“Sinkholes” to Avoid!

I first learned about “sinkholes” when I went river rafting out West. The term sinkhole is applied to a phenomenon that describes the complexities of a river that occur (usually hidden from view) on the surface of the river. It can create a major problem for river rafters when it happens, i.e., when a raft meets a sinkhole. The raft goes in, twirls around, sometimes is spun out intact, other times it just sits there spinning around, or perhaps the forces of nature overturn it. When I use the term “sinkhole”, it’s not necessarily a bad thing. It’s just something we have to watch out for and make sure we
understand the nature of the phenomena.

This in many ways mirrors the complexities that owners of alarm companies face when they start investigating the possible sale of their company. We’ve been helping alarm dealers sell their companies for several decades, and we’ve learned a few lessons about
sinkholes. Here are a few sinkholes you may want to avoid. Please feel free to send in your questions for future articles. Just write me at rdavis@graybeardsrus.com.

“THE HOLDBACK PROTECTS BOTH THE BUYER AND SELLER IN THE EVENT OF SOME UNFORESEEN EVENT”.

A hold back seems to be a unique phenomenon found only in the alarm industry. I have talked to dozens of business brokers in other industries and could not find any industry that has a similar characteristic. The closest I could find is the concept of a “true-up” that
takes place some time after the initial close. This allows for the possibility that the buyer or seller has found something else of significance that would affect the purchase price and the final “true-up” is agreed upon after the close.

In the alarm industry the concept of a hold back seems to accomplish little more than providing the buyer with a lower purchase price than the number agreed upon. For example, if a company has 1,000 accounts and a 5% gross attrition, on average, the buyer knows that he is buying a company with that metric. In other words, everyone knows that there will probably be a 5% attrition rate going forward after the sale. By having an
attrition guaranty, and knowing what the average attrition is, the buyer is, in effect, reducing the purchase price by the attrition amount.

So in the example listed above, the first 50 accounts that attrit are on the seller’s watch,
and, most frequently, because he’s already sold the company, he cannot do anything about it except stand by and let it happen.

While this seems to imply a devious intent by a buyer, it most assuredly is not. It is simply the way things have been done, and I suspect no one has ever questioned this before.

Since most buyers are honorable people, when we point out this phenomenon (guaranty), they immediately want to know what should be done to make it “right”.

One way of dealing with it is to ask the buyer to provide a “basket”, meaning that whatever the historical attrition rate is should be set aside in a “basket” and not counted
against the seller when it comes time to settle up. This seems to be eminently fair and many buyers of alarm companies are following this path.

Another way of looking at this is if you sold a restaurant to a buyer, would you allow that buyer to ask for a guaranty that your existing customers will continue to be customers of the restaurant once new owners are in place? Of course not! Why do it in an alarm transaction?

THE “RIGHT OF FIRST REFUSAL” SINKHOLE.

This is fairly new, and some vendors and/or other types of suppliers have figured out that by asking for something as innocuous as “a right of first refusal”, no one will mind. In fact, many people really don’t mind. In fact, most people forget about it. That’s where they fall into this sinkhole. A right of first refusal, when it applies to the sale of a company, means that the seller has to give the person or company who has the right, an option to meet the purchase price, thus buying the company. On a practical level, what
this means is that let’s say you have decided to sell your company. You’ve agreed upon a price with the buyer and you’re all set to move towards all of the things that happen prior
to a close, only to find out that whomever you gave the right of first refusal to now has 30, 60 or even 90 days in order to meet the purchase price that was agreed upon.

This is a tough one. What it means in a very practical way is that you may have to postpone or even walk away from the sale of a company while whoever is holding the right of first refusal “decides” whether or not he wants to meet it. Many buyers who run across this will not deal with a seller who has given the right of first refusal away. Too
many problems…too many things can get in the way of a successful close.

It seems as though this sinkhole is slipped into all sorts of agreements. It appears innocuous, and when you question what it’s doing in your agreement, you will be told that it will actually help you because it assures that you will be getting a fair price for your company. Beware of this sinkhole; it can really harm you in the negotiation process. On the other hand, there are a number of legitimate reasons that you might give a supplier a right of first refusal, and that should be factored into your conversations with potential buyers. Once it’s out there, known and understood, a potential buyer feels more comfortable rather than finding out about it during the closing process.

There are a lot of other “sinkholes” out there that can hurt buyers, sellers and employees of both companies. Of equal importance is that there are sinkholes that can hurt the customers of the selling company. Whether you’re a buyer, a seller or neither, you just want to run your company more effectively. A good maxim to observe is “Always run your company as though you’re preparing to sell it tomorrow!” If you do that, no matter what happens, you will be ready to take on the challenges.

Yours for greater success,

Ron Davis
President
Davis Mergers and Acquisitions Group, Inc.