Risk Assessment in a Mergers & Acquisitions Transaction

Nov 6, 2020

Backpacking in the Sierra Nevada mountains with my uncle, an academic with degrees from MIT and the University of California, Berkeley, I was introduced to the risk acceptance theory of 9’s.  The principle of 9’s is a straight-forward method for assessing the probability of success or failure in an action by progressively adding a 9 as a digit to the right of the decimal point.  The first 9 is .9 or a 90% probability of success with a 10% chance of failure. The second 9 is .99 or a 99% probability of success with a 1% chance of failure.  The third 9 is .999 or a 99.9% probability of success with a .1% of failure. Each progressive step to the right adding a 9 increases the probability of a positive outcome from the decision.

As a mergers & acquisitions professional it is my job, along with vested parties and their professional advisors, to create an environment of full disclosure where decisions can be made in full sunlight from a foundation of knowledge incorporating associated risk.  It is a given that a business purchase & sale transaction creates risk.  Entrepreneurship is by definition a profession for the risk acceptant.  However, with business risk comes the potential for reward.

The following is a summary of the major deal elements with associated risk in a mergers & acquisitions transaction by party:

Seller

A significant majority of IBA’s clients as a “sell side” representation firm, want to sell, but do not need to sell.  Whether or not to sell is the first risk/reward assessment opportunity for a business owner. This analysis has both tangible and intangible elements.  The tangible assessment involves the financial benefit of selling versus the economic benefit of owning the business another year and selling in the future.  Economic conditions remaining constant or improving, most IBA clients are ahead running their business another year and selling in the future. The intangible assessment traditionally relates to the opportunity cost of continuing to work in the business and hold an investment versus selling to create the freedom to pursue other activities.  Known certainties in life are that father time stops for no one and you can’t take money with you when you depart this world. I encourage all of my clients to assess the value of time versus dollars prior to taking a negotiating position. Multiple months spent exploring the United States by RV can have significantly greater value than retirement time lost because a sale is not completed to a “willing & able” buyer negotiating in “good faith” over trying to obtain the last dollar in a negotiation.

The second risk/reward assessment for a seller relates to the financial terms of a potential deal.  Does the offer on the table achieve sale objectives?  Is a more financially lucrative deal available with an alternative buyer? This is a classic “bird in hand versus bird in the bush” comparison.  Is the allocation between cash, promissory note, equity, and/or a variable element (e.g., earn-out) satisfactory?  Can the negotiations get the parties to “Yes” or is it better to walk away from the table and seek an alternative buyer?   If there is a promissory note, what is the probability of getting paid in full?  If an equity position is held will it appreciate and pay satisfactory dividends?  If an earn-out is accepted, what is the probability that the buyer will equal or exceed expectations? It is wise to lean on professional advisors when making this sophisticated, multi-tiered assessment.  Market conditions and tax rates are often tipping point issues resulting in a professional intermediary being directed to “get it done” or “hold ground”

A third risk analysis commonly performed by business sellers relates to business continuity. All business owners desire to get a fair value for their company at the time of sale.  An almost equal number worry about the health and stability of their company when they leave the helm.  It is common for IBA to generate multiple exit strategy options for our clients at similar financial values.  In these situations, many of our clients have the ability to make the decision of who to sell to based on which buyer they feel will take the best care of the business and its customers, employees, and vendors in the future.

Buyers

“Caveat Emptor” is a concept that applies to all purchases from a restaurant meal to a business.  A significant risk exists in the purchase of a company. That is also why business acquisitions commonly create opportunities for greater investment returns than certificates of deposit, stocks, and real estate.  It is critical that a buyer purchase a business with “open eyes” if they want to properly assess the risk associated with the acquisition and value the company.  Risk assessment should include comprehensive due diligence where financial records, customer concentration, the competitive landscape, and employees are scrutinized.  Assuming an environment of full disclosure is created risk can be quantified and a “good faith” negotiation conducted with the goal of completing a “win-win” transaction.

Supplementing comprehensive due diligence in a “best practice” business acquisition is a strong legal representation.  Risk is mitigated in a transaction for the buyer by having quality representations, warranties, disclosure schedules, and indemnification clauses in the legal documentation.  These contractual elements mitigate risk by holding a seller accountable for the information disclosed during due diligence.  It is also commonly prudent to back these clauses with either an escrow holdback or seller promissory note with an offset clause to create a vehicle for easy reimbursement of unforeseen expenses if a “skeleton comes out of the closet” that is clearly the seller’s responsibility without needing to chase a seller that is role playing a ghost when it is time for them to materialize.

Bank or Investor

“He who has the gold makes the rules” is a common refrain by parties seeking capital to assist with an acquisition. Risk mitigation is a prudently followed religion in the world of acquisition financing.  It is recommended that anyone seeking capital to acquire a business recognizes these two truisms before seeking money to complete a transaction. Expectations of a need for relevant experience; business plans; invasive, comprehensive information provision; personal guarantees; additional collateral; and seller participation in the deal should be baseline assumptions for anyone seeking capital.  A high percentage of deals have bank financing or investment beyond the capital injection of the buyer.  This will not occur if the assessment of risk is too high.  Most parties financing acquisitions are looking for risk between one and two nines on the previously mentioned scale.

Intermediary

As the President & CEO of the oldest business brokerage firm in the Pacific Northwest, I regularly discuss personal and corporate risk and post transaction liability with the professional intermediaries on my team.   The best insurance policy for a mergers & acquisitions firm to mitigate risk is to have knowledgeable, experienced, highly skilled brokers facilitating transactions.  All of IBA’s brokers joined the firm with high levels of education and experience.  We have intermediaries on our team with law degrees and MBA’s.  We have industry specialists that worked for Microsoft, Boeing, and dominant companies in the construction and pharmaceutical industries.  All of our brokers have real estate licenses and the ability to personally value privately held companies and family businesses.  They have worked collaboratively on transactions and learned from many of the top attorneys, accountants, banks, and consultants in the region.  They also benefit from industry and corporate continuing education on a regular basis.  Facilitating transactions with knowledge and experience in an environment of full disclosure employing “best practices” mitigates risk for the broker, seller, and buyer and is standard operating procedure at IBA.

IBA has successfully facilitated over 4200 transactions since 1975.   I have been the President & CEO of the firm since 2000.  We take our responsibility of mitigating risk for all parties very seriously.  Our track record for success is unequaled in the region.  The number of referrals we receive from sellers, buyers, and their professional advisors along with the extremely low number of post transaction issues in our deals speaks to the quality of our work product.

Selling or acquiring a business is an action requiring an assessment of risk with the opportunity for significant reward.  Done right, the probability of success increases and the risk of failure is mitigated.  If you need help assessing risk in a mergers & acquisitions transaction, IBA would welcome the opportunity to serve as a member of your team.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.