Lingering uncertainty about valuations and liquidity is compelling buyers and sellers to consider unconventional negotiation tactics and sophisticated technologies to gain an edge in the dealroom. In a market shrouded by unknowns, dealmakers are thinking outside the box in an effort to protect their interests.

Due Diligence or Espionage?

Concerns about a buyer’s ability to close has led to a surprising trend: reverse-due diligence. In other words, sellers are examining their buyers. “Anytime you’re doing a transaction it takes time away from your business,” explains Daniel Belostock, a partner at Nixon Peabody. Sellers now “want to make sure that the buyer they’re going with can close and close quickly. It’s a rebalancing of power because sellers are now doing more diligence on their buyer.”

Additionally, a debate over valuations has compelled some buyers and sellers to turn to private investigators for enhanced due diligence. Advisory firm K2 Integrity leverages its experience in forensic accounting, cybercrime and national security to offer their clients an informational advantage.

K2 sleuths have helped recover assets from the Bernie Maddoff scandal, uncover capital hidden in foreign real estate, and aided in the investigation of the ‘Con Queen of Hollywood’ – a scam artist targeting high-profile entertainment personalities. K2 claims these skills can help corporations mitigate the risks involved with acquiring private assets shrouded in mystery or corporations from other jurisdictions.

Spycraft is also being applied in negotiations. Massachusetts-based advisor BIA has adopted strategies from the CIA and has used them to identify language and behavioral cues that could assist a dealmaker during negotiations.

“Subtle behavioral cues can provide insights into what others think is important and how they want to be perceived,” says BIA CEO David Nydam. “For example, someone’s word choice and nonverbal cues can reveal information about their level of conviction in a given assertion or a hidden concern they have about a particular outcome, regardless of the impression they are attempting to give.”

Nydam says these strategies can help negotiators uncover red flags and mitigate them before the deal closes. “Techniques applied to management disclosures on earnings calls showed that information was being missed by observers in the market that totaled to a 29 percent annualized return versus the market as a whole,” he says.

Hiring a consultant who worked as a spy or private investigator could add an edge, but Professor Thomas Lys of the Kellogg School of Management at Northwestern University, believes any external advice is helpful. The increasing use of third-party advisors is a great way for dealmakers to avoid psychological biases, according to his research.

Professor Lys partnered with Stanford Professor Margaret Neale to study the impact of behavioral economics and irrational human behavior within the context of corporate dealmaking. Their research reveals that dealmakers on both sides are prone to irrational and emotional decisions anchored in certain human biases.

Professor Lys cites confirmation bias– the tendency to interpret new evidence as confirmation of one’s existing theories– and anchoring bias– the tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions, as examples of irrational barriers to a good deal.

“Once you know these biases exist you can prepare to avoid and take advantage of them,” he says. “One way to avoid these biases is to use an agent. Turns out you’re more prone to these biases when it’s your own skin in the game. ”

In other words, M&A consultants and advisory services could offset the emotional responses and irrational behavior from both sides of a deal.

“Humans are humans at the end of the day,” says Geoff Dover, founder and chief investment officer at Heirloom Family Office. “The reality is a lot of negotiation comes down to gut feelings and whether or not people get along.”

Nonetheless, Dover says hard data and technology have played a more critical role in negotiations in recent years.

Technology’s Impact on Due Diligence

Greater access to data and technology has leveled the playing field, according to Dover. “It’s true that the size of the company is an important factor in dealmaking, but there’s plenty of small companies that have access to even better data and ways to analyze that data than large companies,” he says.

Mark Williams, chief revenue officer of due diligence software platform Datasite, says using technology to assist dealmakers “is important because every week that due diligence drags on, the risk of a deal coming apart increases by almost 50 percent. And with the price of due diligence at around $100,000 a week, costs can add up quickly if there are delays. Having one place to manage every stage of dealmaking gives dealmakers the flexibility to better manage their costs, reduce compliance risks and increase their productivity.”

Besides technology, dealmakers are also turning to legal maneuvers to reduce risk and achieve better outcomes.

Legal Maneuvers Bridge the Gap

Although dealmakers are heading back into negotiations, they’re noticeably more risk-averse, according to Belostock.

“Given the risk appetite of the market, every deal is highly structured,” he says. “There are very few in the private middle-market setting where it’s all cash. Everything is highly structured to bridge that gap between buyer and seller expectations.”

Earnouts were already common in the private equity industry, but are now spilling over into other sectors, according to Kevin Grant, partner and co-leader of the M&A and transactions team at Nixon Peabody.

In 2022, one in five M&A transactions had an earnout clause. In the first three-quarters of 2023, that ratio surged to one in three, according to industry data collected by SRS Acquiom.

“With earnouts, you see more and more clients on the strategic side adopting it and being influenced by approaches that many private equity firms took 10 years ago,” says Grant. “Private equity has led to the increased sophistication level of everyone across the board.”

Besides equity earnouts, business broker David Barnett has noticed an uptick in seller financing, when the seller of a business acts as the lender and extends a loan to the buyer.

“Many SME business [small to medium-sized enterprise] buyers and sellers will know about seller financing and expect that some degree of the business purchase will be financed by the seller,” he says. “But who says there can only be one seller financing note? I’ve worked with buyers who have done deals with six different notes. Each addressed a particular issue within the business such as customer concentration. There are no rules in how you structure a deal other than those imposed by lenders.”

Grant says other legal tactics are gaining steam with buyers and sellers. These include rollovers, where the equity is rolled back into the business; escrow holdbacks, where a portion of the proceeds are held in escrow until a buyer is satisfied with the purchase within a reasonable timeframe; and Reps and Warrants Insurance, a type of insurance policy that indemnifies the buyer for loss resulting from a breach of reps and warrants.

“You’d be surprised that even smaller acquisitions with sellers that are maybe not the most sophisticated will know about reps and warrants and have an adviser who at least raises the question,” Grant says.

He believes the growing sophistication of sellers could be another sign that the balance of power is shifting in their favor in the current market.

Necessity is the mother of invention and the tough conditions of the current M&A market have made it necessary for everyone to think outside the box.