Broad Auctions & Navigating Inbound Offers

If you are a business owner, chances are that you receive daily or weekly inbound emails and/or calls from private equity ("PE") firms or a company owned by a PE firm trying to introduce themselves. There are thousands of private equity firms in the United States, with over $900 billion of dry powder, and all of them are in the business of trying to buy companies for the best possible price.¹ As such, many PE firms employ a team of individuals or hire buy-side firms who are solely dedicated to sourcing proprietary, or "off-market" deals. These are deals where sellers have not hired an investment banking firm to help market their company. Proprietary deals are extremely attractive because many sellers are inexperienced and ill-equipped to negotiate a deal that is representative of market price and/or terms, which could potentially result in sellers taking more risk and losing out on economic value.

We believe it is imperative for business owners to hire an experienced team around them, so they understand what possible outcomes exist in the market and don’t fall prey to the many negotiating tactics of buyers. In most instances, we would recommend casting a wide net with a broad auction.² We firmly believe that a broad, competitive process with strong execution is what drives the most value for a seller. We believe this is evidenced by Yellow Cardinal M&A‘s results in marketed transactions in the last 24 months, which closed on average 36% above our mid-point valuation (where we would expect the vast majority of offers to cluster around).² It is important to note that while transactions have closed meaningfully above our mid-point valuation, this is not indicative of where most offers have fallen on any given transaction. This shows the importance of exploring the market and not taking the first offer that presents itself.

Yellow Cardinal M&A Marketed Transactions in the last 24 Months^{3, 4}

There are plenty of situations where sellers already have inbound interest from a "preferred" buyer that they like, or think would be a great fit. In a scenario where a seller only wants to explore a single or handful of inbound offers, we still believe that hiring an investment banking group can provide significant value:

1. The Option of Going to Market – Even if a seller has no intention of going to a fully marketed process, hiring an investment bank and preparing to go to market is often enough to get inbound buyers to revisit their valuation or terms. Even still, there is a chance that a seller will lose some value by not going to a broad, competitive process.²

2. Managing the Process – Executing a sale is a full-time job. Running your business while also negotiating and managing the extensive due diligence process can be extremely difficult and lead to one of those processes falling through. Having your business performance decline during a sale process could negatively impact the deal value and pose as a risk to closing. Not executing on the diligence process in a timely manner can also cause challenges in a deal closing.

3. Understanding the Data & Framing the Picture – Most private equity firms are data centric and rely on hard data to support their investment thesis in a company. Having an experienced advisor that can understand complex data sets and analyze trends can help frame a business in the most positive light through data. Understanding the data can also highlight areas of weakness where a potential buyer may try to poke holes. An advisor should always be anticipating what questions are next and try to get in front of them and find data to support their arguments. Trying to argue why a buyer is wrong becomes very challenging if a seller isn’t equipped to explain their own data or tell a story using data.

5. Understanding Net Working Capital (“NWC”) – In most deals, businesses are expected to be transferred to the buyer with a normalized level of net working capital (Current Assets – Current Liabilities, excluding Cash and Debt like items) which is the company’s short-term liquidity needed to fund operations (like having gas in the tank to run a car). Both the buyer and seller eventually agree to a target level which will get trued up after close. This target is typically an average over some period (3, 6, 9, or 12 months) depending on the business. Consider a business that is highly seasonal. If a transaction closed at the end of August and the buyer was able to set the NWC target to a 3-month average ($1.083mm), a seller would technically owe $333k to the buyer because August is on the tail end of the high season and the target was inflated from June and July. Conversely, if the seller had an experienced advisor who was able to negotiate the target at a 12-month average, there would be zero money owed by either party, which is typically the goal in setting NWC during a process.⁶

6. Structuring the Transaction – While headline purchase price is important, transactions can be structured in many ways (stock vs. asset, earnout, seller note, rollover equity, etc.) and there are various other non-purchase price or valuation related terms that can provide significant value beyond just cash at close. Understanding what types of transaction structures exist and being able to negotiate market terms is important for maximizing value. In addition to working with an investment banking team, we strongly recommend that sellers hire an experienced M&A attorney to fully educate and advise them on the various nuances of these deal points.

• Transaction Type (Stock vs. Asset)⁷ – Transactions are generally structured as either stock or asset purchases. Stock sales are advantageous to the seller because the proceeds are taxed at capital gains rates whereas the gain on hard assets in an asset sale are taxed at ordinary income levels. Further, if a seller is a C-corporation, they face a double tax on asset sales. Going out to a broad buyer universe can help find a buyer who is willing to execute on the most tax friendly deal structure for the seller.
• Earnout – Depending on various factors, including historical performance, industry, customer concentration, and management team, a buyer may seek to reduce its transaction risk and/or bridge a valuation gap by shifting a portion of the purchase price into a contingent payment, or earnout, based on hitting certain financial outcomes. Sellers should work with their advisor to project the company’s expected near to long-term performance to fully understand the viability of achieving all or only part of an earnout. In some instances, an advisor may be able to negotiate an incremental sweetener if the company exceeds expectations, which could deliver significant upside that otherwise might not be possible in an all-upfront deal.
• Seller Note – Similar to an earnout, a buyer may seek to allocate a portion of the purchase price to a seller note, where the seller acts as bank financing for the deal and gets paid back over time with interest. Advisors can educate sellers on what current market interest rates and amortization periods are for the M&A environment. Seller notes are not subject to hitting certain financial milestones, but they are typically unsecured. If the business fails, a seller may not receive any consideration for their seller note as they will likely be subordinated to other lenders.
• Rollover Equity – Many buyers mandate that sellers reinvest a portion of their proceeds (10-30% of new company equity) back into the company to properly align incentives through the life of a transaction. Rollover equity can be extremely attractive to a seller and in some instances, a seller may walk away with more in the subsequent transaction, or “second bite of the apple”, even though their ownership percentage was significantly less.⁸ Sellers should work with their advisor to assess what a second exit could look like depending on various factors, including who the buyer is, how many years a PE group has been in an investment, the acquirer’s current valuation, and how much debt the acquirer has.
• Real Estate – Many sellers have real estate owned by an operating company or a related entity. Sellers need to determine if they plan on keeping the real estate after a transaction, which involves entering into a long-term lease agreement at a market rate, or if they want to sell both the company and real estate in a single package. In some scenarios, the value of the real estate may be worth more to another third party than to the operating company buyer. In that scenario, the real estate must be sold in a parallel or post-close transaction. Take an example where an operating company that owns real estate and doesn’t pay rent has an offer for 5x EBITDA, but current capitalization rates for that property in the sale-leaseback market are 7-9%. These rates imply a ~11.1-14.3x EBITDA multiple for the real estate, which are ~122% and ~186% higher than the implied valuation of the real estate if it was sold inside the operating company. There is a negative impact to the valuation of the operating company once rent is adjusted from EBITDA but the increase in real estate value still generates an aggregate valuation increase of 12-19%, which is meaningful.⁹
• Representations & Warranties – In a transaction, the seller makes statements of fact about their business to the buyer (e.g. the seller is qualified to do business in the state it operates in) and is typically responsible for listing any exceptions to those statements in disclosure schedules. Sellers should work with their various advisors to understand what market terms are for representations and warranties and to carefully draft all potential exceptions.
• Escrow – Transactions usually have a portion of total deal value held back in the form of escrow to provide direct recourse for various post-closing purchase price adjustments (e.g. Net Working Capital adjustment) and any indemnification claims. The amount of indemnification escrow (average ~11.5% in 2022) and length of holdback (average ~16 months in 2022) are negotiated points which can greatly impact the amount of cash a seller receives at close and how long they wait until all funds are disbursed. In cases where a buyer is willing to consider purchasing a representations and warranties insurance (“RWI”) policy, which serves as a mechanism for recourse, the indemnification escrow is often significantly reduced (average ~1.2% in 2022).^{10, 11}
• Indemnification Caps – An indemnification cap limits the overall indemnification liability of the seller to a percentage of the transaction value (average ~15.5% in 2022), subject to certain exceptions. In cases where a buyer is willing to consider a RWI policy, the indemnification cap is often significantly reduced (average ~5.7% in 2022). Negotiating the cap as low as possible helps sellers reduce their overall liability exposure post-close.¹⁰
• Employment Agreements – In most scenarios where a seller is staying with a business post-close, a buyer will look to negotiate an employment agreement. Sellers should work with their legal and other advisors to ensure that their interests are protected on several fronts, including compensation (cash and stock), benefits, term, grounds for termination (“cause” vs. “good reason”), and restrictive covenants (non-compete and non-solicit).
• Other Items – There are many other important terms and documents that investment bankers and lawyers should be able to advise sellers on, including operating agreements, shareholder agreements, RWI basket, RWI survival period, the definition of cash, the definition of debt, knowledge qualifiers, etc.

7. Being the “Bad Guy” – One of the services of an investment banker is to serve as a buffer between buyer and seller. Most deals will get contentious at some point or another and it helps to have a third party be a sounding board then also the messenger for difficult topics. Assuming a transaction closes, the seller and buyer will likely need to work hand and hand for a significant period post-close. Having an intermediary means getting your future working relationship off on the right foot.

There are many more reasons why hiring an investment banking group to help with a transaction can deliver significant value. We encourage sellers with inbound offers to take a pause when considering next steps. At the end of the day, many sellers have spent years or decades building their company so taking more time to understand their different exit options is modestly incremental to the entire journey. Please reach out to discover the additional ways Yellow Cardinal M&A Services can help.¹²