For clarity I’m talking about an Investor/Purchaser that agrees a deal based at a certain value/price and uses the diligence process to attempt to reduce that number. During the 1-12 weeks potential diligence period, you will be taken away from the running of your business and you may make decisions based on the new investment/sale. You would now be in a compromised position and depend on a completion based on a lower “chipped” number. Broadly speaking this is acting in bad faith by any Investor/Purchaser without a valid reason(s).
When you are seeking investors or selling your business, it is a very serious and stressful time for you as a founder. You and your business are going to be exposed to Investors/Purchasers and their professional teams in a way that you may not have experienced before.
Aside from the time taken away from running and growing your business, there is also the Opportunity Lost in an exclusive diligence that you have missed the right Investor/Purchaser - i.e. one that was going to pay you what you want and need for your business. Furthermore, if a deal is chipped and falls over, there is that horrible feeling of ‘deal fatigue’ which I have written about before. Its hard to get motivated to put yourself through the same process again.
Early Vetting
In most sectors, trade buyers, private equity firms and investors will have established their reputations in the marketplace. Some could be widely known as “bottom feeders”, i.e. they only buy assets on the cheap, through examinerships, receiverships or liquidations and are to be avoided like the plague. The problem might be that you find out what they are too late to matter.
You need to ask around before agreeing terms and exclusivity with any party to ensure that they don’t fall into the “bottom feeders” or “chipper” categories.
Some Warning signs that a Chip is Looming
The legal workflow has not progressed while you are finished operational and financial diligence.
There have been multiple meetings already that have led to lot of duplication of efforts.
You are coming close to the end of your exclusivity and have no firm timelines for a closing, but are being asked for an extended on the period.
The Investor/Purchaser narrative starts to shift that the deal is somehow different now, or not what they understood the deal to be.
When could a Chip be Valid
A chip could be valid, when the Vendor’s business materially changes in the middle of the due diligence process, e.g. its Revenue falls off a cliff suddenly or some element of the business is now omitted from the deal, i.e. IP or contract.
Know, as best you can, your company’s value and only be willing to reduce that value with valid and considered factors, e.g. there is a reduction in revenue because of a new tax treatment / loss of clients, or there is key position to be filled in the business that hasn’t been included in your projections.
Some wiggle room on price is possible to keep a deal progressing in the event of a chip, but remember if you are agreeing to a chip early enough in a diligence process, the Purchaser/Investor could be back again to chip later too. You need to draw a line in the sand early and don’t be afraid to call time on a deal if your exit or dilution stops making sense to you. There will be other opportunities in the future.
Mitigations
From the beginning and before entering into a diligence process, have a clear understanding of your own businesses value and what your base level return / shareholding has to be.
A Market comparable is always useful,
review the Book Value of your business along with the trade premium (what would the Investor/Purchaser have to spend to get to this point - do you have a sufficient barrier to entry (your moat).
double check your projections for the next 2 quarters and know that you will meet them despite being distracted from your core business.
Unfortunately it is extremely likely that you as a founder are going to be dragged into the weeds of a due diligence process and you will be taken away from your core business. Hence, there is an elevated risk that things don’t go as planned performance wise during a diligence. This makes it more important to have prepared the bulk of the heavy administrative burden in advance with a tool like Dillie. Always be Investor or Sale Ready with a proper, sustainable Virtual Data Room solution that has your back.