M&A Negotiating Tactic #1 – Honesty

Jacob Orosz headshot
by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

It was ancient Greek storyteller Aesop who said, “Honesty is the best policy.”

It is Morgan & Westfield who says, “Honesty is the #1 weapon in M&A transactions.”

Is it possible to conceal a few warts on your business from buyers during the sales process? If you hide a few material facts that you should have disclosed, does the buyer have recourse if they find out about these facts after the closing?

Honesty is an underused tool in merger and acquisition (M&A) transactions. Trust is critical to successfully selling your business, and the easiest way for you to build trust is to be honest in all your dealings with buyers.

Acquiring a business is a risky endeavor for any buyer. And the value of a business is directly related to risk.

If the buyer doesn’t trust you, they may reduce their risk by:

  • Increasing the strength of reps and warranties
  • Structuring part of the price as an earnout or a promissory note, subject to a right of setoff
  • Increasing the scrutiny or length of their due diligence
  • Reducing the purchase price (re-trading)
  • Requesting a credit report or background report on you
  • Changing other material terms of the transaction, such as demanding they talk to key customers or employees, even if they previously agreed they would not do so.

With that in mind, we answer the following questions in this article:

  • How can you lower the perceived risk of your business to buyers?
  • How can you help expedite the due diligence process?
  • When should you disclose material facts?
  • Should you use hype?
  • How can you point out the potential in your business without exaggerating?
  • Does it matter whether you make claims orally or in writing?

Being honest saves you time and can actually help increase the value of your business. It can also reduce the thoroughness of a buyer’s due diligence and can also make negotiations far less contentious.

You can take that to the bank. Here’s how:

Why Honesty is the Best Policy

Increase the value of your business by reducing the perception of risk.

Not only is an honest person respected by all parties, but being fully transparent can increase the value of your business (by reducing the perception of risk) and make your business easier to sell. Being honest reduces the buyer’s perception of risk, which means they may be willing to pay more for your business.

Save yourself time by being honest.

Being honest also saves you time from having to remember any half-truths that may have been told. It gives you freedom because you have nothing to hide.

Honesty upfront can reduce the thoroughness of the buyer’s due diligence.

Building trust through honesty and proper disclosure can reduce the intensity of the buyer’s scrutiny during due diligence and reduces the possibility of re-trading. Speaking the truth prevents you from having to remember what you may have said, which makes due diligence a far less stressful process.

Concealing material facts is difficult when selling a business.

Selling a business is a protracted endeavor. It’s nearly impossible to conceal material facts in perpetuity. Your odds are slim-to-none for concealing a material defect all the way to the closing table and even less so after the closing. A sophisticated buyer will perform excruciating due diligence and is likely to discover any material facts. If the buyer discovers a fact you failed to disclose during due diligence, you’re doomed. I guarantee you that the terms of your transaction will change.

Buyers have options for recourse due to reps & warranties.

As a seller, your exposure can last years due to reps and warranties and other safeguards buyers often include in the purchase agreement. If the buyer discovers a material misstatement — even after the closing — they may seek damages pursuant to the reps and warranties you signed in the purchase agreement. Even worse, they may offset any payments due to you via a set-off.

Trust makes negotiations easier.

It’s likely you will have a short- or long-term relationship with the buyer post-closing. Honesty builds trust and serves as the foundation for this relationship, and, frankly, it’s easier to negotiate with a friend than a foe.

From personal experience, I can recount dozens of transactions in which the buyer told me they trusted the seller and agreed to expedite due diligence and immediately move to the closing. I often hear the same from sellers — it’s refreshing to hear when a seller trusts a buyer and has built a strong relationship with them. If the seller trusts the buyer, the seller is often more comfortable disclosing sensitive information to the buyer during due diligence, which can speed up the due diligence process. This would not be possible without trust, honesty, and disclosure, which are the foundations of building a solid relationship.

Put yourself in the other party’s shoes. Who would you feel more comfortable writing a $10 million check to?

  • Vinny, a shady, unscrupulous business owner who paints an unrealistic and overly-optimistic view of his company’s future, who claims revenue could easily triple in three years with a little effort, and who attempts to hide numerous material facts and never gives a straightforward answer to a question, or
  • William, a straightforward, trustworthy business owner who voluntarily discloses his business’s weaknesses and always gives an honest answer when asked.

Here is how William and Vinny would likely respond to the following scenarios:

  • What was your revenue last year?
    • William: $7.3 million.
    • Vinny: Well, you shouldn’t look at the numbers. Let me tell you the real story behind the numbers. First of all, there is a lot of cash (wink, wink) in the business.
  • Who is your top competitor?
    • William: KidsExchange — they are a great company. I know the owner, and they do a few things better than we do, but I think we have one major advantage over them — our return policy. If you aren’t happy, simply bring back your purchase, and we will …
    • Vinny: Haha, we don’t have any real competitors.

If you’re a buyer, who are you going to be more likely to do business with, all other factors being equal? Being transparent and honest can go a long way.

Lower perceived risk means your business is worth more.

Honesty reduces a buyer’s perception of risk. Reducing risk increases value. How do buyers assess risk? They use a combination of legal, financial, and operational due diligence, along with gut feeling.

Different buyers use “gut feel” to various degrees.

  • For individuals who have never owned a business, fear is the one element most likely to hold them back, and these buyers will be highly sensitive to their intuition. If the seller doesn’t make them feel 100% comfortable, they will disappear fast.
  • Individuals who have owned a business before are more willing to take risks. However, they will still be sensitive to any signs of untrustworthiness coming from the seller. If they sense you are anything less than completely straightforward, they may manufacture safeguards in the purchase agreement or transaction structure to reduce risk, or drown you in due diligence requests.
  • Financial buyers are sophisticated. Many have completed dozens of transactions. The ability of these buyers to judge a seller’s character has been carefully honed from experience, and they are likely to be adept at pruning out untrustworthy individuals. Consider how you speak to different buyers and modify your conversation as needed, but keep in mind that it’s critical you are honest regardless of who you deal with.

Tips for Using Honesty and Disclosure to Build Trust

Voluntarily disclose material facts as early as possible in the relationship.

This gives you the opportunity to put a positive spin on any problems before the buyer discovers them. Doing so allows you to go on the offensive. The alternative — being defensive — always makes you look bad, regardless of the veracity of your position.

Anticipate what the buyer will ask and disclose it before they ask.

This gives you the opportunity to put your own spin on the situation and engenders trust. If the buyer uncovers a material fact before you disclose it, you could experience a loss of trust that might take weeks or months to regain. Full disclosure avoids this possibility and builds trust.

Avoid hype, boasting, and exaggeration — or attribute it to someone else.

If you wish to introduce positive opinions regarding the state of your industry, do your research. Find articles that have been written by trustworthy sources and share them with the buyer. If caution is in order — if, for instance, the author of a particular article is overly optimistic — say so. The buyer will respect your discreet perspective.

Plant individual seeds of optimism, but let the buyer form their own narrative.

Provide the raw material via third parties, as discussed above, so the buyer can come to their own assumptions that serve as the basis for any projections. In other words, tell the buyer where the tortillas, beef, lettuce, and cheese are in the kitchen but let them prepare their own burrito. Give the buyer the facts and let the buyer tailor them to their specific needs, desires, or tastes. Their conclusions will have more credibility and be more meaningful in their minds than any assumptions that you spoon-fed.

  • Wrong: If we introduce our new product “XYZ” to the marketplace, it will generate $20 million in revenue.
  • Right: There are 500,000 potential customers for XYZ. This product could be priced at $500, and the market penetration for most products in this space is 8%. The product is currently being user-tested, and we expect to begin production in 90 days.
    • Comment: Every buyer will do the math, often in their heads while talking to you. I couldn’t help but do the math in my head as I was writing this. It’s a natural instinct for most business people. In this case: 500,000 people x 8% penetration = 40,000 customers x $500/each = $20 million in revenue. There is a vast difference between the two scenarios, especially if you delicately handle the conversation so the buyer has to extract the raw data from you.

The trick is to get the buyer to ask you what the ingredients are and let them assemble their own recipe. For example, let’s say you mentioned that you have a new product in development.

  • Buyer: “What do you think you will price it at?”
  • You: “$500. I think the market for this is pretty big.” (This is a vague statement designed to entice the buyer to ask for specifics.)
  • Buyer: “Interesting. How big do you think the market is for this?”
  • You: “The ABC Association estimates the market at 800,000 people for XYZ, but that might be too optimistic. I think 500,000 is more realistic. However, that is obviously just the potential market — I think our penetration would be much lower.”
  • Buyer: “’What do you think your penetration would be?’ (Note that you are teasing the buyer with the goal for them to ask you follow-up questions for specifics regarding key assumptions they will use to perform the math.)
  • You: “Well, the EFG product had a market penetration of 14%, but I think 8% is more realistic.”
    • Note: In this scenario, you capitalized on two immutable human traits: curiosity and greed. The buyer may want to get in on the action before other buyers do [this is known as a fear of missing out (FOMO)]. By teasing the buyer with information, you entice them to ask you for specifics. They may then perform the calculations in their own head — or on the back of the proverbial napkin — often employing dramatically more aggressive calculations than you may have offered. Again, whose projections are the buyer more likely to believe — yours or their own?

Focus on building a strong relationship.

If you focus on building a strong relationship first, everything is more likely to fall in place as the transaction progresses. Naturally, different buyers have different feelings regarding the importance of the relationship, and you should adapt your approach accordingly.

Put your best foot forward.

Point out the positive traits regarding your business but be sure to balance these with a discussion of any potential downsides. As an entrepreneur, you are likely to be an optimist, but you must temper your optimism with realism. Show humility when possible. There is no better tool for building trust than humility.

Be careful with unscrupulous buyers.

You may have to modify your position and style depending on the type of buyer with whom you are negotiating. If you lack M&A experience, it’s best to rely on an advisor’s opinion. A skilled advisor will know when a buyer is acting aggressively or taking advantage of a seller. You must know when to modify your position and style based on the buyer’s approach, and you must know when to dig in. Some buyers take a zero-sum game approach and will attempt to win at all costs, doing little to hide their aggressiveness. Others may be more subtle regarding their approach. They may hide their true intentions and attempt to use your honesty against you. A firm but respectful position is best in these cases. Regardless, employ a professional if you lack the experience.

Be careful what you put in writing.

Put only the absolute facts in writing. You should always convey subjective information through a phone call or a face-to-face meeting, not in writing. Your confidential information memorandum (CIM) should contain a careful analysis of your business and industry. It may include definitive statements regarding the state of your industry and the potential for growth. You will have ample time for this document to be scrutinized carefully and refined by your team of advisors — including your attorney, CFO, M&A advisor, and others — before it’s released to a buyer. You must be careful regarding any ad hoc representations or documentation you create; stick to the facts. If you wish to garnish the facts, then avoid doing so in writing. Imagine anything you put in writing before a judge. Collectively, your statements could be used against you post-closing if the business fails, or if there is a material misstatement or other breach of contract.

Summary

The maxim that “Honesty is the best policy” does indeed have merit. The best weapon in M&A when selling your business is candor.