The Tradeoffs and Pitfalls of Exclusivity with Buyers and Investors
- Why buyers insist upon exclusivity and the real reason they want it
- How to approach the exclusivity discussion and maintain leverage in a negotiation
When founders lack experience in selling a business, they’ll often accept what buyers lead with.
One aspect of selling a business that buyers are particularly dogmatic about is the need for an exclusivity period to finalize the sale.
Exclusivity, simply stated, is a period of time in which a seller is locked into negotiation with just one party.
Buyers will tell founders that in order to diligence the transaction, they (the buyer) will need 60-90 days of exclusivity to investigate the purchase, during which the founder cannot discuss a transaction with any other buyer.
Before you as a founder take buyers’ lead here, consider that exclusivity may not be in your interest.
Why Buyers Tell You They Need Exclusivity
One of the biggest arguments buyers give for exclusivity is that they want to justify the expense they will incur investigating your business (known as diligence).
The cost of diligence resources isn’t small by any accounts, so buyers tell you they won’t make the investment unless they have assurances you won’t sell to someone else in the meantime.
Another reason buyers use to argue in favor of exclusivity is that it is a sign of loyalty to a future partner, which is especially persuasive when you already have a relationship with the buyer. They might even suggest that working with them exclusively will ensure a "quick and easy" process.
Despite these arguments, emotional appeals, and promises of convenience, the story buyers are telling you has some major gaps.
The Real Reasons Buyers Want Exclusivity
If buyers can convince a founder to enter a 60-90 day exclusivity, they’ve secured several advantages in the sales process, including:
- Low competition
- Time to observe performance
- Opportunities to find problems and renegotiate
- Time to raise capital
A competitive process is good for founders but bad for buyers. When buyers have competition, they have to offer better valuations and more favorable terms to win. Consequently, if buyers can get an exclusivity agreement early, they can cut off the competition from influencing negotiations.
Buyers are even better positioned against competition if they can secure a long exclusivity (30+ days) because they can do their diligence while the competition has to wait for exclusivity to end.
Many competitors don’t wait around, leaving founders with only one available buyer, and that buyer knows the founders don’t have many good alternatives.
Some private equity firms base their entire business model around exclusivity: they get as many companies in exclusivity as early as possible, then wear the company down during diligence (all the while monitoring performance). They then pick the best companies and drop the others after 60+ days of beleaguering founders with diligence questions and negotiations.
Founders need to be careful about granting exclusivity too quickly. If a founder grants exclusivity early and without a fight, that action signals to the buyer that there isn’t much competition. If buyers sense the process is not competitive , they will hold harder when negotiating on valuation and other key terms.
Time to observe performance
Exclusivity agreements are a way for buyers to create an option to transact without being required to do so. During the course of exclusivity, buyers will:
- Have access to all your diligence data, including forecasts
- Watch if your company hits those forecasts before deciding to invest
As a founder, one of the worst scenarios to be in is under exclusivity for several months and then a buyer decides not to close the transaction for whatever reason. That’s several months of your time and resources gone to waste because the buyer had too much time to make a decision.
Opportunities to find problems and renegotiate
After a term sheet is signed and exclusivity begins, nothing good happens except the deal closing. In between, buyers are going to dig into your business during the diligence phase.
Diligence never benefits the seller—buyers don’t find good things in data and offer more money for a business. Instead, they dig and dig until they find problems.
These problems give buyers leverage to renegotiate. They will wait until the end of their exclusivity period to spring these issues on you, and then try to retrade (i.e. renegotiate the terms of the contract). Of course, by this time other buyers have fled the scene, giving the remaining buyer even more power. The end result is a bad deal.
Time to raise capital
If buyers are pushing for 90+ days of exclusivity, they likely don’t have the cash to purchase your company. They’ll look to debt providers and private equity firms to offer up the money for the purchase.
These buyers are hardly prepared to pay a premium valuation for your company—they’re just scraping money together where they can. As a result, they know their only chance for a buy is to lock you into exclusivity early so no one else has a chance to compete.
Don’t waste your time with these buyers.
What If Your Investment Banker Recommends Exclusivity?
Exclusivity really only benefits buyers, so if your investment banker is not aggressive in defending your interests in exclusivity, they might have some conflicts of interest.
Some signals of conflict to watch out for are:
If your banker advises on both buy-side and sell-side transactions. A banker that plays both sides of the table is a conflicted advisor who has incentive to favor specific buyers for a quid-pro-quo situation.
If your banker is eager to enter exclusivity with almost any buyer. These bankers are desperate to get you into exclusivity with the hope a deal can close and they can exact their fees on the transaction.
If your banker expresses concern for how much buyers are spending on diligence outside of exclusivity. Bankers should be excited, not concerned, about how much money buyers spend outside of exclusivity. The more you can get buyers to invest in diligence outside of exclusivity, the better you as a seller will be able to identify which buyers have real interest in your business.
If you detect any of these signals in your investment banker, it might be time to shop around.
How Good Bankers Approach Exclusivity
If possible, a good banker will say no to exclusivity altogether, as exclusivity closes off options and reduces leverage for the seller. However, exclusivity can be difficult to avoid completely, so a good banker will adhere to the following practices:
- Delay exclusivity to maximize valuation and contract terms
- Grant short exclusivity periods
- Negotiate an exchange for exclusivity
- Minimize closing risk
- Set up conditions to terminate exclusivity
- Keep the second and third place buyers warm
Delay exclusivity to maximize valuation and contract terms
A good banker will delay exclusivity as long as possible.
They do so because they know the most favorable changes in contract terms come when multiple parties have all invested a significant amount of time and emotional energy into diligence and are eager to close the deal for themselves. Premature exclusivity inhibits competition between committed buyers.
Grant short exclusivity periods
Short exclusivity periods have several benefits, including:
- Keeping buyers engaged during the entire exclusivity period
- Keeping competition open, which helps sellers maintain leverage during exclusivity
- Minimizing the opportunities for buyers to find problems and try to renegotiate
At Vista Point, we grant exclusivity periods between 20-30 days (in some cases 45 days if there are diligence items with previously known long lead times).
Negotiate an exchange for exclusivity
Since exclusivity benefits the buyer and not the seller, a good investment banker will expect some sort of exchange for exclusivity. For example, at Vista Point we might ask buyers to offer one of the following incentives to sellers in exchange for exclusivity:
- A higher valuation
- Reduced indemnification
- Smaller or shorter escrow structures
- More favorable tax structures
- Other items
Minimize closing risk
Closing risk refers to the risk of entering exclusivity and then the buyer deciding not to close, which wastes the time of the seller and could send the wrong signals to other potential buyers.
Shortening exclusivity is one tactic for minimizing closing risk. Another important tactic is to address potential diligence concerns before exclusivity begins.
For example, to minimize that a buyer backs out during exclusivity, the seller would want to make sure the buyer has already completed diligence on key areas including:
- Industry diligence, such as total addressable market
- Key business metrics (e.g. retention, sale pipeline coverage, LTV and CAC, etc.)
- Financials including historical and projection periods
- Technology platform
A third tactic for minimizing closing risk is to have a marked-up purchase agreement before exclusivity begins. The seller will create the first draft of this agreement, and then give the buyer a chance to review and mark it up. Conducting this process before exclusivity reduces the risk of either party surprising the other with a deal-breaker at the end of exclusivity.
Set up conditions to terminate exclusivity
In the event that a buyer strays from previous agreements, a seller would want to be able to terminate the exclusivity period. An investment banker can help add conditions to the exclusivity agreement that give the seller the right to terminate if:
- The buyer tries to change key terms of the term sheet during exclusivity
- The buyer fails to keep the exclusivity schedule for providing legal documents or reverifying their valuation
Keep the second and third place buyers warm
A seller’s threat to terminate exclusivity and choose another buyer is only credible if the seller has alternative buyers on the table. As such, you want to make sure to:
- Let your other buyers know why you are not going forward with them when entering exclusivity with one of their competitors.
- Maintain good relationships with them so you can pivot back to them if necessary.
Having other buyers on hold will keep your primary buyer honest.
Use Exclusivity as a Negotiation Tool
Evaluating a deal is an expensive task for buyers, so one of their biggest fears is that they will come to the end of a deal after weeks of work and then the founder will sell to someone else.
This fear can work to founders’ benefit or detriment, depending on how founders approach the exclusivity discussion. If early in the process a founder suggests they won’t budge with exclusivity, buyers may elect not to participate. Exclusivity needs to be addressed at the right moment.
When is the right moment? Every transaction is different, as is every buyer. An investment banker can advise you on the deal to know when and how the exclusivity discussion will yield the greatest benefit.