Business professionals commonly negotiate transactions by reference to what is “market,” meaning terms that are commonly agreed to in the industry at large. This makes great sense for the people who are responsible for negotiating a price. Valuation and pricing methods are relatively tried and true after all, and math is an exact science. This is not to suggest that buyers and sellers usually agree on price right away. Anyone who has ever been party to a business transaction knows that’s just not the case.
While math is an exact science, valuation and pricing is an art, the result of which is very much in the eye of the beholder. Stated another way, there is not one universally accepted valuation and pricing methodology. At the end of the day, the value of a business, product or service is simply what a willing buyer and willing seller agree the value is.
But price is just one (albeit a very significant) element of an overall deal. Some clients understand it coming into a deal and those that don’t need to be educated about it right away.
Here is a hypothetical transaction that is easy to understand: an owner sells his business to a buyer for $25 million, of which $15 million is in the form of a note that balloons in five years. A covenant of the deal is that the owner will continue to provide services to the business and honor a non-compete clause for three years post-closing. Also included is a rep/warranty that the company is not aware of any customer who has indicated an intention to cease doing business or reduce the amount of business it will do with the company.
As it turns out, three months after the sale closes, a customer does cease business with the company. One of the senior managers of the company knew this was a risk before the deal closed. Also six months after the closing, the owner joins the board of a competitor and provides significant advice to that competitor without considering his non-compete clause.
The above example references a covenant, a promise to do something, and a rep/warranty, a statement that something is promised to be true. Each of these terms was breached by the seller. One result of this breach may be that the seller ends up with a lot less than $25 million from the sale—and perhaps a lawsuit to boot.
Should the seller have made the covenant? Should he have provided the rep/warranty? In retrospect, the answer is obviously no. But what about prospectively?
Buyers and sellers each want language in an agreement that protects them from various risks. At the end of the day, each buyer and seller must decide on terms they will or will not agree to with respect to covenants, reps/warranties, and the myriad other provisions of the legal agreement that governs the deal.
While these are ultimately subjective business decisions, buyers and sellers must be able to rely on their attorneys to advise them on these decisions. This is the essence of what a good deal attorney does. Part of the job is to teach and translate, to make sure the client understands what it is they are being asked to agree upon. Part of the attorney’s job is to point out all the possible ramifications of agreeing to any term and to help handicap the likelihood that certain ramifications will or will not occur.
In practice, many attorneys will try to persuade the attorney on the other side of the table to agree to a contractual term based on the argument that the term is “market.” But what does that really mean?
As mentioned above, market simply means that the term at issue is one that is commonly agreed to. But what it really means is that it is commonly agreed to in the experience of the attorney seeking to include the term.
Did you “hear” the skepticism in the tone of the prior sentence?
There are a lot of law firms in the United States that negotiate and document business transactions. One’s view of what is market is often quite subjective, based on the anecdotal experience of that attorney making the point. This is one reason it is important not to put too much weight on what is market. But it’s certainly not the only reason (more on this below).
“But wait,” the other side will argue, “You don’t have to trust me. Just look at XYZ survey or the ABC compilation.”
There is also “evidence” for what is market in certain circumstances. Some larger law and other professional service firms publish annual surveys to help dealmakers have a less subjective view of what market valuation is. There are also subscription services that do the same thing. That’s a fair point, particularly in the context of public and very large (i.e., several hundred million dollars or more of transaction value) deals, because those tend to be the deals that are most reported to these surveys and services.
However, it is less persuasive, as the vast majority of deals that are done every year are smaller deals.
As stated above, at the end of the day the value of a business, product or service is simply what a willing buyer and willing seller agree upon. The same thinking should apply to any term of a deal: what is or is not market is a datapoint, an important one, but it is just a data point. A confident and experienced attorney understands this, even in the face of incontrovertible evidence that a term is indeed, objectively and universally market.
On the other hand, unless the business person (whether buyer, seller or other applicable title) is willing to kill the deal, then doing what is market may be exactly what needs to happen.
A client of mine was selling his company to a public company buyer. Most business transactions of that type and size that I’ve done have a fairly standard group of representations and warranties that survive for a period of between 12-24 months. This is market. My client’s primary goal besides receiving the purchase price was to minimize any future exposure to the maximum extent possible. Buyer’s counsel pointed out, correctly, that market term was indeed 12-24 months, and Buyer proposed an 18-month survival period. My client understood that this was reasonable, because it was in line with what was market. But he was prepared to kill the deal rather than agree to the 18-month provision. I was ultimately able to reach a compromise that got the deal done even with a non-market term.
Market does matter, of course. Its importance is often greater and certainly more obvious when dealing with matters of money in all types of transactions.
For example, if you are seeking to add a new employee to your company, market terms may matter in employment packages. If industry competitors are generally paying a salary that is twice what you are offering with all sorts of additional benefits you are not offering, then you have to be prepared not to land that wonderful candidate you just interviewed.
However, even in this context, looking exclusively to market and reaching beyond your comfort zone to offer more could be a mistake. What if the candidate is not aware of what market is? What if the candidate would rather work for you even if she has to earn less for some reason you are not aware of? What if you do stretch your budget and it turns out later to have been a terrible decision, regardless of how good the candidate appeared to be?
A client of mine was recently looking to hire a VP of sales and believed that it would be necessary to provide a base salary, bonus (tied to individual and company performance) and equity-type benefits upon the sale of the company (a typical market offer for employees at that level). The client prepared some financial models and presented an offer to a potential employee. The employee declined the proposal and instead just asked for a slightly higher base salary and indicated he would be willing to forego the equity piece completely. The employee still works for that client. Understanding the potential employee’s motivations from the onset would have avoided this expenditure of time and energy even though the result was not market.
Market matters. But so do many other considerations, namely, what is best for you given your particular circumstances. Remember: the valuation and market terms of a business transaction are ultimately what the parties agree to. If your attorney is incapable of pushing for or accepting anything that is not market, hire a new attorney.
©All Rights Reserved. March, 2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Jeremy Waitzman advises his clients on significant transactions and operational issues in their businesses. Described by clients as “an essential business advisor” and “a partner in the success of my business,” Jeremy has substantial experience representing businesses of all types and sizes from inception, guiding them through significant growth, and often through ownership’s exit. His…
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