Caveat Exitus; Caveat Fiscus: Caveat VenditorAugust 18, 2021
Thinking about raising capital for your business? Thinking about exiting it?
You’ve undoubtedly heard the expression, Caveat Emptor. Buyer Beware.
Selling your business? Get a mindset for Caveat Venditor. Seller Beware.
Depending on whom you ask, and what you’re trying to accomplish, raising capital and/or partially or entirely exiting your business can be challenging. There are, of course many variables, not the least of which is the kind of investor being targeted to provide capital to be used for startup, expansion or growth, or often, survival. The road from humble startup to exponential growth and a liquidity event is paved with many good intentions.
Here are some points to consider:
- How much to raise? And where from? It’s often easier to get larger sums of money than smaller sums. No investor is going to run through a process in order to give you $50,000 or $100,000 to cover some unforeseen expense or provide liquidity or float. It’s also often easier to get $2.5 million or more from a private equity group than it is to get $250,000 from a bank or $100,000 from an economic development lending entity. If you are a small business looking for capital, you must weigh whether private equity, venture capital, angel funds and other non-bank loans are the right route to go, versus traditional asset-based lending, lines of credit, secured loans, e.g.
So, when it comes to the change in capital structure or the exit, what do you as the owner and/or senior manager really want? What is it you really need?
- What are the current fundamentals on your business? If the business is marginally profitable, break even, or experiencing losses, especially after running the business for several years, you must ask yourself why that might be attractive to an investor. Do you have good controls? Do you have faith in the integrity of your financials? Do you have financials? Is the industry growing? Is your company growing? Is it likely the key people on your team will stick around if a deal is in the works? Or, if your company is printing profits and you have little or no debt, is the loss of control from a transaction even worthwhile?
Hire a consultant to provide you with an objective assessment of the companHire a consultant to provide you with an objective assessment of the company. Owners/managers often underestimate the cash flow and liquidity needed to fuel growth, and sometimes the best course of action is to tuck in the wings and run leaner. Sometimes it’s just too late to do anything other than sell in the entirety or to divest a major stake, and to take on an investor to shore up a weak balance sheet.
- Stakeholder issues. Many deals wither on the vine of due diligence because there are issues paying vendors, employees aren’t happy or motivated, customers are disenchanted, or there are other lurking exposures such as tax issues, regulatory issues, high workers’ comp mod ratings, union or labor relations problems, or the company is tied to a cyclical industry or disproportionately to one or a small group of clients. As part of investor due diligence, the prospective investor or buyer will speak with your customers, vendors, employees, former employees, and many other people in and around your organization. What’s even more frightening than the fact that they often hear things about owners and managers those folks wouldn’t want known, is the misinformation and incorrect information that some competitors put out on the street. Increasingly, buyers want targets to have sophisticated CRM’s so they can gain visibility into current and prospective customer relationships to prove out backlog and pipeline.
- Profitability. Investors, depending on their orientation, look for opportunity in the form of companies which are profitable or need some managerial and process (or product and service changes) changes to improve results. Seldom do investment groups, even private equity groups, reward poor performance. It’s like asking the buyer to pay more than market value for your home that’s up for sale, even though it needs work, because you stripped out the equity. That’s your problem, not theirs. Investors are, rightfully so, opportunists.
- Size and Scale. Astute investors can see past poor results and spot opportunities for scaling up undercapitalized, or simply poorly managed businesses, but if the business doesn’t have something significant to offer customers or prospects, or doesn’t have critical mass, it’s not worth the investor’s time to clean up the mess. It’s often as much or more work to market and sell a $2, 5 or even 10 or 15 million business than it is to sell a $100 million business.
- Juice vs. Squeeze. Is the juice worth the squeeze? Are you willing to run through the process, give up some confidential information, let competitors look under your sheets, potentially expose problem areas, risk losing key employees, or make your employees speculate about what they think is going on? What if you unwittingly get manipulated into having a potential investor learn all about your business and then capitalize on what they know? Realistically, what’s so confidential and special about much of what you do? Can your “trade secrets” or dark arts be easily copied and taken? Employees come and go all the time, and all of the nondisclosure language in the world isn’t going to prevent seemingly proprietary company information from circulating.
- Valuation. While your small business may be delivering $3 or $4 million a year in revenue, it doesn’t mean anyone is going to pay that much for it. Businesses are valued on numerous methodologies, but a good rule of thumb is a multiple of EBITDA, or taking your Earnings Before Interest Taxes Depreciation and Amortization and figuring out the typical acquisition multiple for your industry and type of company. Often buyers looking for key clientele, key managers, specific geography, processes, patents, contracts, e.g., will pay at strong valuations for companies that can enhance their existing core business. Right now, valuation multiples are rich.
- People. Often owners of small businesses are surprised to find out the new buyer doesn’t want them around, particularly in situations where they haven’t put any stellar results on the board. Investors and companies don’t buy businesses to keep a family jobs program in place, siblings and spouses employed, and excessive perquisites. They buy businesses to drive out cost and make profits. People with key functional expertise, key client relationships and “close to the customer” economic productivity are generally retained and rewarded. I always recommend that sellers read the old but relevant classic, “Who Moved My Cheese.” Yup, you were the big cheese but when control changes, your cheese is getting moved.
- The other side of the table. If you were buying a competitor down the street exactly like your business, what /who would you cut, change, improve or invest in? And why? Why aren’t you doing that now? Remember the WIIFM? What’s In It For Me? What would be in it for any fund or investor or competitor looking to acquire your business? Again, in today’s business climate, being the low-cost provider and having the best team are what enables company to thrive and survive.
- The Suitor. Is the right transaction a total sale? A partial investment of much needed growth capital in exchange for equity? Is the best fit a private equity fund, angel fund, competitor, venture capital fund, or “HNW” — high net worth individual looking for a return on his or her investment? What are their investment criteria? What do they invest in? What do they want — earnings? Top line growth? Are they buying your strategy, your relationships, your contracts, your patents? What are you willing to give up? How much equity? How much control/decision making? What do you want in return? Cash? Exit? Continue working or leave? Equity in the new larger recapitalized entity? What’s the carry-forward if any? Would you hold a seller note in the go-forward entity? The answer to that question tells whether you have confidence in the team’s ability to generate results in the future.
- Egos. Many solid deals are blown, and post-merger integrations derailed because of the egos of one or more of the former owners or senior managers. To use the selling your home example again, sellers are offended when the new owners repaint the kitchen a different color and replace the landscaping. Everything changes, but it doesn’t have to be bad.
- Expectations. Entering a transaction requires realistic expectations. The fact is, it’s much easier to buy something than to sell something. If you’re selling, unless you have something really special that prints money, you may need to adjust your value expectations. Of course, multiple offers and high interest levels always help keep prices up.
- The IOI, LOI, Term Sheet:
- Indication of Interest. This is a letter that simply states that the investor or buyer has an interest level and may spell out some conceptual parameters as to how they envision a deal.
- Letter of Intent. A greater, more definitive offer. Has more deal specificity. Still high level and often IOIs and LOIs tell the sellers or company what they want to hear.
- Term Sheet. Discusses the amount of capital to be invested, source thereof, terms for repayment, categorical use, control issues, e.g.
- Type of structure. Loan, equity, swap, asset deal, spinout, carveout, earnout, mezzanine debt, working capital adjustment, recapitalization, e.g. There are infinite flavors of deal structures. They are often much more complicated than they really need to be. Are you tying yourself to LIBOR or warrants or the direction of the wind?
- Price adjustments. Beware of sticky terms and timing on things like post-close net working capital adjustments, future earnouts, e.g., tied to things that you won’t have much control over, and subjective situations in which you could find yourself in a dispute, or at the mercy of a buyer clawing back sales proceeds.
Are You Ready? Raising capital or selling your company can be a life changing event, and bring the growth of the enterprise (and you) farther than you ever expected, it can enable you to avoid tremendous pain and suffering (such as the case when a company is fortunate to avoid liquidation/bankruptcy), or it can enable you to either work harder than ever before, or sit on a beach chair somewhere without a care in the world.
Before you get to one of those points, you must ask yourself why you got in this business to begin with, why you want to get the business funded or sold, and what your plans are thereafter. Lastly, what is your end game? and how does this capital raise or full or partial divestiture figure into that?
Don’t Try This At Home. Good luck and don’t forget to hire the right advisors. The CPA’s and Attorneys you may have had as advisors for many years may be fine for small, simple transactions, but you may want to consult those with specific experience and consider that the best person to start with might just be a management advisory professional, business broker, or investment banker, depending on your goals.
The wrong attorney can completely botch an otherwise smooth transaction, the wrong CPA can make a mess if they are unfamiliar with the process of dealing with asset purchase agreements, or the sometimes-odd world of private equity; furthermore, don’t confuse a business broker with an investment banker — they are not interchangeable.
Also, the wrong investment banker, for example, can often have his own “inside” buy side buyers ready to pounce at a discounted price if his or her fee is guaranteed — and generally, having any advisors who don’t have your best interests in mind at deal time can cause problems and create lingering exposures (fraud, malpractice, disputes over working capital, e.g.) for months, and years, to come.
Hire the right advisors and you’ll get the right outcomes and results.