M&A Trends in 2023: Processes, Challenges and Solutions

JA:Scott Daspin is the director of investment banking at Triad Securities. Scott brings extensive experience in the capital markets to his middle market advisory work. He has a strong history of creating new relationships and identifying and closing successful partnerships and transactions. Scott, thanks for being here today.
Scott Daspin:Thank you, Jordan.

JA:
Let's jump right in. While every transaction is different, there are many similarities in the process and common issues that arise in every deal. Our goal of this discussion is to discuss some of the general process and trends of the deal space. So Stu and Scott, we'd love to hear your thoughts on the deal process each from your unique perspective. When a client approaches you about selling their business, what's the first thing you tell them, Scott?
SD:Well, what's most important is making sure that the business or family is ready for a transaction and really understanding the needs of what they're looking to accomplish. Selling a family business can be complicated because there could be numerous family members involved in the business. There could be family members that may want to stick with the business, and understanding what the perfect outcome would be I would say we spend a significant amount of time on out of the gate. Then it's very important to make sure that they're prepared for the sale and making sure you have the right people to help you execute the transaction on the seller's side. We call this the deal team, and the deal team would be basically an advisor or a broker like myself that could help in the transaction. There's an attorney, and then there's the financial aspect of the transaction, making sure that you have-
JA:Scott, I'm going to do a little deeper dive into the deal team, so I don't want you to steal too much of our thunder for that. I think it's great making sure that the family's prepared for the eventualities of what a sale means. Stu, what's the first piece of advice that you would give a client thinking about a potential transaction?
SB:I always refer to two things. First of all, I'm always concerned about their emotional wellbeing in these transactions. Transactions are emotional roller coasters, and I always emphasize that. You have to think about it in terms of there are going to be highs and there are going to be lows, and the highs are going to be very high, and the lows are going to be very challenging, and people have to be prepared for that. Secondly, there's a big financial commitment to a transaction. During the transaction people are going to feel more and more financially invested in the deal, and there's no guarantee that the deal will close until the deal actually closes. So people have to be prepared financially and emotionally before beginning a transaction.
JA:I think it's great advice. One of the things we talk to our clients about from the tax and accounting side is understanding that, as you both said, there's a lot of emotional pieces of it and a lot of things to be prepared for and kind of ups and downs and ebbs and flows of the deal. And understanding from our perspective, always what do they walk away with, right? All these numbers sound great and sometimes they're quite large numbers, but how much do I walk away with? Scott alluded in his comment, how much do I need to walk away with for this transaction to be viable and really start setting expectations from the top? So we've decided to sell our business. In most cases, it represents an individual or a family's life work that's usually the largest financial asset. We talked about sort of the emotional piece and getting ready. Are there any pieces of advice to get the business ready for a transaction or one thing they can do or something they should think about before the deal goes to market to kind of get the business itself ready? Scott?
SD:It's very important where I believe that your firm is on the number side, just understanding the financial aspects of the business. A lot of family business spend time growing, making significant amount of money, but understanding gross margins, net margins and valuation. They're owners they believe they know what their company's worth, and then there's the actual reality of what their company's worth. So having a monthly look of that data trial balances going back a few years is fairly important. So when we speak to business owners, we make sure we have a fair amount of data to understand how the business has grown over generations and generations, especially if they've been through a recession and there may be upcoming recessions. That's fairly important.
JA:That's a terrific point especially given the economic uncertainty we face now. Stu, what about your thoughts?
SB:First of all, the financial reality is critical. If you don't have a reasonable expectation as to what the value of your business is, you might as well not go through the transaction. But from our perspective, what we try to do is provide the client with a full exam top to bottom, if you will, before beginning the deal. Because the last thing we want and the client wants are surprises during the transaction. We go through an internal due diligence process with the client as if we are the buyer to make sure that everything's in place. I will tell you that a hundred percent of the time, something will be out of place. So whether it requires financial diligence, legal diligence, insurance diligence, what have you, we try to correct it before the buyer finds it.
JA:I think those are great points. I think from the tax side, sometimes years leading up to a deal, making sure the ownership structure and making sure that we've done some estate planning and we have all of those documents and thoughts in place so that when a deal actually comes to fruition, we're able to accomplish some of the financial objectives of the family. And some of those things in order to have the best bang for their buck, at least from a tax perspective, needs to be accomplished sometimes years in advance. I think some of the pre-planning for a deal that we're talking about is just as critical as the deal itself.
SB:I think, Jordan, you're right, because at the end of the day, what we all strive for the client is what you get at the end of the day, you actually get to keep, that's the important thing.
JA:Absolutely. Sometimes there's a gap between that large number on a piece of paper and what they get to keep. Our job as the tax advisor deal is to help along with counseling with Stu and Scott to help shrink that gap between the top line and the bottom line. And as we all know, what goes into the pocket at the end of the day is the most important. Scott, I cut you off before, and I apologize, when you started talking about the importance of the deal team. Each of us represent a different discipline, but your thoughts on the deal team and the importance of not just each individual advisor, but the team concept, what's your perspective from the investment banking side?
SD:Many business owners we speak to, there are some that actually believe they can execute this themselves, which I believe isn't impossible, but it's very important that each person knows what lane they're running in. Business owners are very good at running their businesses. Stuart runs his legal piece or lawyers run their legal piece. Accountants run their accounting piece. On the investment banking side, depending on the type of banker that you use, could look at various aspects. I believe that a very important aspect is understanding who that you would want to be bought by and what that would look like post transaction. We spend a lot of time understanding what you would like the company to look like and who you would like the buyers to look like. We spend time. There are various types of buyers, institutional, non-institutional, other families, strategic, nonstrategic.
JA:Scott, it's great. Stu, what I was going to say was that Scott from the buyer perspective of putting the deal together and then goes into the legal team. What's the legal team's role, and how do you take the baton, so to speak, once the deal is sort of formulated and run from there?
SB:Sure. First of all, to steal a phrase, it takes a village, and it really does take a village to do a deal. When you think about it, what we always tell the client is, you run your business, we'll help you run the deal. Oftentimes clients get so enamored with the business transaction that they lose sight of their business, which is the last thing you want your client to do. But in terms of the deal team per se, in addition to the three primary disciplines, which three legs of the stool meaning the investment banker, the accountant and the lawyer, you also have to consider the various elements within each. I'll speak to the legal side of it.

Within the Legal Deal team, you often find Transaction Council, which is the role that I play. You also have Tax Council, Environmental Council, Securities Council, Intellectual Property Council, Employment Council and Benefits Council. Those are the usual ones that we find. And if you have a client that's got regulatory issues, then you have Regulatory Council. So there could be eight to 10 different disciplines within every transaction, and the goal here is to coordinate them all so from the client's perspective, they're not being bombarded from all different sides. Somebody has to coordinate that, and that's what we do.
JA:Terrific. Just to give a little perspective from my seat on the tax side and the accounting side, I was going to say, much like you mentioned Stu with having different disciplines here, we pull in different experts within our shop from our transaction advisory services team to help with our Q of E quality of earnings or assistance with some other gap reporting depending on the type of buyer and the type of transaction and the seller. The financial records of the seller may be on a tax basis, may be on a different basis of accounting than the buyer wants to see numbers, and being able to help lend that expertise and support to bridge that gap to make sure that the numbers that the seller has and the number that the buyer sees, everyone speaking the same language.
SD:That's really a good point on the language. Many sellers might not understand terms throughout the transaction, whether it be even M&A, which is mergers and acquisitions, LOI, which is letter of intent. There's different types of agreements; asset purchase agreements, APA; stock purchase agreements, SPA, and your advisors are very familiar with these terms. So when you're working with your deal team, each partner will be able to help educate the seller with regards to what seems normal, what have they seen, what they haven't seen. And it's very important to work with people that understand and have seen numerous transactions to let the seller know what would be normal or not normal.
JA:Thank you, Scott. Scott, I wanted to jump on something that you said a minute ago about the process of finding the buyer and the right buyer. You sort of touched on a couple different types of buyers. Can you give us a minute on the process of finding a buyer and when you have a financial buyer or a synergistic binder, kind of what's kind of the thought process, and is the right buyer always just the one willing to pay the highest price?
SD:Each seller has a different mind of what's the most important to them. And more times than not, it's not the highest price, it's actually the person who's going to take care of basically their baby or generations of a company that have been put together. I would say there's two. They're different processes, but there are two very distinct processes that I would say are different. But one of the most important things that we try to do is keep it anonymous as possible. No seller wants their clients to find out before the right time, their employees to find out the right time, their vendors to find out the right time. So anonymity is very important. That's why the deal team is important to make sure that we're keeping it very tight to the chest. One process that we focus on more times than not is really understanding who the buyer would be, only going out to a handful of buyers that the seller approves and understands and basically running the process organized, and it may be sometimes a little bit slow.

And then there are some bankers or advisors that try to run a very strict process that goes out to a high number of people. It could be 20 to 100 or more than 100 people to get the word out. It's still possible to keep it anonymous, but there's more non-disclosure agreements, NDAs, that are put in place. And there's more vetting to try to get the higher price and deadlines. I would say there's more of the formal process like I said in summary going out to a large number of people, calling it down to the handful, or if you're working with the right advisor maybe starting with that handful to find the right person.
JA:If you could briefly just talk about a quick shot at the types of buyers, just so people understand the terms that we're using.
SD:There's private equity, which a lot of small businesses are afraid of. But we walk them through the benefits of going through private equity, which I call an institutional buyer. Then there's strategic buyers, which could be another type of family run business in the neighborhood around or another region that may want to expand their footprint that are not institutional private equity backed. There could be an individual family office type of buyer or just an individual buyer. We spend a lot of time on institutional buyers, which fall into that private equity bucket.
JA:Terrific. Stu, a quick comment on the secret sauce of finding the right buyer from what you've seen in your experience.
SB:That's an interesting question, and I think it requires a lot of time. But from my perspective, what I've seen recently is limited option processes. What we were talking about a moment ago is either going direct to market through an auction process or going with a sole source buyer perhaps. I found it more beneficial for my clients when they go with a limited auction process so that there's competition to get the best price and the best terms. I just want to mention something about the price. It's always important to look at the top line number, but equally, if not more important, is to look at the method of payment. What I say to my clients often is, look, if I can get you 20 million dollars from one buyer and I can get you 10 million dollars from another buyer, which would you go with? And obviously they say 20 million dollars.

But the other half of the story is the 20 million dollar buyer is going to pay you a dollar a year for 20 million years whereas the 10 million dollar buyer is going to pay you 10 million dollars upfront. Now, which buyer do you want to go with? Obviously that's a ridiculous example, but it proves the point that the method of payment is equally if not more important than the total purchase price.
JA:It's a great point, and I think we're going to touch on it in a second when we really get into the guts of a deal. But a lot of deals are structured with payments post-closing whether it's an earn out or there's rollover equity. I think when we talk to clients about the ultimate buyer, if you are going to be involved in the business going forward because there's an earn out or there's rollover equity and you're going to continue to work there, who can you live with? Who do you want to be married to going forward? And for a lot of these individuals and families that are selling a business, they've never had a traditional boss before. So what is that going to look like going forward? Yes, the dollar amount's important and the payment's important. And as you said, Stu, if there's contingent payments and payments into the future, what does that relationship look like going forward?
SB:That's a great point, Jordan, because I think your experience is similar to mine notwithstanding the fact that there may be payments in the future by earn out or rollover equity or what have you. Most of the time when sellers are now playing with somebody else's baton ball and somebody else's rules, notwithstanding the fact that they may have signed up for a three year commitment, rarely do I find anybody lasting beyond one year. That's important to discuss with the seller right up front.
JA:Absolutely. Okay, so we have a buyer, we have a price, we're done, right? As we know that's not the case. We know all the fun and the hard work is just getting started. I'd like to give the audience a little insight on how the deal works. Stu, can you just discuss a couple of the key milestones of the deal? Scott touched on a couple of the scary terminology that we talked about, whether it's an IOI, LOI, due diligence, we throw these terms around normally, but can you just give a little bit overview of the process with some key milestones?
SB:Sure. From a 30,000 foot view, once the auction process is complete, we move into what's known as an LOI, a letter of intent, which is a non-binding agreement. Think of it as like the roadmap for the transaction. It includes the purchase price, the method of payment, and some particulars with respect to the transaction. While that process is going on, the buyer is usually doing some limited due diligence on the seller. And what is due diligence? Due diligence is really a deep dive into what the seller's about, learning about their financials, learning about their business, learning about their regulatory issues, their employees, so on and so forth. Once the preliminary due diligence is complete and the letter of intent is executed, we move forward with the purchase agreement. Now, traditionally, the process has been that it's the buyer's prerogative to draft the initial purchase agreement, and it's the buyer's obligation to review.

While that's going on, the buyer's deal team is continuing to take a deeper dive into the diligence because the purchase agreement itself is the guts of the transaction. Jordan, I don't think we want to discuss what's specifically in the purchase agreement. But for our purposes today, it's important to know that the purchase agreement includes what's known as representations and warranties. Representations are a snapshot of factual statement at a point in time, and a warranty is the continuing obligation of that factual statement. And so when the buyer is doing its diligence, it incorporates what it finds in the diligence into the representations and warranties. That's what we were talking about before. If the buyer wants to know exactly how many employees there are, exactly how many lawsuits there are, the buyer's entitled to know, and the seller will be better off making full disclosures because in this case, disclosure is the seller's friend.

Once the purchase agreement is basically complete, and I know I've skipped many steps, but once the purchase agreement is basically complete, which includes by the way, the tax analysis of how the transaction is going to be completed, then we move into effectively a closing. The closing means that the buyer has lined up its financing, the seller has received all of the third party consents that it needs in order to close the transaction including consents from counterparties to agreements, commercial agreements, regulatory agreements, permits, licenses, employment agreements have to be in place. So all this process takes, call it six to nine months. And once that's done, then the parties are ready to close, and that's when the money moves.
JA:Thanks, Stu. Scott, I'm going to get to you. Give me 10 seconds. Stu, we know that this six to nine month process is smooth, and there's never any hiccups or unexpected things that occur. Scott, you put the buyer and seller together when Stu and his team are going back and forth with council on the other side and they're nitpicking over words and important provisions, what's your role during this? Where do you get involved when those unexpected events and sort of emotional hiccups happen?
SD:I'm glad you used the word emotional, and then Stuart earlier used the word psychiatrist. I have to tell you, I've been called the psychiatrist more times than you can possibly imagine because I am there managing emotions from the buyer and the seller and getting expectations in order. The process that Stuart started to review, the one thing that comes up that's a little nerve-wracking to the seller is when you sign an LOI, you then are basically off the market. You can't shop for another price, you can't typically go to other buyers, and you're giving that buyer the opportunity to do a deep dive, very deep dive, into understanding the economics and aspects of the whole entire business.

What I do is really hold hands on both sides to make sure that everyone's expectations are in order. I would say different things that come up fairly regularly is understanding especially in sales driven businesses, is employment contracts, which Stuart works on. But talking to the seller, what's normal, not normal, how long you want to stick around or not, what's a fair compensation, what's not. I hold hands on that. Sometimes the buyer has questions about how the business is operated, so I sort of filter through both sides. Everyone's allowed to speak to each other, but sometimes I try to give the buyer a full description of what's going on, the seller of what's going on, and I really hold hands 24/7 through that whole process.
JA:While Stuart and his team are pouring through the document and you are doing handholding, as each change in the deal happens, our job is to explain to the seller how that affects the bottom line. So this happens, who pays for it? And if we pay for it, what's the impact? If we structure it this way, what's the impact? Do I get to deduct it? Do I get to keep it? Does it go into an escrow? All of that, all the financial ramifications to where the money moves is our job to walk through as the deal is taking place. So the title of this sort of discussion is trends in the deal space. I kind of want to do almost a rapid fire bonus round. I want to throw out some terms and just tell me what you're seeing related to those in deals that you guys are working on currently.

Earnouts, and earn outs just to define it is there's a deal that says after the closing, if the business hits certain targets and they can be structured a myriad of different ways, the seller is entitled to additional compensation based on you name it, you can structure it that way. What are you guys seeing related to earn outs in deals, and any specific trends that you're seeing currently?
SB:I'll start. From my perspective, we use earn outs as a bridge. The buyer wants to pay a lower amount, the seller wants a larger amount, and the earn out is effectively the bridge to cross that difference. I think what we're seeing now and what we will see now are more and more earn outs. Why? Because money's getting tighter, valuations are coming in closer, and sellers still want their price. I think earn outs are coming back and they're coming back in a ferocious way. The problem with earn outs is while it's easy to determine the metric for the earn out, meaning is it predicated on top line revenue, is it net profit, what have you, that's relatively easy. The hard part of dealing with an earn out is creating the parameters around which the buyer operates the business while the seller is entitled to that.
SD:I would jump in. Stuart and I actually had this discussion prior to the call. My earn outs have been, I think we spend a lot of time or bankers spend a lot of time making sure the seller has reasonable expectations on what they're going to receive and whether or not it's possible to bring in the right buyer to accomplish that. We spend a lot of time making sure that we can accomplish that net number. Otherwise a lot of people are wasting time. Earnouts that we've seen are really incentive based to make sure everything sticks and runs forward. We try to get that number as close as possible to what the seller expects upfront, and then it also depends a little bit on the structure of how much equity they'd like to keep in the business, what the seller's interested in, and the earn out piece that we've seen a lot of is really making sure that the business is continuing to grow, gross profits are staying in line with expectations historically. And we've seen bonuses that are paid out annually to make sure that everyone's incentivized to stick around and make sure everything goes well.
JA:Thanks, Scott. You mentioned how much equity they want to keep in the business, which brings us to rollover equity or roll forward, however you want to define it. What are you guys seeing in terms of deals with where it's not a straight earn out, where there's actually they're keeping skin in the game in terms of rolling over some equity?
SB:Again, I'll start. From my perspective, rollover equity was very hot in 2021 and 2022. I'm not so sure it's going to be as prevalent in the coming year because of the foibles of the market. People are beginning to think that companies are getting weaker, so they'd rather take their dollars and walk away. However, rollover equity really has a benefit for both sides. From the buyer's perspective, it means they have to pay fewer dollars out. They're using the seller's equity to pay for the deal. And from the seller's perspective, it gives them another bite at the apple. So while it works on both sides, I don't think it will be as prevalent this year, at least in the middle market.
SD:So it's a similar answer, but the percentage of equity that a seller keeps in a business is mainly determined on what they're looking to accomplish on the go forward. Do they want to stick around for one year, move on? Are they willing to stick around for five to 10 years? Just so everyone has a concept of what percentage of the business that people keep, typically institutional investors or private equity firms where you are a platform where they want to continue to grow off your company would be anywhere from 20% to 40%. If you're not the platform, and you may be added into another larger company, I've seen very small amounts of equity worthy, seller may want a second bite of the apple. We really talk about how much money they want now and how much money they're willing to take later to accomplish what Stuart said, which is how much money can I pull off this.
JA:We're running close to the end of the time we had allotted for this. As a moderator and a tax accountant, I failed at leaving enough time to properly explore all the different structures in the tax impact. But there's a lot of terms that are thrown out there; asset versus stock deal, F-reorganization, 338(h)(10), and all of those transactions are different ways to accomplish the goals of the buyer and the seller at competing interest to get to something that's mutually beneficial. A stock sale historically had better tax treatment than an asset sale for sellers, and we see gross ups and all this. What are you guys seeing on the structuring? I know these things kind of come in and out of vogue. Stu, what are you seeing on the structuring side?
SB:Well, basically what you just mentioned, Jordan. Buyers want to be able to deduct or amortize the purchase price, and sellers want to take advantage of capital gains treatment. By using the structures that you're talking about, whether it's an F-reorganization, which is utilized when there is a roll forward of equity or a 338(h)(10) deal, which is effectively doing the same thing, but there can't be a roll forward of equity, it just depends. I would say a vast majority of deals today utilize one of those two tax maneuvers I'll call it.
JA:I will say from the tax perspective, one of the changes in the whole environment, stock sale used to always be historically more beneficial than an asset sale to the seller. With some of the changes in tax law, particularly the limitation on the deduction of local taxes, what we call the SALT cap, and now all the states coming through with these SALT cap workarounds, there are many instances where actually doing an asset deal now could be favorable from a tax perspective. It's interesting how some of these things change over time as we move forward.
SD:I just want to jump in for two seconds on that, Jordan. Again, it's accomplishing the seller's needs, but what we've been very good at accomplishing is giving the structure the buyer wants and the net proceeds the seller wants. The seller doesn't usually care a structure, they just care about what goes into their bank account. So usually stock might give you the highest net proceeds, but sellers and buyers want that asset transaction, but they do the 338 that Stuart mentioned, and they basically round up. So, look, we want to do it this way, we know you need net proceeds that way, and between Jordan and Stuart, you can get the right structure with the right net proceeds.
JA:I think that's a great point. That was a really good way to define the two competing interests. In the couple minutes we have left, I'd like you each to give your final thought to a potential seller with any advice on post-closing. Scott, why don't you start.
SD:Post-closing, it's fairly important to understand your role in the company going forward and what your responsibilities are to report to the buyer. I do hear fairly regularly that some business owners have never worked for anyone before, so there might be a little bit more of an institutional corporate structure and just to understand what that's going to look like with the buyer prior to the transaction. And then there's also some reporting requirements that might be necessary where some small businesses may only focus on annual numbers, where monthly numbers become more important. The last piece I would recommend is typically the employees of the company are not aware of the transaction until closing. It's usually kept fairly confidential and just to understand how to manage employees once they find out when you've been working on something for nine months and they now become aware just to understand the outcome to your employees.
JA:Stuart, your thoughts on life after close for a seller?
SB:I'll give you the answer that's most prevalent in the legal profession. It depends. It depends on the way the transaction is structured. If the seller's walking away and has no further obligations by virtue of an earn out or anything along those lines, then I would say just stay in your lane. Do not disclose anything with respect to the transaction because chances are there are what's known as restrictive covenants going forward. A restrictive covenant is an obligation not to do something, so you're not supposed to disclose any confidential information. You're not supposed to solicit your former company's employees or customers, and you're not supposed to compete with your former company. If you're not working for them, just enjoy your time. If you are going to work for them, be a good employee. I think that's usually very difficult and that's something that Scott discussed before because most people don't understand how to play by other people's rules when they've been the chief cook and bottle washer for the past umpteen years. So what we try to tell our clients is we're going to give you some practical realities and please don't ignore them.
SD:What I was going to add in to Stuart's comments, post transaction you want to be able to communicate not only to your employees, but to your vendors and your customers. I've actually seen a trend in extending out announcements by 20 to 30 days, so the seller has the opportunity to communicate their messaging so people don't see it from various sources. I think it's pretty important to understand what your messaging will be to employees, clients, and vendors.
SB:And what you're allowed to say.
SD:Correct.
JA:Absolutely. Well, I think that's great advice for a seller. I think that the post-closing advice is similar to the pre-sale advice, which is understand what your expectations are and hopefully that post-closing those expectations, whether you're walking away or staying engaged, have met what we set out to at the beginning of this journey. And with that, I'd like to thank the two of you for spending this brief journey with me talking about trends in the M&A space in the middle market. Hopefully our audience got some value out of it, and I enjoyed spending some time with you. Thank you both for your insights and your expertise. Greatly appreciate it.

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