M&A: Buy Side vs. Sell Side

As your company grows, it may be targeted as a potential investment by another company, or you may be looking at other companies as potential acquisition targets. In either case, understanding the major differences between being on the buy side or sell side of a deal is important. This article provides a general overview of deals, the services offered by buy side and sell side advisors, and the incentives of those respective advisors.

Deals Overview

A “deal” refers to business proposals and investment pitches such as venture capital, private placements, syndications, initial public offerings (IPO), mergers, and acquisitions—i.e., major transactions related to buying or selling part or all of a company.¹ This article will focus on transactions to buy or sell an entire company. For more information on other transactions, see our articles on Private Placements and Venture Capital. The typical M&A deal process includes developing an acquisition strategy, identifying targets, performing due diligence, and negotiating and executing the transaction, as depicted below.

Image Credit: Corporate Finance Institute®

The decision to buy or sell in a deal should stem from the strategic focus of the company, which can greatly differ depending on the type of company. Buyers are typically either strategic or financial buyers, and may include asset management companies, hedge funds, institutional investors, private equity groups, and retail investors, among others, hereafter collectively referred to as investors. Sellers can include these same company types, along with startups looking for an exit and companies preparing for an IPO, among others. Buyers and sellers typically hire third-party professional service advisors to aid in the deal process, which can include investment bankers or broker-dealers, accounting and tax advisors, lawyers, and consultants. The company being acquired is often called the target, and investors will utilize capital from internal and/or external sources to purchase the target. The due diligence process can be done internally, externally, or both. Although methodologies of advisors on each side of the deal may be similar, the incentives behind services can greatly differ.

Advisor Services

Buy Side Services

Advisors on the buy side of a deal provide a variety of services to assist in deal valuation, structure, and closure for the investor. One of the major services provided is financial due diligence, which is a rigorous investigation of the target’s financials to verify information accuracy and completeness. Although this service is optional legally, it has high importance for determining the target’s intrinsic value. Acquiring a business and integrating it can be quite difficult, and even more so if certain problem areas are discovered only after the acquisition has been finalized. The following are some items common to most industries that should be considered prior to an acquisition:

• 409A compliance
• Audit history
• Capitalization structure, major creditors, and shareholders
• History of related party transactions
• Intellectual property (IP) rights and obligations
• Off-balance sheet financing
• Accounting and operational systems and related controls
• Pension policies, obligations, and funding
• Status of any current or probable litigation
• Tax returns under audit and any uncertain tax positions (UTPs)
• Material contracts and key customers

Every company will have unique needs, and it would be wise to consult with an industry M&A expert. For example, a bakery acquisition may require more due diligence around health codes and inspections specific to its state, county, or municipality. A target software company may have a lot of intellectual property to be considered, and its proprietary database may be difficult to merge with the acquirer’s systems. A small target outsourcing company may have financing agreements that conflict with those of the acquirer, and if not addressed properly, could result in lost revenue and/or lost customers.

Oftentimes, investors will outsource commercial due diligence and operational due diligence to strategy consulting companies. Financial investors will use the various due diligence reports provided by these third parties for financing purposes, and strategic buyers use the reports for internal approval from various stakeholders. Strategy consulting services can include updates on the current market, risk and industry characteristics, operational improvement assessments, and profitability analysis. Other third-party professional services can extend further, including analysis of human resource and tax impacts resulting from the transaction, financial reporting restatement and preparation, assistance with SEC communications, and IPO advisory services.²

Sell Side Services

On the sell side, M&A advisors assist in managing the overall sales process, which may differ depending on whether the sale is through a broad auction, targeted auction, or one-on-one negotiation. In an auction, the bankers on the sell side provide many services, including structuring and facilitating the deal, analyzing industry M&A trends, setting valuation expectations, assembling an Information Memorandum, establishing a formal bid process for interested buyers, and managing the Letters of Intent (LOI) from potential buyers.³ Before beginning the formal bidding process, the bankers prepare a short executive summary or “teaser” document highlighting the financials and unique selling proposition of the target company. Services for a one-on-one negotiation are similar, except without the formal bidding process needed for multiple interested buyers. Sometimes the LOI will include a ballpark purchase price that will be negotiated later and a time constraint where the target will provide the buyer with information to perform due diligence. In addition, the bankers are responsible to negotiate the Non-Disclosure Agreement (NDA) and create the Confidential Information Memorandum (CIM) that are sent to potential buyers. The NDA restricts buyers from misusing disclosed information and the CIM provides more detailed information about the target company’s operations and financials.

Although due diligence performed by investors is voluntary, sellers are legally obligated to disclose important financial information necessary for investors to perform due diligence according to the Securities Act of 1933.⁴ Bankers also conduct meetings between the seller and potential buyers to build relationships and resolve issues. Once Letters of Intent are received and all rounds of negotiation are complete, the companies involved in the final transaction sign a Definitive Purchase Agreement, which is a legally binding agreement to purchase. There may be a time gap between signing the agreement and closing the deal because of certain necessary regulatory approvals. The bankers act as an intermediary to ensure all required documents are completed.

Advisor Incentives

Buy Side Incentives

Investors are much more concerned with being “right” in valuation estimates than bankers. Although accurate models and estimates are important to bankers, they are critical for investors.⁵ This stems from the buyer’s motivation to avoid risky purchases and major mistakes to improve profitability. A famous study from Kahneman and Tversky (1992) explains that this loss aversion is psychologically about twice as powerful as the pleasure of gaining; thus, investors tend to have more conservative estimates than bankers due to the psychological fear of loss.⁶ This natural conservatism tends to enhance skepticism and increases reliance on sensitivity testing in valuation models. However, occasionally investors do not conduct sufficient due diligence and can suffer a large loss as a result. For example, SoftBank initially invested $9 billion into WeWork⁷—a commercial real estate company that provides shared workspaces and services for companies—in preparation for a proposed IPO. The IPO fell through after WeWork’s $47 billion valuation dropped to less than $8 billion in late October 2019.⁸ SoftBank executives were alarmed to learn about WeWork’s high vacancy rates and big discounts in buildings in China, and they figured that WeWork needed to cut $500 million in annual costs to survive.

The incentives of investors can also differ depending on whether the investor is a strategic or financial buyer. A financial buyer, such as a Private Equity firm, seeks a return on investment through the deal. The primary motivations for financial buyers may include increasing cash flow through greater revenues or cost reductions or acquiring similar companies to create economies of scale. Generally, these investors are looking for well-managed companies with strong and stable cash flows, decent earnings growth, and an exit strategy of 3-5 years; however, the time frame and focus can vary depending on market conditions and strategy. See our Private Equity article to learn more. A strategic buyer, on the other hand, seeks to incorporate the target into its existing structure, which involves a much longer-term business plan. Some of the reasons strategic buyers are motivated to acquire a target company include eliminating competition, enhancing operations, vertically expanding (toward a customer or supplier), or horizontally expanding into a new market.⁹ Strategic buyers often seek to capture synergies, or value-enhancing features, and thus are often willing to pay more than financial buyers.

Sell Side Incentives

Bankers act as the seller’s advocate in all negotiations with potential buyers. Generally, their objective is to “sell the target company for the highest possible valuation.”¹⁰ The bankers’ compensation is often structured as a commission, which varies depending on the valuation of the target when the deal closes. Because the banker’s compensation is usually a function of the target’s selling price, bankers are incentivized to make the target look as attractive as possible. However, the best valuation for a client often includes more factors than just the purchase price. Bankers also have an incentive to keep information confidential and to limit potential liability. The seller can have a stronger position in negotiation when they can provide things like documentation of business policies, valuation history, historical milestones, tax returns, audit history, and other items likely to be part of the buyer’s due diligence.

Bankers are also incentivized to promote all possible synergies to increase the company valuation. Synergies are value-adding characteristics that make the combined firm more valuable than the two firms are separately. For example, SAP’s acquisition of Qualtrics for 8 billion in January 2019 could provide synergies to SAP through combining Qualtrics’ experience data with SAP’s existing operational data. SAP’s management hopes this combination of data will enable customers to improve supply chain management and core processes and allow Qualtrics to scale rapidly around the world.¹¹ Other examples of synergies can come from economies of scale, technology advantages, enhanced revenue capacity, or cost reduction, among other things. Synergies are not fully realized in most deals, which indicates that bankers can tend to overvalue the target company.

To further demand higher valuations, bankers will try to maximize the number of participants in the bidding process by contacting many strategic and financial buyers when preparing the “teaser” and CIM documents. As bankers receive bids from potential buyers through an Expression of Interest, they compare them with internally developed valuation models of the target company. The bankers then discuss these quotes with the acquirer, at which point the top few bidders are typically invited for another round of bidding to achieve the highest possible valuation. However, the highest bid is not the only incentive for sellers. In some transactions, especially with strategic buyers, the seller may care more about strategic fit than the highest bid that’s offered. Some factors determining strategic fit include alignment of management, organizational structure, and objectives. The adaptability and nature of customer relations in one company may be a better strategic fit than the company with the highest bid, which can influence the seller.¹² The inability to reach a consensus on a liability clause could also ruin the prospects for a deal, even if the potential buyer has the highest bid. Thus, the value in a deal extends beyond just the negotiated purchase price.

Conclusion

Whether your company is being targeted as a potential investment or you are looking at other companies as potential targets, understanding both sides of the deal is critical. For example, as a potential buyer, you should be aware of bankers’ natural incentives to overvalue the target company and promote all possible synergies. Use professional skepticism and increase reliance on sensitivity testing in valuation models. As a potential seller, you may find bankers to be helpful in preparing the needed documentation and managing the bidding process. If you’re looking for a strategic buyer, you should consider strategic fit in addition to the purchase price being offered. Whichever side your company is on, this knowledge will help you move forward with more confidence as you progress through the buying or selling process.