I am a big fan of deal postmortems–the time you take to assess what went right, what went wrong and how you would do things differently if you had to do it all over again. With each done deal, volumes can be gleaned as educational and helpful in how you would proceed if you had the opportunity for round #2. Of all the “done deal” postmortems, I have perhaps learned the most from the deals that failed to cross the finish line. Deal failure is certainly not the aim of any intermediary, but anyone who has been in the business long enough is lying if they tell you all the deals in which they have been engaged have nailed the intended outcome. Anyone who has been in the industry long enough has the occasional failure. The hope is that not only do the percentage of failed deals decrease, but that expert deal-facilitators are able to spot deal-crushing issues before they spiral out of control. In the spirit of both transparency and enlightenment, here are some items I have learned from failed transactions.
In my experience, the biggest gap between buyers and sellers occurs on the part of the seller, who thinks his/her business is worth more than the market will bear. This idea is much more prevalent on a deal in the lower middle-market where buyers are often banking on the company sale to over-fund retirement. Once you get above the EBITDA size thresholds, seller’s tend to become more reasonable in how they value their businesses. There are a number of reasons for this including wants vs. needs, seller sophistication, treating comparable outliers appropriately and following the advice of valuation and transaction professionals.
If I perform a simple rough tally on failed deals, the percentage where seller valuation expectations was the big hurdle, would likely hit above 80%. Put differently, most deals fail–or never start–because the seller or issuer is not reasonable in expectations on value.
For sell-side M&A, seller’s often have a value in their mind that equates to their baseline on what they would be willing to receive were the business to sell today. Whether that reverse-engineered number is reasonable or not is typically irrelevant and thus a deal stopper. The deal is often dead before it begins (regardless of the type of offering being run). For instance, a potential pre-profit issuer with only $5M in sales may say, “we want to raise $10M and in exchange we are willing to give up 10% of our business.” For the layperson, this is a $100M valuation on a pre-profit company that is doing only $5M in sales. Even with an astronomical growth rate, most investors will not even get up in the morning unless they can receive >20% of the company’s equity. This is an example of a DOA deal. It is one that most competent and ethical investment bankers will refuse to represent.
In the words of Warren Buffet, “price is what you pay, value is what you get.” Sellers that get greedy and/or unrealistic on value are typically the biggest deal killers, especially if you dip down into the lower middle-market.
Middle and lower middle-market M&A is currently a seller’s market and I expect it will remain so for some time. Gone are the days that buyers could simply acquire company assets for less than depreciated book value. Today’s market includes cheap and abundant capital (which creates high demand for deals), a fairly steady number of company sellers and a large number of financial and strategic buyers. As a prominent private equity buyer put to me recently, “we always pay at least market value for good deals. It’s not even an option anymore.” In other words, the Rational Pricing Theory also applies to middle-market M&A.
The trouble–and potential for deal failure–occurs when a buyer comes in, offers a more than fair price in a letter of intent, but then extracts any premium out (and then some) through an highly over-burdensome due diligence process. These types of buyers are sometimes referred to as “grinders” as they “grind” down value post-LOI. They use the exclusivity position for due diligence as leverage to eek out every last dime from the seller using their prowess in due diligence. Most of this is done through lack of appropriate net working capital disclosures, which we have previously discussed.
Again, most of the over-negotiated deals come as the business sizes dip down into the lower mid-market. Hence the reason the most legit buyers and seller intermediaries have their own limits on the size and type of businesses in which they will work.
It is a known fact, that the majority of business sellers are looking to retire. Some of them are getting on in years and still have a large portion of their net worth tied to their business–which assets are almost always illiquid. A couple of years ago we worked a deal with a company seller who ran an extremely successful and profitable business. He was in his mid-70’s and “logic” told him it was time to sell. After running a typical broad-auction on the business with multiple strategic buyers at the table, a letter of intent was mutually executed by both parties with an agreed-upon sales multiple that was 2x above market. The seller was extremely pleased with the process. However, in the 11th hour of due diligence, something happened in the seller’s brain that caused a complete deal implosion. He reasoned:
Unfortunately, this seller not only rejected a fantastic valuation, but he had burned a bridge with the most strategic buyer in the market who had a strong reason to pay a premium for the business.
It is extremely difficult to admit that all good things must eventually end. And seller’s remorse, regardless of how good a deal the seller may receive, can be an extremely real threat to getting a deal done. Volumes could be spoken regarding the risk/return trade-off of a deal involving an aged seller that has trouble letting go. In my experience, the aged seller is often in the way of potential business growth. It is likely too morbid to say, but all company owners eventually need a transition plan.
Lack of explicitly outlined objectives, at any time during the capital process, means assumptions rule. Undefined assumptions, particularly when the reside in the mind of the seller or issuer, can be extremely dangerous to the process. Getting assumptions, desires and deal specifics on the table early and revisiting frequently helps to grease the skids between issuer and investor.
Here is a simple “for instance” example that may help paint a picture. We were representing a client that had a specific and somewhat non-standard expectation about his employment contract during the transition and post-transaction involvement. In his mind, his desires were typical, standard and–for him–non-negotiable. When he brought them up during due diligence and purchase & sale agreement negotiations, they came somewhat out of left field. He also failed to discuss them with us prior to discussing them with the buyer. Although we had spent hours discussing with this client his desires and requests for the business going forward, he had failed to divulge some of these seemingly small details. In addition, we had failed to dig deep enough to extract these issues until they emerged as near deal-killers.
Fortunately for all involved, the points were ancillary to some of the bigger issues and the deal finally progressed to a close. The story still illustrates the point that all desires and expectations should be voiced, explicit, written and discussed early and often with all stakeholders. It is always best to err on the side of candid communication.
Timing on macro, time to market, speed in market and speed in due diligence all have an impact on the performance of any deal. As the saying goes, “time kills all good deals.” Regardless of the revenue and EBITDA of a particular company, deals can get stale. If a deal is not quickly and efficiently brought to market and the various potential suitors brought to the table quickly, then deals can lose their luster rather quickly. A potential investor may see a teaser on an opportunity, but if proper and quick follow-ups are not made and this same buyer sees information on the same deal several months later, they may begin asking themselves, “why has this deal not yet progressed passed the marketing stage? Have others vetted this deal only to find skeletons in the closet?” There is a natural tendency to second-guess the viability of a deal when they know that several hundred other sponsors have likely seen it and it remains in-market.
Buyers certainly need their time to perform ample checks and rechecks on what is typically a significant investment, but experience has taught that timing is most important on the part of the seller. Issuers who are slow or non-responsive to general information and due diligence requests will find buyers quickly read between the lines thinking the lack of promptness is a result of incompetence, subterfuge or worse. When issuers are the bottleneck on a deal, the potential for deal implosion skyrockets.
Emotion can be a powerful negotiating tool that can pull a deal in the direction you desire. It can also be likened to gasoline on an already-consuming fire. If not kept in check, emotion can cause deal implosion. This is one of the more difficult hurdles for most entrepreneurs. When any of the other issues start to make the deal a bit more difficult and less smooth than they had anticipated, negative emotion easily surfaces. Here are two principles on emotion that are key when it comes to deal-making:
Other waves of emotion, including thoughts parallel to seller’s remorse (spoken of above) are not uncommon. In order to move to a successful sale, the desire, need or drive toward an exit should outweigh any emotion inherent in the investment banking process.
While rare, demographics can play a role in the dynamics of a deal. For instance, during the sale of a software consulting company the seller executed a letter of intent with a strategic buyer who, in his own words, had a higher perceived social/economic status than the seller. This was brought about by cultural, race and country-of-origin differences between buyer and seller. While it is sad this still exists in modern America, it does. This created a completely unwanted and unexpected dynamic to the deal. The buyer routinely looked for ways to create difficultly in the deal, including speaking to employees about transition, badmouthing the sellers and causing grief to all parties involved in hopes to get a better price at close. The deal ultimately closed, but the sellers and the business itself sustained some major blows in the process.
This example is likely a bit rare, but could likely play itself out in other ways and should be given consideration when a issuer or seller is assessing and weighing apples-to-apples comparisons among various buyers.
A poorly worded or structured letter of intent (LOI) is one of the main reasons M&A deals blow up. This is often the case when people try to either navigate this process without an advisor or save money. As with most of the things in life, you get what you pay for. But what is an LOI? When you are looking to sell your company, you often ask for offers from buyers in the form of an LOI. In general, this includes terms and conditions that are ultimately negotiated until the seller and buyer dual sign the LOI. What is very important here and that you need to remember is that the LOI is non-binding. This is important because it ultimately gives both parties an “out”. For this reason, when wording an LOI you need to find a balance between the buyer and seller. Pressing too hard for strict terms as a buyer is a waste of time and being too vague can come back to bite you. Losing a deal due to a poorly written LOI is a waste of everyone’s time and normally your money.
Generally, the buyer will not be a first-time buyer (of course except when they are), especially if you are selling to an institution. They will push you for vague terms, as ultimately this gives them more wriggle room. They will want a LOI that gives them the advantage. The buyers you are dealing with would have probably learned some important and costly lessons in the past. They will, therefore, try and avoid past mistakes but including wording in your LOI to this extent. On the other hand, if you are the seller you will normally be a first-time seller and the whole process might seem very confusing. If you hire a skilled sell-side advisor, they will spot vague terms in favor of a buyer a mile away and will push you in the direction that is best for you.
Ultimately, the plan is to translate this LOI into a definitive purchase agreement. This is often lead by the buyer’s team of advisors. Therefore, any term open for interpretation, or more importantly in favor of the buyer, will be interpreted in favor of the buyer. As a seller, you need to decide which points you want to fight and which you can let through. Being too strict on LOI terms is nearly as bad as being too vague. The longer you fight, the longer you remain off the market. Buyers will be fighting terms across several deals and will therefore be less emotionally attached to the deal. As a seller, you are likely to be emotionally invested in your company as it is often your life’s hard work.
An important point to note is that it is common for the seller to interpret buyer challenges as a sign of bad faith. If you are dealing with institutions, this is simply business and they wouldn’t be doing their job if they didn’t try to get the best deal. You need to be careful, returning to other potential buyers you have previously rejected is likely to result in an even worse deal. The LOI is a very important document to get right the first time around.
The first, and arguably the most important thing you can do from day one, is to explain that there are several interested and qualified buyers. If you don’t have several buyers lined up, spend time finding them. Competitive tension will not only encourage someone to actually sign the LOI but ultimately increase the value of your company. If you can’t find several buyers, this is a job for your sell-side advisor. Don’t try and play this card too hard, or act “hard to get”. Unless they really need to buy your company, this attitude will generally result in them walking away. You should use the LOI to lead the initial negotiations. When you explain that terms are finalized, and you have multiple interested parties, the buyer can’t barter too hard.
We understand writing terms from different perspectives is hard. We have provided a very simple example below for a working capital term.
Although we are not suggesting using this specific term, we are trying to represent that the buyer’s language is vague and could lead to issues. The seller’s language is more detailed, and although there is still room for interpretation, it is more specific. The objective as a seller, during negotiations, is to truly understand the value of the various offers before countersigning the LOI. The last thing you want to do is arrive at the point of signing, and realize you started from a weak position. You can’t backtrack and walking away will affect how you look to other buyers you may have turned down previously. If you go back to the market after you have signed a LOI, it will likely be at a lower valuation.
Yogi Berra said it best. Every deal takes on a life of its own and an investor on fire could find one aspect they do not like and long-sought deal could be quickly doused. The potential pitfalls and challenges that occur from engagement to deal closure are many and varied. Until mutual signatures are on all the closing documents and cash has changed hands, literally anything can and does occur. The key is to be flexible, adaptive, creative and extremely active throughout the process. No one wants the next deal to end in the proverbial deal graveyard.