Earnest Money from the SELLER in LOI
August 31, 2021
by a searcher from University of Massachusetts Amherst - Isenberg School of Management in New York, NY, USA
I'm working on an LOI right now for a company that did not keep great books and has a stubborn seller. The seller's projecting to me the attitude that he doesn't mind waiting to sell the business, and would be happy to run it for another year or so to get what he thinks it is worth--this is probably partially true and partially a negotiation tactic.
My main concern is his books/returns are terrible. There is a chance that after an accounting review and due diligence his SDE & EBITDA are materially less than he thinks they are, and we will have to lower the selling price. (The selling price in the LOI will be based on a multiple of either SDE or EBITDA.)
My concern is that at that point, I will have invested a good amount of money into due diligence and he may get cold feet and try and back out if the final price is "not what he thinks his business is worth".
Any ideas on how to handle this? Have him put earnest money down to cover DD, should he back out? Set a target range in the LOI? Ask the broker to pay for accounting DD and he can keep it if the deal falls apart?
Thanks, any advice is very appreciated!
from University of Southern California in North Palm Beach, FL, USA
#7 – Succumbing to the Sunk Cost Fallacy
https://cenkuslaw.com/common-mistakes-buying-business/
For a buyer who has put time and money into a negotiation to buy a company, it is tempting to be committed to closing the deal no matter what. It’s always tough to walk away once you have made an investment in something. However, staying committed to a course of action simply because of the expense you’ve already incurred when that course of action doesn’t make sense on a go-forward basis is a mistake, one referred to in economic parlance as the “sunk cost fallacy.”
Sunk costs are costs that are already spent, ones you can’t recover, hence they are “sunk.” They are gone and not coming back. Rationally, you should always look at your current course of action based only on your most recent projections of how that course of action will play out and the cost remaining to complete the course of action weighed against other possible courses of action (their likely outcomes and cost to complete).
To see the sunk cost fallacy at work, consider two hypothetical companies that each hire a new salesperson. Company A pays the salesperson a sign-on bonus of $25,000. Company B doesn’t pay a sign-on bonus at all. Two months in, each salesperson is severely underperforming. For this example, both sales people are missing the mark exactly the same – they are both equally terrible (hey, it’s a hypothetical, I’m allowed to take liberties like saying two people are performing exactly equal!). Do you think each company will be equally as quick to let the new salesperson go and hire a replacement? No, they won’t. Company A will almost certainly stick with their salesperson for a longer time. They will be motivated by a desire to not have wasted the $25,000 sign-on bonus. But, that money is gone and it’s not coming back. At the point in time Company B decides their hire was a mistake, Company A should make the same decision. But, they usually won’t. They’ll cling to the sunk cost and make a decision that is not as rational as it ought to be.
In the M&A context of buying a company, you may find yourself tens of thousands of dollars into negotiations, advisor fees, and due diligence fees. You may have even passed on other opportunities. Those things often drive a buyer to close a deal that ends up not looking as great as you get closer to closing. You should make the decision to walk away or stay in the deal without worrying about the money that is already spent. That money is spent no matter what. The only question ought to be, is it a good deal to buy this company and spend the money that has not already been spent? Would another deal be a better option? If you do enough deals, you will hear very intelligent people say things like, “we have already spent $x and all this time, so let’s do this deal.” That’s a mistake. A common one, but a big mistake.
from The University of Chicago in Chicago, IL, USA
2) Variables in M&A are not only price but also what you get for it and how you pay for it. So focusing on price alone is not the way to get a deal done.
3) A deal can crater at the last minute, even on the closing table. Buyer is out of pocket time and money, big time. So accounting DD is just a small cost. To expect recovery of buyer's cost is not the norm. You might get the seller to agree, but not healthy. Flip your DD into a leverage for you.
4) Balance sheet (yes, I mean balance sheet) can tell you a lot if there are material gaps between what the seller says about profitability and what it is likely to be.
5) There are other ways to a high level analysis of profitability. Example: In one case, I collapsed 5 years into one year and made an estimate of total profit over 5 years. That at least gave me 5-year average.
6) Happy to chat more.