7 common mistakes made by sellers in mergers and acquisitions

Why do many merger and acquisition deals fail? In my experience, they fail simply because the seller is not prepared for the deep due diligence that investors and buyers perform on their company. M&A transactions are complex processes with a lot of variables. This article reviews seven issues that are common in the run-up to transactions that can quickly derail promising opportunities for sellers. Sellers should be careful to discover them before speaking with investors or buyers.

1. Seller doesn’t know what state and local taxes (SALT) are involved

The definition of nexus (whether you are subject to sales or income taxes in a state, city or county) has been evolving, particularly since the 2018 Wayfair ruling. If you cannot definitively demonstrate your business’s SALT status, then the buyer will assume the most risk-averse position—that you owe more, rather than less, local taxes. The challenge is quantifying the amount of SALT owed, which can, at best, result in a large escrow or price change, or, at worst, derail the process because the buyer cannot get comfortable with the risk associated with potential unknown liabilities.

It is best to quantify the potential SALT liability and to negotiate voluntary disclosure agreements (VDAs) prior to engaging with a potential buyer.

2. Seller’s company management is too concentrated

If you are too involved in your company’s day-to-day operations, such that you are indispensable, that can make a buyer shy away from the business. Recently, my firm ran a process for two owner/operators of a fast-growing company that is positioned in a large and growing market and has extraordinary EBITDA margins. But some buyers were wary. Why? Because they were contemplating giving the owners a very large chunk of money for the company, which would give the owners the freedom to take off at any time. For some buyers, this risk was too high.

Spread out the management responsibilities across a management team. This provides much less risk for buyers, which will make your company much more valuable.

3. Seller lacks awareness of pension plan liabilities

For those companies that contribute to pension plans for their employees, particularly multi-employer pension plans (MEPPs), the potential unfunded liabilities can be surprising. MEPPs are “joint and several” for contributors, meaning that if any single employer underfunds the MEPP, then all the other employers in the plan are on the hook for the deficit. MEPPs require a withdrawal payment when the employer sells.

Make sure you know what your withdrawal liability is before you start talking to buyers.

4. Seller overlooks quality of earnings

Just because a company has had a few years of good EBITDA does not necessarily mean that that performance will continue into the future. A buyer is buying future cash flows. They will dig deep into what makes up the EBITDA performance, focusing on components that are not sustainable in the future. What the buyer calculates can end up being very different than what the owner expects, leading to a re-trade that can erode trust and scuttle a deal.

Get a firm understanding of how the buyer will view earnings prior to engaging with potential buyers.

5. Seller hoards working capital

Private business owners tend to hoard working capital, whether it be cash or excess inventory. Hoarding WC can be detrimental to perception of enterprise value and it can result in negative purchase price adjustments at close. In many cases, deals have died due to opposing views on working capital. Optimize inventory by getting rid of obsolete inventory and minimize slow moving inventory.

Distribute or sequester excess cash on the balance sheet so you can demonstrate that the business can operate over a period of time (12 to 18 months) with the minimum amount of necessary working capital.

6. Seller gets surprised by hidden environmental issues

Be aware of potential environmental issues regarding your facilities. Even if your business does not participate in activities that would be an environmental concern, make sure that past tenant activities did not result in environmental impairment that might raise risks that buyers would find with a Phase I or Phase II assessment of the premises. Late stage environmental surprises can become serious issues, particularly when remediation is involved.

Have a reputable and preferably nationally-recognized environmental firm perform Phase I and Phase II environmental assessments, and start remediation if any issues are found. This will make it much easier to address when talking to buyers.

7. Seller fails to properly document legal relationships with employees

Ensure that you have employment agreements in place, particularly for employees who are designing or developing intellectual property for your firm. Make sure that IP developed on your behalf is yours, not theirs. But also, consistently apply benefits, 401(k) eligibility, fairness treatment, options allocations, etc. Any one of these items, wrongly addressed, can result in real expense to the business owners.

Review your agreements with employees and make sure that they accurately reflect the relationships you expect with them and vice versa.

All things being equal, a well-run company with a consistent method and practice for developing, maintaining and executing multi-faceted strategic plans over several periods is more valuable than those that do not. By demonstrating that you can plan, execute, measure and adjust, you are demonstrating that the management team—and by extension, the company—is resilient to changing conditions, both internally and externally. The perception is that the management team is more sophisticated and the investment less risky, resulting in higher enterprise value for the owner.