When it comes to extracting the most value in exiting a business, David Hammer is one of the most knowledgeable attorneys and CPAs. Last week, you heard part one of my interview with David - but there is more to share. Here is the second half of my conversation with David Hammer:
When it comes to business transactions, one of my favorite sayings of yours is, "if you have only one buyer, then you don't have any buyers." What does that mean?
I borrowed that quote from a long-time client of mine, which happens to be one of his favorite sayings. And what he believes is that to sell your business for the best price effectively, you need to conduct a process that uncovers as many possible buyers for your business as you can. You're not trying to create a bidding war (because you really can't). One of the fundamental pieces of any transaction is a nonbinding letter of intent. (LOI)
There is one single binding provision of a
letter of intent - the no-shop. The no-shop says that the buyer is unwilling to spend all the money, time, attorney expense, and CPA expense looking at the seller's business unless the seller agrees not to sell it out from under him to someone else for some defined period. And so, while it is important to run a process to uncover multiple buyers to pick from, you will eventually have to pick one. The no shop, by design, prevents the seller from playing buyers against each other.
The importance of multiple buyers is not just good from a pricing perspective; buyer's perspectives change, buyer's desires change. If you've put all of your hope and trust in a single buyer, and that buyer
has something in their environment that causes them to back away, you're back at ground zero. Whereas if you have uncovered multiple buyers, you move on to the next buyer you might want to do business with. So there's a protective element associated with that, even though you typically don't see an out-and-outbidding war for any particular client by virtue of the no-shop.
Like in residential real estate and the whole concept of multiple bidders, you've got multiple bidders coming after one house and raising the price. It doesn't happen very frequently in businesses. I suppose it could happen for somebody with some very desirable technology or a disruptive type of service. Still, they will get a high multiple for their business. And it's going to be based probably on the technology and not risk really on the company's financial performance. But that's so rare. And folks who think they're going to get a bidding war, they aren't, but having multiple buyers, having multiple folks looking at your business, will indicate the price range when their offers come in.
Now you know what my business is worth, and it's validated. And if something happens, as it frequently does, after or during due diligence, you have other interested buyers that you can use as a backup. The worst possible thing that I repeatedly hear from prospective clients is, "I just got connected, or somebody just reached out to me from a private equity firm or a strategic buyer, and they want to buy my business. And I want to understand what it's worth." And I say, well, if you enter into an agreement there, you're probably not getting the best price for your business.
But if all you want is to sell the business to get rid of it, then okay. You can engage with one buyer. But if they're interested, other folks are probably also interested in your business and just haven't reached out to you yet. If you're getting calls from prospective buyers, primarily private equity firms, you get those calls because you're breathing and you have a business. They may say we've been following your business for years. But they are just shopping; they're fishing, looking for opportunities, and finding acquisitions. It's scarce for somebody to reach out with a specific interest in your business. Now it happens because some buyer agents are engaged with specific buyers to go and look for businesses. But if some private equity firm calls you out of the blue, I'm not against private equity. They are an essential part of the M and A ecosystem. But if you get calls from private equity, it's probably because you appeared in some press somewhere, and suddenly you made the list that everybody uses to call you. So it doesn't mean that they're necessarily that interested in that you can close a transaction.
Buyers that call you are not calling to offer you top dollar. If they're calling you, don't talk to them. The difference is between being proactive and being in control of the process. You are selecting the people you talk to, or your representative selecting the people you talk to and being completely reactive, where you're responding to whoever happens to call you on the phone. It is not unusual for businesses to receive two or three calls a week. I have several clients that receive two or three of those calls a week. And because they didn't initiate the process, most of those clients chose not to talk.
I would talk to anybody, give them 30 minutes. I could predict how many calls I would get by how much press we were getting. Every time some of that press hit, my phone rang off the hook with folks from private equity. Why? Because they saw me on a list. And that means if you're on a list, y there's at least a decent chance that you're a well-run company. So if you're breathing, then you're probably getting those calls. David, I can tell you that I would get five calls a day on it after getting some of that press like the Inc. 5,000 list.
Well, and that's, that's the other point to note, those people can consume a substantial portion of your time. And if you give them anything beyond an initial call, they really can, because if, if they express an interest. You buy it, the next thing that happens is that you sign a confidentiality agreement with them, and they start asking you for information. They can consume a massive amount of a business's time, simply compiling information in response to a due diligence request. And then if they go away, you've wasted all the time. That's the reason it's so important to be proactive and run a process, prepare all your information in
advance, disclose the same information to everybody that has been identified as a prospective buyer and deal with them in your time, rather than being reactive and responding to them in their time.
So proactive versus reactive and being in control of the process are very important. A well-run process, by the way, investment bankers do these processes. Some business brokers do these processes, but businesses can run a process independently. And we did that with Granbury. We'd been through enough transactions that we decided to run our own, but we ran it like what we're describing here and a well-run sale process. We'd start by identifying those potential buyers, giving them just enough information to pique their interest, and securing the letter of intent that David referred to earlier. Why are letters of intent important, and why should you pay attention to the points in the letters of intent?
Because letters of intent are non-binding except for the no-shop provision that I described earlier, a lot of people tend to dismiss their importance. Still, they're very important because they allow the parties to flesh out all of the deal, breaking, and potential deal, breaking issues that stand in the way of closing a transaction. Then, the well-drafted letter of intent covers all of the different things you need to discuss whenever you sell a business. And if it does, when you get down from the five-page letter of intent to the 60 to 80 page definitive agreement, you don't find these significant issues popping up for the first time that nobody has thought to talk about or consider.
Use the letter of intent to get all the business issues out. Then the definitive agreement can deal with those business issues in a legal context. But if the business people agree and sign their names, fortunately, we live in a pretty ethical business environment. And even though it's non-binding, both parties will generally adhere to what they've signed their names to in the letters of intent. So if you can get that letter of intent, there's a really good chance that your transaction will close.
The letter of intent will point out the big things that you all need to agree on, right? And, and typically in a letter of intent, they're tossing a grenade across your bowel, right. To just see if you're going to agree to these things, right. And, and you should negotiate that letter of intent, you know, just because someone sends you a letter of intent, don't just sign it before you sit down with your attorney and review it and make sure that the letter of intent is appropriate for your business. You know, it's bitten me before, but because of a provision that I found in a letter of intent that we didn't think was important, it turned out to be way more important than we realized later on. But if you review that kind of thing with your attorney to make sure that you do not agree to something that will be detrimental to the outcome when you sign that letter of intent. And so a very important and it's bit me before.
I have two transactions on my desk from very sophisticated clients who signed the letter of intent before sending it to me. And what that points out is the dangers of what Alan Greenspan described as overexuberance. It is really easy for a business owner to receive a letter of intent for millions of dollars and get excited and sign their names. And by doing so, they deprive themselves of the opportunity to flesh out all of the issues that could be standing in the way of those millions of dollars coming into their bank accounts.
So unfortunate, but again, sophisticated people's purchase price for one was 8 million, and the purchase price for the other was 27 and a half million. So these are significant transactions, and people got excited and signed their names. I understand it, but they did surrender an opportunity to go a long way down the path toward ensuring that their deal would close.
It pays to get that legal advice beforehand. We had a rule at Granbury that nobody signs an agreement without passing it by our attorney. When he was our chief counsel, David looked at many contracts. We retooled some of our agreements while he was our chief counsel. And then, later, when Kirk Isaacson became our chief counsel, we paid him a retainer so that he would look at all agreements. I had a rule within our business. Nobody signs a legal document without having it go by our attorney first because you don't always know what you agree to. We don't understand legal language. It pays just to do it.
And so, indeed, when it comes to selling your business, don't sign anything without running it by your attorney. First, you can get that irrational exuberance, as Greenspan said, and I recognize that that happens, but pump the brakes, visit with your attorney because you're going to uncover some things you hadn't thought about yet. And if you have an excellent M and A attorney like David Hammer, he can help with that.
You know, it occurs to me that I probably should have addressed this in the first half of the podcast, but I want to address it here. One of the important things in the unfortunate outcomes is that only 17% of attempted transactions close.
These are even transactions with a letter of intent that go into due diligence and don't reach the finish line. That means 83%, a full 83% of transactions never reach the finish line. And one of the biggest reasons they fail is unrealistic expectations of the business's enterprise value. While I understand that every business and every situation is different, can you give us some rules of thumb that you use when advising clients regarding the valuations of a business?
In a sane universe, it would be reasonably easy to do that. We don't live in a sane universe right now and haven't for the last three years, but let me give you the sane universe response to that question. Everyone's heard of purchase price multiples, but they don't always understand exactly what purchase price multiples mean. In the M&A area, it typically means the number of times EBITDA that a buyer is prepared to pay for your business.
And suppose you're a seller, and you hear a buyer say. In that case, I'm prepared to pay you a three multiple or a six multiple. You don't always know what that means, but in reality, the buyer is looking for the business at a minimum to continue to perform after closing at an EBITDA level as it performed at the closing date. And they're looking for a specific rate of return or return on investment on the purchase price they're paying. So, if a buyer is offering you a three multiple, then that buyer is saying, "I'm going to continue to perform at an EBITDA level like yours after closing.
And I want to make 33 and a third percent on my money." If you divide the purchase price by the EBITDA, which is what the purchase price multiple is, and state it in percent, that's exactly what you're getting. And so many people don't think about the purchase price multiples as indicative of the buyer's desired ROI, but that's exactly what it is.
When folks talk about multiples, they're almost always talking about multiples of earnings. Just the way David just described it. So many times, I've spoken to business owners who say that I could get four times my earnings. So I'm a $4 million top-line revenue business. My business is worth $16 million. I say, in what universe, right? You're $4 million top line.
You're not making any money to the bottom line, and what universe is going to pay $16 million for your business. Business owners hear what they want to hear when I talk to them. When they talk about multiples, they're almost always talking about multiples of earnings. And so, give us some rules of thumb for business valuation. What kind of expectations are there?
For a public company, you can see the multiples in the PTE column opposite the company's name in the Wall Street Journal every day. Private companies are different. And the reason is buyers attach a greater degree of risk in acquisitions of private companies than they do
public companies. And the reasons are varied; accuracy of financial information, lack of processes and procedures the way big public companies have and who are required by law to have. So in the EBITDA multiple universe of a private company, they will usually range from three on the low end to eight on the high end, and three applies to a bottom line or an EBITDA earnings before interest, taxes, depreciation, and amortization of 2 million or less. When you exceed 2 million, and up to about 2.5 million, the multiple will bump to a four. After that, for every $500,000 of EBITDA, it'll bump an additional multiple up to about 4 million in EBITDA, which is an eight multiple business in a sane universe.
And typically, the multiples for privately held companies cap out. You have to have a massive amount of EBITDA to be able to demand a multiple bigger than eight if you're running a private company.
I completely agree. So look, most businesses are smaller than 10 million in revenue. So the expectation for those businesses will be a three multiple or less, correct?
Yes. And if, if they're a well-run business with 10 million in revenue, they're probably putting a million dollars in EBITDA every year that will likely sell for $3 million in, in the sane universe.
Private equity sometimes messes up some of these multiples because they've got a lot of dry powder, and they're overpaying. There's never been a better M&A time than we're in right now. It is absolutely a seller's market. And you might be able to get higher today. But if you're already not into a process today, don't start one today and hope that it closes this year because it takes time to do that. On average, it's 12 to 18 months to close a transaction. And so, so if you're, if you are for sale right now, you know, congratulations you, I hope that you can take advantage.
So then, once you have a letter of intent, let's go back to the letter of intent. Once you have a letter of intent and before a transaction closes, the buyer and the seller have to agree to a definitive agreement, right? So can you give us some major points of what a well-written definitive agreement should include?
Then, the typical definitive agreement in a million-dollar-plus purchase price, let's say, will be between 40 and 80 pages. And it will say five relatively simple things. It will tell the reader what the seller is selling, what the buyer is paying, how the buyer is paying it, what the seller is telling the buyer about the seller's business. And then the last category is the give-backs which are the circumstances under which the seller might be required to part with a portion of the purchase price. Some of the things or one of the things that the seller sold the buyer about the business turned out not to be born out by the facts after closing.
So those are the five essential things. And out of those 40 pages, typically, about 25 of those pages are what the seller is required to tell the buyer about the seller's business. Now, why does it take 25 pages? The reason is that the buyer is asking the seller to represent that they have the perfect business. Now that's counterintuitive on its face because there is no such thing as a perfect business. And no buyer believes that its seller has the perfect business, but the representations and warranties are designed to elicit disclosure.
A buyer doesn't believe the seller has the perfect business, but the buyer wants the seller to tell the buyer about all the imperfections. And so you have 25 pages worth of representations and warranties supported by seller disclosure schedules that say to the buyer what the buyer believes it needs to know to run the business effectively after the closing.
Those seller disclosures are really important. And why is it important to have full disclosure? Why is that?
Absolutely! Essentially the seller's disclosure is the seller's get out of jail free card. If you tell the buyer about all of the problems in your business and your buyer closes anyway, they can't come back to you after the transaction is closed and say, you never told me I need some of my money back. If you disclose the problems, you generally, and I say, generally, escape liability. Now some of those problems are so significant that a seller will say, look, I can't deal with this problem without some specific financial guarantee from you, should it result in financial liability to me.
And in those situations, you may have specific indemnity provisions that apply to specific circumstances. But I can tell you in 174 closed transactions that I've been personally responsible for, plus the many more transactions when I was at Deloitte or as a young associate in the law firm. It has been decades since I've seen a case of specific indemnity for a particular problem. It's not unusual. Sellers have nothing to fear from full disclosure, and they have everything to gain by fully disclosing.
I love that you call it the get out of jail free card because it is. Whatever you disclose there or don't disclose, they discover later or things that can come back against you. We used a little, a little known mechanism in our last transaction that I remember surprising our friend, Jay Rogers; with we had 36 shareholders, but only five of us controlled almost 95% of the business. And then the balance of our shareholders were very minority shareholders. And so in our, we had two different purchase agreements.
Then, in the majority share purchase agreement, we agreed to the reps and warranties. And in the minority agreement, we excluded them, meaning that those people didn't have enough gain out of this to even, and they were not involved in the business and therefore were the ones who should be held accountable. And it allowed us to get a hundred percent agreement on the transaction. And so I remember when Jay Rogers called me and said, I've never seen such a thing, Bronson. And I explained to him what it was. He said, well, that's brilliant. We need to start using that.
I've used that mechanism on another transaction myself, where there were passive investors who didn't have enough knowledge about the business to be willing to take the financial risk of liability for
representations and warranties.
Yes. So there are ways to do that with very minority and passive investors and things like that. But you know, it's very common for sellers when they get that letter of intent in that initial offer to get those stars in their eyes and sign things without obtaining legal counsel to have a look at it. But it's also equally common for buyers to come back and reduce the offer after due diligence. So I thought I had a $10 million deal, and now I got an $8 million deal or worse, a $5 million deal. Why and how did they do that?
The circumstance is commonly referred to in the trade as a retrade. The buyer comes in and retrades the deal in a way that's always more favorable for the buyer, supposedly because of something they have uncovered in due diligence. And when I say supposedly, occasionally, a buyer will have uncovered something in due diligence that suggests that the business was not what the buyer thought it was whenever they tendered the original offer.
And in that situation, when a buyer can demonstrate the facts they were relying upon, usually because the seller-provided the facts were not born out in reality, that retrade is totally justified. Now, another type of buyer is a more nefarious buyer who believes that no seller will risk a transaction for 10% of the purchase price. And so their standard method of operation is to make an offer. And shortly before closing, come in with a retrade that reduces the price by 10%.
Now they will always come up with a reason why it's the seller's fault, but most of the time, that reason is specious for that particular buyer. And the buyer is simply looking to save 10% of what it originally agreed to pay. Fortunately, we don't see that much in the ethical business environment that we have in the United States. And we do, however, see the situation where the facts as the buyer uncovered them were not the facts that the seller represented. And those are the more challenging deals. And in the first case of the nefarious buyer, the seller has a simple decision to make.
Do I want to do business with somebody that would do this because I know that the circumstance that they are citing is not right? That's a fundamental business decision. Do you want to start over with a new buyer, or do you want to take a 10% reduction in your price to get the thing over with? In the other situation, the parties typically negotiate a mutually agreeable solution because they are both prepared to acknowledge that the facts as born out were different from what one or both parties thought.
It goes to that whole no-shop provision. Due diligence can drag on for months and months and months. And the biggest thing that slows down due diligence is seller responsiveness to their requests. So that's why our whole business model is around preparing a business for transition so that you can be very responsive. You know, the old saying speed kills, right. You know, which was meant to slow down on the highway, speed kills deals too, when they go too slow. Right? But the other thing that happens, especially with these nefarious buyers that you're describing, you're in that no shop period. They drag it on due diligence for a very long time. You are mentally and physically committed to this deal. And then they punch in the face with a, with a 10 per 10% reduction or worse. And just to test and see, you know, can they get that because you're already emotionally and mentally committed to this deal. So many times, you'll just roll back and accept that deal. But there are other times when it's not nefarious that they discover things you didn't disclose in advance. This is why it's so important to run a good clean process in the beginning. Disclose all of the wards in your initial material that you provide them before you sign a letter of intent. Let me give you an example of how that worked for us.
And, and with this last company, they have an IRA with. In our marketing process, we had management presentations before we took final letters of intent to kind of explain kind of the state of the business, what our vision was, where we were going. And in one of those presentations, we disclosed that we had just a horrible customer satisfaction rating in one of our businesses. We had recently acquired some businesses, and we're working to fix them. But we knew on an NPS score, which runs from minus a hundred plus a hundred. We had a minus 27 in this.
Everybody hated us pretty much. Right? So, but, but we knew that. And because of that and knowing that, if they uncovered it, that could cost us. We disclose that in advance. Now fast forward to 30 days before closing, or not even probably three weeks before closing, I get a call from the CEO of the buyer, and, you know, he's making nice. And we're talking about the weather and things going on. And I said, I said, you know, I, I don't suspect that this is a social call. What do you have on your mind? And he said, well, we've just finished due diligence. And there are a few things I want to talk to you about now being a savvy seller, somebody who's participated in transactions.
I'm happy, and this is the retrade conversation because now I know where he wants to take this. Right. So I'm ready. Tell me. And he says, well, what we've discovered in due diligence is that this one division has the absolute worst customer satisfaction rating we've ever seen. And as a result of that, we're going to have to reduce the purchase price $1.2 million. And I said, wow, that is unfortunate. Can you tell me how did you measure the score in that business? Because I'm leading him. Now, I know that I've already disclosed this. And he said, well, we measured it at a minus 24.
I said, really, a minus 24, that's pretty bad, but it's not the worst I've ever seen. He said, what do you mean? And I said, do you happen to have the presentation we gave you? And I'm flipping through my calendar real quick on August 11th, when your team came down, and we gave you our management presentation. Do you happen to have that on your computer? And he said I do. And I said, and I'm frantically opening it and flipping slides. And I said, there it is. What, why don't you open it and flip to slide 76? And he said, well, what will I find on slide 76? I said, you're going to discover that I disclosed to you that we had a minus 27 NPS score and what your, and we also disclosed on that slide, what we were doing to fix it.
And what you're telling me is that what we're doing is working because we've improved three points since that time. And so, while I appreciate the fact that this is the call to retrade, it's not going to be on that. So what else do you have? And so, and so I was able to hold off that retrade because I disclosed it in advance of him providing the offer that we ultimately accepted.
So you also demonstrated an attitude. That's very important there that I think is, is summed up by the business speaker, Herb Cohen, Cohen always advises that in a negotiation care, but not too much. I talk about it in the context of falling in love with the deal, never fall in love with the deal, because if you're a seller and you fall in love with the deal, you are easy prey for both the nefarious buyer and even the buyer that has a good faith reason to retrade your price.
Yes. As I used to say, when I worked in retail, even honest people will steal from you if you give them ample opportunity to do so. So you're right, it's it. You have to go in with that mentality. So many business owners are surprised by the re-trade conversation that I thought we had a deal. Well, perhaps you didn't disclose something, or perhaps you have an affair expire, but our clients know, I tell them this, isn't when we get a letter of intent, this isn't the last time we're having a conversation about the purchase price. We're going to get through our due diligence. And we're going to see what they find and see where that goes.
It's very rare, but not completely rare. It's, it's less than 50%. You might give me a better number, but less than 50% of deals close at the price given on the LOI. There's always some adjustment on that.
And I don't doubt the statistics, but it doesn't square with my experience on either the letter of intent side or the purchase price side. I have never tried to quantify this, but if I can get a nonbinding letter of intent for a seller, it is close to guaranteed that the transaction will close. And when I say guarantee, I don't mean a hundred, but it's well into the nineties in my experience set. Now I may have a different experience set than other people and would submit that I probably do, given the accuracy of those statistics, but the more you get into that nonbinding letter of intent, the more you improve your chances of closing the deal on those terms. And that's why it's so important to get that letter of intent done correctly and broadly as the basis for moving your transaction forward.
Absolutely, absolutely. It starts at the beginning. Don't try to go back at the end and fix those things. Get good legal advice, which is why you're here today. There are some ways that buyers save cash at closing when buying businesses. Can you comment on some of those things, notes set-offs, earnouts?
The biggest way that buyers save cash is through the valuation multiple. They look at your EBITDA level and then try to convince you that your business is flawed to the point where you don't deserve the EBITDA multiple. You know, you should receive even a fraction of one turn EBITDA is significant purchase price dollars. And so that's the primary way purchasers save cash. Probably number two on that list, I would say is, is with the structure. It's very important to a buyer to be able to purchase assets of a business because of the ability to amortize purchase price allocated to intangibles and goodwill over 15 years. If they're buying assets, they will be selling or saving cash by virtue of the intangibles and the goodwill. But then, that's more a function of your organization than anything else.
If you're a pass-through entity, you don't have a whole lot to worry about in the context of the structure because the buyer will get its preferred asset purchase treatment, and you'll only get taxed once. If you're C-Corp selling assets, the buyer will save cash by insisting on an asset deal, and you'll pay two levels of tax and be the sadder for it. The third way is the allocation of purchase price, which we've also touched on. We don't need to revisit intangibles and goodwill. I think we've made a point of that, but one thing that that does happen an allocation of purchase price in an asset transaction, which, as we've said, is, is the buyer's preferred method of operation - a method of structure.
What does happen is that the occasional buyer will not be happy with amortizing the purchase price over 15 years. And they will look for ways to amortize it over a shorter period of time. The way of choice is to look at fixed assets and attempt to mark up those fixed assets above the depreciable basis for those assets. If you're a seller, the problem with that is that you have depreciation recapture under section 1245 and section 1250 if it's a building. So, you pay tax at ordinary income rates on purchase price that is allocated in excess of taxable basis to those two categories of fixed assets.
And you have to be aware that the buyer's motivation for doing that is to reduce the period of time over which that portion of the purchase price is amortized or depreciated. So that becomes a real way for buyers to save cash at closing. They do it with the timing of the closing. There are two ways to accomplish this. There's a close referred to as a sign-in close where the parties sign a definitive agreement where some period of time elapses so that things like buyer financing and sellers obtaining consents to transfer assets and contracts can be obtained. Then they close once those conditions have been satisfied.
The second type of closing is a simple contemporaneous close. This is where the party signed the definitive agreement, and the seller gets their cash right then. While you can get your cash in a sign-in close, the buyer is still delaying the time you get your cash while your business is off the market, and they've imposed certain restrictions on your ability to operate the business in the meantime. So, you don't want the buyer to delay your cash either by suggesting a transaction where there's a sign-in close. Timing of the payments and how the buyer is paying the purchase price is another big area where sellers' cash can reduce.
How do they do it? Buyers do it by offering a portion of the purchase price and a promissory note in an earnout or a contingent payment tied to certain conditions' occurrence or non-occurrence. So to the extent that notes earn-outs or contingent payments are part of your deal, your cash is delayed, and you may not get it because there's no guarantee that your buyer will perform after the closing. There's no guarantee that the business will meet the milestones for an earnout payment will be met after closing. And so, you always have to be aware of the possibility of not receiving that portion of the purchase price that is to be delivered by way of promissory note contingent payments or earnouts. Those are just a few of the ways.
You may want to talk about some of those categories more carefully. We haven't talked about purchase money escrows and holdbacks. We haven't talked about working capital deliverables.