The dreaded price chip

Joe calls me first thing one morning. He's furious. It's rarely good news when you get a call that early...

Three weeks before, he signed a Letter of Intent to sell his business. The deal was £8m upfront, plus up to £3m in an earn out.

Then, in the middle of due diligence, he gets an overnight email from the buyer's lawyers.

They will no longer pay what they agreed. Their new (and final) offer is £7m plus the earn out, and they will walk away unless he agrees.

Joe has just lost £1m overnight.

He knows that the LOI is non-binding, and subject to full due diligence and other conditions. But they can't just do that, can they?!

In M&A, we call this a 'price chip' – because buyer has 'chipped away' at the price after it has been agreed in the LOI.

It's a common tactic. So common, that sellers are often advised to add a buffer to the price they agree in the LOI to account for inevitable price chips. Anecdotally, this is more common with US buyers.

But why does it happen, how should you respond, and can you stop it happening in the first place?

Your weakening bargaining power

For context, let's understand how your bargaining power changes throughout the early stages of a deal.

Hopefully, in the early stages you have have some competitive tension (Creating Heat: Competitive tension in an exit), with multiple bidders competing to buy the company.

But then you sign an LOI with your chosen buyer, and you give them exclusivity.

That forbids you from having any contact with other bidders. You've lost all the 'heat' and the buyer knows they are your only offer.

This the context in which a buyer can chip away at your price.

Reasons prices get chipped

Buyer can try to reduce their price for legitimate reasons, if new data comes to light that impacts the business' value and reduces the price they are willing to pay.

The most clear-cut examples of this are when a specific and quantifiable issue is found. That could be:

• Financial discrepancy: The numbers in historical financial statements were wrong and need to be adjusted or re-stated.
• Litigation or legal issue: A claim or legal risk against the company comes to light.
• Ownership issue: A key asset (some tech, patent or other IP) isn't actually owned by the company.

If the claim legitimate and supported by evidence, these are usually the least contentious price chips.

Buyers might find other data that reduces their valuation of the business.

They run a financial modelling and scenario planning exercise to calculate what to bid (we explored in detail in Behind the Bid: How buyers model their price).

They keep these models up-to-date throughout the due diligence process. Then if new data comes to light, they will adjust the inputs into their model which then changes the price the model spits out.

That could be:

• Weak performance: The buyer will ask for monthly performance updates during due diligence, and track these against your forecasts. A big miss, or a worsening of KPIs, is a big red flag. If you are missing targets a few weeks after setting them, how can they trust your forecasts for the next few years?!
• Concerning metrics: Their deeper analysis into your business might reveal some concerning data or worrying trends. For example, they might find a high level of customer concentration, or churn levels increasing in some cohorts. That would cause them to re-assess how the company might grow.
• Operational risks: Due diligence might also show some risks on the operational side, like supply chain vulnerability, lack of process in some key areas.
• Synergy re-calculations: You will have pitched the buyer on certain synergies as they were making their bid. These are benefits that two companies get when they combine after the deal – such as increasing revenue by integrating products or selling to each other's customers. If they then find these synergies are weaker or less easy to achieve, they can argue that the price should reduce.
• Market changes: If there’s a major shift in the market (such as new regulation or a powerful new competitor) or wider economic downturn, buyers may argue that these changes lower the company’s valuation. This is more subjective, but can still be a valid reason if the changes are major and the impact on company performance is clear.

Strategies to combat price chips

What can do to stop your price from being chipped?

1) Disclose issues up front. 

You should assume that a smart bidder with good advisors will eventually find any material issues through their due diligence. And if they don't, their warranty coverage will protect them later.

If an issue is flagged, there's a chance they will overreact, assume that you have deliberately covered it up and panic that there are other similar issues lurking. It can kill trust and derail a deal.

Assuming they will find out anyway, it's often best to tell them upfront.

You look proactive, honest and can manage the 'messaging' to explain how the issue can be fixed before the sale. This is very context-specific, so take advice from your lawyers and your M&A advisor on how best to handle this in your circumstances.

Before the sale process kicks off, you should run an internal audit to find areas that could make a buyer consider a price chip if and when they find out. For a list of projects, check out 23 projects to prep your business for sale.

2) Move quickly

The faster you get through due diligence, the better.

There's less time there is for things to go wrong. That could be a bad month, some news in the market or economy, or something totally out of your control (like a change of CEO at the buyer).

So you should collate your DD information early and present it cleanly and efficiently, and inject as much urgency as you can through due diligence.

There's more on that in The 24 hour rule.

3) Structure your Letter of Intent

There are some smart protections that you can build into your LOI.

The main issue is giving exclusivity in the LOI, which kills your bargaining power. Here are some ideas to combat this:

• Push for the shortest exclusivity period possible. This will force the buyer to move more quickly through their DD before their exclusive period ends. 8-12 weeks is normal, so try to get to the bottom of this range, or below if you can.
• Require the buyer to confirm the price in writing each week. If they drop the price or don't send the confirmation, exclusivity terminates automatically. This means if they try to price chip you can speak to other buyers.

4) Set expectations up front

When you are negotiating the LOI, you can explain that you are accepting that price on the basis that it won't be chipped unless a significant, material issue is discovered in the due diligence. That might count for little, but it sets some expectations that you will not accept a price chip unless they find something serious.

How to respond to a price chip

Even after doing the above, there's a chance your buyer will try to chip the price.

So how should you respond?

The first mistake is to get emotional. You feel that you have been screwed over, with a deep sense of unfairness. That can lead to a blow-up response, people get upset and it can take time to repair the loss of trust. That's exactly how Joe wanted to respond – luckily he didn't.

It’s essential to stay calm, and be strategic in your response. You want to have a collaborative, objective conversation, based on evidence and data rather than emotions.

You are trying to work with the buyer to solve the valuation gap, in a constructive and solution-focused way, not fight against them. So go for a walk before you send any emails 😊

Ask them to explain their position, and to share the data they have found that supports it. This moves the conversation to the data right away.

At this point you will learn if their price chip could be legitimate, or if they are just trying their hand to get a lower price. The tell-tale signs are aggressive or threatening tactics, often supported by little evidence. You might think they are exaggerating small findings or potential risks to justify a much larger price chip than warranted.

You can then trade points of view and analysis to argue back and forth. You know the business and the market better than them, so you have an advantage here.

Obviously the data will depend on their justification for the price chip. You might get a third-party opinion on a financial issue, or run a sensibility analysis on some forecasts, or show some additional internal data to explain your KPIs.

If you feel like they have valid points, and you risk having to concede on price, here are some alternative options to avoid a price chip:

• If issues can be resolved before closing the deal, you can commit to do so.
• If there is a specific risk, you can offer protections like additional warranties or an indemnity (maybe with an escrow) to cover that risk without reducing the price.
• If the debate if over future performance, you could propose moving some value to the earn-out. That increases the risk for you, but would be preferable to reducing the price entirely.

Lastly, consider walking away. If the price chip feels excessive and you believe the deal no longer makes sense, you have to be willing to walk away.

Come back to your walk-away number (see here) and consider your options.

Back to Joe

So what happened with Joe, and how was it resolved? Hopefully this can be a useful reference if you go through a similar situation.

Joe's company did not own part of their technology infrastructure – it was used under licence from the owner. This came out in their technical DD.

As a software company, the buyer was concerned that this was a critical issue that impacted their valuation. What is the licensor terminated the licence? Or demanded 10x the licence fee next year?

Their CTO said it could cost up to £1m to build that tech themselves, hence the attempt to shave that amount off the price.

Joe responded as follows:

• He explained the role of that piece of their tech stack as relatively minimal, certainly not mission critical.
• He gave a full roadmap and costings should they need to build out the tech themselves should the licence fall away, with a full cost of £150,000. He spent time with the buyer's tech team to run through the specifics of the roadmap and the technical approach needed.
• He offered to negotiate an extension to their current licence on similar terms to protect the buyer in case of any issues.

The buyer dropped their request for a £1m discount. The two parties agreed to put £150,000 of the purchase price into escrow for two years in case a re-build was needed, and they jointly approached the licensor to negotiate the extension.

A sensible compromise, with no reduction to the purchase price!