitability, access to customers products / markets or technology)? How is the buyer going to measure and validate these criteria?
Financial projections: under promise and over deliver: The most common reason for a re-trade is missing the budgeted financial performance during the exclusive diligence period. If near-term projected numbers are missed, then management loses credibility, valuation can be renegotiated, and often leads to a deeper dive into other due diligence processes.
Negotiate (heavily) while you have the leverage: Many sellers are so excited about getting a seemingly great valuation for their business that they jump to “yes” too fast, assuming that the hard work is done. While valuation is critical, sellers should also think about other definitions of value that are equally important (transition plans for owners, taking care of employees, integration plans, etc.) It”™s critical to negotiate these while the seller has maximum leverage ”” which is right before accepting an offer.
The Seller”™s Options
Re-trades are dreaded, but they happen. Even with a revised offer, the seller has options:
Restructure the transaction to maintain overall valuation, such as converting some cash at closing for a contingent payment in the future
Address the issue(s) being raised (assuming the issue can be resolved quickly) and re-engage with the buyer after a brief pause.
Terminate the LOI with the existing buyer and potentially begin discussions with a different bidder.
Walk away from the transaction all together: This may be a painful reality after the investment of time, money and emotion. However, it may simply be the best course of action if the revised terms of a transaction no longer meet the seller”™s objectives and it is unlikely to realize it with other bidders.
The best advice in this situation is to take a deep breath and then take an analytical approach to this emotion filled situation. Sellers should keep their focus on the bigger picture and examine if a transaction still meets the objectives that that prompted a transaction in the first place.
Michael Carter is managing partner with Carter Morse & Goodrich, a boutique M&A advisory firm headquartered in Southport, Connecticut. An earlier version of this article appeared on the company”™s blog.
