Mergers and Acquisitions for Small Businesses

Business brokers cite the oft-worn stat that half of the deals close, and half don’t. Those M&A transactions in which the deal did not close generate a range of emotions from both the purchaser and the seller. I recently represented a client in the acquisition of a small business in which the deal died. She offered to share some of the lessons learned from seeking an acquisition target, but failing to close the deal. In this article, she provides four lessons learned from the ultimately unsuccessful negotiations. After each lesson, which are in her words, I provide some brief comments.

Lesson 1: Seek legal guidance early on.

We waited a bit on this, mostly just a rookie move; but I think it would have helped to connect with a small business lawyer out of the gates when we voiced interest with the business broker. It was clear the broker was used to working with people that did not have a lawyer involved (i.e. she sent us a LOI and just expected us to sign it), but having the guidance of someone who understood the entire process could have prepared us a little earlier on in the conversations and could have saved us a lot of time.

Discussion: The clients came to me very early in the process, and we crafted the letter of intent together. Most clients do not recognize that business brokers are often times not representing the interests of the purchaser. They only get their commission if the deal closes. They may have a form letter of intent (LOI) that cements in key business terms, which may work to the detriment of the purchaser. It is better practice to nail down key terms and conditions of the transaction at the LOI stage rather than wait until the negotiations for the purchase and sale agreement.

In the acquisition of a small business, the key consideration may be the price. Nevertheless, sometimes it is not clear what the purchaser is getting for the price. This is especially true if the transaction is structured as an asset deal. The owner may intend on keeping some of the intellectual property. Is the purchaser keeping any of the working capital? At what point does the deposit go “hard”—non-refundable. Usually the owner will not be allowed to compete with the business being purchased for some period of time—how long? What will be allowed in terms of due diligence and at what point will the prospective purchaser be given access to some of the more sensitive information to a small business such customer lists.

The more key considerations you can nail down at the outset in the LOI, the higher the likelihood that you will recognize whether there is a good chance that the deal will go forward. And the clients are correct: do not let the broker be the lead in your negotiations.

Related article: Checklist for Buying or Selling a Small Business

Lesson 2: Be specific about due diligence requests.

Coming from the tech world, I am used to very detailed diligence processes with M&A deals post signature of the LOI. I was incredibly surprised with this deal that there was no transparency about what we would get post signature of the LOI, nor was there the invitation to really ask for a lot. We forced the ask actually and we were told that we got very limited access to client details, staff interviews and more. My partner and I spent a good amount of time coming up with a very detailed diligence request list that we were unsure if the company would have complied with, but we felt we needed to see / have access to in order to feel good about the deal.

Discussion: Due diligence checklists are meant to be intrusive because in any small business, the owner may want to secrete certain transactions. Run for the hills if you hear that there were off balance sheet transactions that would make the company look more attractive. The main issue in mergers and acquisitions of small business is that due diligence can be very time-consuming and then you find out that the owner has been hiding something all along. I have represented several sophisticated buyers who had a chunk of money that they wanted to spend but simply could not find a company that met their criteria or found a prospective seller who was willing to be subject to the due diligence that would have been required to satisfy the purchasers that they were getting what they thought that they were getting.

Due diligence is and can be informative, but you should recognize that the small business owner, even if he or she has received a non-disclosure agreement, may still resist providing certain sensitive information. Sometimes creative ways are needed to provide the assurance to the prospective buyers without having the seller reveal everything about the company.

Then we should refer back to Lesson 1. The earlier in the process that you can determine that there may be some insuperable barriers, you may save yourself a lot of time. You can let the seller know at the outset what information you will require before you close on the transaction.

Lesson 3: Early misalignment is a sign of the future to come.

At the end of the day, if you don’t agree on the terms pre-LOI signature, it’s not a good sign. The owner felt that the company was worth more than how we valued the company. She wasn’t willing to budge, but in the same sense wasn’t willing to provide all the details about her client base and pipeline to help make us comfortable with the company’s overall potential and valuation. From what information we did see, it appeared a good amount of the company revenue was attributed to one client who had been working with the company for over a year; and that the average client lifecycle was about three years–meaning that we could purchase the firm and then lose its major client within a year. Obviously, this raised some flags with us.

Discussion: My friends in private equity tell me that buyers and sellers should come to within 15% of the fair market value for a company. If you can’t come to within reach on the valuation for the company, it is better to walk away early. It will be a bridge too far and you are simply spinning your wheels. If you can come to within 15%, then there should be no reason that you cannot bridge the gap through mechanisms such as earn-outs. And it is good to have some alignment of interests. Even after closing, you will have a continuing relationship with the other party, either by way of a consulting agreement, an earn-out, seller-financing.

Lesson 4: Better understand certifications for government contractors.

We needed to better understand the certification status associated with the business and contracting business in general (for example, 8(a), women-owned, HubZones, etc.) to also factor that into the decision.

Discussion: Government contracting adds a whole other layer of complexity to a merger or acquisition. If the seller has substantial business in the government space, then you will have to add whole new set of vocabulary to your transaction. If the target company is a party to a government contract, and particularly if the business is a holder of an indefinite delivery/indefinite quantity contract (IDIQ) or a long-term General Services Administration (GSA) contract, you need to try to structure the purchase transaction so you will not lose the government contract.

After the purchase, you may need to go through a process known as a “novation” in which the existing government contract is transferred to the new company (in an asset purchase) or is confirmed for the existing company (in a stock purchase). And if the company has qualified for one the classifications that may give it a preference in government contracting, you need to make sure that the business is able to maintain the certification. This may sound obvious but some purchases may not be aware of all of the requirements to maintain a certain certification.

Purchasing a small business is not for the faint of heart. Transactions under a million dollars are especially difficult because they require the same amount of due diligence and legal fees as a larger transaction. The time expended on due diligence and the amount in legal fees may seem disproportionate to the value of the deal. But I have seen clients making the investment of time and money in small deals with good rewards at the end. And if you follow these four lessons, you may be able to reduce the time and expense of acquiring a small business.