It’s a tragic story seen time and time again in the M&A world, specifically in strategic acquisitions…
On one side, you have a Seller.
A relatively small company. An owner/founder who has worked hard to build the business to what it is. They are elated to have caught the eye of a larger company seeking to acquire them, whether they will take on an executive role post-sale or will take the sale proceeds and invest in a new venture or sail off into the sunset for a much-deserved retirement.
On the other side, you have a Strategic Buyer.
Usually, the company is 50… 100… times the size of their target… maybe even bigger. They’ve found a small company that offers a technology they need… or access to a new market… or whatever else.
Sounds like a match made in heaven. A win-win for both sides. It should be easy enough to hammer out a deal that makes everybody happy.
However, all too often it doesn’t turn out that way due to fear, distrust, greed… in other words, human emotion.
Fortunately, there is a way to overcome that element and get these deals done quickly, in a way that is amenable to both sides. But first…
How Deals Fall Apart
In these types of lower middle market acquisitions, a Strategic Buyer (or even a PE firm) is experienced in the process of acquisition. They do it all the time. To them, this is just another transaction.
But the Seller, the original owner and founder of the business, while good at what they do and very accomplished in their industry (which is why the Buyer has an eye on them) … is inexperienced in M&A.
This is probably the only deal they’ll be involved in in their life. They might even be intimidated by the process.
Two very different perspectives.
And this can create a lot of friction that can hamper the negotiations and delay the deal… or even cause it to fall apart all together. And we’re not even talking about disagreements on the sale price, stock options for the executives to be newly onboarded after the acquisition, or anything like that.
It comes down to the process, and there are several elements at play.
- The acquisition itself can be a distraction to the Seller. They’re spending their time looking at contracts, talking with lawyers, pulling together financial and other records for due diligence, and other tasks. This takes time away from actually running the business, which can be impacted negatively as a result. This is very frustrating to the Seller.
- Speaking of due diligence, this process can be difficult. First, as a smaller company, they might have had all their records organized in a way that are not easy to pull together. They’re having to dig deep to find the information the Buyer wants. And, not accustomed to what is required for thorough due diligence, it feels invasive to the Seller. They get tired of answering all these questions. (Again, remember that the Buyer does this all the time – they don’t “get” why the Seller might feel this way.)
- This is a big one… indemnification. The Buyer says to the Seller: “We went through all this due diligence. We’ve gone through your records with a fine-toothed comb. We know you found the process frustrating, and we appreciate your efforts.”
“But… in case we missed anything and any of the Representations in the Purchase-Sale Agreement are inaccurate, we need to hold money in escrow from the sale price for a year or two. Just a few million dollars. Oh… and we’ll take that money if there is a breach to cover our financial damages. But that almost never happens, so it’s no problem.”
This is the last straw. The Seller feels like the Buyer has looked at every single file they have. They’ve been upfront and honest about everything related to their company’s finances, contracts, intellectual property, tax situation, and everything else.
This indemnity provision feels like an insult. They feel like they shouldn’t be held responsible for something they didn’t know about that the Buyer missed. Not only that, but the owner/founder can be personally liable for breaches as well. That dream retirement could be at risk.
At the very least, they will not get the full proceeds from the sale for years down the line. They won’t have that money to invest in a new venture, for example.
From the Buyer’s point of view, they’re making a multi-million-dollar investment and they need to protect themselves. It’s part of doing business.
But the Seller takes it personally. They feel distrust. They’re confused, stressed out, and upset. They feel taken advantage of by this “big company” swooping in. The air goes out of the room. Human emotion comes into play.
It turns what was a smoothly running collaborative process into a tense, confrontational one. Everything could potentially be sabotaged.
And if it’s not, it can still create an acrimonious relationship between the incoming management team from the Seller’s side and their new employer. They might be able to forgive the process, but they’ll never forget what went down. This can be huge as that first year after an acquisition is critical in integrating the acquired company.
How to Avoid All This Drama
There is a simple way to sidestep these issues that will make both sides happy and maintain a strong relationship going forward.
The Seller will avoid the indemnity obligation and potential clawback.
The Buyer will still remove risk.
And when included early in the negotiations, it will smooth out negotiations and make the deal-making process easier.
It’s a specialized insurance product called Representations and Warranty (R&W) insurance. I feel strongly that any Buyer today who doesn’t offer this option to the Seller in a lower middle market deal is not acting in good faith.
With a R&W policy, the indemnity obligation is transferred away from the Seller to the insurer. And the Buyer has certainty they will be made whole if there is a breach. They simply file a claim with the insurance company – and these claims do get paid.
It’s a no-brainer, especially when you consider that:
- This coverage in recent years has been made available for lower middle market deals, including those with transaction values as low as $10M.
- The cost has been decreasing as more insurance companies enter this market. And when you deal with a “boutique” broker that specializes in this type of coverage (instead of the big companies that offer R&W among hundreds of other products), the cost for commissions and fees is even lower because they have much less overhead. The starting cost for a LMM R&W policy today is just under $200K (including fees and taxes).
- And especially noteworthy for the Buyer, when offered this coverage, most Sellers will happily pay for the policy once they realize the advantages it offers them. It’s a small price to pay for the peace of mind knowing they won’t be on the hook in case of a breach… and can take home more cash at closing.
Still, some Buyers are hesitant. They want to limit the time and effort they spend on the deal, especially on some of the extra due diligence R&W policy Underwriters might ask for. They might feel like using some of that leverage as the bigger company and simply leave the Seller on the hook.
That’s very true. However, let me stress again that I feel that is borderline bad faith on the part of the Buyer not to at least offer this coverage. And it’s in their best interest to do so, as it’s a strategic way to show good faith and will reap rewards in the form of smoother deal-making and a good relationship going forward.
The Seller no longer feels “bullied”… they feel like the Buyer has their back. And that is priceless.
Even experienced Strategic Buyers might not be very familiar with Representations and Warranty insurance. They might have heard of it, but only know what it used to be several years ago, when it was only offered for larger deals and the costs were higher.
A lot has changed with this specialized insurance product in recent years. It’s more affordable and more widely available.
I’d be happy to get you up to speed and share how this coverage could specifically benefit your next deal.
For details, please contact me, Patrick Stroth, at email@example.com.