You’ve received and accepted a letter of intent from a buyer, and now you’re just wading through the due diligence process. But then you hear a phrase that no seller wants to hear: I think we need to reprice the deal.
It’s a dreadful prospect that you want to avoid, but sometimes it’s difficult to do so.
Before we look at the math of how a buyer would reprice a deal, let’s examine a couple scenarios that might trigger a repricing request.
Scenario 1: Let’s say that you put your company on the market for acquisition, and the firm is producing good numbers at the time of sale. For ease of math, let’s say $2 million in EBITDA.
To get the company sale process started, your investment banker (aka sell-side broker) sends a deal teaser out to prospects.
In short order, you get some interested parties, and – whoa, isn’t this fun!? – someone comes in with a letter of intent (LOI) or indication of interest (IOI) that offers a nice price and a solid multiple for the cannabis and hemp sector at 8X adjusted EBITDA.
In this case, the offer would be $16 million total enterprise value (TEV).
The LOI document will often contain a clause that cites your projections for the EBITDA you expect to book between the acceptance of the offer and the closing date. To maintain that $2 million EBITDA pace, you must continue to put the projected EBITDA on the bottom line each month, around $166,666 a month.
Unfortunately, the due diligence process can take months. A 90-day process is fairly typical, but it can last longer. During that time, you’ll be distracted with a boatload of requests for information – information that you never dreamed someone would ever want to know, e.g., environmental assessment of your various real estate locations, introductions to customers for interviews, criminal background checks on employees. The list goes on and on.
In fact, you’re going to be so distracted by the due diligence process that you might miss your numbers.
The first month you miss your numbers, the buyers might have a few raised eyebrows, and they might even voice some mild concern.
But the second month that you slip off the pace, well, that’s real trouble. The buyer might view that as a downward trend, and they will surely vocalize their worry.
Scenario 2: During due diligence, the acquirer will spend a lot of time with management understanding the relationships the target company has with its customers.
The acquirer will look at the likelihood that customers will continue to do business with the company under new ownership.
At any stage of the due diligence process, the acquirer may want to speak with key customers or even do a third-party satisfaction survey.
If the acquirer ascertains that some high-volume customers could be at risk of leaving for a competitor after the deal closes, repricing could come into play.
Even if the company is hitting its sales and EBITDA targets during the due diligence process, a meaningful customer loss during the due diligence process – especially any top-10 customer by sales volume – could materially impact the performance of the company of a go-forward basis. And here, too, repricing could come into the picture.
The math of repricing is simple – and rather brutal.
Since the acquirer is paying on a multiple of EBITDA (e.g. 8X), they will apply that same multiple to the new EBITDA, adjusted downward.
The $2 million EBITDA that got you a $16 million valuation might drop to $1.7 million with due diligence distractions or lost customers, dropping the purchase price to 8X $1.7 million. That moves the total enterprise value from $16 million to $13.6 million. That’s a $2.4 million hit.
Worse, the multiple itself might change.
The acquirer may say, “You know, we agreed on an 8X, but that drop in EBITDA has caused us to re-evaluate our offer. We are moving to a 7X now that we see you have fallen off the pace.”
You, the seller, can always walk away, of course, but then you’re going back on the market in a position of weakness – with a falling EBITDA. It might take months to recover enough to take the deal back out.
Even if you exceed your projected numbers during the due diligence process, there is little chance the buyer will reprice upwards to give you a higher valuation. But negative repricing is all too real.
The ultimate solution
Avoid distractions during the due diligence process. That might mean bringing on staff to whom you’ll delegate parts of the due diligence as well as have them carefully prep reports and data long before you even go to market.
Having someone on your team who has gone through a due diligence process – in or out of cannabis and hemp – can be immensely helpful. He or she can offer guidance on the hours required for each task and even where some tasks can be outsourced.
For the potential customer-attrition issue, note that the sale of your company should not come as a surprise to your top customers. Put an effective communications plan in place to discretely alert them of an impending sale, offering ample opportunity for them to voice concerns to you – rather than to the prospective acquirer.
The same holds true for informing key employees, whose departure might negatively affect the company value.
There’s nothing worse that working for years to prepare your business for sale, only to have a couple of months of bad performance knock a million dollars or more off your value.
John D. Wagner is a managing director of Colorado-headquartered 1stWest Mergers & Acquisitions, which offers a specialty practice in the marijuana and hemp sectors. 1stWest M&A has transacted more than $1 billion in deal values.