Monday, April 25, 2016

The #1 Cause of Middle Market M&A Deal Failures

New Article just published on Divestopedia

I believe one of the biggest reasons for M&A deals blowing up is a poorly worded letter of intent (LOI). The standard process to solicit offers from buyers in the form of an LOI includes terms and conditions that are negotiated until one winner emerges and the seller and buyer dual sign the LOI, which is non-binding. This basically gives either party an "out" should something be discovered in the due diligence process that is not to their liking or is not as presented in the initial materials. Buyers Have the Advantage of Experience

When I say poorly worded, what I really should have said is that it is worded much to the advantage of the buyer and gives them a lot of wiggle room in how the letter is interpreted and translated into the definitive purchase agreement. The best comparison I can make is a lease agreement for an apartment. It is so one-sided in favor of the landlord and protects him/her from every conceivable problem with the renter.

Business buyers are usually very experienced and the sellers are generally first-time sellers. The buyers have probably learned some important and costly lessons from past deals and vow never to let that happen again. This is often reflected in their LOI. They also count on several dynamics from the process that are in their favor. Their deal team is experienced and is at the ready to claim that "this is a standard deal practice" or "this is the calculation according to GAAP accounting rules." They count on the seller suffering from deal fatigue after the numerous conference calls, corporate visits and the arduous production of due diligence information.

When the LOI is then translated into the definitive purchase agreement by the buyer's team, any term that is open for interpretation will be interpreted in favor of the buyer and, conversely, to the detriment of the seller. The seller can try to fight each point, and usually there are several attacks on the original value detailed in the dual-signed LOI that took the seller off the market for 45-60 days. The buyer and his/her team of experts will fight each deal term from the dispassionate standpoint on one evaluating several deals simultaneously. The seller, on the other hand, is fully emotionally committed to the result of his/her life's work. He/she is at a decided negotiating disadvantage.

The unfortunate result of this process is that the seller usually caves on most items and sacrifices a significant portion of the value that he/she thought he/she would realize from the sale. More often than not, however, the seller interprets this activity by the buyer as acting in bad faith and simply blows up the deal, only to return to the market as damaged goods. The implied message when we reconnect with previous interested buyers after going into due diligence is that the buyers found some dirty laundry in the process. These previously interested buyers may jump back in, but they generally jump back in at a transaction value lower than what they were originally willing to pay. How to Even the Playing Field

How do we stop this unfortunate buyer advantage and subsequent bad behavior? The first and most important thing we can do is to convey the message that there are several interested and qualified buyers that are very close in the process. If we are doing our job properly, we will be conveying an accurate version of the reality of the deal. The message is that we have many good options, and if you try to behave badly, we will simply cut you off and reach out to our next best choices. The second thing we can do is to negotiate the wording in the LOI to be very precise and not allow room for interpretation that can attack the value and terms we originally intended.

We will show a couple examples of LOI deal points as written by the buyer (with lots of room for interpretation) and we will counter those with examples of precise language that protects the seller.

Sample Earnout Clause Within an LOI

Buyer's Proposal

The amount will be paid using the following formula:

-75% of the value will be paid at closing

-The remaining 25% will be held as retention by the BUYERs to be paid in two equal installments at the 12 month and 24 month anniversaries, based on the following formula and with the goal of retaining at least 95% of the TTM revenue. In case at the 12 and 24 month anniversaries the TTM revenue falls below 95%, the retention amount will be adjusted based on the percentage retained. For example, if 90% of the TTM revenue is retained at 12 months, the retention value will be adjusted to 90% of the original value. In case the revenue retention falls at or below 80%, the retention value will be adjusted to $0.

Seller's Counter Proposal

The amount will be paid using the following formula:

-75% of the value will be paid at closing

-The remaining 25% will be held as earnout by the BUYERs to be paid in four equal installments at the 6, 12, 18 and 24 months anniversaries, based on the following formula:

We will set a 5% per year revenue growth target for two years as a way for SELLERS to receive 100% of their earnout (categorized as "additional transaction value" for contract and tax purposes).

So, for example, the TTM revenues for the period above for purposes of this example are $2,355,000. For a 5% growth rate in year one, the resulting target is $2,415,000 for year one and $2,535,750 in year two. The combined revenue target for the two years post-acquisition is $4,950,750.

Based on a purchase price of $2,355,430, the 25% earnout would be valued at par at $588,857. We can simply back into an earnout payout rate by dividing the par value target of $588,857 by the total targeted revenues of $4.95 million.

The result is a payout rate of 11.89% of the first two years' revenue. If SELLER falls short of the target, they fall short in the payout; if they exceed the amount, they earn a payout premium.

Below are two examples of performance:

Example 1 is the combined two years' revenues total $4.50 million - the resulting two-year payout would be $535,244.

Example 2 is the combined two years' revenues total $5.50 million - the resulting two-year payout would be $654,187.

Comparison and Comments

The buyer's language contained a severe penalty if revenues dropped below 80% of prior levels, the earnout payment goes to $0. Also, they have only a penalty for falling short and no corresponding reward for exceeding expectations. The seller's counter proposal is very specific, formula-driven and uses examples. It will be very hard to misinterpret this language. The seller's language accounts for the punishment of a shortfall with the upside reward of exceeding growth projections. The principle of both proposals is the same - to protect and grow revenue, but the results for the seller are far superior with the counter proposal language.

Sample Working Capital Clause Within an LOI

Buyer's Proposal

This proposal assumes a debt free cash free (DFCF) balance sheet and a normalized level of working capital at closing.

Seller's Counter Proposal

At or around closing, the respective accounting teams will do an analysis of accounts payable and accounts receivable. The seller will retain all receivables in excess of payables plus all cash on cash equivalents. The balance sheet will be assumed by the buyer with a $0 net working capital balance.

Get the Specifics

The buyer's language is vague and a problem waiting to happen. So, for example, if the buyer's experts decide that a "normalized level of working capital" at closing is a surplus of $400,000, the value of the transaction to the seller dropped by $400,000 compared to the seller's counter proposal language. The objective in seller negotiations is to truly understand the value of the various offers before countersigning the LOI. For example, an offer for cash at closing of $4,000,000, with the seller retaining all excess net working capital when the normal level is $800,000, is superior to an offer for $4.4 million with working capital levels retained at normal levels.

These are two very important deal terms and they can move the effective transaction value by large amounts if they are allowed to be loosely worded in the letter of intent and then interpreted to the buyer's advantage in translation to the definitive purchase agreement. Why not just cut off that option with very precise and specific language in the LOI with formulas and examples prior to execution by the seller? The chances of the deal going through to closing will rise dramatically with this relatively easy-to-execute negotiation element.

Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital

Saturday, April 23, 2016

Clients Represented Software and information Technology

We got our start after working for a very fine "Generic" Merger and Acquisition Advisory firm. I do not mean this to be a dig, but just a way to describe that our former firm was industry agnostic in engaging with all types of companies. Generally they did an excellent job relying on a proven M&A process. One area that they struggled with, however, was in representing software and information technology companies. In analyzing the competitive landscape, we found this to be the case with the vast majority of lower market M&A firms and business brokers. They did not speak the language and felt uncomfortable in pursuing transaction values that were not based on rules of thumb or a multiple of EBITDA. They struggled with unlocking strategic value for their clients.

MidMarket Capital was originally founded based on our deep roots in technology in our prior business experience. Our ideal client is one that has a significant part of their company value contained in their technology and intellectual property. We have chosen to focus on representing businesses in this space and our value proposition is to drive strategic transaction value for our clients.

For buyers of technology companies, it is important that the seller's representatives "speak the language" and if you are a technology, software, information technology, or healthcare information technology company, odds are that we have represented a similar company to yours during the past fifteen years. Please see below for a list describing companies we have represented:

MidMarket Capital Clients

An IBM Cognos Partner - Performance Management, Professional Services, and Software Development Firm

A Distribution ERP Systems Software Company

Web Enabled Supply Chain Management System

eCommerce Company

Document Imaging & Management Software Company

Textbook Content Service Provider

Managed Information Security Services Company

Information Technology Consulting Company

IT Services Provider SMB

Affiliate Marketing Management Firm

Digital Communications Company

Pension Administration Software Company

CRM and Integrated Product Performance Management Software Company

Live Virtual Computer Training Company

Telecom Alliance Channel Partner

Rich Media & Interactive Marketing Software and Services Company

Wireless Electronic Monitoring Company Hardware, Software, Firmware, Software as a Service

Third-party Provider of Software for Bentley’s MicroStation

Mobile, On-Demand Data Collection, Management & Reporting

IT and telephony system design and support SMB

Publishing Management Software and Services

Network Integrity and Switch Provisioning Software Company

Advanced Networking Technology Development Contractor

ECommerce software-as-a-service (SaaS) Company


Smart Grid Software and Engineering Company

Web Content Distribution and Compliance Management Software Company

Recreational Team Management and Group Management Portal

.Net - SaaS Based Sales Collateral Management Software and IT Services Company

Pool and Spa Service Management and Store Software Systems

Systems integrator and reseller of IT products to Federal Government clients

Mobile Field Merchandising & Data Collection Software

The BI Life Cycle Management Company - IBM/Cognos Enhancement Software Solutions

Security Solutions Value Added Distributor

A Pathology Laboratory Information Systems Company

A Cost Analysis and Control Software Company for Healthcare Facilities

An Evidence Based Patient Acuity Measurement and Nurse Staffing Systems and Services Company

A Web-Based Staffing, Scheduling and Nurse Shift Bidding Software Company


Ophthalmology Information System (OIS) Company

Healthcare Revenue Cycle Management Company

Cloud-Based Vendor Neutral Archiving & PACS Software Company

Hospital Services & Software Company

Electronic Health Record and Personal Identification Wristband Company

Big Data Analysis Engine for Repositioning Drug Discovery

Smart Pharma Cap for Medication Adherence and Compliance Recording
Dave Kauppi is a Merger and Acquisition Advisor and Managing Director of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology companies. To view our lists of buyers and sellers click to visit our Web Site MidMarket Capital