The Basics of Sell-Side M&A

The most common mistake people make when selling a business 

The number one mistake I see entrepreneurs make is assuming that the expertise they have in building their business translates to expertise in selling a business. 

And these are very successful people. Only 7% of people who start a business get to a million dollars of revenue, and only about 4% of those get to 10 million in revenue. 

These people are unicorns, and they're really special people that could be entrepreneurs, start something and build it. And I think there is a success factor at play as they've built the business and then think about an exit, they just assume they’re an expert. They're a novice, they're doing it for the first time! 

Think of anything you've ever done in life and you did it the first time versus the hundredth time, and lessons learned across all of those different things. And selling a business is complex. It's not like renting a car where you could do it the first time and be successful. It's difficult. It takes a lot of time and effort. And there are a lot of bumps in the road along the way.

And if you've never done it before, you're in for a rude awakening and you'll never know if you got the best outcome when you're alone just doing your own thing. And so that's why I always recommend a team of advisers too. 

Don't rush into it or go rush into it. It's a false sense of security people get into. I don't want to call it arrogance because it's not.

What types of objectives to have when selling a business

When you're selling a business, first of all, there are a lot of different people you could potentially be selling to. I call it the universe of buyers. 

Financial buyers like private equity firms who offer one set of experiences because they're bringing a checkbook and typically not bringing a leadership team.

The expectation is you're going to be a rollover investor in the business and invest alongside them and continue to run and grow that business alongside them. Maybe you want to retire, maybe you're 65 years old and you're ready to hang up your cleats and you want to go fishing or go spend time with the grandkids, maybe that's not the right fit for you. 

There are strategic buyers which mean a company buying another company. Doesn't matter if they're private equity-backed or if they're public or private, or what their capital structure looks like. It's just essentially a strategic buyer as a company, buying a company. 

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When you think about selling and wanting to do some prep work, it really comes down to before you have people in your office and people starting to call you on the telephone and ask:

• What are your goals and objectives? 
• What are you trying to accomplish? 
• Are you seeking to walk away or to stay? 
• Are you willing to make a meaningful rollover over investment? 
• Are you wanting to just cash out your chips? 
• What about your employees or the people that help you become successful, what do you want to have happen to them? 
• Is it important to you that their lives continue and not be disrupted or does it not matter or it's not a factor? 
• Is price the only thing? 
• Is legacy important? 
• Who's the partner that I want to partner with? 

These are all kinds of things that a person should really be thinking about. 

2 Kinds of Strategic Buyers

• Lights on 

You're going to stay, keep growing your business, but you're now going to be part of a larger organization and you're no longer going to be the boss. 

That means you have a boss for the first time, and it could be the first time in your career you're going to be reporting to someone farther up the food chain who can fire you. 

• Lights off 

They fully integrate your business after they buy it. You're going to just retire and get a consulting agreement for a year and walk out the back door. They’re going to literally turn the lights off on the business that you had because they’re maybe after your people, your process, or if you're a manufacturer, your capability, service business to your customer, contract portfolio, and things like that. 

There are other things out there: 

• Public
• IPOs
• ESOPs
• SPACs 

Selling a business doesn’t just mean a high price. There are a lot of different paths that you could take and help you navigate to the desired outcome. The problem is that you have to know what that desired outcome is ahead of time. So when you face these different forks in the road, you know whether to go left or right. - Adam Coffey.

People chase dollars, they don't necessarily even think about that. They get led down a path because one path is offering a slightly higher price than potentially another. So a lot of forethought needs to go into an exit as an entrepreneur.

Diversification of Risks and Assets  

What I've really seen across the universe of companies that I've bought over the years, the typical seller is not at retirement age. They're not 65 to 75 and hanging up their cleats. The majority of them are in their 40’s or 50’s. They are seeking to diversify assets, to not be a hundred percent at risk with all of their net worth tied up in a business, and need to pull some chips out but aren't necessarily ready to stop going.

If your business is worth 125 to 150 million, set it aside, extract that value from the conversation, and then talk about your assets outside of that business. Are they also a hundred million or 125 or 150 million? 

Ah, hell no. It's a million or two or three or four. Okay. We got a lopsided equation here. You got a $150 million asset that if something happened to it and it became worthless, God forbid, there's not much left outside of the asset that you have and call a company. And so, from just a pure diversification of risk and diversification of assets felt to me like it's a really good time to either sell a piece, do a recap and pay yourself a dividend.

But somehow you need to start monetizing some of that asset because you have to protect your family. I see more of that than I personally see people who are just saying they did it for 40 years and they’re retiring.

I do see that, but I'd say probably at least 90% of the time, it's asset diversification that is the driving factor behind someone leaving. 

Because one of the other problems you have is, for the person who says they’re going to cash out their chips, sell the business, and they don’t want to keep going. 

Okay. You're in your forties, in your fifties, you've got a pile of money. What's the first thing you have to do? You have to decide how you’re going to invest that pile of cash and what you’re going to do. And I often tell people, why not keep investing in the business that you knew? The business that you grew that you created because you know that better than anybody else on the planet. 

Take that diversification. Get the chips off the table, but make a roll forward investment. Work with some of the world's most sophisticated financiers and investors and let them help you:

• Raise your game
• Bend your curve
• Take your business to a new place with a new capital structure
• And get paid again. 

My goal is always to roll enough to where the second payday is bigger than the first just to keep life interesting. So that's the kind of buyer I see most often in today's world.

How to prepare your business for sale 

Tax lawyers 

It's the most valuable asset that you probably have. And if you sell it, there's going to be a liquidity event or a lot of money that's going to be generated. And so you as an individual are going to need tax advice. And how am I going to prepare for that windfall? Am I going to have some type of trust? Am I going to have a network of trust? And there are all kinds of strategies. 

I'm not an accountant or a lawyer, and I don't pretend to be one, but there are other people that we're going to bring into this equation here. Big windfalls come and I’m going to need some planning and probably some preparatory time and work to build that structure. 

If you're going to have a domicile change, you want to do it well in advance of any sales transaction ideally and you're going to need tax advice, that quickly is going to lead you to a lawyer. So you need competent legal advice. We want to make sure we get top-flight M&A attorneys on our team with our tax help. 

A Good Accountant

We're going to need an accountant for some accounting help for the business we're going to have to go through. It's common when you're running a business that your goal and objective is not to pay taxes. So you're going to minimize your cash profit and have a lot of write-offs. 

You have different kinds of expenses that are running through your business. You might be using a cash method for accounting and you need to get to an accrual method of accounting, there's a lot of work. 

Quality of earnings is probably the most important thing. Whenever we're going to sell this business it's really nice to have three years of clean, normalized financials ready to go, a sell-side quality of earnings that says what the business is actually doing today, this is the EBITDA. Why? Because it is the magic line in the financial statement where most businesses are valued from as a multiple of. 

Growth plan

Doing prep work in advance is very important to present the right picture depending on who you're selling the business to. There needs to be a growth story. If it’s a stagnant business that's doing nothing, you can't expect a premium multiple from somebody or a high price if the business isn't a growth company. It's really about: 

• Working on your operations.
• Understanding the levers of growth.
• Starting to build that team of people who can take the business to the next level especially if you're going to leave. 

Leadership succession

If you're going to leave, who's going to run the business? If I'm buying a business from you and you're walking out the door, is there competent leadership underneath you or do you micromanage everything and will what I buy disappear because you walked out the door? There are so many different things that you need to plan in advance. If you're making changes to operations. 

Real estate  

A lot of times, entrepreneurs who run small businesses also buy the buildings that they occupy, and they have to separate those assets from the business and put it into a different legal entity because the vast majority of buyers don't want your real estate. It's not an investment-friendly vehicle for a private equity group that's buying and selling companies to buy a different asset class and mix it in together with the business. It creates difficulty and hurdles. 

I'm not a real estate fan. So I always tell entrepreneurs, split the real estate off, and put in place a fair market rent between the business and the business that you create to hold the real estate part of your empire. 

Investment banker

They are the people that will ultimately take your business, and market it to the universe of buyers based partially on your input and the desired outcome that you're looking for in terms of your future involvement in the business. They can help:

• Navigate that universe of buyers
• Create competitive tension
• Market the business
• Help you get to the ultimate outcome

Oftentimes mistakes are made, and steps are missed. Opportunities are missed to maximize the potential exit of the business. 

There are a lot of people out there who would take advantage of an unprepared seller, the one who doesn't have a sound team of advisors or that seller that has that false sense of security.

For buyers, they're the best deals. You could have four or five-word differences in indemnification clauses that take a balanced contract and totally tilt it in the buyer's favor and put a lot of risks on a seller. A lot of different things can take place and it's a caveat emptor, unfortunately, there's probably a lot more that goes on than people know about.

When to do Quality of Earnings (QofE)

If I were a seller, I would want to make that a part of my sales process. I would be doing that right before I hire a banker. Before I do the banker bake-off, where I might invite four or five bankers in to look at the business, I would want to prepare them because I want a good estimate of what my business is going to be worth. I have to know what my true adjusted earnings are. 

It's very helpful if they understand where the business is truly at. From my perspective, it's going to happen. Question is, does it happen the month I hire a banker or three months later once the process is launched? And I would like as early as possible to be populating a data room.

Putting all of this information up there so that as we get closer to letting potential buyers into a data room to look at my financials or the quality of earnings, it also takes some workload off of me as a seller potentially.

If I don't do this pre-work, then in diligence, we’ll really scrambling to get information up there. If I can do it leisurely before it gets really intense, I'm well ahead of the curve as a seller. 

When to get the Legal Representative 

There may be multiple paths to get me where I want to be, but I can start to frame up who I think is the probable buyer. I then engage the tax person first. As I'm thinking about my business, there's going to be a windfall generated. 

It doesn't matter whether it's 50 million or a hundred million, it’s still a windfall. So how do I prepare for a windfall? I start thinking through that because it might include a domicile change, which is a big deal.

Then engaging the accountant to help me start normalizing financials, and maybe I'm going to make some business improvements along the way. Then, right before the banker, make sure I’ve got the lawyer involved. 

Engage the M&A attorney right prior to doing the bake-off with different investment banks or brokers, depending on the size of the business. It may be an investment bank that you're dealing with. If it's a small business, it may be a broker or two that you're interviewing and talking to. 

In either case, legal documents to engage them will start coming soon. It’s good to have that M&A attorney geared up and ready to go to help you with that step, and to help you subsequently with the associated contracts related to the actual sale itself. That's how I think of it. 

It could be peer networks, it could be guys like you and me who earn a living doing things like this and have a lot of experience doing it.

• Start to think through the buyers
• Get tax help
• Get accounting help
• Make business adjustments     
• Setting up a structure for your real estate

The Sales Process

The Teaser

The typical first step for the investment bank or the broker, or the person representing the sale, is to create a one-page teaser. It won't say the company name and they send it out to their connections who they think are the universe of buyers. 

• It may say the city, or ‘a commercial HVAC company is going to come to market next month’. 
• The relative size, relative earnings. 
• The customer base. 
• What it does, and it's got a code name for it.
• It's got some verbiage to describe generically. 
• It's got some pretty pictures and it's a teaser. 

NDAs

Once NDAs happen, generally, a book that they've been working on while this teaser was being prepared goes out. 

Confidential Information Memorandum (CIM) or the Confidential Information Presentation (CIP)

One's a word document, one's a PowerPoint document. Ultimately, they may also be a physical book or a PDF. And that book then goes out to the people who have signed an NDA and who have had interest and want to learn more. 

It goes into a great amount of detail about the business. Now, because we've got to sign an NDA, we're disclosing names. Now we're talking about the market-serve, customer-serve, and customer information may still remain somewhat generic. It may be customer A, or customer B.

But we're now talking about specific verticals in the industry itself:

• How big it is
• How we play in it
• What differentiates us from our competitors
• History
• Leadership team
• Org chart
• Pictures and bios of different people

Fireside chat 

A subset of those people who get that book may be afforded a phone call or a Zoom with the CEO. 

This is to allow the CEO or the executives to give some type of an elevator pitch about the business and to educate and potentially make 10 out of 25 people who got the book feel a bit more special. 

In the banker's opinion, those are the 10 who are probably going to stretch the most.It's also good intel because now as a banker, I'm hearing early questions where people are going to test the company and the management team for the management presentations that come later. 

Management Presentations

These are often a four-hour meeting that includes dinner. It's not just you, but it's plus the team of your leadership talking about the business, answering questions generally about a four-hour presentation.

It generally mimics what's contained in the CIM or the CIP, very repetitive. Then there are questions and interactions and potential tours of a facility if the sale process is being done in the open and not hidden in a conference room in a hotel somewhere.

Indication of interest

It's between the CIP and the CIM and the management meetings where the indication of interest comes due. We invite a subset of those groups of people who gave an early indication of interest. We're going to invite them to come in and get a management meeting. Once we've had the management meetings, then people are really starting to do work from a buyer perspective.

• They're building models. 
• They're trying to understand at what price to come in for an offer. 
• What's their growth story going to be post-close? 
• What can they underwrite for limited partners and the investment committee who governs how they invest the money that's in the fund?

Bidding

Those bids come back. Usually after you get the book, it's an indication of interest and it's a range. As a seller, I love to take all of the indications of interest and I stack them up as a horizontal bar chart. Then I look for the midpoint. If I'm seeing a tight midpoint, I feel good as a seller because I know that the buyer universe is understanding my story. 

When I see wide bid ranges, then it means they're shooting in the dark. They're including a high number because they want to get a management meeting, but they got a range because they're hedging against not understanding the business or maybe they're not as interested.

I can learn a lot just by stacking and looking at these bids, but then the management meetings happen. 

When these next round of bids come in, they're not a range, they're typically going to be a number. Now I can also potentially get in a letter of intent some of the salient business points that they're going to ask me for when it comes time to contract. 

Exclusivity

Someone's going to be awarded the bid, but we're not going to necessarily tell everybody else yet that they didn't quite get it. We're going to slow them down and we're going to let this other party move ahead and give them some kind of a fixed window to start doing their work and affirm their bid, and then they'll be awarded. 

Diligence Tracks

Diligence is like a proctology exam that never ends. So if there are a thousand questions that could be asked about your business, they're going to find 2000 ways to ask it, ask those thousand questions. 

This is where all that prep work with the accountants, preparing the financials and is also why entrepreneurs don't want to sell alone. They want to have a team of their people under the tent because those are people that can help them at that point, and answer the multitude of questions. There are going to be several different tracks of diligence:

Financial Track

The buyer wants to affirm the earnings that are reported. If you have a QofE, you're ahead of the game, they now get a quality of earnings that's been done by a competent accounting firm. They work off of that QofE, they probably do their own, but they want to get very comfortable around the financial dynamics of the deal. 

As they get comfortable with those financial dynamics, they'll turn on their legal fees and different outside advisors. But there'll be a financial track to understand all the financials of the business. 

 Legal Track

There’s going to be a legal track to understand two facets to that. 

• One is to understand potential liabilities, trailing liabilities, lawsuits that are pending, or past wage and hour misclassification type of stuff.
• Then there are the physical contracts. Because we're buying a business or selling a business, there's a contract that has to be negotiated. 

HR Track

•  What do the benefits packages look like?
• What the insurances are like?
• The commercial insurances
• The worker's comp
• The safety history of the business
• General liability type insurance investigations

In a nutshell, it typically takes four to six months from the time you launch and hire a banker and that can take longer, or it can be done really short in a truncated fashion when you have a hot asset and a bunch of buyers who want that asset. 

Generally speaking as a seller,  if I know it's going to be a broader process, I like to work the circuit. I found that if I do that first before hiring a banker and launching a process, I'll have the buyer universe worked up into a little bit of frenzy. 

They know my company, they know the asset, they know it's coming. As soon as they get the mandate, find out who got the mandate to represent me as a banker, they're all over it. 

It launches the process with some energy and it helps the entrepreneur to get used to talking about their company to potential buyers, working the kinks out of their own presentation methodology by doing some conferences ahead of time. 

How to keep the management team focused 

What I like to do is talk about the business and the executives to get a number of people in the tent. We are going to run a process, sell our business, monetize our assets, roll over, and keep going. 

Usually, the senior people on the team have got some stock or they've made some cash investments in the business and they're going to get a payday. What I like to do is break up the team and focus on the ongoing concern, which is running our business. 

Maybe the business has a founder who’s a CEO, a president, or a COO. Who's going to be responsible for running the day-to-day operations of the company while some of these other people are highly distracted. 

Larger accounting firms have what are called transactional diligence teams or they have a group of people who can help either the sell-side or the buy-side with some of this work.

“Selling a business is a team sport, and shouldn't be an individual sport because there's a lot of work to be done.” - Adam Coffey

And if you don't have a wider group of your management team participating, it's a whole lot of work for an entrepreneur, especially if they also have a business to run. 

Earnouts

An earnout is very much applicable when a business that's growing really fast and has a big book of business that is on the come. It's signed deals, or it's in the backlog, but the business isn't going to ramp on for some period of time. In that case, the entrepreneur has two choices: sell now or wait until all the revenue ramps on and get paid for it.

There's no wrong answer, but again, time is never your friend, world events can happen. One way to capture the total value is if you include an earnout over a specific period of time, which essentially gives the entrepreneur a payday for the close and lets them ramp up revenue that's on the backlog or let them do pending work. Then in a year, it's almost like a true-up, and now you're getting the rest of the enterprise value. 

I'll also do earn-outs in a new geography or new business lines. So I'm making a strategic pivot. If it's a strategic pivot or a new business line, I don't have to worry about separating my revenue from the revenue I'm acquiring and I can track it easily. Then in that particular case, there also could be a potential to do an earnout. But generally, the reason to do the earn-out is growth. Growth is happening. 

Other than that, the joke about earnouts is they're just a lawsuit waiting to happen. The only question is who's the plaintiff because they generally aren't smooth. 

Earnouts are divisive when it comes to team dynamic. The time and place are usually fast growth or strategic pivot, new business line, and there's some rationale behind it. Other than that, I don't like earnouts. 

Who are better acquirers: PE or strategics? 

The right answer to that question is: who meets the needs of the seller and takes them to the place they want to be, which they scripted long ago as the first step of this process. That's the right answer. 

When you are sold to a PE firm directly, you become a platform investment, where you are the company, and the leader. And you're going to work with that private equity sponsor to bend the growth curve, to do M&A, improve organic growth, and do things to improve your business. And 100% of the risk belongs to you in terms of execution.

If you sell to a strategic, that large strategic generally moves very slowly. It generally takes a lot of approvals to get a deal done, and you're going to join this massive thing, which may or may not frustrate you. They may pay the most money as they have the capacity to. 

It's really about risk diversification because the returns that are modeled are going to pay you the same either way when you're with a strategic backed by a private equity firm or you're selling to a PE firm directly. 

It's like the same kind of return thresholds are going to be generated. One is “I own all the risk of execution.” The other is “I'm joining a bunch of people and we're sharing the risk.” 

There is no right answer. It goes back to what were your goals and objectives the day you thought about selling, and who's going to guide you on that best path to get you the best outcome.

How to get top-quality advisors to produce the best outcomes 

The easiest examples for me are lawyers. When I choose a competent M&A attorney: 

• They know what the market is. 
• They know what market conditions are today versus six months ago, or where conditions may be turning to. 
• They know what's reasonable and customary for a given industry or a given size deal. 
• And they're generally highly skilled at getting you through the paperwork part of selling a business. 

When I choose a generalist who doesn't necessarily sell businesses every day, and I see it as a buyer all the time, they focus on the wrong things. I often see people who aren't specialists actually cost more because they spend more time arguing things that don't need to be argued and less time arguing things that should be argued. 

So if the agreement that we end with isn't a fair and balanced agreement, it isn't a good agreement. It's not optimal for the seller. I see that most often in legal. Fortunately, you can talk to your friends, and to your attorney that you need competent business representation. 

There are the top 400 law firms in the United States and you can look them up in Google based on the number of attorneys. Any decent-sized firm is going to have a business practice within it, along with a trusted practice. 

• You can do research
• You can ask for referrals
• You can interview people

In my book, I put a list of questions, that might stimulate someone thinking:

• How many entrepreneurs have you represented in the last three years?
• How many businesses did you represent sellers on? 
• What was the average transaction size? Etc.

And then you can start to qualify. 

• Talk to some clients who sold their business and understand their area of expertise
• Ask for a list of referrals but do diligence and check them out

You have to do diligence. There's no easy, cheap way around this. With bankers, it’s the same thing. 

Oftentimes, if you're hiring one professional, you may be able to then leverage their expertise. 

There are a lot of different ways to get there but you need to get there. No quick exit to that question. You just need to do the work and network and do your diligence.

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