How to bridge the gap between Seller and Buyer expectations in SME transactions?

For a founder or seller, the sale of a SME business will be one of their key life events.  For a buyer it can be a springboard to a faster growth rate.  In recent months buyer and seller expectations have changed in relation to SME transactions.

Francis Dalton, Corporate Partner at national law firm Freeths, explains that :It is now taking an average of 12 months for transactions to complete leaving buyers and sellers in limbo.  In this article our Corporate experts identify some of the frequently occurring gaps between seller and buyer expectations in Small and Medium-sized Enterprise (SME) transactions and methods of addressing them to determine the best possible outcomes for both parties and to reduce transaction timetables.

Price

Price can often become the main point of disagreement during negotiations because the seller and the buyer rely on different approaches when valuing the business. Sellers have become accustomed to higher multiples and in some cases valuations based on future earnings.  As the economy has tightened, pricing from buyers has dropped and this has led to lower multiples.

Multiples

Multiples, which is a commonly used price metric, works on the basis that a company is worth several times its profits (EBITDA) or its revenue.

For some tech firms, revenue multiples (or annual recurring revenue) have been the basis of valuations as part of the market for a few years.  However, where these were once closer to 6 times, now they are more settled around 3 or 4.  For non-technology assets, it is more common to see a multiple based on EBITDA.  Again, these are sector specific but have reduced in recent years.

When choosing between profit-based and revenue-based multiples, it is crucial to consider the specific characteristics of the SME, the industry in which it operates, and the transaction context. Some additional considerations include:

whether the SME has consistent and predictable profit margins, if it has then profit-based multiples may provide a more accurate reflection of its value. However, if profitability is low or volatile, revenue-based multiples may be more appropriate; and
whether the SME is in a growth phase with significant revenue expansion potential, if yes, revenue-based multiples may better capture its future value. Conversely, profit-based multiples might be more suitable if the business has stable or declining revenue but is capable of improving profitability.

Working Capital Targets

Most transaction required that the Seller leaves the business with a normal of working capital in the business.  However, agreeing on what counts as a normal level of working capital is often a source of disagreement.  These disagreements typically arise due to differences in perspectives regarding the appropriate level of working capital that should be included in the transaction. For example, disagreements can arise regarding the treatment of cash, accounts receivable, inventory, or accrued liabilities and the period over which the target should be set.  In a recent transaction, this resulted in a difference in the price of over £1m and ultimately caused the transaction to fail.

When a disagreement in relation to the working capital targets occurs, it is important to have clear and open communication between the parties. Efforts should be made to understand each other’s perspectives and work towards a mutually acceptable resolution.

Earn-out provisions

Earn-out provisions are often used to bridge valuation gaps and align the interests of the buyer and seller as these are payments usually contingent on the business’s future performance.  Of course, a buyer will look to put as much of the overall consideration as contingent on the businesses’ future performance as possible whereas sellers will want more money up-front.

It is generally advisable to exclude the impact of uncontrollable external factors from earn-out provisions. For example, economic downturns, changes in industry regulations, or unforeseen market conditions can significantly affect business performance. Excluding these factors from the earn-out calculations ensures that the outcome is based on the performance within the control of the buyer or, more commonly, a seller/founder who is remaining in the business.

Earn-out provisions should be designed to focus on the performance of the specific business being acquired rather than general market conditions. Both parties should agree that earn-out provisions should not be subject to financial engineering or accounting manipulations. This ensures that the earn-out payments are based on the genuine performance of the business rather than artificially inflated or manipulated financial figures.

Earn-out provisions should be drafted with clarity and precision to avoid ambiguity or misinterpretation. Clear definitions of performance metrics, milestones, and calculation methodologies should be included to minimize the potential for disagreements and disputes in the future.

It’s worth noting that the specific exclusions or considerations for earn-out provisions can vary depending on the unique circumstances of the transaction and the preferences of the parties involved. It is strongly recommended that both the buyer and seller consult with experienced professionals, such as legal advisors, to ensure that the earn-out provisions are fair, balanced, and accurately reflect the intentions of both parties.

Liability Caps

In SME transactions, a seller will make a number of promises about the state of the business to the buyer (known as warranties).  In the event that the these are untrue, the seller will be liable to the buyer for the loss.

It is normal for this loss to be capped but the level of this cap is a point of contention.  Historically sellers have got used to caps of 20%/30% of the consideration whereas buyers will want to make sure that they have protection for the entire consideration amount.

Ultimately this will come down to how comfortable a seller is with the business that they are selling.  Many sellers will say that they know their business and are comfortable giving the warranties.  In other circumstances, the parties may seek warranty insurance protection to bridge the gap.

Basis Liability

In SME transactions involving multiple founders or shareholders, the allocation of liability can be structured in different ways. Two common approaches are joint and several liability and several and proportionate liability.

Joint and Several Liability

Joint and several liability means that each founder or shareholder is individually responsible for the full extent of the liabilities of all founders. In case of a breach or financial obligation, any one founder can be held fully liable for the entire amount, even if other founders are unable to fulfil their share of the liability. If one founder has the means to satisfy the liability, it ensures that the affected party can recover the full amount owed. This approach can provide a stronger level of protection for the buyer but it can seem unfair to sellers who don’t feel that they should cover the liability of their co-founders.  However, where a buyer insists on this approach the co-founders are able to regulate the position through an agreement between themselves.

Several and Proportionate Liability

Several and proportionate liability means that each founder or shareholder is responsible only for their respective share of the liabilities based on their ownership or agreed-upon proportion (i.e. if they have 30% of the shares they are liable for 30% of the claim).  This approach is preferred by sellers but it can leave Buyers exposes of required to bring claims against a number of people which is costly and time and consuming.

The choice between joint and several liability and several and proportionate liability depends on several factors, including the specific circumstances of the SME transaction, the relationship and trust among the founders, the financial capacity of individual founders, and the preferences of the parties involved. In some cases, a middle ground can be reached by incorporating a combination of both approaches. For example, certain liabilities may be subject to joint and several liability, while others may be subject to several and proportionate liability.

Next Steps

In conclusion, bridging the gap between seller and buyer expectations in SME transactions requires a win-win approach. Both parties must be willing to compromise on key issues and understand each other’s positions to arrive at a mutually beneficial agreement. With proper preparation and open communication channels, the likelihood of a successful deal increases. It is important for both seller and buyer to consult with legal professionals who specialise in corporate law and SME transactions due to the complexities and potential risks involved. If you have any questions relating to a SME transaction or you’re contemplating embarking on a sale or acquisition, please speak to Francis Dalton (Partner) from our Corporate Team.

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How to bridge the gap between Seller and Buyer expectations in SME transactions?