Under the hammer

By Daniel Bellau | Publication date: 15/08/2012 | Category: Tactics > Management

 

Owners of direct commerce businesses may not immediately think of selling their business by auction. The idea of competitive bidding seems far away from the complex process of negotiating price and warranty terms of a business the seller has spent many years building up. However, when handled properly, an auction is far more likely to achieve the best price and terms for the seller, especially in the current market, when deal volumes are low.

Advantages to the seller
• An auction may be the best way of marketing the sale of a business. Unless agreed to be confidential, each bidder’s participation can be used to stimulate interest among others.
• It enables the directors to demonstrate to shareholders and creditors that they have obtained the best price for the target.
• The balance of negotiating power favours the seller and he can use this to significantly improve the price and terms he can obtain as compared to a bilateral sale process where only one prospective purchaser is involved and the balance of power is more evenly balanced. This will be dealt with in more detail below.

Disadvantages to the seller
• The seller’s costs on an auction are usually higher because his lawyers will draft the sale documents and there may be negotiations with more than one potential buyer. However this may be more than compensated for by getting a better price.
• Not all businesses are suitable for sale by auction. For example, if there are few potential buyers, if the structure of the business is particularly complicated or where there are regulatory or competition issues or the need for third-party consent.
• The additional complexity of an auction process also places burdens on management. More management time is involved, and additional problems can arise if the management is itself a potential bidder or, as in most private equity purchases, will have equity in the acquisition vehicle.
• The knowledge that a target is for sale is less easy to conceal and this is inevitably disruptive of the company’s business, leading to a potential loss of customers and even key staff during the course of the sale process.
• It is harder to maintain confidentiality because of the sheer number of participants. Some bidders may participate only to fish for information about a competitor. While confidentiality undertakings are intended to deal with these problems, it is not always possible for a seller to enforce these or to discover the source of a leak. If practicable, the seller should hold back his “family silver” from Round 2 and disclose them to the preferred bidder only in the final stage. But leaving key disclosures so late is also a risk—if the buyer walks away, the target will be seen as soiled goods.

How the process works

Round 1 - The seller asks for indicative non-binding bids from each of the potential bidders. This is based on sight of basic management information, usually in an information memorandum (IM) and recent management accounts.

The seller must not do anything amounting to unauthorised investment business or the issue of financial promotional material, or make unsolicited calls in breach of local law. It is also vital to ensure that each candidate has entered into a Confidentiality Agreement before receiving the IM. The invitation to offer should contain a timetable and details of what the indicative offer must contain; particularly the price, any conditions, any regulatory issues that are likely to affect the structure of the deal, any key assumptions that underpin the valuation, any plans for the business and how the purchase will be funded. Indicative bids are used to narrow the field to a smaller group who will be asked to participate in the due diligence and final offer phase (Round 2).

Round 2 – The bidders selected by the seller are able to:
• view the due diligence materials, classically in a physical or virtual data room,
• see the seller’s form of share sale agreement
• see a “vendor due diligence pack” consisting of an accountant’s report into the target company’s financial history and projected earnings, a report by the seller’s lawyers on the key commercial contracts, property and intellectual property rights and, if appropriate, an environmental report.

Once Round 2 has been completed, the bidders are asked to make a final—but still non-binding—bid.

The buyer’s viewpointBuyers hate auctions. A buyer much prefers a sale by private treaty where he is more in control of the negotiations. To mitigate some of the disadvantages of an auction, he should usually aim to get selected as the preferred bidder as early as possible and to negotiate a period of exclusivity. During the exclusivity period, he should try to redress the balance and to proceed as far as possible as on a bilateral sale. Alternatively, a bidder may be willing to make a knock-out bid to exclude other bidders. The seller should be wary of this tactic, especially if it is conditional on agreeing documentation, as it risks destroying the competitive pressure the seller has built up through the auction process without securing a binding deal.

Unless he can achieve exclusivity at an early stage, a bidder should be wary of being sucked into the competitive process on cost grounds. At first sight it may seem sensible for a bidder to over-bid in his indicative offer to eliminate the competition or to match what the seller tells him about the other bids. A bidder should be wary of any seller representations and should ask for evidence of the competing bids before taking them seriously. He should also consider carefully whether a place in Round 2 is worth winning. A place in Round 2 is merely an opportunity to incur significant costs on due diligence while there are still, possibly several, other bidders. This puts bidders in a vulnerable position. They will usually want to know how many other bidders are left in the game and where they rank. A rational bidder would probably drop out, even after making a successful indicative bid, if he finds out he is low in the ranking.

Using the competitive process effectivelyIn deciding the number of bidders to go into Round 2, the seller should balance the need to maintain competitive pressure against devaluing the target by disclosing confidential and commercially valuable information too widely. The level of the bids may not be the only consideration in selecting bidders to go into Round 2. There may be strategic reasons to encourage one of the lower bidders to continue or the seller may believe he can negotiate higher bids by representing the level of the other bids. This is where astute advisers can play an extremely important part in communicating between the seller and the bidders. Only the most experienced of sellers should conduct this process himself.

Based on the final offers, the seller will consider choosing a preferred bidder with which to conclude the purchase but he must ensure that the rules of the process do not oblige him to pick a single winner at this point; it is in his interest to continue the multilateral process for as long as possible. As well as a higher price, the competition between bidders should also enable the seller to obtain better sale terms than on a bilateral sale. The seller prepares the first draft of the sale documents, and the competitive process forces bidders to make minimal changes to the seller-friendly documents. The seller also has the option of continuing negotiations with more than one bidder until the key terms have been completely agreed. To do otherwise is to take the pressure off the preferred bidder but it is surprising how often a seller selects a preferred bidder on the basis of his final offer (still not contractually binding) and then submits to prolonged bilateral negotiations. The best way of avoiding this is, if possible, to agree all important issues before appointing any of the bidders as preferred bidder. However this may not be possible and the best alternative is to conduct a multiple track process with negotiations continuing in parallel with a number of bidders to ensure that the competitive pressure is maintained right up to the point of clinching the deal.

Daniel Bellau, partner and head of corporate at Hamlins LLP.