Chapter 3

Previewing the Generally Accepted M&A Process

In This Chapter

Walking through a typical M&A deal

Discovering the difference between an auction and a negotiated transaction

Looking at both Buyer’s and Seller’s position

Keeping tabs on who has power

Although the truism “always be prepared” applies to just about everything in life, it’s especially true in mergers and acquisitions. To the uninitiated, the world of M&A may seem to be a Wild West of sorts: chaotic, bizarre, and full of strange nomenclature and acronyms. But believe it or not, the buying and selling of companies has a clearly defined process. To be a successful Buyer or Seller, you need to understand how that process works so that you can think many steps ahead and plan accordingly — just like a chess game, but without the checkered board.

In this chapter, I break down the phases involved in a typical M&A deal as well as define the two methods of selling a business: auction and negotiation. I also look at the constantly changing power balance between Buyer and Seller in a deal and provide suggestions on preserving as much power as possible in less-than-ideal circumstances.

Take Note! The M&A Process in a Nutshell

You don’t wake up one morning and suddenly decide you want to buy or sell a business. A good deal of planning occurs before Buyer or Seller can undertake the process of buying or selling a business, let alone successfully close a deal.

The number of steps in the M&A process may vary depending on the type of deal you’re negotiating (a quick auction versus a drawn-out negotiated sale, for example), but overall the process more or less remains the same. That’s why being well versed in the generally accepted steps in the following sections is so important. M&A professionals have honed these steps over the years, and each step has a specific purpose.

The process to buy or sell a company isn’t as linear as you may think, and it often takes longer and costs more than you expect. These steps aren’t carved in stone, nor are they the be-all and end-all. Don’t become rigid in your approach to doing deals; feel free to riff on these steps and write your own variations on a theme. The key points are to disseminate information in a timely, orderly, and appropriate manner and to close mutually beneficial deals.

To keep the process moving along, Seller needs to create a line in the sand by instilling due dates. The first due date will be for indications of interest. Buyers will almost always be late in submitting their indications, so Sellers are wise to allow for a little padding of time.

Step 1: Compile a target list

If ownership decides to sell or make acquisitions following discussions with advisors, family, friends, and management, the process begins by identifying prospective Buyers or Sellers. The key word here is prospective; these businesses may or may not be interested in doing a deal. You begin to make that determination in the following steps. Chapter 6 provides a much deeper dive into the process of researching, compiling, and culling a list of targets.

For a successful acquisition or sale campaign, I strongly recommend having at least 75 prospects, and preferably more than 100. Having a small universe of prospects simply lowers the odds of finding the right deal, but a list of many more than 150 targets gets untenable.

Step 2: Make contact with the targets

If the target list seems viable enough to warrant going through an M&A process (see the preceding section), Seller or Buyer begins to reach out to the targets. Some people prefer a passive approach (e-mails or letters), while others prefer a more assertive approach (phone calls). I prefer making calls when contacting Buyers (believe me, most of them are literally sitting by the phone waiting for a Seller to call). Contacting Sellers is far trickier. Check out Chapter 6 for more on contacting Buyers and Sellers.

Avoid hyperbole at all costs. Although I’m a big fan of creating a sense of urgency and having a call to action in my correspondence, telling prospective Buyers they need to act quickly or else they’ll lose out on the greatest thing since sliced bread makes you sound like a snake oil salesman.

Step 3: Send or receive a teaser or executive summary

If Buyer wants to learn more about the company for sale, Seller will forward a teaser to Buyer. The teaser (sometimes called the blind teaser) is an anonymous document that provides just enough nonconfidential information to pique the interest of Buyer. As the name implies, the teaser is designed to tease Buyer into a frenzied state of wanting to know more.

An executive summary is similar to a teaser but isn’t anonymous. These documents are the doorway that leads to the other steps in the process. Chapter 8 provides a lot more information on these documents.

Step 4: Execute a confidentiality agreement

If, after reading the teaser (discussed in the preceding section), Buyer is interested in learning more about Seller, the two parties often execute a confidentiality agreement (CA). (On planet Let’s Use More Words, this document is called a nondisclosure agreement [NDA]). Essentially, Buyer promises to not share any of Seller’s confidential and nonpublic information with anyone other than Buyer’s advisors. Chapter 7 offers a detailed look at all the ins and outs of confidentiality.

The confidentiality agreement doesn’t just extend to confidential information. As part of the agreement, Buyer usually agrees to not even mention that M&A discussions are ongoing.

Step 5: Send or review the confidential information memorandum

If the confidentiality issue in the preceding section is socked away and settled, Seller provides Buyer with a boatload of information, usually in the form of a book known as an offering document, deal book, or some similar title. The offering document provides a huge amount of informational about Seller: financials, customer info, employee info, products, marketing, operations, legal, real estate and fixed assets, and more. The offering document should provide sufficient information for Buyer to make an initial offer. I cover offering documents further in Chapter 8.

Step 6: Solicit or submit an indication of interest

If the Buyer reviews the offering document (see the preceding section) and is interested in pursuing a deal, Buyer indicates that interest in the aptly named indication of interest (IOI). An IOI provides a valuation range (not a specific price) Buyer would consider paying for the company, as well as some other basic info (estimated closing date, source of funds, basic composition of the purchase price, and so on). An IOI is nonbinding, which means it can’t be enforced in a court of law. See Chapter 9 for more.

Step 7: Conduct management meetings

When the Indication of Interest covered in the preceding section is acceptable to Seller, the next step is for Buyer to meet with Seller’s management team. Seller conducts the meeting, which provides a financial update as well as updates to any other issues that may be pertinent for Buyer, such as new customers, lost customers, new hires, new product launches, litigation, and so on. The meeting also allows Buyer and Seller to interact and engage in question and answer sessions — and to gauge whether both sides can play well together. Chapter 10 gives you the lowdown on these meetings.

Step 8: Write or review the letter of intent

If Buyer’s management has met Seller’s management as noted in the preceding section and is interested in making a firm offer, the next step is the vaunted letter of intent (LOI). The LOI is a nonbinding document that forms the basis of the final deal. It contains a specific purchase price (rather than a range) and provides the steps needed to close the deal. The LOI usually includes an exclusivity clause, which means Seller can no longer negotiate with other Buyers. Flip to Chapter 13 for details on making and receiving offers.

Exclusivity is an enormous issue! Grant it carefully.

Step 9: Perform due diligence

When Seller accepts Buyer’s LOI (see the preceding section), the process moves to due diligence, where Seller discloses all its contracts, financials, customer info, employee info, and much more to Buyer. These days, the due diligence info is usually provided in a secure, online data room. Seller’s investment banker manages this process, which I cover more thoroughly in Chapter 14.

Step 10: Draft the purchase agreement

If due diligence (see the preceding section) is progressing reasonably well, the parties draft a purchase agreement. The purchase agreement is the final document, which means it’s the binding document (at long last!). The lawyers for Buyer and Seller work out the details of the purchase agreement; see Chapter 15 for more.

When drafting the purchase agreement, make sure the lawyers hammer out the legal details and only the legal details. All of the business particulars should be handled by the investment bankers. Lawyers should never, ever, upon pain of death, negotiate a single business term! It’s not their job. Lawyers aren’t the deal-makers; they’re the people who make sure the deal-makers don’t agree to something illegal or unenforceable in a court of law. Business and legal issues are two separate worlds and each should be handled by the appropriate party.

Step 11: Show up for closing

When the parties are ready to wrap up the deal, both sides meet (usually in a lawyer’s office) to close the deal. It’s mainly a sign-this, sign-that kind of a day, much like the closing for buying a house. After all the documents are signed, the money is wired to the appropriate parties, and the deal is done! Chapter 16 provides more info on closing.

Step 12: Deal with post-closing adjustments and integration

After the deal actually closes, the real work begins: tying up the loose ends of the deal in the post-closing adjustments and integrating the acquired company into Buyer’s company. See Chapters 17 and 18 for more on how to do just that.

For those of you who successfully complete the M&A process, there’s a special Step 13, a hidden track on the M&A CD, if you will: enjoying your success. One of the benefits of successful deal-making is the money, the wealth creation, and the self-actualization that comes from success. Before you think that’s merely a joyful ode to money making . . . well, okay, it is. But more than that, successfully doing deals means creating wealth and opportunities for others. A consummate deal-maker expands the economy as she improves her personal balance sheet. The best deals, where both sides make money, come from the value creation of hard work and ingenuity and the hardnosed ability to negotiate mutually beneficial deals. If you don’t believe that — if you can’t sleep well at night because engaging in M&A activities bogs you down with some sort of guilt — you may want to find a new line of work.

Exploring Two Types of M&A Processes: Auction versus Negotiation

The world of M&A breaks down into two large camps: negotiated sales and auctions. Although they’re similar (they both follow the same steps outlined in “Take Note! The M&A Process in a Nutshell” earlier in the chapter), auctions and negotiated sales have a few key differences.

An auction is a business sale process where a group of Buyers makes their final and best bids and the company goes to the best bid. So what does best bid mean? In most cases, the best bid is the highest price, although Sellers do examine other factors, including Buyer’s ability to close a deal, how much of the sale price is in cash, and when Seller will receive that cash.

For example, say Seller is examining two bids. One bid has a total deal value of $10 million, with $1 million in cash at closing and $9 million in the form of a note (a promise to pay later). The other offer is for $5 million, all cash at closing. Which is the better deal? Perhaps the first bid ($10 million total value) makes the most sense; after all, it’s more money. But depending on the situation, the second bid, although lower, may make more sense; perhaps Seller is willing to forgo a higher potential price for the certainty of more cash today.

A negotiated sale occurs when Seller (or Seller’s advisor) talks with each Buyer and perhaps tailors the pitch to highlight those benefits that will be most appealing to each individual Buyer. A negotiated sale still has elements of an auction (numerous participants making bids), but a negotiated sale involves a lot more hand-holding of the Seller.

Which process is better depends on the situation. An auction usually works best for larger, well-known companies. In these cases, Buyer may be willing to pay a premium for a famous company.

A negotiated sale works best for smaller companies or companies with losses or thin profits.

Some Buyers shy away from auctions. Although an auction can be a great way to sell a company, the auction may result in an unintended consequence: no bids!

Who Has It Easier, Buyer or Seller?

Anyone who has worked a sales job has probably dreamed about being on the other side: the buyer, the person who seemingly has all the power. Buyers, after all, are the ones who pick and choose. They get to interview numerous possible vendors and pick the one that delivers the best combination of price, quality, and, often, the intangibles of an interpersonal connection.

But in mergers and acquisitions, that scenario gets flipped on its head. Buying companies is actually more difficult than selling companies because the M&A Buyer plays the role of vendor; Buyer has to market its deal to Seller the way a traditional salesperson would sell his or her product. The following sections look at each of these positions.

Selling is easy if you know what you’re doing

M&A is a strange industry because it’s one of the few that I can think of where the selling functions are in many ways easier than the buying functions.

Simply put, quality companies with critical mass are in demand. (For more on what that means, see the nearby sidebar.) Suffice it to say that after a company gets above a certain revenue level and especially a certain profit level, Buyers of all shapes and sizes start chasing it. When an owner decides she wants to put her company up for sale, she stands a good chance of being in the driver’s seat. Assuming she follows the proper M&A process (as I outline in the earlier section “Take Note! The M&A Process in a Nutshell”), she’ll likely have multiple offers, thus putting her in a position of control.

Although I call selling “easy” earlier in the chapter, keep in mind that that’s a relative term. Selling is typically easier than trying to make acquisitions, but selling a company is fraught with challenges, difficulties, ups and downs, and sheer white-knuckle poker playing. For more on actually navigating a sale, check out Chapter 11.

What’s a quality company of critical mass?

Although definitions vary from Buyer to Buyer, critical mass simply means a company that has size, scale, and scope. In other words, it isn’t a start-up or an unprofitable company selling a product indistinguishable from the competition.

In a very general sense, critical mass may mean any of the following:

Revenues north of $10 million (and the farther north, the better): Larger companies usually have more critical mass than smaller companies because they’re often able to withstand an economic decline. They have more company to go around! Nothing is particularly magical about $10 million other than the fact that it’s larger than, say, $1 million. But after companies pass this threshold, they’re often considered lower middle market companies, which simply means they’re not a small company anymore. An unprofitable company with enough revenue may even have value to the right Buyer. Think of it this way: Say two companies each have an annual loss of $2 million. Everything else being equal, would you rather take Company A with $5 million in revenue, or Company B, with $100 million in revenue?

EBITDA north of $2 million: Similar to revenues, the higher the EBITDA (earnings before interest, tax, depreciation, and amortization), the more critical mass for the company. Companies with large-enough profits will always be in vogue with Buyers. A company with only $500,000 in EBITDA may be more susceptible to an economic downturn than a company with $5 million in EBITDA.

Access to C-level decision-makers at clients: C-level executives are the top-ranking (CEO, CFO, and the like) executives at companies. Selling products or services into the executive ranks is often a coveted level of access, and companies that lack that sophistication may be willing to pay a premium for it. Wouldn’t you rather have the CEO, CFO, or some other high-ranking official than some low-level flunky as your decision-maker?

A strong name, good reputation, and/or brand awareness: Many Buyers are interested in obtaining these intangibles. In fact, a solid brand and reputation can help an otherwise troubled company generate a good price during a sale.

Buying is difficult even if you know what you’re doing

Believe it or not, buying a company is more difficult than selling one. Owners of companies are bombarded on an almost daily basis from all sorts of Buyers. I’m constantly amazed by the fact that these would-be Buyers, be they private equity firms or investment bankers working for a strategic Buyer, are often oblivious to the fact that a Buyer is little more than a commodity to the owner of company with $10 million or more in revenue. Buyers are a dime a dozen.

An added difficulty in buying a company is that Sellers fall into two basic camps: those who know they want to sell and those who don’t want to sell. Deals offered by those who know they want to sell are difficult deals for Buyers because a wise Seller has gone through the M&A process I cover in this chapter and has hopefully generated interest from multiple parties, thus putting her in the enviable position of having options.

Those who have no interest in selling are difficult deals because they aren’t looking to do a deal! They aren’t selling their business. Period. And if the company has critical mass — that is to say, sizeable revenues or profits or a strong brand name — the owner is tired of receiving a constant barrage of phone calls, e-mails, and letters from Buyers of all shapes and sizes who all say the same thing: “We have money, we’re different, and we want to buy your company.”

Even worse, many of these so-called Buyers aren’t seriously looking to buy and instead are on fishing expeditions and have entrusted the cold-calling to the lowest-level executive they can find. Many times, the person making the phone call is fresh out of business school, which means he probably hasn’t yet learned any real-life business lessons.

Buyers, take note: Never say “We have money, we’re different, and we want to buy your company.” Everyone says that! For tips on how to better entice an otherwise uninterested business owner, see Chapter 6.

Another obstacle for Buyers looking for acquisitions is that targets are quite often the Buyers’ competitors. Understandably, the owners and executives of these companies are extremely reluctant to talk to a competitor, let alone give up sensitive information such as revenues, profits, customer data, sales compensation, and the like.

Following the Power Shifts in the M&A Process

During a typical M&A process, the power shifts from Buyer to Seller and back again many times depending on which party has more riding on a particular stage of the deal. This swing in motivation, plus a little poker-esque bluffing and tell-reading, means the power balance in a deal is constantly shifting.

Being cognizant of the power issue is extremely important as the savvy deal-maker navigates the sea of deals because, as negotiations progress, who’s in power one day may not be who’s in power the next.

Looking at the factors of motivation

The most motivated party in a deal is the one most likely to cede power to the other side to make sure the deal goes through. But what exactly provides this motivation? Several factors:

Interest: The side that has the most interest in doing a deal probably has the least power because that party will be most willing to compromise in order to get a deal done.

Although you don’t want to appear overly interested to do a deal, you don’t want to inadvertently appear blasé, either. Failure to show interest, respond to requests, and answer questions may cause the other side to call a halt to the process because it’s concluded you’re not interested.

Desperation: Nothing spells “weak negotiating position” like the smell of a desperate owner who is desperate to do a deal desperately quick! Desperation often indicates an impending business failure, thus greatly increasing the willingness of the owner to accept a deal, any deal.

Boredom: A business owner who is bored and wants to move on to something else can unwittingly become a highly motivated Seller. Broadcasting that boredom to potential Buyers puts those Buyers in a huge power position.

Time: Time is the wild card in the motivation game. A Seller who wants (or needs) to do a deal right now will likely cede power to Buyer. Conversely, the longer the process takes, the more the power may flow back to Seller because Buyer becomes the one who has invested time and money and increasingly needs to get the deal across the finish line.

Money: Deals don’t get done for free. Buyer and Seller have to retain advisers. The more money one side spends, the more that side (often Buyer) wants to get a deal done so as to not waste that money. Buyers are most often guilty of overspending.

The more money a side spends during the process, the greater the odds are that that side will want to get a deal, any deal, across the finish line. No one wants to spend money and have nothing to show for it.

Understanding who has power

Typically, Seller has a lot of power early in the process. As the party being courted, Seller controls whether meetings occur and whether information is exchanged.

One way Buyers can get more power early in the process is by submitting a pre-emptive bid, making a bid before other Buyers have made their bids and knocking out all other possible suitors. Eliminating competition is a boon for any Buyer and puts Seller in a vulnerable position. If Buyer subsequently decides against closing a deal, Seller has lost time otherwise spent talking with multiple Buyers and thus finds itself back at square one.

Even without a pre-emptive bid, the power balance swings toward Buyer when the parties sign an LOI with an exclusivity clause. (You can brush up more on these terms in “Step 8: Write or review the letter of intent” earlier in the chapter.) At this point, Seller can no longer speak with other Buyers.

If Seller accepts a pre-emptive bid from Buyer, Seller should insist on removing the exclusivity clause from the LOI. Short of that, Seller should include language in the LOI that ends the exclusivity period and allows the Seller to speak with other Buyers in the event that Buyer attempts to change the price or terms of the deal.

From the signing of the LOI through closing, Buyer most often calls the shots. However, the longer the due diligence and purchase agreement drafting takes, the more the power may shift back toward Seller because Buyer is investing more and more money as the process goes on.

Some Buyers, most notoriously private equity (PE) firms, retain advisors whom they pay after the deal closes. The longer the process takes, the more those bills accumulate. PE firms typically pay those bills with the proceeds from the closing. And guess what? The PE firm managers making all of these decisions probably don’t have the money at ready access; they need to request cash from various sources (the fund itself, the fund’s limited partners, and other lending sources such as banks).

If a deal falls apart and doesn’t close, the firm employees working that deal probably don’t have the ability to simply write checks. They have to go back to their bosses, tails between their legs, and ask for money. The employee’s spiel goes something like the following (apologies to Monty Python’s “Dead Parrot” sketch):

Hi, boss. Bad news. The deal is no more. It has ceased to be. The deal expired and has gone to meet its maker. It’s an ex-deal. Can I have a couple hundred grand to pay off all the professional services firms that did all kinds of work on this deal that turned out to be all for naught?

As you can imagine, that’s not an enviable position to be in.

To give you a visual of all these power shifts, Figure 3-1 details who has the power in the various steps of the M&A process. For more on the steps themselves, check out “Take Note! The M&A Process in a Nutshell” earlier in this chapter.

Figure 3-1: Following the power during the M&A process.

Reading the other party’s situation

Whether you’re a Buyer or Seller, in any sale process you want to be able to read your opponent like a poker player. You want to know whether you’re in a strong position or a weak position. The stronger your position, the greater your negotiating leverage.

The four positions are as follows:

You have a strong position and your opponent knows it. This situation is where you may need the most skill. You have the upper hand, but if you push too hard, you lose the deal or get a less-than-ideal return. In poker, if the table knows a person has a great hand, all the other players fold. Although he wins that game, the strong hand can win bigger by downplaying his hand and keeping the other players betting for longer.

You have a strong position and your opponent doesn’t know it. Being underestimated is a great thing! Hubris is the great enemy of getting deals done, so let your opponent crow and brag. Check your ego at the door and play the simpleton. Remember, what people think of you during the process isn’t what’s important; how the deal ends is. And if it ends in your favor, what do you care about what other people think?

You have a weak position and your opponent knows it. This position is the danger zone. Your options are limited, and the other side is calling the shots. In this situation, your best bet is to move as quickly as you can and close the deal. Take your lumps, lick your wounds, and move on. The longer you linger, the worse your deal may get.

You have a weak position and your opponent doesn’t know it. Time to test your poker-playing skills and bluff. I’m not saying you should lie, but you have no reason to say (or show) you’re in a precarious position simply because you are. Finding that out is the other party’s job, and you don’t need to make the other side’s argument.

So short of having ESP, how can you ascertain the strength or weakness of the other party’s position? Here are a few pointers:

Ask questions and shut up. Let the other person talk. You may be amazed how much someone divulges when given a chance to talk.

Find out about the other party’s personal interests and likes. What seems like an innocent discussion about hobbies may reveal that the guy on the other side can’t wait to sell the business and pursue his real passion (be it sailing, travel, golf, volunteer work, or whatever).

Pay attention to details. For example, observe the faces of the employees when you visit the other party’s office. Are they generally upbeat and happy, or do you see a lot of long faces? How clean and orderly is the business? Messes, clutter, water stains, burned-out bulbs, mold, and so on are often the signs of a business in decline. The employees (and ownership) no longer have the pride of a well-run business, and they simply may be ready to give up.

Keep an eye out for these tells (those subconscious habits or mannerisms that belie your true position) on your end as well. After all, you don’t want to unintentionally give away helpful information either.

Although this section helps you get as much negotiating power as possible, keep in mind that negotiating isn’t about taking advantage of other people. Deals only get done if Buyer and Seller find a mutually agreeable deal.

Maintaining as much power as possible when disclosing undesirable news

At some point or another in a deal, you may find that you need to give the other party a piece of information that gives that party more power over you. These suggestions can help you control all that you can.

Don’t lie. It’s an old adage, but it’s true: Honesty is the best policy.

Deliver the news in a matter-of-fact manner. Although being honest is vital, how you present your information is also key. If you have bad news to share, don’t editorialize or tell a long, drawn-out story. Simply say what you have to say as neutrally as possible.

You may be surprised by the other side’s reaction. An issue you think is problematic may turn out to be no big deal for the other party. However, if you phrase the news in the form of a negative editorial, you may transfer that negative vibe and thus turn a nonissue into a weapon your opponent may use against you. As I note earlier in the chapter, never make your opponent’s argument.

Disclose everything early. If you have a disclosure to make, do it sooner rather than later. And if you think you can hide negative or bad news, remember that those kinds of skeletons usually come to light during due diligence.

What to Tell Employees and When

Informing employees that a company is in the process of being sold is a tricky proposition. If employees find out about a potential sale that doesn’t eventually occur, the management/ownership may lose face in the employees’ eyes. Worse, employees may begin to leave because they think, correctly or not, that the company is in some sort of trouble. A failed sale process can become a self-fulfilling prophecy of doom for an otherwise-healthy company. For some thoughts on what to say to employees after the deal closes, see Chapter 17.

Keep news of a sale process confidential

Simply put, the greater the number of people (even employees) who know about a pending business sale, the greater the chance someone will inadvertently spill the beans to someone else, who will mention it to someone else, who will talk about it in a public place where anyone can overhear.

The first concern is a competitor learning of the sale process. A competitor may use knowledge of a business sale as leverage to steal clients by spooking the clients into questioning the company’s future. The second concern is gossip among employees. In the absence of fact and communication, people can be extremely creative as they attempt to fill in the blanks with some sort of guesswork. Ambiguity is never a friend to business.

Never lie

If an employee asks if the company is for sale, don’t lie and say, “No, absolutely not.” A better option is to simply say the company is exploring bringing in a financial partner to help take it to the next level. That’s a true statement.

A staggered release

If a business is going through a sale process, certain employees need to know about the business sale at different times. The owner doesn’t need to inform everyone at the same time. The controller (or similar accounting employee) should be taken aside and told of the sale process. Because financial documents are one of the main items collected during the sale process, accounting employees usually figure it out on their own. However, talking with the controller ahead of the process reduces the odds that she tells other employees. Other than accounting employees, the remaining employees should be told about the potential sale on a need-to-know basis. If at all possible, tell the employees after the deal has closed.