KUHN CAPITAL Saturday, February 24, 2018
Dispatches from the front

Why M&A Advisors Work the Way They Do

We love to talk about what we do, but over the years we’ve noticed similar questions from the same source -- the less experienced would-be seller.

Perhaps that’s because the stakes for many first-time sellers are personal and high, so they’re all ears and ideas; or maybe they’re heavily immersed in operating their businesses and are less acquainted with the external world of deals.

Whatever the reason, if you’re thinking of selling your company, this article’s for you. But even if you’re not currently a seller or buyer, you should find it a useful overview on how and why M&A advisors work the way they do. We’ve used the Q&A format below to address the most common inquiries we encounter.

Why Does It Take So Long to Sell My Company?
Doubt the intermediary who promises a sale inside six months. That’s because only about one-third of the total time elapsed is under our direct control -- primarily the identification of prospective buyers and the preparation of a “book” or offering memorandum (for details on the stages of a sell-side campaign, see below).

The remaining four months are taken up by prospective buyer analysis of the book, arrangements for the buyer to access the seller’s “data room” and carry out related due diligence, meetings with seller management and -- most time-consuming of all -- negotiations over the minutae of a purchase agreement. Since this last stage is in the hands of lawyers and accountants, and since these professionals are usually not, like intermediaries, compensated specifically to close, it’s common for progress over the nuances of document language to slow substantially. But beware: excessive dawdling over details kills deals. Owners need to stay proactive.

Why Are You Paid Both a Retainer and “Success” Fee?
Intermediaries typically charge two sorts of fees, a “retainer” and a success or contingency fee. The retainer fee, a flat monthly payment, compensates us mostly for the out-of-pocket costs of getting a transaction underway. Retainers keep the lights on, and they further assure us that the seller has as much on the table as we do. We find that low or absent retainers seem to convey the unfortunate impression that our services may not be worth much. But in fact, a lot of work goes into preparing a company for sale.

That work consists of several things:
• Researching and contacting qualified prospective buyers;
• Obtaining their signature on a non-disclosure agreement;
• Writing up and sending them a book describing the opportunity in detail;
• Building and managing a “data room” for buyer access to further proprietary information on the seller and to seller management team members;
• Then finally, ranking and managing the more attractive buyer candidates through purchase agreement negotiations to close.

Of all these processes, the intermediary’s most demanding is book preparation, since doing so requires not only a thorough knowledge of the seller’s business, and the ability to describe it succinctly, but also often means “packaging” the company for sale -- including actions by the owners to clean up or better organize the condition and direction of the business, or to resolve certain outstanding issues that can distract buyers. Examples: personal loans, unrelated businesses on the books, ineffective accounting or control systems, etc. It’s rare that we don’t recommend that the seller take certain steps requiring from several days to six months to complete before we publish the book.

While these campaign stages may be deserving of a retainer in their own right, another reason is, frankly, to observe the dictates of the M&A Advisor Risk Reduction Act. The Act acknowledges that most would-be deals don’t work -- that lots of things can go wrong, including a seller's decision to refuse all reasonable offers, or a surprise last-minute buyer demand, or -- in a situation we recently experienced -- a sudden withdrawal from the market due to Byzantine seller corporate political machinations.

In other words, the seller has wide latitude to decline any deal, thereby negating the main reason we’re in business: to realize a success fee, usually phrased in the form of a percentage of the deal’s value upon close. In sum, the retainer fee is insurance that our time will be at least partially compensated, and it keeps the client moving in a timely fashion toward a successful conclusion.

Why Is Your Success Fee a Declining Percentage of the Deal’s Value?
Contingency fees are usually expressed as some variant of the “Lehman Formula”: they feature a diminishing fee percentage for each increment in deal value. So for a $10 million deal, the fee percentage that applies, say, to the first $2 million in value is higher than what applies to the last $2 million. Shouldn’t this work in reverse, you say, to inspire the intermediary to obtain the highest price possible?

There are two reasons that intermediary's success fees are usually "regressive". While we can calculate a company’s value by using five or six separate financial techniques, the terrible truth is that the market has the final word. Try as we might, we can’t do more than lead the horse to water. Lots of external factors, all beyond our control, can affect value, including the sudden appearance of a strategic buyer who boosts the sale price in competitive bidding. Or an industry-wide depression that drives prices below levels that even the most thorough analysis shows are “fair”.

So while we may have an idea of seller value, a progressive fee wouldn’t make us work any harder, within the bounds of integrity and accuracy, than our usual maximum effort. Setting up incentives designed to make us do so may even have the paradoxical affect of depressing sales value by tempting us to alienate buyers by playing hardball.

On the other hand, the traditional declining percentage structure recognizes the fact that the bigger the deal, the less incremental work we deliver to close it. For us, the costs required to set up and close a deal tend to be fixed, and we always agree to do the best we can.

Why Does Your Success Fee Cover Buyers With Whom We Are Already In Contact?
"And, while we're at it, why is direct contact between myself and a prospective buyer off limits?" As noted above, the buyer identification phrase of a sale campaign is not its most demanding aspect. While a seller who brings prospective buyers to the table may prove helpful, we will almost certainly find them on our own anyway.

So the issue isn’t the value of identifying buyers. Rather, it’s direct contact between seller and buyer that’s bad news for several reasons. First, some buyers are not above using personal contact to wheedle concessions out of the seller, or to catch inconsistencies, or to otherwise play the process to their advantage. The representations buyers may make in such conversations can lead to legal problems.

And if the seller entertains inside conversations with a buyer, he also risks losing other buyers who may have superior offers. Last, the seller can find himself diverted from the demands of maintaining company operations at a most critical time.

From our perspective, if a seller client grants special access to a buyer, our job of managing the campaign process suddenly gets far tougher. “Managing” buyers means that we herd them through steps of increasing interest and qualification to the point where they generate purchase proposals that we then present to the client in a standardized format. We rank buyers by attractiveness, select one with which to enter into detailed negotiations, and try to hold onto the remaining prospects as insurance until we’ve closed the leader. To do this, we need perfect information about what each buyer knows or has been told, his attitudes and his rationale. We don’t have this information if a buyer is enjoying special access.

Another risk of direct contact is familiarity breeding contempt. The seller wants to appear as a desirable bride at the altar of closing ceremonies. Insulated from the eyeball-to-eyeball negotiations with buyers that preceded the event, the seller is proudly presented as a fresh start on a hopeful future. It’s hard for us to carry off this vision if the seller’s been sullied with money-grubbing details -- that’s our job, the “bad cop” intermediary.

Finally, we want to avoid at all costs the prospect of competing against our client for the successful buyer. Both seller and intermediary should be on the same side of the table, motivated by similar incentives.

So for these reasons, most intermediaries require success fee compensation regardless of who first identified the winning buyer, though they may concede to a reduced success fee in cases where a very strong relationship existed beforehand. But please know that their reluctance to make these concessions isn’t based on greed alone: it’s rooted in a concern that their ability to act as impartial consultant may be compromised when they can earn more compensation by recommending "their" buyer over the client's.

Ryan Kuhn

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