I. Introduction

An Entrepreneur:

Attorney Zhang, a listed company wants to acquire my company. How should I respond? If the price is reasonable, I’m willing to be acquired. Of course, I do feel a bit失落 — I originally dreamed of taking my own company public. Now that a listed company wants to acquire it, it’s not bad to latch onto a big player…

The Author:

Don’t get too excited yet. Let me help you sort things out…

I believe many entrepreneurs, upon hearing that a listed company wants to acquire their company, inevitably feel their heart race like the entrepreneur above. If it were me, I’d probably be laughing in my sleep, haha…

II. How to Respond to the Acquirer’s Acquisition Approach?

So, what is the correct posture for responding to a listed company acquirer? In my view, the following measures or actions should be taken:

1. Confidentiality Agreement

The acquirer generally needs to conduct financial and legal due diligence on the target company. This means the acquirer will conduct a thorough investigation, and the target company may need to disclose significant confidential business information. Moreover, the acquirer has only expressed a preliminary intention to acquire the target company; the deal may not ultimately close. If news of the potential acquisition reaches employees, some may become unsettled due to fears of post-acquisition layoffs, or may have other thoughts that could affect the acquisition process.

Therefore, signing confidentiality agreements is very important. This includes a confidentiality agreement between the target company and the acquirer, as well as confidentiality agreements between the target company and certain employees involved (since the acquirer’s negotiations and investigations require the participation or cooperation of some target company employees).

Generally, target companies are more attentive to signing confidentiality agreements with the acquirer, but may overlook confidentiality agreements with handling employees. After all, many business managers believe their employees are “their own people” and won’t talk. In my view, this cannot be taken for granted. If a target company signs a formal and legally binding confidentiality agreement with handling employees, those employees are generally more likely to keep their mouths shut, resulting in better confidentiality. Without it, handling employees have no psychological burden and might one day tell others: “Let me tell you a secret, don’t tell anyone…“

2. Consideration of Past Financial Handling

Many private enterprises maintain two sets of books (internal and tax), and some even have up to eight sets (in addition to internal and tax books, there are bank books for bank loans, customs books for customs inspection, high-tech enterprise books for applying for high-tech status, etc.). Such accounting practices hide significant tax risks.

If a target company is acquired by a listed company, the listed company’s compliance standards and information disclosure requirements are higher, meaning the risk of past financial non-compliance being exposed is greater (of course, if the financial compliance risks were too great, the acquirer would likely abandon the acquisition upon discovering this during due diligence).

I once handled a client consultation. The client was a construction labor subcontracting company with huge annual revenue and had long been under close scrutiny by government authorities. At that time, a listed company wanted to acquire this company. I asked the client three questions: Was the company’s past financial handling compliant? After the change of de facto controller, could the communication channel with the tax authorities remain畅通? If, after the acquisition, the risks of past financial non-compliance were exposed, could the company bear the consequences?

After hearing my three questions, the client ultimately decided not to sell the company’s equity.

Therefore, the controlling shareholder of the target company needs to first self-assess the magnitude of the company’s financial non-compliance risks and whether, if exposed, the risks are within tolerable limits. If the answer to the former is no, it is advisable not to consider selling the equity.

3. How to Determine the Acquisition Price

In projects where I previously advised the acquiree, the acquiree often did not know how to determine equity valuation or negotiate the transaction price.

Regarding how to negotiate the transaction price, I recommend using a written “Equity Sale Prospectus,” which may include the following:

#01 Target Company Introduction

Including business model, product types, management team, core competitiveness (e.g., technology, brand, product substitutability), etc.

#02 Market Analysis

Including the industry the company is in, industry scale, comparison with competitors, upstream and downstream supply chains, customer and supplier concentration (acquirers are very concerned about customer concentration; the lower the concentration, the stronger the company’s bargaining power and the lower the risk of de facto controller change due to acquisition), synergy between the target company and the acquirer, etc.

#03 Financial Information

The target company’s core financial indicators for the past three years and financial projections for the next five years, to provide a basis for equity valuation.

#04 Equity Valuation

Provide an equity valuation calculation model to give the acquirer a quote. To put it bluntly, the purpose of the Equity Sale Prospectus is to help the buyer understand the target company’s strengths and bright future development prospects, thereby helping the target company sell its equity at a good price. Although the content of the Equity Sale Prospectus can be appropriately optimistic, it must be based on the target company’s existing operating conditions so that it remains defensible under the buyer’s scrutiny.

From a negotiation technique perspective, it is more advantageous for the equity seller to quote first. Because people have a psychological tendency to seek advantage and be primed by first impressions, if the buyer quotes first, they generally quote on the principle of “the lower, the better.” Therefore, from the seller’s perspective, it is better to let the buyer negotiate down from the seller’s quote, giving the buyer the psychological satisfaction of “getting a bargain,” rather than considering a markup on the buyer’s quote.

From the equity buyer’s typical approach, the buyer often first locks in the seller with a preliminary agreed意向价, then conducts due diligence and “finds fault” with the target company to压低 the final transaction price. Therefore, I suggest the seller consider quoting first at an appropriate opportunity to gain the initiative.

4. Assessing the Impact of the Acquisition

#01 Impact on Customers

An acquisition can be a full acquisition or a controlling interest acquisition (i.e., acquiring more than 50% but less than 100% of equity). In a full acquisition, the founding shareholders of the target company can often pursue “poetry and远方” and enjoy life after the acquisition closes.

However, to reduce the risk of performance deterioration due to a change in de facto controller and to establish a mechanism for sharing risks with the original shareholders, many acquirers prefer controlling interest acquisitions or phased acquisitions using an earn-out mechanism (paying consideration based on performance targets). In such cases, founding shareholders need to consider whether the acquisition will bring synergies to the target company (or the impact of the acquisition on customers). If Company A is a supplier to Company B, and Company B wants to acquire Company A, then after the acquisition, although Company B’s procurement needs may be directed to Company A, other customers of Company A that are competitors of Company B may seek alternative suppliers, unwilling to rely on a competitor.

#02 Impact on Company Partners and Senior Employees

After the acquisition closes, the acquirer will generally gradually replace the target company’s原有 senior management. Therefore, for the founding shareholders’ partners and the target company’s core senior management, the decision to sell the target company will significantly impact their career prospects and financial situation. At the same time, the stability of senior management is important to the target company. After all, these people have worked alongside the founding shareholders for many years. Emotionally, the founding shareholder may find this issue difficult to resolve. I have two suggestions:

(1) The founding shareholder can request that the acquirer retain these personnel during negotiations; (2) If possible, the founding shareholder can also set aside a portion of the equity acquisition proceeds as compensation for these personnel.

5. Earn-Out Clauses

In a broad sense, earn-out clauses include valuation adjustment mechanisms (VAM) and earn-out provisions. In equity acquisitions, information asymmetry exists between the acquirer and the acquiree. To reduce the risk of equity valuation decline due to information asymmetry, the acquirer often requires adjustments to the equity valuation or continued purchase of equity based on the acquiree’s performance. Thus, valuation adjustment mechanisms and earn-out provisions are created.

In practice, founding shareholders of target companies often resist earn-out clauses. After all, unless one has a “time capsule,” no one can predict the future. However, for stronger acquirers, earn-out clauses are indispensable. If both sides refuse to compromise, the acquisition may reach an impasse.

At this point, if the founding shareholder still considers selling the equity, I suggest the following considerations:

(1) Self-Assessment of Product Competitiveness.

In this regard, I suggest using Porter’s Five Forces analysis model. Porter identifies five main sources of competition: rivalry among existing competitors, threat of new entrants, threat of substitutes, bargaining power of suppliers, and bargaining power of buyers. Founding shareholders can start from this Five Forces model to quantitatively self-assess their product’s competitiveness. If the assessment shows that the product’s competitiveness is strong, the industry ceiling is far from reached, and the company is still in a profit explosion or stable growth period, it indicates that the risks and instability faced by the company in the near term are relatively small, and accepting earn-out clauses may be considered; otherwise, it is better to avoid earn-out clauses.

(2) Assessment of Profitability.

The target company’s profitability is based on projections of its operating efficiency. The most direct manifestations of operating efficiency are maximizing revenue and minimizing costs and expenses. How to achieve both simultaneously?

Maximizing revenue means increasing sales volume or sales price. In the short term, increasing sales price is generally difficult to achieve (easily causing customer dissatisfaction), so the strategy often adopted is to increase sales volume. Increasing sales volume means expanding production capacity, which requires long-term asset investment and significant capital expenditure, potentially harming the company’s operating efficiency in the short term.

Minimizing costs and expenses means improving production efficiency and reducing costs. In the short term, production processes are generally difficult to substantially improve, so a more feasible approach is to eliminate waste and leaks, squeeze out potential procurement inefficiencies, and shift from seeking returns from the market to seeking returns from operational management.

(3) Setting Performance Targets.

After self-assessing product competitiveness and profitability, if the founding shareholder believes both are good, accepting earn-out clauses may be considered. From the equity seller’s perspective, the lower the performance target, the better. Therefore, the equity seller should try to压低 the performance target during negotiations with the acquirer. Performance targets should be quantifiable to avoid disputes during execution.

Additionally, if financial performance targets are set, since the acquirer generally requires financial performance to meet the quality standards of securities issuance for financial audit reports, and the target company is often a中小 enterprise accustomed to double-entry bookkeeping, the equity seller may find it difficult to adapt. From the equity seller’s perspective, for certain costs and expenses that affect accounting profit under accounting standards but do not actually result in cash expenditure (such as share-based payment expenses arising from employee equity incentives,加计 research and development expenses, etc.), the equity seller should seek to specify the measurement standards and exceptions for financial performance indicators in the investment agreement.

(4) Worst-Case Scenario Thinking.

If the operating environment changes or customer development is not ideal, is it possible to achieve targets through “other means”? For example, expanding customer credit limits, reducing production quality to lower production costs… (These measures can increase the target company’s revenue in the short term but will damage its competitiveness in the long term; I do not encourage such measures.)

In the worst case, even after adopting the above “other means,” if performance targets are still not met, the founding shareholder needs to calculate the amount of compensation payable to the acquirer. From this, it can be calculated whether, in the worst case, the founding shareholder would obtain net benefits from the acquisition. If the required compensation amount is far less than the net benefits obtained, accepting earn-out clauses is harmless. If the two are similar or the compensation amount exceeds the net benefits, further consideration is needed.

Through the above four levels of consideration, the founding shareholder of the target company can basically determine whether to accept the acquirer’s earn-out clauses.

Additionally, it is worth noting that if earn-out clauses are accepted, the founding shareholder also needs to agree with the acquirer that during the earn-out period, the founding shareholder shall retain all or part of the company’s operational management rights (without operational management rights, the founding shareholder cannot control the target company’s performance).

III. Conclusion

The above summarizes the main measures I recommend for responding to an acquirer. Of course, each target company’s situation may differ, and analysis can be tailored to the company’s specific circumstances.

As the saying goes, “every profession has its specialization.” Equity acquisitions involve complex business, financial, and legal matters that may not fall within the knowledge scope of the acquisition target’s founder. Therefore, for acquisition targets with the financial means, I recommend engaging professional advisory institutions as a more suitable option.

Attorney Zhang Jing

Senior Partner, Long An (Guangzhou) Law Firm, with long-term practice in legal services related to equity structure design, corporate mergers and acquisitions and restructuring, private equity funds, equity incentives, technology transfer, and cross-border investment and financing.