redactedWe all know our ABCs, but it’s easier said than done when it comes to always closing deals. When those deals are multimillion dollar business transactions, there’s guaranteed to be more hiccups than Dumbo after drinking “water.” I’ve got plenty of experience ironing out these issues, but I wanted to get even more perspective from the legal side of things, so I met with Bill Barlow at Barlow & Williams. He’s got a background in private equity and M&A, and today, his firm represents buyers, sellers, independent sponsors, searchers, and business owners across Main Street and the lower middle market. While we approach things from different perspectives, we kept coming back to a few of the same conclusions. I’ve unpacked them below, or you’re welcome to watch the video. Advisors…Schmadvisors As an advisor myself, it’s a bit strange to start off with this, but I will. The most important people in a transaction are not the advisors. It’s always the buyer and the seller. Bill shared a story about a particular $6-7 (yes, I see it) million acquisition that started with a difficult negotiation around the LOI and deposit. For whatever reason, the process became challenging and delayed the closing. Despite the rocky start, the sellers continued operating the company and supporting the transaction. During the delayed closing period, the sellers generated roughly $200,000 of additional business. Lawyers, CPAs, lenders, brokers, and QoE providers need to know when to push on an issue and when to get out of the way. A good advisor protects the client without creating problems between two parties that ultimately need to work together. In this case, the seller was not pulled away from their business in order to address the delayed closing, which ended up yielding plenty of value for both sides due to the growth. Sellers Still Have to Run the Business One of the biggest mistakes a seller can make is mentally checking out once the LOI is signed. Much like the “happy weight” people gain after getting married, sellers sometimes take a LOI as a ticket to sitting back and relaxing. Unfortunately, the deal is not done yet, and the company still needs to perform. As we discussed, “winning cures all.” Revenue will have a direct effect on how the diligence process goes. If revenue and earnings continue growing during diligence, buyers and lenders tend to feel much more comfortable. If year-to-date performance suddenly declines, everyone starts asking questions. While buyers might be willing to overlook a dip in revenue, the lenders would be less lenient. Inconsistencies will lead to questions, which will lead to delays, which will lead to dead deals. The #1 Problem in M&A Transactions I’ll spare you the suspense. It is a disagreement about EBITDA. The original EBITDA presented to the buyer ends up not matching what popped out the other side after the diligence process. That being said, not every difference will kill a deal. In my experience, the threshold falls around 10% for it to be manageable. Anything over that typically leads to some sort of renegotiation. When the gap becomes extremely large (say, more than 35%), the transaction becomes very difficult to save. I may have pulled those numbers out of thin air, but regardless, they should serve to prove a point. Sellers need to validate their earnings before going to market if they hope to close the first time around. During the EBITDA evaluation process, it is common to see some aggressive add-backs. For example, eliminating marketing expense isn’t necessarily a legitimate add-back, assuming you can make the argument that marketing helped generate revenue. Another example would be payroll, where a seller likes to argue that certain employees aren’t needed. These discrepancies will all need to be sorted out during the diligence process in order to arrive at a common ground regarding EBITDA. It’s All Latin to Me Bill got to flex some of his legal muscles in this part of our conversation, particularly about where legal negotiations can become overly aggressive. On sell-side transactions, he is particularly careful with unlimited indemnification and extremely broad representations. His goal is to make sure that the seller can actually keep the proceeds from the transaction rather than remain exposed indefinitely. Of course, this goal stands without the presence of something significant such as fraud, tax liabilities, or another major issue. According to Bill, representations and warranties should survive somewhere between 12 and 24 months. These periods can actually be a part of the negotiation process, and certain fundamental representations or tax liabilities may survive significantly longer. Another protection sellers should look to understand is tail insurance. Bill explained that tail coverage can protect sellers from post-close claims that relate to pre-close events. Depending on the circumstances, the way these claims shake out can be important in both asset and stock transactions. Do You Take Cash, Card, or Working Capital? We spent a fair amount of time discussing net working capital, an area that buyers and sellers frequently misunderstand. When a business is purchased based on a multiple of EBITDA, the purchase price generally factors in a normalized level of working capital necessary to operate the company. The age-old metaphor here is having some gas in the tank when you buy a new car. In simplified terms, net working capital is current assets minus current liabilities, excluding items that are treated as cash-like or debt-like. Let’s look at an example with inventory. A buyer shouldn’t necessarily pay extra for every dollar’s worth of inventory sitting in the warehouse. Let’s say a business historically requires $500,000 of inventory to generate its earnings and has $700,000 at closing. If you have a fair discussion going on, it should really focus on the excess relative to the normal amount (i.e., $200,000) rather than the total amount. Doing this evaluation properly means the buyer is not simply paying separately for the entire $700,000. Personally, I strongly disagree with the idea that a buyer should simply “get the working capital from the bank” after closing. I think it should be factored into the price of what you’re actually buying. Be Diligent With Your Diligence One of my favorite points from Bill was how his firm sequences a transaction. His team may help clients perform initial diligence for a week or two, but they generally don’t begin heavily drafting the purchase agreement until the quality of earnings report is substantially complete. In his experience, there’s little reason to spend significant legal fees negotiating a purchase agreement for a transaction that may die during diligence. Along the same lines, the amount of diligence can vary by industry. For example, construction has some complicated financials because of its percentage-of-completion accounting, working-capital requirements, regulation, and project-level margins. Bill brought up asset-heavy businesses, including non-emergency medical transportation. In that industry, EBITDA can look very attractive if you ignore the economic reality that vehicles or equipment constantly need to be repaired and replaced. Buy the Horse, Not the Jockey Bill closed with an analogy I thought summarized the entire conversation well. He compared an M&A transaction and its players to a horse, a jockey, and trainers. The horse is the company, the jockey is the buyer, and the trainers are the advisors. While all three parties matter, the most important variable in a race is the horse. I think. I don’t know much about horse racing outside of Secretariat being pretty fast. At the end of the day, if the company is a mediocre one, there’s no combination of buyers/advisors that’s going to turn it into a big-time winner. Of course, there are situations where a good company has bad management or missed opportunities. In that case, new owners can certainly introduce upside. The key is determining whether it’s the financials that are weak or the underlying business itself. Closing Thoughts All of the stories and details we talked tended to orbit around the idea that buying and selling businesses is hard. Our advice is to surround yourself with people who regularly work on transactions. Part of the value of an experienced M&A attorney, QoE provider, lender, or other advisor is pattern recognition from hundreds of other challenging deals. We are well aware of what things are normal, what differences can be negotiated, and what disagreements should cause you to reconsider the deal. If you’re considering navigating through this process, feel free to set up some time to talk with me.