In The Trenches: Interview with John Carvalho
7:28PM Aug 22, 2022
John Carvalho, welcome to the show.
Thanks for having me, I really appreciate it, Steve.
Well, as usuall, we have a lot to get to today. So let's dive right in. Maybe before we get to the nitty gritty, John, maybe you can provide us with some context. And just tell us a bit more about yourself and your background, and what has led you to stone oak capital, and maybe a bit more about what Stone Oak Capital does?
Yeah, sure, definitely do that. So, started my career in corporate finance at a big accounting firm, was doing that for 10 years by sellside, due diligence, valuations, you name it, everything having to do with transactions. And just really kind of got a passion for doing deals, knew that that was kind of my highest and best use, I guess, you can say. But felt that I wanted to do it in a little bit more of a boutique setting. So after I felt like I had enough experience, and maybe enough kind of capital socked away that I couldn't live on my own for a little bit, I started Stone Oak Capital, you know, just knew I wanted to help entrepreneurs with buying and selling businesses in the lower middle market, I felt that there was a lot of kind of like, lack of education in that space, and just just need for really high quality professional advice. You know, through forming Stone Oak, I also jumped into a number of other ventures that I think are relevant.
Divestopedia is one, I partnered with an individual that had internet website, SEO experience. And we thought that we could really try to educate this lower middle market on buying and selling businesses. So, that's been moderately successful, I guess. One of the largest online publications providing kind of this educational resource on buying and selling businesses. And then in addition to that, I also partnered with what was originally a client, but became kind of a business partner, helped him acquire a business. And before I knew it, we had acquired 17 businesses and grew it from kind of $5 million in top line from that first business, we acquired to $250 million. Took it public in 2019. So that was kind of like a side venture that I never really anticipated, but one that I enjoyed thoroughly. And now I'm back into kind of the merger and acquisition advisory world with Stone Oak Capital, we do buy sell side engagements for lower middle market businesses, kind of in that 10 to $50 million space. So apologize for that long winded intro there, Steve?
No, that's great. Honestly, I wish my side ventures were as successful as a $250 million IPO.
Yeah, you know, it was again, credit to my partner, he was a guide that I could probably, in my history of working with entrepreneurs, he's probably like, one of of three people that I think could have executed on that strategy. So, if I'm being honest, I was just riding his coattails. I was good at doing acquisitions, but he was good at everything else.
Well, this podcast is my side hustle. So I have about $250 million to go to catch up to you. But anyways, that's for another day. So you are the guy to talk to as it relates to selling small and medium sized businesses. And that's what we're going to talk about today, John. So we're going to divide our discussion today into three sections. First, I want to talk to you about how to select an M&A advisor. I know a lot of CEOs listening to this who might be considering liquidity, have a lot of questions about how to select the right advisor. Section two, we're gonna get a little deeper and talk about fees because certainly when a CEO looks at an engagement letter from a potential sell side advisor, their eyes understandably, tend to go straight towards the fee section. So we're going to dig into that.
And then lastly, we'll kind of conclude with some more general questions related to selling businesses. But again, let's start with selecting an M&A advisor. And where I want to start is talking about how important is it? Or perhaps is it not, that the advisor in question has experience in the industry in question? So let's say that I'm running a software company, and I sell my software to construction companies. How important is it that my M&A advisor has either software experience or construction experience? And how do I weigh that against other variables? So for example, you know, they have specific experience with companies in my general size range. How do you think about weighing all those variables against each other?
Yeah, I mean, you know, great, great question. I don't know that I've I guess I have thought about this quite a bit. And you know, There's kind of a, the way that I view it if I was ranking kind of criteria that you should be looking for when selecting an M&A advisor. I'd put dealmaking at the top of the list, like how successful has the advisor been in just closed successfully closing deals. And that's a little bit of a loaded criteria, I guess. Because, you know, like a guy like myself, who has a very boutique advisory firm, I'm going to be selective in picking the firms and the clients that I think A, have a reasonable expectation of value. B, have a really good business that I think is attractive to the market, and then C, somebody that I believe that I have chemistry with, right. So, I try to increase the probability of me closing because obviously, that's how I get paid and compensated.
But first, I would say if someone is looking to select an advisor, are they a dealmaker? Can they actually close deals, what's their track, record their success record of closing deals? Then if you kind of get that out of the way, and there's like one person that has industry expertise, versus one person that doesn't, but they both have a good kind of close ratio, I definitely go with the person that has the industry expertise. Somebody that's kind of understands the nuances might understand the buyer landscape, understand, you know, maybe some of the characteristics that buyers would find attractive in that space and try to position your business for that. So that would definitely be a secondary criteria that I look at is like industry expertise. And there's other things to consider as well. And I think I think this one might get overlooked a little bit, but I would say, kind of proximity to the client.
So there's some times M&A advisors will come from these faraway lands in what's that saying where, you know, people trust profits from faraway lands more than they do profits kind of in their own backyard. I can't remember the exact saying, I'm probably butchering that. But I think people, if an M&A advisor approaches them, and they're from, you know, like, let's say Big City, USA, right. They kind of like think that that expertise or coming from that market is much more beneficial to them than kind of their local advisor. And I almost say it depends, right, it depends on how big the business is, it depends on how far reaching your businesses. So if your your business is national, then for sure, finding an advisor and kind of that bigger center might be bigger, because you're approaching bigger buyers.
But if you're most likely buyers, someone that's local, either a local competitor, or it's like a high net worth individual, a local private equity group, finding local representation might be beneficial. Just because that person might have a better kind of grasp on the landscape and who the most likely suitors would be for your company. So again, super long winded answer. I apologize for that. But I do think that some variables that you might not think are is important, are really important when you're thinking considering who the best advisor might be.
Yeah, another layer, I might put on top of that, in addition to the geographic one, which I think makes sense is the size of the advisor in question. So more specifically, in my experience, your transaction, so let's say if John near my advisor, my transaction, ideally needs to be big enough to be meaningful for you and your company. While in an ideal world, some entrepreneurs might convince themselves that they want Goldman Sachs or Morgan Stanley being your investment bank, ultimately, a $20 million dollar transaction would be less than a rounding error for them, but for a boutique, that would be very meaningful. And I suspect the resources that that boutique would put behind it would reflect just how meaningful that transaction is for them. How true does that ring in your experience?
Yeah, I think I think you're right. I don't think that I get in, if I take on a client, I don't look at like, okay, what's the size of the fee? And then how am I going to allocate my time and resources? You know, I look at it as I made a commitment to this company, and I'm going to help them close their deal, right. So the attention kind of goes to where the attention is needed. So if one deal is kind of in the throes of negotiating an LOI, then obviously more of my attention is going to go to that versus, you know, another company that might be just at the beginning kind of strategy phases of the transaction. So that's definitely important. The flip side of that, too, is also everybody wants to do a bigger deal, right? If a firm came to me and they were a half a billion dollar company, you know, I definitely want to do that because the fees would be substantial. But in some cases, you need to kind of match up the advisors, I guess, really kind of area of success. And that's not only industry, but that's also size. So you want to make sure that the advisor has experienced in closing deals for the size of business that you actually are. So definitely need to kind of do your due diligence when you're kind of interviewing for advisors and talking to various advisers on their capabilities and what they can handle.
So how does a CEO know whether she needs let's say, an investment bank, or a business broker, or, for example, the M&A firm within like a big four accounting firm or anything in between? How do you know what you need as the CEO? And maybe what are some of the major differences across each of those categories of sell side advisors?
Yeah, how do you know, I mean, a really tough question to answer from a business owners perspective, I think, it almost comes down to, you know. I know, from my perspective, I'm interviewing my clients as much as they're interviewing me. So it needs to be a real chemistry between the two of us. And I think that's something that's hard to quantify and put behind the checklists like, these are the things that you need to have to, to establish chemistry, right. Like, you just can't do that. So I would say, size really dictates if it's a broker versus kind of the M&A advisor. And I think the term M&A advisor, and investment bankers, a little bit more fluid in Canada than it is in the US, like investment banker would be more kind of bigger, you know, also deal with public companies. Where in most cases, M&A advisors on the private end, may be kind of that sub 100 million dollar business enterprise value wise.
So I guess I make that distinction first is size. S if your sub $5 million business, you're typically talking to a business broker, and the way that you even market, a sub $5 million business is different than how you would market a bigger business, right, with a sub $5 million business. It's probably isn't big enough to really be super attractive to strategics. So you need to cast a maybe a little bit, much wider net, and a business broker would be able to do that in a more efficient and effective manner with, say, $5 million, $200 million, and putting some really wide ranges here, but $5 million to $100 million, you're probably looking at an m&a advisor, that's maybe looking at a much more targeted approach. Those businesses can get on the radar screens of strategic buyers and also private equity firms. And then greater than 100 million, you're probably looking at investment banks, maybe you're even consider considering, like public equity markets. So you definitely want private or investment banking firms that have access to kind of institutional investors access to the public markets. So, again, not sure if that kind of gave a really good kind of categorization of the different segments. But I think that's how I would look at it is more by size.
Sure, that makes sense. And you mentioned a couple times this idea of a CEO kind of qualifying or perhaps doing due diligence on their M&A advisor. I mean, maybe two part question at a general level, how does the CEO perform diligence on a potential advisor? And more specifically, you mentioned, hey, you have to double click on how successful any given advisor has been in doing deals. I mean, what questions do you ask if you're a CEO, and you're trying to tease that out? Just how successful is this firm in closing deals? So part one, how do you do diligence on a potential advisor? And two, what do you ask to tease out that variable that you view as being very important?
Yeah, I think I think CEOs can get a lot of free advice from just like any procurement process, right? If you're, if you're trying to find, let's say, a supplier for a very important piece of your business, you're going to talk to a number of different suppliers. Right? I think the same is true for you know, either M&A firms, Business Brokers, investment bankers, whatever kind of category you're in, I think you need to talk to two or three or four or five, however many you feel that you have capacity to talk to until you find that right person that you just A, have a lot of chemistry with and B, you believe has the, you know, the resources, the capacity, the capabilities to actually sell your business. And I think, as I said, you get lots of free advice. So I think if you go through a very diligent process, I think you can get A, what's the valuation for the business, if they were to take you to market. Take you to market, what types of firms would they take you to so you get an idea of, you know, if you're going down the area of strategic buyers versus private equity. So I think the process has to be very methodical and thought out. So that's one. And then the second piece is, yeah, so I think I think that that laying out that process, in a very kind of, again, linear method with lots of parties, I think, is how you kind of land on the person that you feel comfortable with.
Very tactically, one thing that I found to be helpful is talking to other CEOs who have gone through an exit process with that advisor. Now, of course, it's really hard to track down those CEOs who have worked with any given advisor, and the transaction was not consummated, because there's no press releases that you'll find on a failed transaction, necessarily. But I found a asking for references. But frankly, I mean, any advisors probably going to give you good references. So I just did some Googling, looking for press releases. Because often in a press release for any given M&A transaction, it will say something to the effect of company ABC was advised by advisor XYZ. And I just cold called and cold emailed those CEOs. And generally speaking, they're very willing to talk to me, and because these are people that worked with any given M&A advisor, but they weren't necessarily recommended as a reference, I found that I got a lot of really helpful information, just by some simple Googling and looking through press releases.
Yeah, no doubt. And not only that, like your lawyers, your accountants, I mean, they're gonna know people that are in the market in there that are pretty good. The one thing about this industry is it, because the fees, you know, are generally large, let's say, on to half a million dollar fee for $10 million transaction at a very high level, let's just use that metric, right? Like, that attracts a lot of people into this space that you know, are just chasing fees, and maybe don't have the necessary skills to actually execute. So you really do have to be wary of the people that you're bringing to the table to help you help a business owner kind of monetize their life's work.
And I'm not under exaggerating that. So, getting referrals, talking to other CEOs that, you know, have worked with these individuals, lawyers, bankers, accountants. The good advisors that have done lots of deals and that have been in the space for a long time, people that are ancillary to the deal are going to know about these people, and they're going to have their, you know, they're going to have their opinion on if these people are good or aren't good. So I think, yeah, to your point, you need to do that, not only the CEOs of past transactions, but also other ancillary advisors.
John, usually my segues from topic A topic B are not particularly good, but you just set me up very, very well there when you started talking about fees. So that's where I want to jump next.
I just throw the softballs and you hit them out of the park.
Thank you, you set them up, I knock them down. I like this. So let's start with a bunch of questions as it relates to fees. But let's start with a pretty simple one, or at least a seemingly simple one that I presume our listeners will learn, it's not so simple. Fees undoubtedly, range from transaction transaction, and a lot of things affect what either the percentage or dollar amount of fees are charged will be. But for CEOs who might have never done this before, they need some sort of context. So what amount of fees whether it's $1 amount, or a percentage or a range should CEOs reasonably expect to pay an advisor? And maybe what are some of the variables that can make this fee, you know, a little bit higher, a little bit lower?
Sure. So and just for your listeners, I think it might be useful. I partnered with Firm X, which is a global data room provider. And we did a we did research on m&a fees. So anybody can kind of Google you know, for an extra Investopedia M&A fee report, and they probably find the latest version of that, that highlights all of the things that we'll talk about here, but I'll go into more depth. So M&A fees are typically charged on success. So they're contingent on closing a deal, and they are typically a percent An image of the enterprise value or transaction value of the overall deal. So as the size of the deal gets bigger, the percentage gets smaller, because the absolute amount of the actual fee gets larger, right? So, you know, let's just say, and I gave that $10 million at 5%. And let's just say that's kind of the midpoint, a $5 million deal might have a higher percentage, let's say, seven or 8%. A bigger deal, let's say $100 million deal might have a 3% success fee, right?
So you can see that although the percentage is getting smaller, as the deal gets bigger, the absolute dollar, the fee gets much larger, right. So, you know, some of the variables that come into, into affecting what that percentage is, so the attractiveness of the deal, and just how many investment bankers are competing on winning the job will actually. I(f it's a real attractive deal, you know, the investment banker thinks it's a no brainer to take this to market, and they can sell it, they might want a lower fee, a lower percentage fee. But they might think that they can get a higher kind of absolute value or enterprise value of the business. So their fee is actually greater, you know, the difficulty in the transaction might make the fee higher. So, you know, if somebody came to me, and it was a business that I really felt like, hey, this is going to be really hard time to sell, I might ask for, and maybe this is something we'll get into.
But I might ask for a much higher work fee. Because I know that kind of my effort and my energy into selling this business is going to be harder, so I need some more kind of guaranteed fee up front. So I might ask for a higher work fee, and then higher success fee at the end. So, you know, those are the some of the variables that I see is just how attractive is the opportunity from an actual, you know, asset that you're taking to market? And then how difficult would it be? How complicated is a transaction? How difficult would it be to actually sell?
For whatever it's worth, that report that you mentioned, John was incredibly useful to me as I was shopping between M&A advisors myself, so I would absolutely encourage anybody listening to check that out. It's a very, very informative, very digestible document. Let's talk a bit more about those work fees John, for people who might not be familiar, what is a work fee? And what is its relation to the success fee is it netted against success fees? Is it in addition to success fees, maybe for people who aren't familiar, you can expand a bit on that?
Yeah, so work fees is kind of like, you know, table stakes, I guess, for the investment advisor, or the investment banker to be engaged by the company that's looking to market. I would probably say that a red flag for me would be if somebody came to a business owner and said, I'll just do this purely for success for you with no kind of retainer or fee involved. You know, kind of indicating that, that somebody's just kind of putting out a lottery ticket out there, and not really worried about marketing the business or doing a good job. They just are putting the business out to the market. And if somebody, you know, closes a deal on this business, they get a big success fee, and there's really kind of no work or effort involved in that. Right. So, a work fee is used to, for me, it's used for me to kind of see the commitment of the business that is engaging me, right, I want them to be committed in the process.
So they're writing kind of a either an upfront work fee, which is not as typical or a monthly work fee. So they typically range from five to $10,000. At least, that's kind of what our report showed. And it really is to cover the costs of, you know, marketing the business, putting together all of the kind of information packages, gathering due diligence documents, reaching out to prospective buyers, so work fees, would sometimes be netted against the success fee. It depends how you negotiate the engagement letter, but you know, kind of see that's 50/50 and a lot of cases, something you can definitely negotiate and ask your advisor to do if you want it to. But you know, if a deal doesn't close those work fees would not be refundable. So those word fees would be kind of cost paid for the effort of going to market.
So, with respect to the success fee, this is the percentage of enterprise value most typically that you discussed. As you know, John, and perhaps as most of our listeners know, it's almost never as simple as, for example, a seller getting $20 million in cash at closing, and everyone goes on their merry way, it tends to be certainly much more nuanced than that. And there are many instances where the consideration that the seller receives is contingent upon something. So for example, an urn out scenario where you get an incremental amount of money if some revenue or gross margin or EBITDA target is hit, for example. So how does the success fee work in instances where components of the enterprise value are contingent in nature? Like an earn out? And how does it work with with respect to components of consideration that are not cash at closing? So rolled equity debt assumed by the buyer, an earn out, the working capital adjustment, I mean, these are all things that represent consideration that is not necessarily in the form of cash. So how to considerations like that dovetail with the success fee expressed as a percentage of enterprise value.
Yeah, I mean, so this is where the fine print in judgment letter really is important. And you know, it's difficult for a business owner, I think, to conceptualize some of these things, because they've never been through it, right. Like they, it's almost like you're learning on the fly as you go through, right? You never really get an appreciation for what the risk is around an urn out until somebody offers that to you in exchange for purchase of your business. So I just kind of giving really typical ranges, and I think this is coming from from our report that we did on M&A fees. But, you know, the earnout is, I'll use my kind of preference. So the earnout is typically paid on closing. And it could be discounted a bit for kind of the anticipated timing of receiving those payments. But, for me, I most often and I don't think I ever have not negotiated it this way, but I always negotiate full payment on the full enterprise value, including the earn out at closing.
Now, will I discount the earn out for again, kind of that time value of money? Yeah, I might consider that. But, again, like, I am negotiating a deal that my client is accepting, right, and so if they're willing to kind of accept an earn out in that transaction, that means that there's potential upside for them as well. So, we're a team, we're both in agreement in terms of what that transaction looks like. So And truthfully, just from an administrative perspective, I don't want to be chasing my client down, you know, two or three years to see if earn outs have been paid or haven't been paid, right. So from an administrative perspective, it comes a little bit more difficult to A, you know, know exactly, because you're sometimes you're not privy to those amounts after the fact, right on how much of the note is actually paid. So preference for me would be everything's paid out at closing. And that's probably the more typical way that it's structured.
Again, with with things like vendor take back or vendor financing, or seller financing, whatever kind of terminology you want to use, those are all kind of, you can interchange all of those. Again, you know, with vendor financing, maybe we can negotiate its security around that vendor financing, right. So to say it's only based on the payload of that vendor financing. Well, we've tried to really secure terms where that vendor financing is agreed to in the context of the transaction. So, you know, I would say that the vendor financing or any payment that's like, kind of subsequent to the actual closing date is still paid at closing. It just it just from an administrative perspective, it makes it a lot easier. And then also, again, as mentioned, it's kind of like, you know, we're negotiating this as a team, and we're agreeing that this steel structure is fair in all contexts.
What happens if less than 100% of the equity is sold, John? So for example, if we're selling 100% of the shares of some company and it's worth $20 million, okay, we can we can apply a agreed upon success fee to $20 million. That's easy to understand. What happens if, let's say 70% of the equity is sold at an enterprise value of $20 million. So the difference between example A and example B, it's the same enterprise value. But as a CEO, I'm selling a lower percentage of my equity and I am receiving fewer dollars in my pocket as a result of, let's say, rolling 30%. Does that impact the fee at all from the perspective of the sell side advisor?
Yeah, again, it's in the fine print. And this is where I think pre planning with your advisor is important, right? Like knowing that, hey, we're going out to market, and we're selling a minority equity interest in this business, right? So, you know, are you going to charge me on 100% of the enterprise value when you're only selling 30% of my business? So, you know, it'd be typical that you're only paying fees on the proceeds received for that 30%. But you really want to read the fine print? And then you also want to have alignment before you go to market? On? Okay, what is the transaction look like? Right. So that's where, and this is probably another podcast conversation. But I think that's where maybe a lot of people fall down is that, you know, pre market strategy, exit Planning.
So, exit Planning kind of staking morphed into this, you know, five years before the sale, operationally getting the business ready. Making sure that you have the right people in the on the bus in the right seats, all of that. But But there's something even more narrow that needs to be done. And that's this conversation around, when are we going to market valuation is obviously important. You know, who are we approaching, is it private equity, is it strategics? What objectives do we want to get out of the transaction? And then, you know, out of that falls out, okay, what does that fee arrangement look like? For this very specific, you know, execution of the transaction that we're going after?
Yeah, yeah. This is all really helpful, nuanced, I think in this section, John, what I'm trying to get across to our listeners, as best as possible is that their eyes need to go well beyond the simple percentage under the fee section, because, as you correctly pointed out, the devil truly is in the details. And these details can have an enormous impact on on what you pay. And I guess.
Sorry, just adding to that, Steve, I think one other thing that all business owners can do to really understand this is so you know, let's play with some scenarios, right? With your investment bankers, all of the investment bankers that you've included in this, you know, they call it a bake off, right, and investment Bake Off, or beauty pageant contests, right. Where you're actually interviewing all of these investment banks to see which one that you want, have them walk through what the fees look like, under the different fee structures, right. And you asked me this before, and I didn't touch on it. But you know, non cash working capital is usually what's left in the business.
But a lot of times, businesses will be sitting on a lot of cash that's pulled out. And under the definition of some engagements, that cash would also be included in the fees that somebody that would be paid to the investment banker, right. So, talk about that, you know, is the cash that's sitting on my bed, the two or $3 million of cash that's sitting on my balance sheet, if I dividend that out, is that now included in the fees that I'm paying? Because, you know, in a lot of definitions, I see that it is if you're really kind of going by the letter of the law, and engagement letter.
Yeah, that's such a good point. Again, something that seems so simple the definition of transaction value, the definition of enterprise value, this does not have in my experience and objective, unambiguous, absolute truth to it, these can be negotiated. So maybe this is a good opportunity, John to discuss. I mentioned the the average CEO their eyes go straight to the percentage fee when they look at an engagement letter with a potential M&A advisor. But just as in evaluating an LOI, one has to look well beyond the price. And at the other components of the loi, when evaluating an engagement letter, one must also look far beyond the price. So other than the dollar amount of the fee or the percentage of the fee, what are some kind of big important things that CEOs should be sure to look at and understand outside of the fee? You know, you mentioned what's the definition of transaction value? That's a great one. What are some other examples that come to mind?
The netting of the workforce, I think is a big one that people look at, or don't look at, like if it's not an engagement you might not look you might not consider to net those fees against the success fee. You know, the tail fee is an important one. So the tail fee is. So if I'm marketing a business and I talk to 30 different companies that have interest, and then say a transaction isn't consummated, we don't close a deal. And then subsequently, after our engagement period, you reengage with one of those 30 parties that I have talked to and introduced you to, a fee might still be owing if a deal is subsequently consummated with one of those parties. So let's call it tail fee. So you know how to tail fee, which parties are included in that in that kind of tail fee provision. So those would be the two important things, right?
And just for context, how long again, respectful of the fact that there's a lot of variation, on average, based on the data that you've accumulated, how long does that tail period lasts for?
I'd say 12 to 24 months, 24 months would be kind of long. And you got to think like, so let me just give kind of worst case scenario here on a tail fee provision. So things don't work out with your investment banker, for whatever reason, you just are not getting along. Nothing ever gets closed, nothing's consummated, you terminate the engagement letter with that advisor. And then, you know, six months later, one of the interested parties comes back and says, Hey, like, we age and have a conversation. And then you want to close a deal. So you get other advisors involved, maybe another investment banker, but you still owe that advisor a fee. Right?
So it kind of precludes you from being able to market your business, again, fully with that vies, that tail fee provision still being in there. So it really kind of hinders someone from doing something for the kind of length of the tail fee period that's there. But typical is 12 to 24 months. And I think the other thing I would do is SEO, I would really limit the conversation, or the parties included in that tail fee to ones that you've actually, like, kind of negotiated an LOI with right, like, if you've just because a lot of times, what some lesser advisors might do is they might have conversations with 1000 people, and then go back to the company and the CEO and say, well, you know what? I spoke to all these 1000 companies. So it's all thrown into this tail fee provision, which is not not fair I don't think.
That's right. A great example of again, where the devils in the details, a, for lack of a better way to put it conniving advisor, could suggest that within the tail is conceivably every potential exit option for a CEO. So it's a really, really important nuance to consider. John, let's move on to some more general questions that are not related to the selection of an M&A adviser but are certainly related to exiting small and medium sized businesses. And we are recording this in August 2022. And I want to talk to you about the concept of timing the market and whether or not that's a good idea or a bad idea. So I've observed in my capacity as an investor, some CEOs, who let's say we're contemplating selling six to 12 months ago are no longer considering selling, due exclusively to changes in the market. They're saying, well, the markets kind of gone down, I'm going to sell my company for a little while, and then I'll go back to market once it looks like things have improved. How should CEOs think about timing the market the merits and risks? Is that simple, common sense or is that a dangerous exercise? Is it somewhere in between? How do you think about timing the market?
Yeah, I mean, I don't know if you've ever come across the work of Rob Slee. But he's the I say, the father of private capital markets, and actually wrote the book in on with that title. So anyway, he talks about like, almost like a slot machine, right? You're trying to line up your personal objectives, with your company being in order with the market, like being ripe and in, you know, just ready to kind of find that perfect buyer at that perfect valuation. So I mean, lining those up are difficult, right? Like you really have to do work on the personal side to say, okay, what are my objectives? You know, what happens after I sell the business, do I you know, have some hobbies or do I have some passions that I want to move into? The company, we talked a little bit about, you know, this idea of Exit Planning or getting your business ready for sale.
That's definitely something that takes time and needs to do but the market I think you can, if you have those other two lined up. So those two are kind of always in perpetual alignment and ready to go. When when the market was ready, I think you can look out and see, again, August 2022. Today, you can see some headwinds, right, you can see some rising interest rates, you can see kind of a slowing economy with kind of inflation, right? You can definitely see kind of political unrest and geopolitical unrest. So you can kind of time and see some of these bigger kind of macro things in the market. And then I would imagine that a business owner would have a pretty good preview on their industry specifically, right, so you can, you know, gather information on are there strategic buyers in my space?Is there consolidation? You know, what, what are banks doing?
Are banks becoming more restrictive? Or are they, you know, really lending? So, to your question, I think you can look at those general macro economic things on kind of a national or international scale, and then also within your industry and say, yeah, now's a good time to sell. 2021 was record M&A In the US, right? And it, you wouldn't have known it because the pandemic, you didn't really know how the pandemic was going to, you know, play into all of this. But it turned out that it was it was, deal volumes were at record levels. So to take advantage of that, if the other two pieces again, that personal, and, you know, your business operations were in line and ready to go, then yeah, for sure, you can time it right, you can see the market is hot now, let's do it. Let's go to market and let's get the best kind of valuation terms for my business.
Now, we've talked about the terms and loi a few times now. So I want to get to that when you're advising a sell side client. And let's say you are negotiating an LOI with a prospective purchaser. What do you tend to advocate for? Do you tend to advocate for detailed LOI, so you can front load the difficult conversations and negotiations? Or do you advocate for like a simple high level LOI and just say, hey, you know, we'll punt these difficult discussions until later. And hey, LOIs are non binding anyway. So what's the point? Where do you fall on that spectrum? And maybe what variables do you consider as you consider where you are on that spectrum?
I think there's a couple of big variables, like price and deal structure is obviously important, right? Like, you know, what components of price or cash are vendor financing, definitely want to get that in place. The working capital is a big piece that I think even buyers miss, right. So I really want to flush that out, I want to know, and a lot of people, as you had said, try to punt some of these things to the end. I really want to work out the working capital piece, because it's difficult to know, and it really impacts, you know, kind of the valuation and the cash, that's the net cash proceeds that will be, you know, provided to my client at closing. You want to work out timing, obviously, if somebody's wanting exclusivity for, you know, 180 days, and not giving them that I think that's unreasonable, to tie up a business for that long. So, you know, that comes back to maybe a little bit of reverse due diligence, like, okay, do you have your financing in place?
What is your buyer, what is your kind of experience and your track record on closing deals? So definitely want to do some kind of buyer due diligence on that end. You know, those would be the big ones. I know, there's, there's no way that you can, you know, negotiate everything that's going to go into a purchase agreement. But you definitely want to negotiate those big ones, like what a transition period for the owner looks like? Do they want them around for the next two years? Or do they want them around for the next three months? So that's a big one, you know, if there's if there's kind of real estate involved, what what are terms around kind of leasing the real estate? So it really depends on the transaction and what's involved in the business, but the big ones need to kind of definitely get, you know, dealt with upfront. But there is absolutely no way that you can negotiate all the points that would go into a purchase and sale agreement and all other ancillary agreements.
Of course, of course.Now, as you have dealt with different categories, buyers, private equity strategics and the like, I've noticed that and I'm sure unfortunately, many others have noticed that some private equity firms in particular seems to be less common. visa vie strategics. But you can correct me if I'm wrong, some PE firms have developed a bit of a reputation where they basically shave off value in the transactions very late stages. And presumably they do that because they understand it to be true that they've built a bunch of switching costs, and a seller is much more likely to just kind of begrudgingly accept the new lower price, as opposed to starting the process all over again, with a new buyer. If they're in the ninth inning of a transaction. I guess A, how frequently does this happen? Is this a real risk that sellers should be aware of? And B, is there anything that sellers can do to get ahead of this risk or mitigated or eliminate it altogether?
Yeah, I'll go back to the first kind of overarching concept is, for me, it's trust, right? Like, do you trust the buyer? Do you think they're of high integrity? That's the first kind of comment that I always come back to with my clients is like, hey, going into this, how you feel about the buyer? Do you think that? Do you think you know their word, they'll stick to their word in the LOI? So just getting that feeling? You know, I do my own kind of evaluation on that, too. And then the other thing that I think is important to consider is, you know, has there been, is a renegotiation or retraining of the deal warranted? Has there been some material change in the business, like, you know, so we forecasted and projected a certain level of cash flow, and the business hasn't been able to deliver that over the course of negotiating the purchase agreement? Did something big in due diligence come up, that that, again, warrants some sort of change in in kind of the structure, in what we've contemplated as the deal.
So those are other things that I would question. If none of those things have come up, then I would, you know, I'd really try at the beginning. And I do try at the beginning to tell the buyer like, hey, we were not, if there's any sort of retreating, if nothing material has changed in what we have told you to be true, and through your due diligence, none of this comes up, then we just won't proceed with the transaction. Right. And, you know, not to say that we that there hasn't been some renegotiation, and we still continue to proceed with the transaction. But that's kind of a game time decision, right. But I really want to place you know, be upfront with the buyer and say, Hey, like, we just will not accept a retraining. So if that's one of your practices that you have, then let it be known that if you come back to us and really try to renegotiate this deal, but nothing material is changed, then we'll just pull the pen and we'll go to the next buyer. That's kind of in line in our process.
Yeah. And you certainly hope that buyers would avoid doing that if for no other reason than not developing a reputation for themselves as someone who retreats late in the transaction, because that that would be the death knell for a buyer. And if a buyer has a habit of doing that, then that's probably warranted.
The only thing I'd say to that is, I guess, you know, unfortunately, you know, a lot of the details of a transaction never really become disclosed, with confidentiality agreements and everything else. So, you know, even if a buyer did have a reputation of doing that, it would only be through rumors and speculations, right. It wouldn't be any sort of, like, real kind of knowledge that somebody did that. And then they could put a spin on it and say, things changed in the agreements, you know, we thought this and this was the actual case. So, you know, unfortunately, if a buyer does have the reputation of doing that, or does use that as a practice, it won't really get out in the marketplace, enough that it kind of, you know, hurts the reputation of the buyer.
You know, one thing that does strike me though, as a potential tactical takeaway for CEOs listening to this is my opinion, you tell me what yours is, John, is front load the bad news. So if you've got, let's say, you've got key person risk within one of your employees. Let's say you're a software company, you've got some technical debt in your codebase. Let's say that three years ago, someone sued you and you haven't heard anything for three years, you're pretty sure it's gonna amount to nothing. But it still hasn't been settled. Like in my experience as a seller, it always behooves me to front load that bad news so that you can just have those difficult conversations early, often, and honestly, to avoid, kind of give Being a buyer a reason to shave some value off in the late stages.
Yeah, you know, you definitely don't want to hide any of that stuff. I mean, you don't want to, like advertise it right? Like you don't want it to be, you know, the the highlight of the transaction, but you don't want to hide it as well, right? Like you want to be open and transparent and say, hey, like this is, and you want to come with solutions as well, I think. So if there is this litigation, to your example, you know, you want to kind of give reasons and support on why you don't think it's material. Why you don't think it will come to fruition, what you've done from a legal perspective to mitigate the risk, how you would carve it out in a purchase agreement, right, and maybe put reps and warranties around that. So if you definitely come with a game plan around some of these maybe more negative aspects of the business, which every business owner has, your right, it does limit a buyers ability to come back and just try to retreat, or renegotiate something that was kind of known upfront.
So two questions remaining John, before we conclude today, this one might sound like a bit of an odd one, but I do want to ask it anyways. And the reason why is when I was selling my company, the most frequently asked question that I got, I presume is the most frequently asked question that most sellers get, which is a very, very simple one. It's so why are you selling? Now this is asked for understandable, logical and intuitive reasons. But in my experience, there's a bit more behind this question than might meet the eye. So can you help CEOs think through understand like, what is the buyer really looking for when they ask this seemingly simple question? In your experience what would constitute a, quote, good answer from a, quote, bad answer to that question?
Yeah, you know, buyers, I think every buyer I've ever came across is coming to a transaction with a healthy level of skepticism, really trying to find the question why why is this owner selling, right? If he has such a great business, and it's kicking off lots of cash? And, you know, he's passive in the business? Like, why would he give that up, right? A buyers mentality is kind of that growth mentality, they're investing in the business, to see it, you know, kind of go on, where the seller, obviously, is on the opposite end of that spectrum, right. They're trying to monetize it. So I think they're trying to get to the real, you know, kind of depth of what is motivating the seller. So, they're trying to craft a transaction agreement or deal structure that might help, you know, reach some of the objectives that this buyer might have.
And they're also trying to kind of get a sense for, you know, is the buyer telling the truth, right. Is it really that he's tired? Or is there something underlying, you know, some headwinds in the business that he's seeing that maybe he wants to get out and kind of hand off this flaming bag of dog poop to someone else? Right. So, you know, I think that's what the buyer is trying to do. I think, I think they're trying to A, really understand what will motivate the seller to kind of craft a deal that that gets consummated, and then B, also trying to see what the risks are around. You know, is there something that I'm not seeing and a reason why this buyer is trying to run for the exits?
Yeah, yeah, that asymmetry of information between buyers and sellers is huge. The seller has forgotten more about her business than the buyer will ever know, throughout the course of a due diligence process. So certainly a good due diligence process yields a lot of information. I found that for the buyers listening to this, an interesting way that I've seen many buyers kind of try to get to the bottom of this is they'll ask this question many times throughout the course of weeks or months, and they'll ask it in different ways. And ultimately, what they're looking for is inconsistencies in the answers. So perhaps a useful tactic for buyers, and certainly something for sellers to just be mindful of.
I think it comes out over time, like, you know, the first time it's asked like, I coach my clients in terms of okay, they're gonna ask this right, like, this is question number one or number one A. So be prepared with an answer. My advice to CEOs on on this, you know, listening here, just be honest. Be truthful in terms of, you know, why you're getting out and what you're really wanting out of the transaction. And then this kind of goes back to my point of, you know, there couldn't be better work from advisors in terms of the preparation for the exit, really understanding what the motivation, really understanding what the intentions and objectives of the owner are. And then come to the table and tried to, you know, build a transaction around that.
Versus the other way around where, you know, you're finding deal structures and trying to jam them into, you know, what your objectives are. So, I think I think, going to market with that clear objective like, hey, you know, I'm 75, the pandemic's been hard on me, you know, I have an awesome business, I want to spend more time with my kids, and enjoy time at my lake lot. You know, buyers understand that right. And, you know, that's totally legit. aren't that at that stage of your life?
I totally agree. Honesty is always easier. Last question for you, John, this will be kind of a question that I hope will kind of wrap things up and kind of a summary fashion. If you were to survey all of your sell side clients who have successfully exited over the years, and you just asked them, what were the two or three most surprising or unexpected things about selling your company? What two or three answers do you think you'd hear from them most frequently? What tends to be a real lesson or a real surprise that sellers have that maybe they weren't necessarily expecting before selling their companies?
I think they just recognize, hey, this is way harder than I thought it would be. A lot of business owners think it's as easy as kind of, yeah, I've decided to sell, I'm going to go to market, there's going to be, you know, three 410 buyers that approached me and put offers. I'm going to pick the best one, and I'm going to move on. And I've been doing this for 25 years now. And I'm still surprised at how hard it is on each and every transaction. So I think I think that's a real kind of eye opener, it's just like, oh, you know, we didn't get the level of interest that we thought, we weren't as prepared as we thought, the valuation was lower than what we thought.
So I think, and maybe, maybe that's more of a function of kind of that lower middle market, sub $50 million. So I think that's kind of the biggest eye opener that most business owners will get. It's just, it's hard to sell a business. And, you know, it needs a lot of thought preparation, advanced planning, all of that. So, you know, the people that are kind of banging this drum, including you and I, are not wrong. But most business owners need to kind of feel it for themselves before they recognize that.
Yeah, in my experience, one of the most common surprises that some folks have when selling businesses is that they're not able to kind of have a clean 100% break and kind of, you know, go off to the proverbial beach the day after a transaction closes. And they're often surprised that even when you sell a business, due to various risk sharing mechanisms, you can still bear some risk, whether it's an earn out, or an equity roll, or a seller note or some contingent consideration. That also tends to be a big surprise. I mean, I don't have as many data points as you do. But can you maybe talk to that for a minute or two, and maybe just to calibrate expectations for lower middle market CEOs? Like, how often do you see a, quote, clean break transaction versus a transaction that features some risk sharing mechanism like this?
Yeah, and the lower middle market, I would say, very rare, it would probably have to be a very attractive kind of strategic asset for a large kind of international buyer that has. It'd be a drop in the bucket if they were to write a check for all cash. So, you know, typically, they just see it as Hey, like, you know, say a $10 million tech deal or something, this is a perfect add on for our business, we're gonna write a check, this guy's gonna walk away, and everybody's happy. But I would say that's, you know, maybe 1% of all transactions out there. And it really is, as you mentioned, that kind of a risk sharing mechanism, right. So all stakeholders kind of want to ensure that there's an appropriate transition of the business, from buyer to seller, so not only the buyer, but also their financing. So typically, most buyers are going to have some sort of financing that they use, they're not just going to use all have their own equity to finance a transaction.
So banks are going to be pushing for some sort of risk mechanism, you know, either through an earn out, or through that seller financing. You know, other investors, if there's outside investors, obviously, they're going to be pushing for that. So, yeah, you're right, it is definitely a risk mechanism to ensure that that transition from from business owner to buyer happens seamlessly, and happens at all right. And in some cases, you know, a lot of the knowledge and kind of know how within the business resides within the seller. So, if that person just leaves and there's no kind of hooks into that person, then sometimes the business, you know, kind of falls apart. So, definitely need this, it's definitely again, I'd say 99% of the transactions I work on, have some sort of risk sharing mechanism or note or some sort of hold back.
And, you know, I guess I would say it's not, I don't see that as much of a surprise, because you know, my clients, we talk about deal structure before going into it. So I'm very kind of upfront to say, hey, like, you're not getting all cash, this is probably what a deal structure looks like. Are you okay with it or not okay with it? So, you know, I would say that my experience is that, you know, I don't see as much of a surprise from my clients, just because, you know, I've tried to educate them. And I've really, you know, walk them through what I think a market deal structure would be before we even go to talk to buyers.
Yep, yep. Such an important point. John, as we wrap up any concluding comments, anything you want to leave our audience with questions to ponder resources to check out anything you want to leave our audience with, before we conclude today?
Yeah, I mean, for sure, I'll be a little biased here. But destopedia, I think, is a great resource. It's our educational website on mostly selling mid market businesses, great articles in contents in, you know, is Steve is doing very tactical areas of doing a deal. So that's one resource, I guess, I would leave in also commend you, Steve, on this. You know, as we talked about, not a lot of people go deep on this topic. And I think it's probably because maybe the interviewer doesn't have the level of expertise and knowledge that you would have. So they keep it at a very superficial level, but I think it is deep, that really helps business owners and CEOs find success in again, you know, not understanding but you're monetizing one's life work, right. Like you spent the last 20 years building a business, trying to create value in it. And so much value is either created or lost in that period when you go to market. You know, it's such an important piece of value creation. And I think you're doing a really awesome job of helping business owners tactically at a real substantial level of depth, figure this stuff out.
Your check is in the mail. Thank you, John. Thanks for your time for your insights and for being generous with both of them today. We really appreciate it.
Yeah, thanks for having me.