As in all elements of business, there is risk when buying or selling a business. One of the key roles of a professional M & A Advisor is to mitigate that risk. The Catchfire team uses an approach, based on their experience in countless transactions, to ensure their clients maximize their return and minimize their risk.
Risk is an essential part of business—and an inevitable part of life. When you bought or started the business, you took a risk. Every day in running the business you are managing risk. And when you sell your business there is risk. What are those risks and how can they be mitigated?
Bear in mind, that whoever you are transacting with will also want to mitigate their risk. That’s where skilled negotiation and creative solutions become essential.
In this article, we’re going to delve into how you can reduce your risk when selling your business and what you can do to lower your risk after your business is sold. To be clear: As business people we know there is always an element of risk, and selling your business has its own unique set of risks. We know there will be a ‘leap of faith’ at some point, but as M & A Advisors and brokers, our job is to make that leap as small and safe as possible.
What Is Risk Mitigation
Risk mitigation is a catch-all term for tactics and strategies used to lower unwanted exposure – legally, financially, operationally. People are constantly mitigating risk, from buying insurance for their homes to putting on seatbelts when in a moving vehicle. Risk can be sorted into four categories: Avoidance, reduction, transfer, and acceptance.
Risk Avoidance
Risk avoidance means taking no risk. Sometimes, this can make a lot of sense (refusing to jump out of an airplane without a parachute) or very little sense (refusing to buy a house because of your fear of house fires).
Risk Reduction
Buying a high-quality parachute before going skydiving and getting a smoke alarm for your new house are two examples of risk reduction. They don’t eliminate risk (your parachute could snap and your smoke alarm could malfunction), but they do reduce it.
Risk Transfer
Risk transfer involves moving risk—usually financial risk—from yourself to another party. If your parachute snaps while you’re skydiving, your life insurance policy might pay out—that’s financial risk transfer. The same holds true if your home burns down after your smoke alarm malfunctions; your home insurance policy might pay to replace your home.
Risk Acceptance
No matter how hard you try to mitigate risk, you will always accept some level of risk—that’s life. Risk acceptance is about evaluating which risks are worth mitigating and to what extent.
How does this apply to selling my business?
There are some common risk factors that arise in every transaction.
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Closing Risk.
How certain are you that the deal will close? There can be many reasons for a deal to not close. Perhaps the buyer discovers something in Due Diligence that concerns them enough to walk away. What if they aren’t able to secure funding? Sometimes seemingly small details can cause one party or the other to say “enough is enough” and walk away.
The time, energy and resources to going through a due diligence and negotiation process.
To mitigate this we use several strategies, some of which are: thorough vetting of prospective buyers, deposits and break fees, and staged due diligence. You wouldn’t hire an employee without a solid understanding of who they are; why wouldn’t you approach a buyer the same way?
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Due Diligence Risk
A common expression in our line of work is that “nobody minds a few warts, but everybody hates surprises!”, meaning that every business has its blemishes, its less-than-ideal characteristics. Buyers can tolerate those, and in fact, many appreciate knowing about them as they shed light on opportunities to improve performance and profitability. But surprises are something else altogether. Finding something unexpected and undisclosed, especially if its material, will send many buyers to the exit, or at least will downgrade their valuation of the business. It’s not just that the ‘surprise’ had never been adequately disclosed, it also may suggest that there are other “hidden gems” waiting to pop up. This type of situation increases the risk profile of the business in the eyes of the buyer. In managing their own risk, they may walk away.
To mitigate this we do a deep dive into understanding our clients and their businesses, and the good and bad of their operations. We developed a product – Catchfire 3D: Due Diligence Diagnostic – where we assess the business through the eyes of a buyer and identify any areas that require greater clarity. And we have a transparency-based approach in all our communications with stakeholders.
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Competitive Risk
Often buyers are strategic buyers, which typically means they already operate in your industry. They may be direct or indirect competitors and they may already be operating in your market. The risks associated with disclosing confidential and proprietary information can be high. They will know your pricing systems, your employees, your customers, and everything else there is to know about your business. What if the deal doesn’t close, for any one of a number of reasons? How is the disclosing company protected?
To reduce competitive risk, we take a number of steps. As above, we carefully vet prospective buyers. Further, all of our discussions occur under mutual non-disclosure agreements prior to confidential information being shared. In addition to the legal protection and remedies, we use other tools and methods. Those include, but are not limited to, break fees, staggered release of information, third party assessments, and penalties for ‘no cause’ cancellation.
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Exhaustion Risk
Selling a business is a complex process with many moving parts. Purchase agreements are lengthy and complex and every detail has to be agreed to by both parties. The negotiations that take place can be difficult, with each side pushing hard to protect their best interests. Often, the last 30 days pre-closing, when the big details have been ironed out and the plethora of small but important issues remain to be addressed, is the most stressful part of the process, especially to a first-time vendor. The stress can be anxiety-inducing and exhausting which can cause vendors to either walk away or give in too much, just in the interest of getting the deal done. In one case, a deal was scheduled to close on the 30th of the month. Due diligence was complete and the definitive agreement was done, when one issue arose. The vendor was beyond upset, had hit their limit, and told us to call the deal off. (We didn’t and the deal went through).
Mitigating this risk involves reliance on professional Mergers and Acquisitions Advisors, who have been through the process many times, and can rely on past experience and creative solutions that have worked on other deals. We aren’t emotionally invested and can push back where necessary, compromise where appropriate, and get deals over the finish line.
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Deal Structure Risk
The way a deal is structured can increase or decrease the level of risk. A deal that pays all cash-on-closing contains little to no risk for the vendor, post-transaction. A deal with a significant vendor take back, earn out, and other forms of deferred payment has risk. What if the purchasers can’t or don’t pay? What if the business underperforms? What if the vendor has to step back in after a few years of poor management to rescue the business and protect their future payments?
We mitigate these risks by structuring deals with lower and shorter vendor financing amounts and terms. We also make sure that the vendor’s position is fully legally protected.
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Legal Risk
Once the terms of a transaction have been determined, they need to be documented in a definitive agreement. As with the M & A process, relying on support from an expert in securities law will help ensure that you are protected through and after the transaction.
Legal risk is mitigated by using lawyers with specific experience in this area of law. Like doctors, lawyers often specialize, and for something as important as the sale of your business, a specialist is essential.
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Other
There are other risks as well – some that are manageable and others that are beyond the control of buyers, sellers and advisors. Economic turmoil, global pandemics, and other “black swan” events can occur through the process, and all present risk. Often, sales processes are paused, deal structures are altered, or called off completely, to be revisited once the dust settles.
Summary
Business is comprised of risk and risk takers. As experts in managing your business, you address your operational, financial, and other risks daily. In a process as complicated as selling your business, it
Steps To Take Immediately After Identifying Issues
Your risk mitigation plan should include detailed steps to take if an issue is identified. For example, if a key employee learns that you are selling the business and decides to leave, do you have a plan?
Communication And Negotiation Tactics To Resolve Problems
The risk mitigation process involves continuous risk monitoring and risk identification. When you’re in the closing phase of the sale of a business and a problem occurs, communication is key. You may be legally required to disclose previously unknown issues that could materially affect the business.
Should a new problem arise, it may affect negotiation. Effective risk mitigation strategies in business sales require the buy-in of multiple parties; your advisors should all be made aware of risks as early as possible, so you can adjust your negotiation strategy if they materialize.
Post-Closing Considerations To Mitigate Future Risks
Ensuring A Smooth Transition After The Deal
One of the most common risk mitigation strategies in business sales is for the seller to stay on for a period of time after the transaction in order to ensure a smooth transition. This is a form of risk management that can benefit both sides, as it helps the buyer acquire institutional knowledge about the business, improving their risk assessment and mitigating the risks of employees and other stakeholders jumping ship. It also helps the seller when there are future payments owed to them, as they can continue to operate the business to ensure its continuity and ability to make future payments.
Monitoring And Addressing New Risks
After the deal is closed and the transfer period is complete, your risk mitigation strategies will change. Though business risks are less of a concern, you should still keep in contact with lawyers and advisors in case new problems arise. You may also want to start a new venture or a new adventure—and once you do, risk management will once again become an important part of your thought process.
Conclusion
Want a simple way to identify potential risks and create a risk management plan? Work with advisors who have decades of experience in mergers, acquisitions, and business sales. Work with Catchfire. Take advantage of our ready-to-sell assessment, our value creation support, and business sales services.