Mitigating Principal-Agent Misalignment in M&A Transactions

Mergers and acquisitions (M&A) transactions are inherently complex, involving multiple professionals with varying incentives and goals. Steven Levitt and Stephen Dubner, in Freakonomics and SuperFreakonomics, explore how compensation structures can create conflicts of interest. While they do not specifically focus on M&A activity, they do highlight a key issue: investment bankers are often incentivized by deal volume, not by the quality of the deals they close. This can result in a situation where their goals diverge from the best interests of their clients - what are called principal-agent problems.

The misalignment extends beyond investment bankers and brokers to a broader group of agents involved in M&A transactions - what I call the "M&A Academy" - which includes lawyers, accountants, and valuation firms. While these professionals usually get paid for their services regardless of the transaction outcome, their long-term success is closely tied to transaction generation and volume. Simply put, the more deals they're involved in, the better it is for their future compensation.

Some Academy professionals view M&A deals as a steppingstone to future business, especially with buyers and sellers who are involved in multiple transactions. Accountants and lawyers, for example, may want to establish a relationship with the buyer to provide ongoing services after the deal is closed. Similarly, valuation firms may seek to offer future services to the acquirer, potentially creating a misalignment between the business seller's interests and those of the advisor.

A major contributing factor in these misalignment issues is that business sellers are typically one-off participants in the M&A process. They don't have the same ongoing relationship with other parties that their advisors do. With the stakes so high, business owners can easily feel pressured by advisors who may have post-transaction opportunities in mind.

Protecting Seller Interests

How can business owners mitigate principal-agent misalignments? A key is to determine and protect the disclosure of the seller's minimum cash selling price objective. A business seller has the power to say yes or no to the selling price, terms, and other conditions of a deal. While it is common to rely on advisors for guidance on the structure and details of a transaction - due to the asymmetry of experience and education -sellers do not have to disclose their minimum acceptable price to anyone involved in the transaction. In fact, divulging the minimum cash price will likely result in that figure becoming the near-maximum the seller will be offered.

Sellers who keep their minimum acceptable cash selling price confidential can avoid the risk of advisors pushing them toward deals that don't meet their financial goals. This minimum cash price should exclude the value of any contingent earnout amounts offered by the buyer. Additionally, it is advisable to add the amount of any escrowed funds required by the purchase agreement to the minimum acceptable cash price, as these funds can sometimes be targeted for recapture by certain buyers.

Conclusion

There are many divergent interests at play during a business sale, often subtle and difficult for sellers to mitigate. An essential protection strategy is for sellers to establish a clearly defined, realistic minimum cash price and keep it confidential. This approach allows sellers to maintain control over the most important factor in deal negotiations (cash at closing) and to mitigate pressure by agents with potentially different objectives.