Strategy appetite alignment
Suppose you want to set up an M&A shop that's decent at getting deals across the line and delivers a reasonable amount of volume for the organization. In that case, the first step is to ensure a clear strategic appetite for the types of transactions you want to go by.
Presumably, we're talking about bolt-on transactions where you're buying things that look like you but are much smaller and leveraging your economies of scale and your existing infrastructure to deliver services for the business you're acquiring.
If you have a clear strategic appetite, then the universe of potential targets becomes significantly clearer. The first thing we do is make sure that we've got a view of what the universe list looks like. And you can do that through various third-party data sources or databases that you can acquire or build yourself with the help of some consultants.
After completing that homework, the next step is to get your sourcing team working. We have a sourcing team staffed by very senior, experienced hires in the wealth management industry. These are individuals that are nearing retirement or are retired and are just looking for some extra things to do.
They are very good, and they got a very deep Rolodex. They know the industry very well, and they've got a good feel for whether there would be a strategic fit between you and a target. We have a couple of individuals on staff that help us with that, and they do the initial outreach to these targets.
It's crucial that that outreach is done by somebody credible to the targets you're going after. But all of this presumes we're talking about a very proactive search process instead of being reactive to processes run by bankers.
Bilateral is the best way and will yield better outcomes than auctions. Bilateral deals mean just two parties in discussions. They may have a banker acting as an agent for the seller, but you do get in trilateral deals occasionally, which are not fun.
Those generally involve a partnership or some type of other minority investment where you got a bunch of different parties coming together. They are a nightmare and are exponentially more complex. It's very challenging to get multi-party transactions done.
But for bilateral deals, the issue is just first making the outreach. You will find that some people hire consultants. I've done this three times where I've helped a business that was already engaged with a consultant, trying to build their universe list, and the consultants would flip, do some outbound dialing, and try to gauge appetite with those particular targets on whether they would be interested in having a discussion.
Those have gone very poorly. I didn't succeed with those at all, and the quality of the consultants was high.
In one instance, it used a pretty high-quality banker on the buy side. We engaged it on buy-side engagement to help us identify targets in a specific area of interest. They did a great job of making that universe list, but they were poor at converting those targets into actionable ones.
We've had a lot more success if the individual doing the initial outreach is somebody that is:
- On staff
- Has a pre-existing relationship
- Has a name or credibility in the market that is easy to test
Engaging with the target
You have to have the right person doing that initial conversation, and it has to be somebody credible. Suppose you have your junior analyst doing the outbound dialing and they're simply dialing for dollars. In that case, it is unlikely to be successful in the context of what we are attempting to buy.
If you were buying private seller, owner-operated businesses, meaning the individual you're calling has probably been building that business for the past 30 years, and they're also the CEO or the larger shareholder of the business. This transaction will be the biggest financial transaction that they ever do.
They have hired every single person that is of any consequence in any organization, and they spend more time with those individuals than they have their own families. They care about their employees, and their clients are probably their friends and families, so they care about their clients a great deal as well.
In any transaction, as you approach the sellers' mindset for a private seller transaction, they want to get top dollar, but at the same time, they care deeply about their people and clients. So they want to ensure they're not embarrassed in any part of the transaction.
With that backdrop, your sourcing and initial outreach must be aware and respectful of the seller's priorities. So if you have somebody who believes they are simply trying to maximize purchase price and have no other concerns, you're likely to get a fairly cold reception.
That being said, there are also other sellers, like corporate sellers do carve-outs, and their priorities are very different. So how you activate those transactions is also very different. But for the most part, the larger universe is privately owned businesses.
In general, you can't have analysts lead the charge, although I know some industries do that. Those are hot industries where everybody is looking to sell. That could work if you've got an overload of businesses looking for buyers. But for the most part, have a senior person do that initial outreach and see if there is an appetite for a conversation.
You're not calling to ask whether they want to sell their business. The initial outreach is about having that first conversation to get to know each other. The goal is to understand their vision for how this business evolves and let them guide the conversation.
Depending on where that conversation goes, there might be an appetite to explore the art of the possible between you and the target. That's what you're attempting to get them into.
There will be objections to that. The primary objection to exploring the art of the possible is if people were to find out that you were in discussions, that could potentially harm the business. There is a bit of a Hippocratic oath when you go through this: to "do no harm."
You need to be credible when you have those conversations with them that you're going to keep it very tight, and any exploration between the two parties would involve a very small number of folks involved, a handful of the corp dev team, and the CEO, CFO, and that's it. Make sure it will not leak and assure you can have those conversations safely.
As a demonstration, you can lean on the fact that I've had 50 of those conversations already this year, and you haven't heard about any of them. There are ways to give proof points that you can do that transaction successfully for the seller. But the goal is to explore the art of the possible. If you can get them to that mindset, you're onto the next process.
The first thing you need to do is promptly put an NDA in place. Signing the NDA will almost always trigger certain things in the process, like notifying people, depending on the steps in your corporate development process.
In our specific process, I look after the sourcing and the other senior executive who does that for us. But once we get to a signed NDA, the members of my corporate development team, the directors, and the folks leading the deal teams get involved.
The reason is that the first thing you need to do is to do some diligence so that you can start to figure out the following:
- What would a transaction structure look like
- What would valuation look like
For that, you will need a little bit of data. You want to avoid hitting them with a hundred-line due diligence request. You want to hit them with something very limited around historical financials and enough legal information so that you can understand how to put the deal together.
Then you bring in just a small number of folks. In this instance, I would bring in a director and his analyst to help him with the transaction. To introduce them to the team, provide an initial data request and ask and ensure that the seller understands that we want canned information. It should be historical financials for three to five years and a basic legal structure.
You want to understand the perimeter of the transaction so you can understand what the financial statements represent. Then, there's probably one call with the bookkeeper to walk through their financials to ensure you know what's in and out. Then you can build or populate your valuation template.
The valuation template provides a value, and there are assumptions around synergies, both revenue and expense. The most common mistake companies make is that they want to get an accurate number when delivering an LOI.
This often comes at the expense of speed and requires significantly more diligence than is needed. So the way you should approach it is the amount of diligence you want to do pre-LOI needs to reflect the cost of your full-blown due diligence effort after you sign the LOI.
If you're going to spend a lot of money on external advisors, say half a million dollars or a million dollars on advisors, in your diligence effort to get to definitive docs. You probably should make sure that your LOI is pretty close to being in the ballpark.
You can take a bit more risk if it's a more minor transaction with significantly lower diligence costs. The inexperienced Corp Dev team generally has enough thumb rules around where these synergies are going to be, how to estimate the rough size and magnitude of each of those sources, and the viability of achieving them so that they can come up with a decent estimation.
If you document your assumptions, structure, and value in the LOI, you can adjust the value as the assumptions change during your diligence process. The key is you don't want to seem random or capricious. You certainly don't want to be viewed as retrading value.
Documenting assumptions in an LOI
The assumptions are easier than you expect. Sometimes, the sellers indicate revenue, EBITDA, the number of assets, and a specific key metric. It doesn't necessarily need to be only financial metrics. It can be non-financial metrics as well.
For example, your LOI will have a structure, value, contingent consideration, and earnouts section. Then the fourth or fifth paragraph is about assumptions. Then you'll get into employees, legal structure, integration, operations, and a whole bunch of other things.
But in the assumptions, you can indicate that this letter of intent is predicated upon the following assumptions that have yet to be diligenced.
In the financials, you can list off revenue and EBITDA.
If the number of widgets being sold per year is an important metric, then you put the number of widgets in there that you believe have been sold or were represented that have been sold.
Even if it's not provided to you but is a critical metric, and that's how you're basing your value, you can write that down. But it needs to be the key metric, not every metric.
You can also put something in there about people, such as retention. The assumption is the management team will come over as part of the transaction and be retained through close. It doesn't necessarily need to be there. You probably got a paragraph on employees indicating that:
- You desire or require that the management team will transition through close
- Certain members will have agreed to employment contracts
- The retention plan will be implemented to ensure the management team is retained post-close.
Who is involved
The probability of a successful outcome when you're courting targets in this stage is still low. It's always low because it's not diligence yet, so the burden you want to put on the organization needs to be commensurate with the probability of a successful outcome.
Because you're just doing LOIs and churning through LOIs, I don't want to be grinding 50 people in the organization to help me come up with what will look like a phase one around one bid now.
If it's a billion-dollar acquisition, that's a different topic. But still, with a round one bid for something like that, the number of people involved will look very different than a round two offering when you're making a full-blown diligence effort.
For small deals, from 20 to $150 million, you want to keep it in the corp dev team, leveraging preexisting or historical precedent or some of the other transactions you've done. That is so that you can build those models without burdening the rest of the organization on helping you construct a financial model.
Usually, the people involved are my deal team - director, analyst, and myself so you've always got two sets of eyes on a model and our legal attorney. You're not even using outside counsel yet. I don't get HR at this stage, not for a smaller LOI.
You've got pattern recognition on how certain deals will get structured and the likely outcome of synergies. You're ballparking it at this stage, so it's good enough to get the LOI out the door. You're not going to be that far off if you've done this.
If this is the first LOI you've ever issued, involve the functional leaders, but you must keep it small for your initial LOI. If it's a bigger deal, around $500 million plus, I will review my assumptions with the key functional leaders to ensure we're in the right ballpark.
You wouldn't need advisors in the pre-LOI stage. The likelihood is it's going to fail. They cost money, and I wouldn't want to do that until you know you got a deal.
Negotiating the LOI
When negotiating the LOI, there will be a back and forth and you will be trading risk for value. So you're trying to find out if there's a middle ground that allows both parties to be equally happy or unhappy.
In professional services organizations, since the people are the most important asset of the firm, often the way to bridge those valuation gaps is by using contingent consideration or earnouts.
In an earnout, the seller wants a multiple of (X), but the buyer is only willing to pay (Y). For the buyer to believe the business is worth the multiple of (X), it must grow at a specific rate. The buyer will pay a portion of the value at closing. For the rest, the buyer will put in an earnout, contingent upon the seller's ability to demonstrate that the business can grow at the levels they indicate it can.
If the seller achieves those growth rates, the buyer will pay additional consideration in years, however long you want to put it out there. That's an easy way to bridge valuation gaps between buyer and seller.
That comes with the warning that earnouts can go bad quickly if they're not properly documented, structured, and thought through. You need counsel to help you if you haven't done them before.
Counsel is critical as they understand how to structure earnouts and how not to structure them, and they can also have unintended consequences on integrated entities.
For example, integrating a new team into an existing one; if they've both got sales functions, you could cause disharmony between the two organizations if part of the organization is subject to an earnout and part of it isn't. Many considerations need to be considered when doing those types of structures.
I am a pro earnout. I like using earnouts, and they motivate the right behavior. We've had enough scars that we know what mistakes not to repeat, and we've got enough experience with them to use them safely.
But they can lead to some true horror stories. So there is a risk for sure, so it is critical to get good and competent counsel to help you structure them appropriately.
During the pandemic, there was a market risk like any other market risk and a market variable like any other market variable. Depending on how you've agreed to share risk with a seller, you've either agreed to bear that, share it, or push it all to them. That's one of the many risk factors that will have to be taken into consideration.
- People risk
- Client risk
- Market risk
All of that boils down to the framework you've adopted in the transaction.
Making them look formal is important. Generally, it has good optic value, looks official, and will be given better consideration than if you just slapped it together.
There's a lot of it that you can reuse. There's almost always a lead-in section on who you are and why you're a wonderful firm and a good acquirer. Even if they're friendly and they've known you for 30 years, it's still important to reiterate that and ensure that you deliver your best show.
We've already had a verbal conversation with the seller about value. So we step them into a couple of conversations before the LOI gets delivered.
The first conversation is after we get the financial metrics and build the P&L. We then walk through that P&L that's been recategorized into how we view PnL, what was reported, and any proforma adjustments we may be making.
Just so we can get an agreement with the seller around the numbers that we're bidding off of and get them to tell us their EBITDA. That's valuable because the next verbal conversation with them after you've locked that down will be a discussion about how you value the business.
What is the multiple of EBITDA, what is the transaction's structure, what would it mean for the seller, and sometimes, discuss earnouts? Either you're talking through an email you sent before that conversation, or you're walking through a document you shared on a zoom call.
Then you're gauging their response after that. If they've thrown up all over that, there's no need for an LOI. On the other hand, if they react from neutral to positive, then you need to send the LOI.
We put the same content in a pitch deck. We're doing around 5 to 8 pages for a letter of intent. It can be 15 pages long for big transactions, and it's all text. If it's a simple transaction, the first couple of pages is about the firm's background and the relevant history they're going to care about. The intent is for them to understand the key elements of your value prop.
We're a mature acquirer, and we want them to walk away knowing we've integrated and delivered value to sellers. The next step to focus on is the proposal and how it'll be structured.
- How do you value their firm?
- What shareholder proceeds would look like based on the balance sheet that you got?
- What were the assumptions that went into your evaluation?
- What to do with the employees?
- How to integrate the firm?
- What would operations look like post-close?
In the end, you get into the non-binding nature, the confidentiality paragraph, and the exclusivity paragraph. You almost always want that, so it adds. You get the five pages or eight pages quickly.
Public company deals
Public company deals happen very differently. There are three different processes:
- Bilateral process - where we're talking with other private companies about potentially acquiring them, which is what we're talking about here. There are only two companies involved in this process.
- Corporate carve-out - has a slightly different process in terms of sourcing.
- Auction process - another major way to get deal volume with bankers on inbounds. That process will be much more scripted. They'll give you a process letter, which will spell out what the bankers want to see in your bid letter and cover several paragraphs.
It behooves you to deliver a compliant bid response, so you want to ensure you're touching on every item they have questions about.
When sourcing carve-out, you would want to rub elbows with other Corp Dev leaders or CEOs to find those opportunities. In this case, your sourcing leader is leaning on you trying to set up conversations with you and other Corp Dev leaders within those organizations to ask them. If they've gone through a strategic review or if there's an appetite to even look at what the art of the possible might be with a division that their competitors have recently sold.
What you may be seeing is a certain segment or business unit within an industry is frequently being sold at the moment that many industry participants are, feel that continued ownership of a specific segment is no longer attractive and it's more valuable land of somebody else, and they're going through a lot of disposals.
Not everybody in the industry may have come upon that revelation or believe it is the correct outcome. So we will call those folks and ensure that we see the same rationale that other folks have seen.
More often than not, the way to approach them is to acknowledge that they are going through a strategic review process, either expressly or implicitly, through the budgeting process every year. It would be helpful and best if they had real numbers when deciding whether to retain a business unit or explore strategic options.
But you're not engaged with them, so they would sell you the business. Inform them of how you value the business so they can have a real view of what they are worth instead of hypothetical numbers. The goal is to get in early so that if they decide to sell, they may reach out to you before running a process.
This only works for private companies because rarely do publicly-traded companies sell without an auction. They almost always go through an auction because they have a fiduciary duty to get the maximum amount for their business.
Other things to negotiate in an LOI
You're going to move, so you're certainly not opening with your final value number. You always have to leave some wiggle rooms that you can negotiate. But you don't want to be overly conservative in your initial offer.
You want to avoid being in a position where you have to pull your offer. If you're overly conservative, you can easily either turn off the bidder, and they won't even engage with you, especially if they feel like they've been offended by your valuation.
You might not even make it in round two if it's a competitive auction. You need to be careful on the sandbagging to deliver a good value, but you still have enough room to maneuver.
Any other term that's material to negotiate in an asset deal or an equity deal is: is there a key employee that you need? Or is there a key management team that you need? Anything that is front and center and critical that would torpedo the deal in your eyes, you ought to put in the negotiations.
Every seller has a different motivation to sell. You'll figure that out in your discussions with them about what's motivating the transaction. Why are they discussing this with you? Have that talk first. And if there are almost always priorities outside of just transaction value, rarely are they going to simply say they want to maximize purchase price. There are other things as well.
- Do you want to continue to engage in the business?
- Do you want to retire?
- Are you willing to spend more time with your grandchildren?
- Are you looking to start a different business or enter a different chapter of your life?
All of that matters and influences the terms you can offer, and if you can be highly responsive to those other needs, that's complimentary to your purchase price. You don't necessarily have to be the person with the highest purchase price to win the deal, especially if you can fully address the other crucial considerations to the seller.
We step into that initial conversation, the financials first, and agree on what is truly the EBITDA of the business, because there are many performance adjustments that you've missed or some one-time expenses that ought to come out, especially if they're owner-operated businesses.
Frequently, personal expenses flowing through their P&L wouldn't continue post-close, so you need to ensure you're getting the right performance adjustments.
Once you've agreed on the numbers, it's going to be hard to argue that you're going to be offensive. The risk that your deal is offensive goes down dramatically because market multiples are what market multiples are.
Speed and accuracy
You've got some historical financials. You're making assumptions about what the CapEx will be moving forward. You're making assumptions around the seller's balance sheet, historical find, revenue, and EBITDA.
From that, you can build your P&L by stating those assumptions to the extent confirmatory diligence reveals:
- undisclosed liabilities that didn't reflect on their balance sheet
- inaccuracies or perform adjustments that need to be made
- Potentially, alleged one-time expenses aren't one-time but recurring.
Then, you've got a basis to go back and adjust the value. So coming out with a quick bid is important, and you can get a lot of the accuracy needed.
The goal isn't getting the right number. The goal is to provide a number that has a solid basis where you can make adjustments so that you do not look like you're retrading the price. If it takes you forever to do pre-confirmatory diligence to get to an LOI, you're sending a signal to the seller:
- that you are difficult to negotiate with
- that it's going to take forever to get a contract
- that you're going to take forever for confirmatory diligence.
If this took three months to negotiate an LOI, how long before you get to definitive docs, and what will that look like? It's helpful that you get as many at-bats as possible and get them quickly. The faster you are, the fewer internal resources you're consuming to get there so that you can do more LOIs with the same amount of resources, costing the organization less.