There are different kinds of buyers out there interested in your business, believe it or not. And it's important that you know what they're thinking before you engage them when selling your company. If you want to know why what they are thinking matters to you, you've come to the right place.
From our studio in Southern California, with guest experts from across the country and around the world, this is "Deal Talk," brought to you by Morgan & Westfield, nationwide leader in business sales and appraisals. Now, here's your host, Jeff Allen.
Hello and welcome back to the web's number one content source for small business owners committed to building a business for eventual sale. Here on "Deal Talk," it's our mission to provide information and guidance from our growing list of trusted experts worldwide that you and all small business owners can use to help you build your bottom line and improve your company's value.
If you are interested in selling your business at some point — as listeners to "Deal Talk" are — this program is for you because we're going to tell you why it is important that you get to know your buyers, those prospective buyers out there. You may not even have any contact with them any time soon, but you need to understand what people might be thinking, the stuff that's going on in their head about your company. It's very important.
Why does it matter? We're going to find out. We're talking with the President of Telementrix today. His name is Mr. Mark Johnston. We're so glad to have you on the program today. Thank you for joining us.
Thanks for having me on the program. I appreciate that.
A key part of what you want to do as a seller is make the buyer as comfortable as possible.
It's just a way to break the ice a little bit, Mark. Let's talk a little bit about your background. You have depth of experience in the M&A space. Tell us a little bit about where you've been and what you do.
Thanks. I took an unconventional route to M&A frankly. I started with an engineering degree with no intention at all of doing even though I knew what M&A was. And I got from there into technical sales and marketing, and product development, and strategic planning. And then finally I got into M&A. I actually went through most of the different paths you take in a company and as a result it really taught me how engineering works, sales, marketing, operations, how these aspects of the company work, which really helped me when I got on to M&A.
So while most people come to M&A from a financial perspective or with a financial degree, I come from more of a strategic and operational perspective. I can certainly read and understand income statements and balance sheets. My focus has always been more on attractiveness of the business and the market they're in.
I think that's OK. I'm not a numbers guy myself, quite frankly, Mark. So you and I, I think can relate on a very level wavelength. And I'm so glad once again that you've agreed to join us on our program today, really looking forward to our conversation.
One thing that we know about buyers, we may not necessarily know what's going on in their heads right away, but we do know that there are kinds of buyers. We understand that there are financial buyers and we understand that there are strategic buyers. If you could share what some of those fundamental differences are to help us understand what separates the two.
A financial buyer, or in fact all buyers clearly are looking for a good return on their investment, that's pretty obvious. But for a financial buyer, that's really their only focus. They're looking to see if they can increase revenues. So if they buy your company, their thesis is I can increase the revenue, I can decrease the expenses, I can increase the profitability so that in three to five years, I can flip the company and make money. So they see it basically as a financial investment where they can apply operational excellence to improve your performance and profitability, and then sell you at a higher price. That's really their only focus.
A strategic buyer is also looking for a good deal, of course, but they have other concerns. For example, a strategic buyer might say, "We want to increase our share in a certain market, or consolidate a fragmented market, or maybe take out a competitor, or maybe the market they're in is not growing that quickly but there's an adjacent market that's much more attractive and they want to get into that market. And so they're going to buy a company that helps them get into that more attractive market segment, or maybe they want to gain access to a key customer or a set of customers they don't have currently.
Or maybe the market that your in is a desirable geographic location, and the market they're in is not, and they want to gain that geographic capability. Or perhaps your company has got some patents or some manufacturing process know-how, or some other trade secrets that really give you an advantage in the market and they want to gain that intellectual property.
A strategic buyer basically is looking for ways that they can accelerate their business. So often, an acquisition is done to simply accelerate that internal strategy the buyer has.
Given what we know then about financial and strategic buyers, which one of those would be more likely to give me more for my company, do you think, based on your experience?
The financial buyer is going to have a hard-nosed approach. They're going to look at the spreadsheet they put together, they got a financial model, and the information you provide. And then they're going to run some numbers, and they're going to look at the return on invested capital or some other similar metric, and compare this investment against other alternatives that they have.
And often they're going to have an internal, what they call a hurdle rate, they're not going to disclose. That's their go, no-go limit. They might say, for example, we want to have at least a 10% return on invested capital by the third year.
And they're not going to pay more than what I would call a market rate. And they can go and look in the market, and they can see what have similar companies in the same space sold for in the last 18-24 months. And that gives them an idea whether it's a multiple of profitability of EBITDA, or multiple of revenue, they get an idea for what the market rate is for your kind of a company. They don't want to overpay for that.
They're going to have this financial model template, and they're going to plug in your actual historical numbers for bookings, revenue expenses, head count, things like that, and they're going to forecast the future outlook. And this outlook is going to be based on several factors, obviously the data you provide, including the future forecast, and then their own assessment of how likely those numbers are to be true, how well they're supported, how consistent they are with prior periods and growth rates, and how much confidence you inspire on other factors.
For example, are your revenue forecasts optimistic or reasonable? For example, do the numbers tie? I've seen as an illustration where a company shows a big ramp up in forecasted revenue after you buy the company, but only a very small change in sales head count, which if you do the math implies a massive increase in salesforce effectiveness, which doesn't compute. So obviously there's no basis upon the higher forecast.
Are you depending too much on a small number of key customers, or is there a risk that your key customer goes to a different player and they lose a whole lot of business. These are the sort of things that they're looking at. Strategic buyers have got a similar process. Because of the strategic considerations, they might pay more.
So generally the short answer is a strategic buyer will often pay more because maybe what you've got is scarce and they covet what you have and they really need it. The financial buyer doesn't care. They’ll go to a different market and buy some other company. They don't care what market as much but the space you're in, whereas a future buyer does care about that.
Sometimes there's a sense of competition to buy your company, and they want to deny your company to a competitor of theirs. A buyer's going to try to get as much information as they can without having to make an offer. And once they make the offer, they're probably going to request what they call exclusivity. And this means that so long as you're in an active process with that buyer you're not going to discuss the company or accept any other offers from any other parties.
The rationale for the buyer is twofold. First, obviously they want to eliminate any potential buying competition, and any kind of upward pressure on valuation. And second, they tend to commit significant human and financial resources and diligence, and they want your undivided attention if they do so. Generally speaking, I would say the strategic buyer is the one who is more likely to pay more than a financial buyer.
You talked about due diligence there or the diligence and taking extra time for that. It sounds to me like any more these days, and you can confirm this, the tendency these days is to spend a significant amount of time where diligence is concerned, and particularly you might say for the financial side, the financial due diligence is concerned, because the value that is placed on value is in fact so high on either side, is that right?
Yes, it is. There are actually several types of diligence that people can do. The first one might actually surprise you but it's what we call market diligence. The buyer's going to be interested in how well you understand your market. Is the market growing, by how much, how to segment it, what are the market drivers, who are the competitors, what head winds are there or tail winds are there? Do you have a sustainable, competitive differentiation?
A buyer is more interested in a weak company in a great market than a great company in a weak market. Because in a great market, you can have a mediocre company and they can improve your performance. A rising tide raises all ships, so you still get good results. But in a weak market, even the best performers are going to get clobbered. So to the extent you can show your buyer that you understand the market you're in, your positioning, and you can articulate why the market is attractive. That's going to help increase their confidence in buying your company.
Beyond that, the phase of diligence they would look at, diligence of course happens after they submit non-binding offers, so the process would be... They may contact you first and you go back and forth a few times in conversations. You sign a nondisclosure agreement typically. Then you might release a little more information. And then you may say, "Now, I want to get a nonbinding offer." If the other party's interested, they lobby a nonbinding offer, and that's subject to diligence, and typical financial diligence, legal diligence, and so on.
And then at that point, you would then open the kimono and disclose pretty much everything that they would want to ask about your company, and the talent, and all aspects of your business. The first phase that a buyer's going to go through at this point is business diligence, which typically looks at your historical and forecasted revenues and profitability, the talent, the org chart, business segments you're in, trends that you have.
The phase of this diligence, the purpose here is to verify whether your original business case or thesis still stands, and there aren't any major customers who are going to defect, or problems with IP ownership, or some other disaster. And assuming this toll gate passes, there’s a lot of toll gates, it's a step they have to get through.
Then the next phase would be legal and tax diligence, which involves all the lawyers and costs the most money, and that's why it's usually delayed until the end. If anything is found in diligence, what the buyer is going to typically do is propose a haircut on the price or some other concession. Like you might say, I want to have a portion of the total price as an earn out rather than I'll pay to closing. So maybe rather than say
ing, "We're going to pay you $25 million in cash," they might say, "I'm going to pay you $18 million, and then I'm going to pay you another 7 after 12 months if you hit the forecast that you promised in your diligence information you provided."
This means that your company has to perform as you predicted in order to get fully paid. If you're the seller, you should be thinking about how you can reduce risk from the buyer's perspective, because you can bet that the riskier they think the deal is the lower the price they're willing to pay, or the more portion they want to push into an earn out.
So to the extent, you can show a buyer that you have clean, consistent financial, stable employment with key employee retention, clear records of IP ownership, clean sales pipeline, good customer list with stable and consistent buying behavior, all these things are going to decrease your risk from a buyer's perspective and help support the valuation that you're seeking.
Let me tell you about my $3 million stapler. This is a funny story. Earlier in my career, actually before I was in M&A, I worked for a firm that acquired a small company with some innovative intellectual property based in Silicon Valley. And this small company had two key guys who developed intellectual property.
And the founders got $3 million for their company, and shortly after the acquisition, they decided they didn't want to work for us and they both quit. And it turned out that we couldn't monetize very well what they had done in the past. We're really counting on their help in integrating their intellectual property into our next generation of products. But with both of those guys gone, all we really had was a company name, which had little value, and some basic office equipment.
Years later, I ended up inheriting the last remaining item, which was an electric stapler. I still have it on my desk. And it's a great reminder that buyers need to structure any agreement to ensure that the key contributors are identified, and there's a mechanism to keep them what I call in the socket, or at least as long as it takes to assimilate their IP or their key customer relationships, or any other specialized knowledge they've got into the organization of the buyer.
Because in a great market you can have a mediocre company, and they can improve your performance. A rising tide raises all ships, so you still get good results. But in a weak market even the best performers are going to get clobbered.
Mark, having said that, how often will a buyer know right away from the get-go who those key individuals are? That's actually something that is going to be born out of that business diligence that's done later on as we get further into the process, is that right?
Yes, it is. And they're going to count on you for that. If you're the seller, they're going to say, "Let's sit down and go through the org chart. And let's talk about every single person here. What is their role, what are their responsibilities, how long have they been employed, how much are you paying them, and what do you see their outlooks are going forward? Are they an A, B or a C? That's often asked. How would you rank them in terms of priority if you're picking people for a baseball team? How important is this guy to be on the team going forward?
And from that, they're going to get a sense of who the key people are. And they'll also get a sense from the description on what the rule is, what the impact could be if they decided to leave the company or bail out.
So typically what happens in a deal structure is the buyer will include in their financial model some money that they're going to have to pay to retain key people. So when the business closes, they're going to pull on the key folks one at a time and they're going to say, "We've identified you as a key employee. You're vital to the business going forward. And to keep you here, we'd like to provide a special incentive, so that if you still show up and have a pulse after 12 months we're going to give you $100,000," or something like that.
That's obviously done to keep the key folks employed there so that you have enough time to learn what they know, to replicate the relationships they have with key customer sites or understand the R&D information that they have, things like that.
Good stuff, Mark Johnston, President of Telementrix, an M&A and strategic planning firm, with us. Once again, Jeff Allen with you looking forward to continuing our conversation with Mr. Mark Johnston when "Deal Talk" returns right after this.
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Welcome back to "Deal Talk." This is Jeff Allen along with Mark Johnston. He's the president of Telementrix of Scottsdale, Arizona. And we're talking about what the buyer is thinking. We talked about those four areas of diligence, market diligence, business diligence, legal and tax diligence. Which of those areas have you found in the past that really do have the most questions, where the most questions seem to come up, where the most issues arise?
The market diligence is usually invisible to the seller. The buyer is going to look at a market they may be interested in and they're going to spend a fair bit of time trying to understand the science of the market, what are the market drivers and tail winds. How is this segmented? What is the outlook for the market, how fragmented is the market, things like that. We're trying to understand what is the attractiveness of the space and what are the things that are really key to being successful in that space.
They're going to be looking at a competitive situation, the customer concentration. How actionable, for example, are the valuations rational? We've all seen markets that are really hyped. For example, a few years ago, the security market was super high tide. And it's pretty hard to do a deal on the security market and feel confident you got a good price, because the prices were just sky high for any kind of security company.
So you might look at markets, understand you're going to have rational price points. And they're going to do all that work before they reach out to you for the very first time because they're going to have already decided that they think the market you're in is attractive. Obviously you're a key player in that market, so part of what they do when they talk to you is they're going to try to verify some of the hypothesis they've developed in their original market work when they talk to you and see whether you understand the market as well. But much of the work is done before they knock on your door.
Then after that, the business diligence is usually where deals fall through. In the business diligence, and I've covered some of these things before, there's a lot of things that can go sideways. And in fact, if I could take a bit of a detour here and talk about why deals may fail and what you can do to try and correct them, the first thing that's going to be a big turn-off in business diligence is if the information you provided turns out not to be quite true, that you exaggerate the revenue, that you claim a major customer, it was key to you. In fact, it turned up to be only a trivial purchase they made. Are your books clean? Do you have some big debt or some other unpleasant financial surprise they find out in business diligence? Are you paying a big licensing fee to someone who is going to cripple the profitability? Is your forecast well-supported? Do you have a lot of stale or obsolete inventory?
All these sorts of things are going to diminish, if you get the wrong answer, the attractiveness of the company. Maybe you've recently cut way back on expenses to make the company look good. They're going to find that out in diligence.
I can't tell you how many times I've seen presentations with this hockey stick revenue forecast. So the revenue up to now has been maybe a 5% growth rate. But as soon as we buy the company, it's going to be a 25% growth rate. So do you have a solid sales pipeline that you can show a buyer that is it more of a wish or is it a real forecast? Do you have trends that show sharp changes and what's happened? These are going to be red flags and investigated extensively by the buyer. In fact, you may find out as a diligence process, whereas as on and on you get what we call “deal fatigue.”
That's where you have to be firm with the buyer and let them know, to say, "Enough is enough." We've spent enough time looking at this stuff and I've given you all the information you asked for. Let's do the deal or part ways. Because some buyers will keep asking forever until you just go crazy.
During diligence, the one thing a buyer is going to do is probably give a haircut to his valuation internally. It's rare they're going to find something you didn't disclose that's going to increase the amount they're willing to spend. Usually the only reason for a price increase is if you're in the very fortunate position of a competitive bidding situation with two buyers that are competitors.
It's almost impossible to bring someone back to the table who's walked away. This is not the situation where you want $30 million and they're offering $25 million and they walk away. That's just negotiation. What I'm talking about is where they decided your company is no longer attractive and they're going to break off the diligence process and return all your materials.
You get a formal letter that says, “We've decided that it's not going to work for us. Here's all your materials back. We're done. Thanks very much.” They often don't give a reason, which can be really frustrating for the seller. But usually the reason is that their adjusted financial model now looks so ugly that the return says there's no point for us in continuing. And when that happens, typically the CEO of the other company has made the decision and they're going to move on to focus on something else. So once they made that decision, it's rare that you're going to have some new piece of information you can give them that will reverse that.
Sometimes you might just be the victim of bad luck. I've seen situations where the CEO or the responsible executive of the buyer suddenly gets fired or replaced, and the new guy doesn't want to do what the old guy was doing. Or sometimes some unforeseen major issue comes up in the buyer company that distracts them from the deal, and they decided they want to bail out.
This comes back to the point I made earlier about the whole risk mitigation. A key part of what you want to do as a seller is make the buyer as comfortable as possible that this is a low-risk transaction. That the revenue is supportable, it's profitable, there's opportunity for improvement, sky's the limit as far as growth possibilities, the talent is strong and will be retained. All these things make the buyer feel comfortable and lessen the risk that they're going to lower their evaluation internally, and therefore make the model look less attractive and have the whole thing go south on you.
After the business diligence, which is the major reason things fall apart, you get to the financial and the tax diligence. And this is where you get the CPAs and the lawyers involved, and they're digging into things. Usually that's not a problem here. Sometimes there's intellectual property, sometimes there's some software companies, for example, that are a bit sloppy. There are some regulations we have in the U.S. that say, for example, that you can't sell software, you can't give some of the intellectual property to companies like North Korea and Libya, and places like that.
I've seen companies that have had free, try-it-before-you-buy download capabilities on their website. Somebody in North Korea clicks on “try it before you buy” and downloads the website, suddenly creates, say, a $500,000 fine liability to your company. In your website, if you haven't put structures in there to ensure that anybody from restricted countries cannot perform this download, you're actually setting yourselves up to be very liable for some big risks.
But beyond things like that, I think the financial and the legal diligence — as long as you don't have any big skeletons or lawsuits you haven't disclosed or things like that — they're usually fairly perfunctory. And you'll end up going to a close if you pass the business diligence.
Is there any assurance that I have as the seller, and I'm a good guy. I try to keep my books clean. I try to do everything I can to lift the value of my company. I do have some people of value here. I want to be able to ensure that they continue on with the new organization. Is there any way that I can work to make that happen or try to make that happen for them?
That's a tough one, Jeff. The easiest way to avoid staff layoffs is to be running lean and profitability in the first place. A financial buyer is generally an expert at process improvement and cost reduction. And they're going to be looking with a very sharp pencil at your average spend in G&A, in R&D, in sales and marketing. They're going to compare those percentages against industry averages. And if they see that you're high, you can bet they're going to plan to make some cuts.
A strategic buyer is likely to be looking for opportunities for staff reduction where there's overlap with their firm. For example, if they're buying your company because you have more products in their same market they're going to say, "Look, we don't need to have two sets of payroll departments. We don't need two IT departments. We don't need two marketing departments."
Maybe some of your product lines overlap with theirs and some of the R&D people are redundant. And there's opportunities for cost savings. The word they use, they've got a code word for this. The word is “synergy” in the sense of we see good acquisition synergies. That means we find ways we can cut costs by reducing some head count.
A certain amount of acquisition synergy with a strategic buyer is usually inevitable, especially in the G&A area, like accounting and areas like that. You don't need to have two sets of AP and AR people, and two sets of payroll people. So unfortunately some of those people, it may not be yours. They're going to look at the talent, and they may find that some people you have are more talented than the people that they have in the same role and they may cut their own people. No guarantees of one way or the other there.
But unless there's really no overlap at all of the new parent company and you're running lean in the first place, the best way you can protect yourself is to be running very efficiently and very effectively so that every single person is vital in your organization. They're all contributing a lot, and they're being paid at market rates, then those people are pretty safe. But to the extent you have overlap with the buyer, that's where they're going to look for opportunities for consolidation.
Mark Johnston, we have arrived at the end of the program or nearly the end. And as we have just a couple of minutes left I was wondering if you might be able to provide our audience here a couple of takeaways that are really, really key about our discussion we've had today about why it matters what a business thinks when it comes time to sell your company.
I think to the extent you understand how a buyer thinks, you're going to make them more comfortable with their process and get a better price. So we’ve talked extensively about how you can mitigate risk. I think you want to be honest with the buyer. If you have a situation where you have a very competitive environment and a lot of price compression, you want to say that. And you want to say, "Here's the situation in our market, but it's a very competitive market. But we have some differentiated products, and here's what we're doing to mitigate this problem."
The extent they can see that you're open and honest and transparent with them, and clear about both the positives and the negatives, because every company's got warts. It's not that you want to make them front and center, you don't want to hide them necessarily. They're going to be found in diligence anyway. And they're going to respect you a lot more and tend to believe what you say if you disclose things. They're going to find out anyway.
When you do that I think you'll find that the process goes faster and it costs you less money. And you'll have a better result that gives you the best price you want.
If we've got some folks out there who are listening to you right now and they would like to talk to you about utilizing your services, Mark, they've got specific issues or they have needs that they know that only you would be able to address for them. Maybe they're in your area of the country, how can they reach out to you, how can they connect?
They can reach me by email at email@example.com. And also on LinkedIn, you can find me there. That's got my contact information as well.
Generally speaking, I would say the strategic buyer is the one who is more likely to pay more than a financial buyer.
Great conversation today, Mark Johnston. Really appreciated having you, and I would like to maybe hope that you would consider joining us again on a future edition of "Deal Talk."
Thanks very much, Jeff. I enjoyed it.
That's Mr. Mark Johnston. He is President at Telementrix, an M&A and strategic planning firm in Scottsdale, Arizona. And I hope that you enjoyed our conversation today as much as I did.
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