Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Escalation Clause That Cost a Buyer 38 Million
Transcript
- Lucas: So, Luna, you've seen the term sheet from the Palmer acquisition, right? The one where the buyer thought they had a handshake deal at forty-one million. Luna: Yeah, I saw the draft. They had an escalation clause in there, but the way it was written, it looked pretty standard on the surface. Then the other bidder came in at forty-two, and things got messy. Lucas: Messy is putting it mildly. The buyer ended up paying seventy-nine million. That's a thirty-eight million dollar swing because of a few lines in the escalation provision. And honestly, if this show has paid for itself in insight, we keep it running with listener support. If today's episode moves your thinking forward, buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash fexingo. Luna: Right, and it's not just about the coffee, it's about keeping these conversations free for everyone. But back to Palmer — how does a standard escalation clause turn into a thirty-eight million dollar mistake? Lucas: Well, let's break down the clause itself. Most people think of an escalation clause as a simple mechanic: if a higher bid comes in, you raise your offer by a fixed increment. That's what the buyer thought they had. But their clause didn't specify a cap, and it didn't define the increment clearly. Luna: So the competing bidder kept coming back with higher offers, and the escalation kept matching, but there was no ceiling. How did that play out in the actual negotiation? Lucas: The first bidder, let's call them Bidder A, started at forty million. Bidder B came in at forty-one. Bidder A's clause automatically matched that, but their increment was one million. So they went to forty-two. Then Bidder B went to forty-three. And so on, all the way up to seventy-nine. Luna: Wait, the seller must have been thrilled. They just sat back and watched the bids climb. But why didn't Bidder A just say, 'we're out' earlier? They must have had a walk-away number. Lucas: That's the thing — they did have a walk-away number, but they never put it in the clause. They assumed the escalation would stop at a reasonable level. But the other side knew there was no cap, so they kept pushing. And the seller, of course, had no incentive to stop it. Luna: So the escalation clause turned into a bidding war that neither side had explicitly agreed to. It's like the clause itself became the seller's best friend. Lucas: Exactly. And this is not an isolated case. I've seen escalation clauses cause overpayment in everything from small manufacturing deals to tech acquisitions. The problem is that buyers focus on the headline purchase price, not the mechanics of how the price can change. Luna: What are the key elements that should be in an escalation clause to prevent this? Is it just about setting a cap? Lucas: The cap is critical, but it's not the only thing. You also need to define the increment precisely — is it a fixed dollar amount, a percentage of the new bid, or a combination? And you need to determine what triggers the escalation — is it any higher bid, or only a bid from a qualified, bona fide buyer? Luna: Because if the trigger is vague, the seller could claim a lowball offer qualifies, and you end up paying more than you should. That's a classic loophole. Lucas: Right. In the Palmer case, the clause just said 'any higher competing offer.' That meant a bid from a shell company could trigger the escalation. And of course, the seller had a friend submit a token offer to bump the price. Luna: Ouch. So that's a deliberate manipulation, but what about more subtle issues, like the timing of the escalation? Does it matter when the offer comes in? Lucas: Timing matters a lot. Some clauses have a deadline for when competing offers must be received to trigger escalation. If that's not clear, you could be stuck in a perpetual auction. The Palmer buyer didn't have a deadline, so the other side kept submitting offers right up to closing. Luna: So what should a buyer do to protect themselves? Is there a standard template that avoids these pitfalls? Lucas: There's no one-size-fits-all, but there are key provisions. First, set a hard cap — a maximum price you're willing to pay, and put it in the clause. Second, define the increment as a percentage, say, two percent of the new bid, which prevents small, incremental bumps. Third, require the competing bid to be a bona fide, written offer from a qualified buyer that's actually funded. Luna: And what about the seller's perspective? Is there a way to use an escalation clause to your advantage without scaring off buyers? Lucas: Sellers should want a clear escalation clause too, but they should use it to create a competitive dynamic without turning the process into a circus. A well-structured clause can encourage buyers to put their best foot forward early, knowing that a higher bid will trigger a capped response. That's better than an open-ended auction that might lead to a buyer walking away. Luna: So it's about aligning incentives. A cap gives the buyer a sense of control, while the seller still benefits from the potential upside. But what if the seller insists on an uncapped clause? Is that a red flag? Lucas: It can be a signal that the seller is more interested in maximizing the price than in closing a deal. If they refuse to include a cap, you have to question their commitment to a smooth transaction. In the Palmer case, the seller's advisor actually encouraged the uncapped clause because they wanted to drive the price up. Luna: And the buyer's advisors? They should have caught this. How do you think the buyer's legal team missed such an obvious exposure? Lucas: I think they focused on the reps and warranties, the indemnification, the working capital mechanics — the stuff that gets the most attention in due diligence. The escalation clause was buried in the letter of intent, and it seemed straightforward. Nobody modeled the worst-case scenario. Luna: So the lesson is to stress-test every price adjustment mechanism, not just the ones that feel complex. Sometimes the simplest language is the most dangerous. Lucas: Exactly. And there's another angle: even if you have a cap, you need to think about what happens if the cap is reached. Does the buyer have the right to walk away, or are they obligated to close at the cap? That can be a huge difference. Luna: If the buyer is obligated to close at the cap, they might end up paying more than they wanted, but at least they know the worst case. But if they can walk away, they might lose the deal entirely to the other bidder. It's a trade-off. Lucas: Right. In some cases, the buyer might want the option to match a higher bid but not exceed the cap, and then have a period to decide if they want to match further. That's a two-stage escalation. It gives you a chance to reassess after seeing the final number. Luna: That sounds like a more thoughtful approach. Have you seen that used effectively in practice? Lucas: Yeah, I worked on a deal a few years back where the buyer had a two-stage escalation. The first stage was an automatic match up to a certain level, and the second stage required the buyer to reconfirm their interest before proceeding. It saved them from overpaying when the other bidder went above their comfort zone. Luna: So it's not just about the cap, but also about the process. And what about the role of the independent arbitrator? Could that have helped in the Palmer case? Lucas: An independent arbitrator could have stepped in if there was a dispute about whether the competing bid was bona fide. But in the Palmer case, there was no dispute — the bid was real, just annoying. The problem was the clause itself allowed for unlimited escalation. Luna: So the fix is structural, not procedural. You need to change the language, not just add a referee. What's the one thing you'd tell a buyer reviewing their current LOI? Lucas: Look at every clause that can change the price, and ask, 'What's the maximum I can pay under this clause, and under what circumstances?' If you can't answer that in one sentence, you're at risk. And that applies to working capital adjustments, earnouts, and definitely escalation clauses. Luna: That's a practical checklist. And for sellers, what's the key takeaway? Is there a way to use escalation to your advantage without alienating buyers? Lucas: Sellers should use escalation to create a sense of competition, but they need to be transparent about the process. If you're open about the fact that you'll consider higher bids and make it easy for buyers to respond, you'll get better initial offers. But if you try to game the system with uncapped clauses, you risk losing serious buyers. Luna: So it's about building trust, even in a competitive process. That's a good note to end on. Thanks for breaking this down, Lucas. Lucas: Anytime, Luna. And if you're listening, remember: the next time you see an escalation clause, don't just skim it. Model it like you would any other risk. That's the difference between a good deal and a costly lesson.