How to negotiate long-term succession planning/incentive structures

November 15, 2024

by a searcher from Harvard University - Harvard Business School in Salt Lake City, UT, USA

I presented a seller with an LOI this week in a highly niche/technical space. The company manufactures parts for use in the semiconductor space. The seller came back and said "I know there are ways to improve the efficiency of the manufacturing process even further, and after considering your offer I feel I need to do that before I sell". Obviously seller has cold-feet, doesn't want to let go of his baby, and believes the company will be more valuable with another 6 months of effort. However, the seller is open to other ideas about how to structure a deal that he feels compensates him for the effort he aims to put in. I originally proposed an earnout tied to sales, but his goals to make the company more streamlined would have an impact on the bottom line if anything, and an EBITDA tied earnout is messy/complex to manage. I could just raise the price, but I don't want to do that on faith the seller's improvements will materially move the needle for the business. I could retain him as an employee, or let him keep some of the equity in the business? Any other ideas on how to align interests here? This is an unsophisticated/off-market/technical seller that has built his business over the past 20 years. We have a good relationship, he's clearly not trying to just claw more money out of me, it just seems he is hesitant to sell in its current state because he's emotionally attached.

Reply by an investor
in Boston, MA, USA

It sounds to me like he’s emotionally attached (like most sellers) AND trying to claw more money out of you. Has he countered with an actual price/structure or indicated how much he was looking to walk away with? Try not to let him force you to negotiate against yourself with subjective, open-ended proposals and figure out how large the gap actually is.

What type improvement is he going to make? Can he demonstrate the potential direct impact on profitability in a way that makes sense to you? If it’s a manufacturing process improvement, you can take baseline gross profit on current/historical sales and give him a portion of the increase that’s attributable to the improvement (to the baseline only – no additional compensation for increased post-acquisition sales), and perhaps cap it to bridge the gap. If the economics work in both of your favors and it’s a good deal with a low/reasonable unconditioned purchase price, it may be worth pursuing.

Administrative process improvements will be more difficult. The seller might just not be ready to sell and you risk wasting time and effort.

Adel is right though in that it’s never-ending – what sort of miraculous change can he really make that will materially increase the value of the company in the next six months and why hasn’t already implemented it in the last few (or 20) years?

Reply by a searcher
from University of Calgary in Calgary, AB, Canada

Cliff - lived something similar on a past transaction (in my case there was definitely value to be created based on how it was being run by management but he hid behind an outrageous ask on price), think you have called the pyschological attachment correcly......borrowing from Charlie Munger, always invert in the sense that what is he going to do in 6 months that he hasn't had the chance to do in 20 years? Can you push on this hesitation respectfully to quantify what it is and what he expects it do for the financial side of the business as Step 1, then come up with how you structure to lock this in as step 2. Earnout messy as you noted, could be clarified though with more definition around the pending efficiencies. Friend used an earnout to bridge value to get to a transaction done only to feel like he is working off someone else's gain with improvements he has made that have stemmed what would have otherwise been a decline in the business based on how things were done. If you can get clarity on valuation impacts, bridge with VTB that has grind if it doesn't happen. ‌

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