The Anatomy of a Deal Newsletter April 19, 2019
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
This piece is a collaboration with Michael Shaw, Partner and Managing Director at Copper Run Capital.
This month, we look at a sad truth: some deals die.
Deals die for a variety of reasons. Sometimes, deals die for reasons that are mostly out of the parties’ control, such as market conditions, inability to obtain financing due to tightness in the credit markets, or a sudden and unexpected loss of a key customer.
However, many times, a deal’s death can be blamed on factors that could have been prevented, if only someone would have been diligent enough to catch the issue before it became a real problem. So, let’s look at some potential deal-killers and how to avoid them before they sentence your deal to death.
1. Ugly Financial Statements
One of the benefits of owning your own business is that you can do whatever you want, right? Taking a trip to Vegas for “business?” Just charge it to the company!
However, using your business as your personal bank account is a ticket to deal death row. Even if you and your accountant are comfortable with how you’re accounting for things, a potential Buyer is going to have to sort it all out when kicking the tires on a potential acquisition. Ultimately, the Buyer will need a clear picture of what the finances of your company look like on a stand-alone basis so they can gauge whether the Buyer will be able to produce the return on investment it’s looking to make. While Buyers can often make some adjustments to their pro forma financial model to account for these items, too many of these will cause the Buyer to have serious misgivings about the quality of the financial information.
Let’s say you can get the Buyer comfortable with these adjustments, it’s oftentimes an even bigger hurdle getting the Buyer’s lender on board. Most traditional lenders have a very hard time getting comfortable with financials that are littered with unusual transactions.
And there’s the potential legal liability issue that may scare off a Buyer. A business owner who uses the company as his personal piggybank may very well have weakened the limited liability protection of the corporate or limited liability company entity itself.
The best advice is always to keep business and personal finances separate.
To understand the potential dollar impact to the Seller, a worthwhile exercise would be to understand the valuation range based on the company’s operating earnings before interest, tax, depreciation and amortization (EBITDA) – if the company is able to be valued on EBITDA.
As an example, let’s say all signs indicate the company is worth six times (6x) EBITDA in a competitive market. Compare the tax savings you receive by running personal expenses through the company to that dollar value of the personal expenses coming back to the owner at six times (6x). It’s easy to see how having a clean income statement can add more value than using it as a personal piggy bank.
If owners don’t have time to remove all the personal expenses in a business, it is typically beneficial to have a third-party accounting firm review and verify potential add backs and reconcile them to verifiable receipts to head off any potential issues during a potential acquisition.
2. Cap Table Chaos
One surefire way to scare away a potential Buyer is being unable to show who actually owns your company. Nowadays, it’s easier than ever to set up a legal entity; it’s also easier than ever to screw it up.
If you can’t clearly show ownership – including clear ownership history showing how each current and former owner acquired its equity interest and/or disposed of its interest – most Buyers will start running for the hills. Even if you’re selling assets rather than equity, the Buyer needs to know whether you have sufficient authority to approve the deal, and whether any unknown owners might crawl out of the shadows after the closing to claim a piece of the deal.
Messy ownership records also lead potential Buyers to question how you’ve operated your business; if you can’t pay attention to something as important as the ownership of your company, what else have you neglected?
Moreover, a convoluted cap table – even if the records are immaculate – adds risk to the deal as one or more potential investors may have hold-up power to deny the deal. Even if you don’t give away voting control, a significant block of disgruntled minority investors might still give Buyers pause about proceeding. In some cases, these minority owners might also have rights to challenge the deal in court.
That’s not to say that you shouldn’t give equity to investors. You need to take in smart investments to get the capital needed for success. The lesson is to be careful about how and when you give away equity, and to treat your cap table and ownership history with great care.
3. Unsustainable Projections
Who doesn’t like to show hockey-stick growth projections? Buyers will almost certainly ask for a projection and/or budget for the next few years as they perform due diligence on a potential acquisition. A Seller who isn’t able to provide this information or complete this exercise demonstrates a lack of preparation and business acumen.
When approaching projections, revenue growth should (1) reflect realistic goals backed by tactical strategies and (2) consider historical performance. Presenting projections with explosive upside can show you’re more of a dreamer than a realist and become a cause of concern for a Buyer.
Buyers get comfortable with projections when evidence and data can be provided to demonstrate how revenue growth was formulated. For example, a contracting business might be able to share a pipeline and backlog report to support its revenue growth.
Regarding expenses, Buyers like to understand the cost structure of fixed vs. variable expenses attributed to this revenue growth. Sellers should demonstrate care in projecting cost structure to confirm that expenses support the projected revenue. For example, an IT consulting company that relies heavily on employees to support its growth would need to project increased payroll expenses based on the number of consultants required to execute the work and keeping up with current labor rates.
An experienced financial advisor, as well as your CPA, can provide a reasonableness check on projections – but also make sure the people at your company responsible for key revenue and expense categories support the projections.
4. Going Without Protection
Before going down the path toward sale, it’s important to explore what options you might have to ensure protection for your business’ most important assets.
One surefire way to kill a deal is to neglect to take the steps necessary to prove your ownership of your key intellectual assets. For technology companies, this usually means having robust intellectual property ownership (e.g., “work-for-hire”) agreements and confidentiality agreements with anyone who is involved in the development of your products. Under copyright law, independent contractors own all of the rights in the materials they develop, even if you pay them for it. And, the legal distinction between employees and independent contractors is sometimes gray. As such, we strongly encourage companies to require employees and contractors alike to sign appropriate work-for-hire and confidentiality agreements as part of the standard new hire package.
We’ve had experiences trying to find software developers years down the road on the eve of a potential sale. Trust us when we say that you definitely don’t want that risk in your deal.
Aside from the legal risks, it’s also important to make sure that you have continuity plans in place that allow your business to continue even after the unavailability of a developer or other key employee. You may have complete confidence in your ability to keep these people engaged and happy, but a Buyer may not share your optimism.
5. Loose Lips
Most Sellers are very concerned about a potential deal becoming public knowledge, and with good reason. In one case, our client was as surprised as anyone when one of its largest vendors sent a note of congratulations to our client on the sale of his business – before the deal had closed and our client had disclosed the transaction to anyone.
In that transaction, the premature disclosure fortunately didn’t kill the deal. But that’s not always the case. Premature disclosures can have lethal effects on any deal.
So what can you do? Confidentiality agreements are great, but agreements don’t always dictate behavior.
First, limit the group of people who know about the deal to be as small as possible. You can’t do it alone, but you can keep the circle of knowledge to a few key individuals.
Second, implement equity compensation, incentive compensation, and/or transaction bonuses with these individuals so that they have some skin in the game. If they stand to benefit from the deal financially, they’ll be aligned with your goals in preserving the deal. They’ll also be less tempted to focus on future employment opportunities, which may end up resulting in inadvertent disclosures about the deal to prospective employers.
6. Cutting Corners
Especially when you’re first starting your business, you know that time and money are precious commodities. For many young companies, it’s nearly impossible to be aware of every potential compliance issue and then to expend the necessary time and money to address each of those issues – particularly when those resources could be put toward seemingly more fruitful pursuits.
However, cutting corners with something like legal compliance can have major repercussions to your deal. While the particular issue may appear to be low-risk from your vantage point, potential Buyers may be the proverbial “bigger fish” that is under greater scrutiny by regulators. In some cases, legal compliance issues – no matter how seemingly insignificant – can be a deal-killer for certain Buyers.
Moreover, inattention to these types of issues – or conscious non-compliance – can shake the Buyer’s faith in how the Seller has operated the business. If the Seller has a lax attitude toward compliance issues, what has been its approach toward other fundamental aspects of the business?
Unfortunately, this leaves Sellers with a bit of a Catch 22: I don’t have the money I need to ensure compliance with the myriad legal requirements that exist, but I can’t get money unless I can show that I’m complying. To address this conundrum, the Seller should take the following steps:
- (a) Talk to other business owners of varying sizes – Believe it or not, you’re not the first company to wrestle with these issues. See how other businesses have addressed these issues and whether they’ve found solutions that can be replicated in your business. However, while this is a great start, don’t rely solely on what you’re hearing from other business owners. Even though the solution might work for them – and you can’t even be sure that it is actually working for them – it may not work for you. Nonetheless, these discussions may give you some food for thought to discuss with your advisors. Also, be careful about disclosing any information that might suggest you’re not currently in compliance because “Anything you say can and will be used against you.”
- (b) Use free resources – There are a lot of good, free resources out there that can provide some helpful guidance. A Google search can yield a lot of great information, and some of it might even be accurate. Again, don’t rely on what you see or read, but put it on the list of potential options for further analysis. Also, while not appropriate in every case, many governmental agencies will talk with you and help you to better understand what options might be available to you. In many cases, they’ll accept “de-identified” calls where you don’t have to disclose who you are. However, even in these cases, you’ll still want to be careful about what you disclose so as not to inadvertently put yourself on the agency’s radar because, well, “Anything you say can and will be used against you.” Finally, take a look at whether local business schools, law schools, or non-profits offer any free or discounted services for start-up companies that are grappling with these issues.
- (c) Use not-free resources – At some point, you will want to get expert advice and counsel, which unfortunately isn’t free. However, if you do your homework (as noted above) and if you select an attorney who has substantial experience working with companies that are similar to yours in terms of maturity and industry, he or she should be able to give you valuable advice and guidance about how to make sure you deal with these issues thoughtfully and in a cost-effective manner. And, unlike the other resources noted above, you can share information freely with your attorney and rest assured that the information is generally protected under the attorney-client privilege.
Nobody likes spending time and money dealing with red tape and bureaucracy, especially when your resources can be spent executing on the business plan. However, a thoughtful and careful approach to dealing with these issues now will save you time, money, and headaches later, and just might save your deal.
7. Unjustified Delays
Selling a business takes a lot of time and effort. When a Seller embarks on a sale process, we generally tell them to expect that they’re going to have two full-time jobs for the next several months: running the business and selling the business.
While it can be incredibly hard to juggle everything that needs to be done, it’s critically important for both sides to move quickly for several reasons. Why? Here are a few common ones:
- (a) Time creates more wounds than it heals – Especially from the Seller’s perspective, once the letter of intent is signed, the deal almost never gets better. Bad things happen. Until the ink is dry and the money is wired, there’s always a real chance that something unexpected happens and craters the deal.
- (b) The parties may be weighing multiple opportunities – In many cases, either the Buyer or the Seller has decided to pursue a particular deal in lieu of another. However, if it becomes apparent that the deal it chose isn’t going according to plan, one of the parties may decide to bail out and resurrect one of those other potential deals.
- (c) Expenses are racking up – Both the Buyer and the Seller are incurring substantial fees and expenses in pursuing the deal. If things aren’t going smoothly or quickly enough, these mounting expenses may be enough to push one of the parties to cut bait before things get worse.
- (d) Third party pressures – Some of the urgency comes from external sources, such as investors, lenders, franchisors, or other interested parties. Those third parties aren’t going to care about why the deal wasn’t done in a timely manner.
- (e) Impressions matter – Until the deal is done, each of the parties should be aware that every interaction with the other will help form an impression, good or bad. If a party – rightly or wrongly – associates the delay with the disorganization, inability to execute, poor management, or poor judgment of the other, the deal could fall apart quickly.
Before getting into an exclusive relationship, it’s important for both the Buyer and the Seller to have identified and engaged an experienced deal team. While Sellers often think due diligence is the Buyer’s problem, the Seller needs to be organized and responsive to the Buyer’s requests. The Seller should even undergo its own internal due diligence investigation early in the process so that it’s prepared to address any issues that might arise.
Both the Buyer and the Seller will need to be flexible and able to respond quickly and thoughtfully as things develop in the deal. Save the six-week cruise around the world until after the deal is done.
8. Hiding the Skeletons
Every company has a few skeletons in its closet – those not-so-flattering items that keep the owners up at night.
The natural tendency is to keep those skeletons in the closet. “Whatever we do, we can’t let the Buyer know about that!” However, tempting as it might be, it’s actually a terrible idea to try to conceal these skeletons.
Buyers don’t like surprises. Disclosing these skeletons is uncomfortable, but it’s important to disclose these items – in a strategic manner. If done properly, this disclosure builds valuable trust with the Buyer. On the other hand, if the Buyer finds these skeletons on its own, it immediately begins to question whether you’re actively concealing other problems, or aren’t even aware of the problems. Neither is a good look.
However, before disclosing to the Buyer, it’s important to have a strategy in place for how you propose to address the problem. Identifying the issue without presenting a possible solution will not give the Buyer much comfort.
That’s not to say that Buyers will be thrilled when they learn about these issues. And, it’s still possible that the issue becomes a deal-killer. But dealing with these issues in an upfront manner and with a proposed potential solution stands a much better chance of saving the deal than letting the Buyer uncover it on its own.
Next Month: Material Adverse Effect After the Akorn Decision
Read last month’s piece: Survival Periods