How Buyers are Beating Sellers at the Merger and Acquisition Game
By Dexter W. Braff

Consider the Following Scenario
A buyer and a seller agree on what appears to be a fair market value price for the seller's home medical equipment (HME) company. As is typical in most non-public acquisition transactions, the purchase is structured as an asset transaction, in which the buyer purchases selected assets and assumes selected liabilities of the firm. In the buyer's letter of intent, those assets and liabilities are clearly spelled out. Then, the seller has the following conversation: "Should I do it? The price seems fair. I'm getting a decent amount of cash up front. Why not, let's go for it!"

Unfortunately, sellers will often jump at what appears to be a fair market value price when, in fact, it is often anything but fair. Transactions such as these are ripe with opportunities for professional buyers to manipulate the deal in ways that can substantially reduce the value a seller ultimately receives.

The problem is rooted in the interpretation of fair market value. It is a term in the industry that few individuals, with the exception of professional buyers, truly understand.

By definition, fair market value is the cash or cash-equivalent price for which property would change hands between a willing buyer and a willing seller, both being adequately informed of the relevant facts, and neither being compelled to buy or sell.

Note that the market in this definition can be thought of as all the potential buyers and sellers of like businesses1. If we break down the fair market value concept into its key elements, we can see how buyers can manipulate a transaction to their advantage.

Defining Property Properly
The definition of fair market value alludes to the value of property. However, in the sale of a business, what constitutes property? In general, the term property assumes that all of the assets and liabilities are being acquired, regardless of whether or not it is a stock- or asset-based transaction. When fair market value is being determined, sellers cannot predict whether the deal will be an asset- or stock-based transaction, and even if sellers presume an asset deal, they cannot predict which assets or liabilities will be acquired.

Therefore, when determining fair market value, a seller must assume that all assets and liabilities will be acquired. If the buyer omits certain assets and liabilities in their proposal, then the fair market value price should be adjusted accordingly. In determining fair market value, the firm's capital structure must also be analyzed to determine whether or not it is sufficient to support the firm's current and projected revenues and earnings. Fair market value should also reflect any excesses or deficiencies in a business' capital structure.

Buyers can alter the definition of property to their advantage in a myriad of ways, including the following:

1. Buyers can inappropriately structure the transaction. Buyers will often offer an agreeable fair market value price that theoretically includes the acquisition of all assets and the assumption of all liabilities, but then exclude certain of these liabilities from the actual purchase agreement. By doing so, the seller must pay off these liabilities, which could substantially reduce the value received for the company.

2. Buyers can finance deals with excess working capital. Buyers are entitled to a capital structure that supports the current and projected revenues and earnings of the firm. But, in an effort to maintain maximum liquidity, many firms keep excess working capital on their balance sheet, which buyers quite happily use to finance part of their acquisition of the company.

3. Buyers can set inappropriate net book value guarantees. Buyers are entitled to acquire a suitable capital structure, so they usually establish a minimum net book value that must be validated within a specified post-transaction adjustment period. Any shortfalls are then deducted from an escrow account before the funds are given to the seller.

The problem lies with the guarantees. Buyers often structure these net book value guarantees in ways that almost guarantee them of a reduction in price following the adjustment period.

Avoiding Risk With Cash
Fair market value assumes that a transaction is being paid in cash or cash equivalents. Cash is the only payment that is completely devoid of risk to a seller. Remuneration in any form other than cash generally carries some level of risk, and therefore should be discounted to reflect its true value to the seller.

Using nondiscounted, noncash remuneration to pay for acquisitions is an extremely effective strategy buyers can use to reduce the value sellers receive. Here are some of the ways this is accomplished:

1. Buyers can finance deals with restricted stock. In lieu of cash payments, publicly traded companies often finance transactions with restricted stock at face value -- that is, instead of $1 million in cash, a buyer would offer $1 million in restricted stock. The problem is that restricted stock generally cannot be sold for a minimum of two years. Therefore, the holder bears substantial risk because the future value of the stock is not guaranteed.

Regardless of the buyer's confidence that the stock will appreciate, it can just as easily go down, leaving the stockholder with diminished value. Lest a seller believe this an unlikely scenario, consider 11 transactions analyzed by Telesis that were financed in part by restricted stock. In four of these deals, the stock values fell significantly in the two years following the transaction. Additionally, in two transactions completed less than two years ago, the current stock prices are substantially down.

In six of 11 recent transactions, sellers have seen the value of their restricted stock fall between 67 percent and 77 percent at some point during the normal two-year holding period. Given the risks a seller faces in holding restricted stock, the market value of these shares is substantially lower than face value and should be discounted accordingly.

2. Buyers can offer below market interest rates. Buyers often finance transactions with promissory notes issued to sellers at below-market interest rates. Buyers usually peg the interest rates they offer on promissory notes to the prime lending rate. Given that these notes are frequently unsecured, or if secured, are often in the lowest positions with regard to payment priority, the risk-adjusted interest rate should in many cases be substantially higher. As a result, notes paying below market interest can be worth substantially less than their face value.

3. Buyers often set unreasonable or inappropriate earn-out provisions. In situations where the future earnings of a company are unclear, buyers often offer sellers earn-out provisions, wherein the seller receives payments over time based upon future performance. In structuring these provisions, however, buyers adopt two distinct strategies.

One, future performance hurdles are usually set unreasonably high, making them practically impossible to achieve and thereby worthless to the seller. Two, buyers will often ignore the fact that even when earnings are unclear, a minimal steady state value does exist. Accordingly, they will shift part of this steady state value to an earn-out agreement, which essentially provides them with an interest-free loan.

Comparing Fair Market Value and Investment Value
With all the emphasis on sellers trying to obtain fair market value, which by definition assumes that the buyer is not compelled to buy, they can overlook the certainty that for various strategic reasons, buyers are sometimes indeed compelled to buy a company. The value a specific buyer might be willing to pay for a specific seller is termed investment value, which can often be substantially greater than fair market value. Generally, in order to obtain investment value premiums, sellers must present their companies to multiple buyers in order to stimulate bidding.

Buyers frequently minimize the opportunity for investment value. Buyers abhor bid situations which can drive the price above fair market value. Therefore, they try to limit sellers' options by aggressively seeking out prospective sellers before they have an opportunity to present their companies to the marketplace as a whole, or by locking sellers into stand still agreements early in the process to eliminate the opportunity for multiple buyers.

Idenfitying the Relevant Facts
The final component of fair market value that buyers can exploit is knowing it can only exist when buyers and sellers are both adequately informed of the relevant facts. Since a significant portion of HME companies are purchased by a relatively small number of buyers, and the details of these transactions are largely unknown to the public, professional buyers have a distinct negotiating advantage over sellers because they possess a disproportionate share of the relevant facts.

Consider what it might be like purchasing a company's stocks on the open market without the breadth of information made available to investors through daily stock quotes, brokers, investment analysts, newsletters and annual reports. Without this information, investors would need to rely solely on the company itself to guide them when making their investment decisions.

Selling a company in a closed marketplace is just the reverse of this situation. Without readily available information regarding the purchase and sale of other HME companies, sellers must rely on professional buyers -- whose objective is to acquire at the lowest possible price -- to guide them in the divestiture process. With buyers in possession of bulk of inside information, it is unlikely that a fair market value purchase offer will emerge in a given acquisition transaction.

A buyer's implementation of fair market value isn't always fair. In order to receive full value for a company in the current HME merger and acquisition climate, sellers must fully understand the components of fair market value and the strategies buyers use to confuse sellers, catch them off guard, and reduce the value of acquisition.

Reprinted in HOMECARE Magazine, January 1994.