Today we’re diving deep into what most startups dream about and are striving for – the exit. Hutchison PLLC partner and mergers & acquisitions expert attorney Dan Fuchs shares what both founders and buyers should be looking out for throughout the acquisition process.
Transcript
Trevor Schimdt: Today’s guest is Dan Fuchs, one of the partners at Hutchison who has spent his career guiding companies through all shapes and sizes of mergers and acquisitions.
On previous episodes, we’ve had our attorneys come on to talk about various legal considerations for startups such as Intellectual Property protection with yours truly, the legal side of raising money – with Anna Tharrington – and the biggest mistakes we see startups make – that episode was with Justyn Kasierski. If you have not listened to those episodes, I you really should check them out as they cover a lot of the major steps in the life cycle of a company/
And today we’re diving deep into what most startups we work with dream about and are striving for – the exit. But what we see, is that even for this big event that many dream about, it can often be harder than some expect.
Dan Fuchs: You know, a lot of people compare it to sort of giving up their child. You sort of raise this baby from, from inception and it’s your idea. You’ve nurtured it throughout. It’s probably going to do that with still some guidance from you, but in the hands of other people and sort of on its own and running forward.So that’s one of the things that I think startup founders don’t necessarily think about when they think about acquisition it’s, it is sort of pulling yourself back from this thing that you’ve been so committed to for so long and really letting it run and have a life of its own beyond you.
Trevor Schmidt: And even before your company gets to that life beyond you, many times with the sale of a company, the founder is required to stay on for a certain period of time. For those who have been their own boss, that can be a challenging transition.
No matter what, selling the company you’ve committed yourself to is challenging and there is a lot to consider. So let’s get to the legal aspects of how it all works…
Dan Fuchs: I think the two primary types of exits that we see in our practice are, you know, stock acquisitions or asset purchases. The stock acquisition is the buying of the entity, and so it encompasses all of the assets, all of the liabilities of the entity in one nice package. An asset purchase acquisition is cherry picking certain assets and certain liabilities. And I like to think of it as buying the business, not necessarily the entity in which the business resides. So those are the two main areas of exit that we deal with in our practice.
The third one that entrepreneurs often focus on that we don’t directly represent is an IPO or an initial public transaction. Those are generally handled by larger national firms that have strong relationships with the FCC. But in that situation you would have and these are probably the most public and what people know about not listening to this podcast, but then the public markets come in and become the owners of the business. And you would see existing investors, all sort of convert to common stock, still be owners going forward, but have the liquidity after some lockup periods to sell their stock and actually monetize their investment and liquidate it in that way.
For those companies, you don’t see as much transition of management as you would in a private company acquisition through either a merger or a stock sale or asset purchase. But it is another route that a lot of companies, especially the unicorns that you hear about, they will often go public.
Trevor Schmidt: So what are the different situations where a company might either choose or have forced on them, an asset purchase versus a stock deal versus going public? I mean, what’s the advantage of those different kinds of forms?
Dan Fuchs: The primary advantage for a seller of doing a stock deal is you’re getting the money into the hands of your equity holders directly. You’re not passing it through the company, and as you can imagine, if you’re a corporation and you’re a C Corp, there’s going to be taxation at the corporate level if you were to sell assets, because it’s the entity selling the assets instead of the owners selling their equity in that entity, and so you can get money directly to the stockholders and shareholders. If they’ve held it for over a year, you get long-term capital gains in most instances. So it’s a, it’s a tax advantage play.
So if you’re a seller, you’re, you’re generally going to want to push for a stock deal, if you are selling the entirety of your business, there are certain situations where, and we see this most often in our life sciences practice, where you might be doing the exit in a way where you’re not actually selling the entirety of the business. You might be selling rights to your drug or your device in a specific geography, and in that instance, a stock deal would not be favorable to you because you can’t parse out what you’re selling and what you’re not, unless you sort of create new entities and spin things out prior to the deal.
From a buyer perspective, they’re generally, if they have their druthers kind of want to do an asset deal, and the reason for that is there there’s many, but the main ones are the ability to pick and choose and sort of get some separation between historic liabilities and assets that they might not want. You might have a long-term lease that the buyer doesn’t necessarily want to assume. It’s very difficult to handle that in a stock deal, whereas in an asset deal, you could just leave it behind with, with the sellers.
The other main advantage of an asset deal for the buyer is they generally will be able to take a step up in the basis of the assets. And, and so if they’re buying equipment they can, you know, step up the basis to what they’re paying for the equipment in the deal, and then re depreciate it instead of inheriting sort of all of that tax treatment from, from the earlier owner.
In most instances, the buyer’s going to come and sort of dictate what they want in terms of the structure, and there’ll be sympathetic, I guess, is the best way to phrase it, to, to addressing the seller’s tax concerns or other issues with, with why they might not be advantageous to them if they were going to do an asset deal.
But again, it largely comes down to price. So if you’re, if you’re doing a stock deal, you might accept a little bit lower price as the seller, because you get all of the benefits that we talked about before, whereas if you’re doing an asset to you, you would want to price into that. What are the tax ramifications of that for you? What are the liabilities that are staying behind? Those sorts of things. So that at the end of the day, you as the owner, Ha can sort of get to the same place or at least compare apples to apples if you have a multi bidder situation.
Trevor Schmidt: Yep. And then the IPO is just, if you have the option, is there other, other reasons to do the IPO?
Dan Fuchs: So the IPO is, is a great exit tool for the right company. It is very expensive to be a publicly traded publicly reporting company in the United States. And so for a lot of companies who either don’t have the revenues or, or are great companies, but they’re not sort of at that multi hundred-million-dollar level, you’re going to be spending probably conservatively one and a half to $2 million a year, just staying public and staying with your public reporting. Accounting and every, in all these ancillary costs go up significantly, because of the exposure.
So if, if you’re the right company to do it, it is a good path. And you can, by accessing the capital markets, you can instead of borrowing money. You’re, you’re getting it from the capital markets more efficiently, which lowers your cost of capital. It allows
people to come in and out without sort of having these major transaction events and exit events. So if you think about, you know, the blue-chip companies like Apple and AT&T who have been out there for forever, all of their metrics build in sort of the cost of being public, and there’s really no other way for them to operate. They’re just so large that they would do that. But if you’re talking about a startup who, you know, five years ago was three men and women in a garage who are used to making all the decisions themselves, could hold a shareholder vote within a matter of minutes or hours, being public that becomes weeks and sort of tens of thousands, if not hundreds of thousands of dollars of legal time to solicit and do all sorts of other things that you need to do just to run the business, quite honestly.
So for our clients and, and I don’t want to disregard that as a, as an avenue, but it’s not something that we work with a lot. And, and for our clients, it’s just not something that, that I have a lot of familiarity with, but it is a third option.
Trevor Schmidt: No, that’s helpful. And so what, when does, or when should a company really start to think about and plan for an acquisition and what does planning for an acquisition really look like?
Dan Fuchs: the earlier the better is always is always the lawyer answer, but I do think that that’s not entirely facetious. I think thinking about it is something that you should do from the beginning, from, from when you’re setting up your company. And the reason why I say that is it influences sort of the path that a lot of companies take.
In our practice and our business, our clients are not what I would consider lifestyle business. So this might be a family run business that likes to throw off some, some cash every year, they live off that cash, but they’re running the business and they’re not planning to eventually sell, but that’s a decision that I would think that you would make earlier than just sort of fall into it. So as soon as you start forming your team, you need to be on the same page with your co-founders and the other people that you’re working with, is this a lifestyle business, or is this something that we’re eventually going to sell? That’s the first thing, so thinking about it is important early on.
When you start taking outside capital, that becomes the next sort of main point that I think you need to really think about, what does an exit look like for this company? And the reason why I say that is if you’re taking sophisticated capital, not friends and family, they’re going to be on, let’s say four-to-seven-year investment horizon.
And so in the next four to seven years, they’re going to want to exit that investment and the likelihood that you will have the money as a company to buy them out is very low. So you need to think about how are we going to exit? What does that look like? And also think about what’s realistically a buyer for this company look like? How much money do we think they’re going to spend, because your investors are going to come in with certain returns in their mind, whether that be five X or 10 X, or hopefully not 20 X as a, as an expectation.
But what you need to do is take those expectations and you know, what would be a good result for those investors and factor that in when you’re doing things like pre money valuations and other things of the company. Because if you go and raise money on a $50 million pre money, and the likely exit for your business is $150 million, that sounds like a win to most investors, but a three X return for venture capital is not what they’re targeting. So I think if you’re going out with a $50 million valuation, you should be thinking this is a $500 million and above company.
Aligning with your investors early on about what this looks like, being realistic about what it might take the shape of, those are things that you need to be thinking about. You’re not going to have all the answers. You’re not going to know what this could turn into. And, and everybody thinks they’re going to be the next unicorn. But if you have a niche product that there’s only one or two buyers that you could see buying the company, you need to factor those things in pretty early on.
To get to when do you start preparing for an exit? My standard answer is, you know, 12 to 18 months, if you can. That’s where you really start engaging with If you’re going to use bankers, investment bankers, you really look at the team around the table and think are these the right people to, to get us through a transaction like this?
And that is to my mind, everybody. Do you have the right CFO in place? You have the right outside counsel? Do you have the right accounting firm to prepare some of the documentation and reports that you’re going to need to get through due diligence? And then do you have your house in order, like, do you have copies of your contracts? Have you sort of buttoned up equity, issuances? Have you thought about estate planning and things like that as a founder? Because all of that, especially the estate planning and sort of tax related items, you’re probably have a fairly rigid sort of 12-month cutoff to actually doing things, to put in place a plan that would maximize savings, whether it’s moving things into trusts and other things.
So the earlier you can think about it, the better. That being said, I’ve had companies come to us and, you know, they just received an inbound LOI, letter of intent, that they weren’t expecting. They like the letter of intent. They want to move forward on the deal and we just go off to the races. And so it’s, what’s ideal, what would you like to have versus what sometimes happens more often happens to be honest.
Trevor Schmidt: I think that’s really helpful. And, and you, when you say 12 to 18 months, that’s in advance of when you anticipate closing or when you 12 to 18 months before you kind of go out looking for an acquirer?
Dan Fuchs: I think if you’re trying to run an organized process, you should start thinking about it 12 to 18 months before you start going up to the market and trying to find buyers, you know, inbound interest, you can’t control that that’s going to come when it comes. I think that’s why we advise our clients to really stay on top of their, the organizational aspects of it. Keep copies of your contracts, have somebody who’s a point person in your organization to keep an organized data room.
If we’re working with a company that is looking to eventually transact in this way, one of the things that I try and push on our clients is, here’s a copy of a due diligence checklist that you’re going to get in an acquisition. Here are the types of things that you’re probably going to be asked. Okay, whatever you can do internally or with our assistance, you should be thinking about organizing your files, your day-to-day practices, your, your things along the lines that would be responsive to this in a good way.
Because when you’re in a sale process, as much as anything it’s storytelling, it’s what is the story of this company? Where has it been? What has it overcome and what is the bright future that you can sell to a new buyer or, you know, a new owner that gets them to the leave that, you know, this is just the start? Nobody buys a company that has sort of plateaued and is going to stay in the same place where they bought them, they want it to continue going up and improve so that they can get the returns that they want from their investment.
So if you think about it like that, it really influences everything that you do as a founder and as a company. What’s the story you’re pitching to your investors? How are you proceeding on that trajectory over the course of time? If you’re making presentations to investors, it is not uncommon for a future acquire to in due diligence ask for those presentations that were made, ask for copies of things that were provided to investors. And they’ll with hindsight, compare what you said you were going to do versus what actually happened. And so you need to be prepared to celebrate that victory, if everything went according to plan, or explain why it didn’t go according to plan and how that’s actually puts you in a better place than if it had, or at least how you overcame it to get to where you are today.
Trevor Schmidt: Yeah. I think that’s super insightful. Cause you know, this idea that the sale is a story and having understanding of what your documents are, what your financials are and do those line up with the story that you’re telling. And if not, how do you explain that? You know, I think being able to do that in advance, it would be amazing rather than trying to, you know, pull all the documents together, you know, to respond to a diligence request and then try to make the story up on the fly. I mean, it all seems to be the more you can plan in advance, the more compelling it’s going to be.
Dan Fuchs: Yeah. And, and for, for clients where we have the time in advance and they have, you know, some resources cause, cause none of this is free, but we do run at times sort of mock diligence processes we’re, we’ll come in, in the same manner as a buyer council and sort of go through the company’s documents, identify where gaps are and try and plug those gaps before we ever opened the data room to, to the other side. A lot of clients are a bit hesitant to do that. They don’t necessarily see the value, but what that does is it lays the foundation for whether it’s Hutchison or whoever your outside counsel is, to be very prepared as they go into the negotiations, to help draft things like disclosure schedules, which will accompany the purchase agreement and provide exceptions from some fairly blanket and widespread representations and warranties the company is going to be asked to make.
And by having that knowledge within your council, as well as within the company, you can sort of stress test the story that you’re trying to tell. Lawyers tend to be a bit cynical and skeptical so, so they’re not going to accept it at face value. They’re going to sort of push and, and make sure that you’re prepared to answer those questions in a very nonthreatening collaborative way where we’ve even gone so far as to sort of role-play and answer due diligence questions on a call before we get on the call with opposing counsel to just, you know, never deceive, never hide things, but raise things that need to be disclosed in a manner that sort of puts the issue to bed, instead of prompting 13 more questions on something that’s relatively minor and should not be an issue.
Trevor Schmidt: Yeah, no, I think that’s great advice. And we may have touched on this to a certain degree kind of, as you talked about the, unbalanced view for investors versus the potential exit, but what are some mistakes that a company can make early on in the life of the company that are going to come back and haunt them when it does come time for an exit?
Dan Fuchs: The most fundamental one is not having good control over their cap table and making sure that they haven’t made promises about equity to people that are not reflected on the cap table, which, you know, seems like a fairly basic thing.
But you know, when you’re a founder and you’re just starting out, you’re scrappy, you’re trying to get, you know, whatever money you can in the door, and so writing equity ownership in terms of percentages, as opposed to fixed share numbers is a disaster, from my perspective, because when you, when you get to the exit, you need to have a very good understanding of who owns what, and who’s entitled to what, and what votes do you need to approve the transaction?
Because in most cases, it’s not going to be unanimous and you don’t want to have it be unanimous. So putting in place agreements that can’t be amended by a less than unanimity is a problem, which none of our clients would ever do, I’m sure, but you know, occasionally they come across our desk where it might be a stockholders’ agreement or something else that requires everyone to consent.
Other things that that come up and mistakes are just not, not reading contracts that you signed with third parties, not understanding what your rights and obligations are. Things like most favored nations clauses, where you, you lock in best pricing for someone else, or you agree not to compete in a certain area.
These are all categories of contracts that any sophisticated buyer is going to ask you to make a representation as to whether or not they exist and tell them exactly what those contracts are, provide them copies, allow them to review it. And so, again, getting back to the storytelling, you, as the selling management team, want to portray and convey a sense of competence and that you know, where, you know your business inside and out, you know, where everything is.
Even if you have skeletons buried, you know which closet they’re in and, and, and you need to be prepared that those are going to come out during the diligence process. It’s not a good look, it’s not a good story to sort of get the reps and warranties, which asks you to disclose all these contracts and say, well, we’re going to need three and a half weeks to review all of our contracts to make sure that we’re covering everything. These are things that you should know and have readily available to, again, convey that story that you’re in command of this business. You’re running the business. The business is not running you in some ways.
The acquisition process, especially in private company acquisitions, it’s a courtship. It’s, it’s a, it’s a relationship that you’re really entering into. And so you don’t go on a first date and sort of tell everything that’s ever happened to you, but before you get married, you should have a pretty good idea of everything that’s happening with you with, with your partner.
And again, it it’s storytelling, always being truthful, always, you know, full disclosure. This is when I say storytelling, we’re not making things up, but it’s painting things in a way that is accurate and truthful, but also favorable and moves the company forward in the way that you want.
Trevor Schmidt: Now you touched on some of the different players that are involved and making sure you have the right people involved. So you talked about the CFO and your financial advisors and your legal advisors., kind of what are the different roles that these, these play kind of in the exit, but then I also wanted to get to the question of kind of the investment bankers, because we get the question a lot of what is an investment banker or when should I engage an investment banker? And is it something that’s really needed for this acquisition? So can you talk a little bit about those different pieces?
Dan Fuchs: I like to think of investment bankers as, you know, market makers. So if you want to sell your business and you haven’t identified sort of potential targets, or you don’t have a vendor or a customer that you think is a natural sort of fit for a strategic kind of roll up acquisition, investment bankers can be very helpful in identifying people within their network and in the industry and helping pitch the company to them as an acquisition target. It can also take, you know, some of the burden of an acquisition off of the management team because the investment bankers have teams and they will, help run diligence processes. They’ll run interference for the company management with potential buyers.
And so if you’re looking to have a highly competitive process with no sort of identified lead buyer or bidder, I think investment bankers can add, it can add value. As with any outside, advisor investment bankers come with the price tag and that price tag can often exceed in some instances, the value that I, that I identify or our clients have identified that the investment banker has brought to the process.
There are great investment bankers. There are, you know, less great investment bankers, I will say. And so what you really want to do is you want to work with people that either you, as the founder know, and know their reputation and know kind of how they know your business, or you want to ask other trusted advisors, whether that be counsel, whether that be you’re now an incubator program that you might have gone through other founders that you’re friends with, because identifying the right banker can significantly impact your view of how that relationship goes. Investment bankers, unlike council, are generally paid on a success fee. So upon the sale of the business, they will take some percentage of it. And there’s all sorts of ways that that that can be structured. What’s what counts for consideration, what doesn’t.
That’s all negotiated upfront, and so one of the, one of the challenges of this process is you’re hiring someone to be an advocate for your business. And the first interaction that you have with them is you negotiating against them for how you’re going to pay them if they are eventually successful, right? So that brings up an odd dynamic. That’s probably the first time that you’re going to want to have, if you don’t already, you should absolutely have some sophisticated legal counsel to help negotiate that for you to, to understand what’s market.
And you should also be aligning the payments and the fees that you’re paying the banker with your own sort of realistic expectations of, of what the deal is going to be worth. So bankers will generally have a minimum fee, but then above that they get, you know, a percentage, as I mentioned. Some lenders try and have sort of a fixed percentage regardless of what the deal is worth. In my view, that is not ideal. It doesn’t really align incentives. What we try and work with our clients to identify as what would be a good reasonable exit for you in terms of money, what would be a home run and, you know, what’s something you can’t even imagine that. You’d be happy to pay a higher percentage on because it’s just so great.
And what we usually do is try and structure it. So you get, so the banker would get, whether we say a three, 3% fee on up to the first, if that, if that average exit was a hundred million dollars, 3% up to a hundred, then maybe they get four on the amount between 100 and 200, and then anything about 200 million, they get four and a half percent of that amount.
And so you align the incentives where if they really hit it out of the park for you, they get more. So investment bankers have their place. If, if you’re just doing kind of a deal that you’ve already identified, the buyer, or you think is just one or two, I probably wouldn’t engage in investment banker in that instance, just because you’ve already made the market for yourself. You don’t need them to do that, and so to pay three or four or 5% of your company for that service. I’m not sure you’re getting the return there.
Other players, your accounting firm, or auditors are important and they should be brought up to speed and kept apprised of what’s going on because there’s likely going to be diligence requests coming in that they’re going to need to respond to. And then council, is the other big sort of outside player. And on that, I think companies should not be afraid to realize that the counsel that they’ve had for a while may not be the right council to get them through the deal, right? Because doing the deal is a very different skillset and sort of market knowledge than day-to-day contracting or other things that they might be very happy with their current council with.
If you’re looking for transaction counsel and it’s someone different than who you’ve been using before, I would recommend you find counsel that works well with your existing council and finds a place for them because that will save the founder money in the long run to sort of divide that up instead of sort of coming in and reviewing everything, as if they’d never seen it before. So there, there is a way to work together with existing council, and it’s just, an open dialogue to, to figure out when that works.
internally you’re going to need to devote significant resources from your management team to this process, and you, you just need to identify who those people are and who’s going to be let in because you’re not going to want to tell the whole company that you’re at for sale until you’re further along, but at a minimum, it’s definitely the Chief Executive Officer. Yeah, usually who’s ever in the COO and CTO roles, if it’s a tech company and your CFO, the whole C-suite should be in the mix, but those are going to be the heavy lifts, in terms of responding to diligence and other things.
Trevor Schmidt: Yeah, and I think sometimes companies underestimate the amount of distraction or the amount of time and effort it takes for companies to kind of go through this process, and so making sure that not only do you have the right people involved, but enough people to kind of offset that load, I think is important.
Dan Fuchs: Yeah, and our clients have routinely said it’s like having two full-time jobs, hopefully at the end of it, they have a great, great payoff and, and, and see the reward there, but I also think you need to be thinking to that point, if you have members of that senior management team who are going to have significant workloads from this transaction, you need to look at your cap table and look at where those proceeds are going to flow. And if they don’t hold an equity, that’s significantly in the money or, or compensating them for that., the founders to the something don’t control the board should start thinking about going to the board early in the process and floating the idea of management bonuses and carve-outs and set asides to say, we need to compensate these people to get you to the end result that you’re looking to get to as an equity holder. And that is very customary in, in deals.
Trevor Schmidt: So if a company’s not using investment bankers and doesn’t have kind of inbound acquisition offers, how do they go about kind of trying to attract potential acquirers and, you know, talked about strategic versus other types of acquirers can talk a little bit about the different types of acquirers?
Dan Fuchs: Yeah. So there’s two main types. One is financial and one is strategic. And so a financial acquirer may have an investment expertise in your industry or may have kind of a broad investment basis, but, but they’re really just focused on the financial returns they get out of the business. There’s no sort of strategic interplay with another company or otherwise.
And so those buyers’ kind of skew the deals in a different way than strategic. So for a financial buyer, most, if not all of the management team is could, you know, continue on with the business because a financial buyer doesn’t necessarily have the expertise or know how to run the business. With a strategic buyer, which is industry more likely to be a vendor or a customer of yours, they already have some of the expertise to run the business. And so especially higher up in the C-suite those executives may be replaced. There’s going to need to be very thoughtful integration as to how these two businesses are going to be running together.
And what you’ll often see from a strategic buyer is they may be willing to pay a little bit more because they’re, they’re going to look at the two businesses, not as two independent businesses, but where can we achieve synergies? Where can we do cost savings to sort of grow the value of both together.
And so strategic buyers, generally move a little slower., just so if you’re looking for a quick sale, financial buyers can generally move a little bit faster just because this is what they do. Day in, day out. They have the teams ready to go. A strategic buyer, this might be their first acquisition. And so they’re building a team just like you’re building a team and learning to work with them. And it just takes a little bit more time, but those are the two main types of buyers. How you attract them, you know, one have a good business., it kind of goes without saying the more attractive you are, the more, the better your numbers are, the better story you can tell, the more you can attract them.
If you’re a life sciences business, you know, particularly if you’re in sort of early-stage drug development, you would go to places like JP Morgan conference and things like that and get in front of them, find places where you can get in front of a lot of people to, who might have interest. And again, just put out feelers with your network, feelers, have people know what your business is doing, and you’ll be surprised how far those little nuggets of information can travel through networks and LinkedIn and everything else.
If you’re in the tech business, chances are you’re more customer facing or you’re not sort of hidden in the lab. You’re, you’re interacting with customers, you have users, you have more vendors. Generally we’ll see sort of organic things happening there and what you can, even if you’re not doing a strategic deal, if you’re interacting as a business with other companies that have venture financing behind them.
You’re getting exposed to whoever’s on their cap table or on their board. and there’s all sorts of resources, PitchBook and other things to see who’s investing in what, and you can do outreach and, and other things. But, you know, if you really have no idea, you should be thinking about an investment banker, but a lot of people already know sort of who the two or three are. And then, you know, they run a process with those and, and move forward.
Trevor Schmidt: Well, it kind of speaking of that, that process or after that process has gone on for some time. And now all of a sudden we’ve got an LOI in hand, kind of what should a company be thinking about when that LOI first crosses their desk?
Dan Fuchs: The first thing to think about is, you know, most LOI’s are nonbinding and most of the provisions in them are non-binding so. First thing is to take a deep breath, no matter what the number is on that paper, it’s not in your bank account yet. The deal has not happened., and buyers and their counsel, and we represent buyers as well. You know, our goal is to get it down as low as we can while still being accurate to the LOI, unless we’re intentionally sort of repricing the deal. So one, there’s a long way between the LOI and the end in terms of sort of mentally preparing yourself.
The second is of the few terms that are binding in the LOI, one is exclusivity. And so a buyer will generally ask for a period of time for them to complete their due diligence, where you as the company agreed not to talk to other buyers during that time, depending on what sort of process you’re running or intent or. This can either be a very easy give if it’s sort of an unsolicited inbound requests where you otherwise weren’t thinking about selling the company, or it can be a very challenging give where you were running a process and all of a sudden you need to tell everybody else to stop work.
if you’re in a competitive process, we try, we advise clients to hold out on giving exclusivity as long as possible, you should do all of the primary negotiation around the terms upfront so that you know you have a good offer. And then as part of the exclusivity, we generally put in no matter how long the period is that’s being requested or that we’re going to agree to, if there’s any material change in those terms, in a way that’s adverse to the seller exclusivity immediately terminates. That is a good way to keep the buyer in line, that even though they’re not bound by those terms, if they diverge, they’ve lost, you know, really the, the primary benefit of, of the term sheet and exclusivity at that point.
Well often also, especially as the period gets longer, build in provisions as checkpoints. So if you have a 60-day exclusivity period, you might request for the initial draft of the definitive document to come within 20 days. And if they miss that deadline, you can terminate exclusivity as well. Again, it’s trying to keep guard rails on the process to keep it moving forward in a direction, understanding that it’s very unlikely that you’re going to get actual binding terms, upfront.
As a buyer, the reason why they need exclusivity is because they’re going to be spending a lot of money to investigate your company. And so they don’t want to do that. If really the only role that they’re playing is as a stocking horse for somebody else. That’s, that’s the rub. The other things to look for in the LOI, what structure is it? Is it a stock or asset to you obviously? Do you like the price that they’re offering you? How is the price paid? Is it all up front? You get it all at closing. Is it subject to earn outs in the future? and sort of what is the expectation with respect to employees?
Essentially as the seller, once you commit to a buyer, once you sign an LOI and grant exclusivity, you want as few roadblocks to closing as possible. And so if one of their conditions to closing is your CTO has to sign a new employment agreement and agree to stay with the company for two years, you better be sure that your CTO is on board with doing that and have that conversation as early as possible. So that, one, you don’t get to the end and run into an unforeseen problem after you spent all this money, and two, you don’t give your CTO a whole bunch of leverage to sort of extract a pound of flesh from you and the new buyer, cause the new buyer may not be unwilling and then two pounds of flesh are coming from you.,
we generally try and have any employment conditions to closing, not be fixated on any individual employees, but perhaps six out of 10 from a list or a three out of five, some somewhere where you can sort of play the odds and as bad as it sounds, play those employees against each other. Like, cause it’s must much less likely that they’re going to sort of band together, and try and extract more as a blocking tool. And if they are, you really need to think about, is this a good deal for the company, if you have that sort of resistance from the team?
Trevor Schmidt: Yeah. I think that’s all helpful. And I think identifying those points of, you know, who is the one person or people that can hold up this deal and kind of addressing that at an early stage makes a lot of sense. So if, if an LOI is not binding, talk a little bit about kind of why so much time is spent negotiating it kind of at the outset.
Dan Fuchs: Yeah. I think, want to, you want to know that there’s a deal to be done. So the buyer’s going to come in and they’re going to put forward terms and, you know, either explicitly or implicitly, those terms are going to be built on certain assumptions that they just haven’t completed enough due diligence to know if those assumptions are correct., we generally like to see as many sort of key assumptions that those are built on put into the LOI so that we have a baseline for negotiation or, you know, for lack of a better term righteous indignation, should they, should they try and renegotiate in the future.
So, you know, you told us we would get paid $200 million based on an EBITDA of $98 million for the last year. Our EBITDA was $98 million. Why are you now lowering the price 50 million dollars? So, although they’re not legally binding, they do carry a lot of moral authority in the negotiations.
it also gives a good roadmap for both councils to start drafting the documents. and you know, to the extent you can address points upfront, you should be treating them as if they were settled, unless there is, a good reason or something emerged in due diligence that would cause it to move. That is the practice within the industry. And so yes, while we say it’s non-binding, we’d like to get our clients to think of them as if they’re binding, but not necessarily rely on the other side to follow through on that commitment.
Trevor Schmidt: Yeah. Well, and I think I’ve heard one of our fellow partners say too, that from a seller’s perspective, the deal’s never going to get better than what you see in the LOI or term sheet. So if you’re not happy with the deal at that stage, you best not be proceeding on to kind of further diligence and negotiating the deal.
Dan Fuchs: Yeah. And the other thing is it, you’re going to, as I mentioned before, you’re going to have to get certain corporate approvals to do the deal. And so by having the term sheet, it gives you something you can put in those, in front of those decision makers to say, we’re still negotiating the documents, but here are the terms.
Would we have your support? Would you vote in favor of the deal, because the worst thing is to sort of get everything negotiated, management’s happy with the deal, everybody thinks that’s kind of go forward, and you go to the stockholders who have to approve it and you can’t get the vote. And then you have to go back and renegotiate or try to do other things.
Everybody looks bad in that situation. So, and if you’re going to confront that, you need to sort of, start hedging your bets with the other side early in the process to say, look, we’re willing to sort of move forward on, on these points. We don’t know where the stockholder vote is going to come out on this and, you know, both move forward with that sort of understanding.
Trevor Schmidt: So I know this next question is a very big question, but maybe if you could give some high points, I mean, when it comes to actually negotiating the definitive agreement, you know, what are some of the terms that a seller is going to be looking for and kind of pushing for and what are some of the terms that are going to be important to an acquirer?
Dan Fuchs: these sort of fit into two main buckets for the seller. The first is how do I get the money and keep the money? That’s one point and then the second is how are we allocating risk for the unknown., you know, sellers want to protect themselves against, buyer’s remorse. So they, the buyer buys that the company starts to tank a little bit going forward.
You don’t want any recourse back to the seller for, for things related to that. And so occasionally you’ll see buyers try and include forward-looking representations or representations that something is sufficient for the business as it’s currently conducted and as proposed to be conducted in the future, that sort of forward-looking representation while sometime is appropriate, in many times it’s not, and it’s shifting risk back onto the sellers for things that they can’t control. So the sellers, as, as you negotiate, you’re trying to put things into boxes. And allocate the risk of the unknown. And so anything that, you know, you should be comfortable being responsible for that, that is my view.
Anything that sort of is unknown to you, but later comes up and hurts the buyer and happened on your watch, that’s an area of negotiation., and so on the reps and warranties in the agreement, as you know, there’s a lot of back and forth about the use of qualifiers, such as knowledge or materiality or things like that. So, you know, a seller is trying to tell the buyer what they know, put as much of the unknown risk on the buyer as possible, and keep it into nice tidy boxes.
With respect to the money and keeping it. You know, you want to make sure that the purchase price that you’ve been promised makes its way into your pocket. And once it’s in your pocket, it stays there. And so that back concept focuses on indemnification, which is the obligation of you to make the buyer whole for losses in the future., caps on indemnification, baskets, whether that’s a true deductible or it’s a tipping basket, which means, you know, a deductible it’s like your car insurance, first 500 it’s on you. The rest the insurance will cover., a tipping basket is if you have a loss for $450, that’s on you. If it was $501, the seller covers all 501, once you, once you eclipse the 500, it tips over. And so though that’s really. You know, who gets to control if there’s a dispute. Who gets like, is the buyer spending your money to fight a claim? That’s not a great position to be in.
There are market terms, depending on the industry that you’re in for sort of all of those concepts. A company that we work with and a lot of companies work with is SRS., they put out a deal point study every year, which gives good data, all of this which can be very helpful for a practitioner or entrepreneur to sort of understand where the bounds are of that. All of these are highly negotiated items and things that, you know, your counsel should be working with you to really understand, the risk profile around,
For a buyer, they really want to make sure that they’re getting the business, they think they’re getting and so they’ll focus on the reps and warranties. They’ll focus on having protection in the event that something’s not the way that they thought, and whether that’s escrows or, you know, hold backs, in general, hold backs are viewed as more buyer favorable or friendly than an escrow., largely because the buyer gets to use that money in the intervening period, that has exposure for a seller though, because you don’t know that the money is going to be there at the end and vice versa.
If you distribute money to the sellers, there’s no guarantee that the sellers aren’t going to go out and spend it. And so you can have the best indemnification in the world as a buyer. And if there’s no money to go after you’re out of luck. So that’s why a buyer would prefer. Either a hold back or an escrow over just straight distribution to the sellers.
Trevor Schmidt: Yeah, awesome. So I guess in your experience, what, what causes the deal to fall apart? You know, you’ve already gotten LOI in place. You’ve got some initial buy-in what was going to cause my deal to go away.
Dan Fuchs: What causes deals to go away is a misalignment of the story that the buyer has heard and the facts on the ground., you know, that can take a variety of forms, but you know, if you’re doing anything that even comes close to perhaps touching sales and use tax, you need to be on top of that, you need to have addressed it before you get into the process. Depending on, you know, your sales that can be multimillion dollar exposure, which the buyer is going to leave behind one way or another. Whether it’s a stock dealer, it’s an asset deal and they’re going to do it through hold backs, indemnification, and other things.
So I don’t think a lot of deals go sideways based on the parties not being able to negotiate or somebody making a wrong statement or pushing too hard on a point, you know, one way or the other. It’s really the underlying facts of the business. And do they match. What the buyer has been told or what the buyer believed they had been told at the beginning.
And, you know, to the extent you’re missing your forecasts, that’s a, that’s a big issue to the extent that your purchase price is a multiple of ARR and your ARR is 10% lower than you projected it to be. If you’re getting an 8, 12, 15 times multiple on your ARR, all of a sudden you’re out a lot of money. And then does the deal make sense for you to do? And is the buyer even confident that your 90% ARR is going to stay there?
So a lot of times people say, oh, my deal went sideways because we pushed too hard or, and I honestly don’t think that that’s ever the case. I think it’s the underlying business and alignment of expectations that caused deals to go sideways. The other thing that I have seen often, so sellers will engage with certain representatives of buyer who don’t ultimately have decision-making authority. They’re not the right person in that organization, either it’s a sales person or, you know, it’s some junior analyst out of venture fund or something that really loves your company.
But ultimately they’re not the ones who write the check. Early in the process, you need to make sure that the right people on both sides who can actually make the decision and make this move forward are on the same page about doing the deal and about, you know, getting it done., We have had, you know, a few instances, some junior person reaches out to the entrepreneur, gets them all gassed up and is like, you know, yes, this would be a great investment for our fund.
We’re more than happy to take out sort of all of the existing investors and own this with you as the management team going forward, and it’s never gone to investment committee. It’s never gone to anyone with actual authority. And so, you know, when it gets there, that’s where you see significant retreats.
You have a founder who’s already sort of bought into the idea of them selling their business. Now it has a momentum all of its own. Quite honestly, in my experience, if you take a significant downward retread in price and you continue with the deal. You’re probably not winning many points the rest of the way.
And so, you know, you really need to think about sort of positioning and posture, you know, not over committing yourself to the deal before, before you’re sure there’s a deal to be had there.
Trevor Schmidt: That’s very helpful. So we are the Founders Shares podcasts, and so even though you’re not a founder, I do, I want to ask you if there’s one piece of advice that you would share with a founder or somebody thinking about starting a company or in this case, selling a company, what, what would that advice be?
Dan Fuchs: You need to think about what you want to get out of the sale. The money is an important part, like I will not, you know, a lot of people think when. They start one company that will be the only company they ever start. We have seen that not to be the case, but you know, that’s where they are at that time. And financial security is very important, but as we started off with your company, especially if you’ve put multiple years in the ups and downs and you know, it has probably been with you through multiple life events, outside of the company, you really need to think about what it is you want out of the deal and what you’re comfortable sort of accepting as the changes that are going to come from it.
Uh, we had, a founder who reached out to us. We had done some work with them before and they got. Unsolicited inbound offer for their company. And a lot of what we talked about, or what I talked about with the founder was how would you feel if the only money you got was the upfront? It was, it was some upfront and then a significant earn-out on the backend.
You know, how do you feel about if that’s the only money you got? Cause that’s the only thing you can control. How would you feel if somebody else was all of a sudden making decisions with respect to your business? Because you’re not going to have the CEO seat under this deal., would you feel like it was a good return on your investment in terms of money and time and other things to, to take this deal?
Um, and at the end of the day, you know, he, he didn’t think it was, he thought the company had a lot more potential., he felt like he was getting out a little bit too early on the flip side of that. I have another founder who we’re talking about exiting their business. And he said, you know, the money is not exactly where I want it to be. You know, I, I obviously wish I was getting more, I want to spend more time with my kids. I want, I don’t want to be doing this. I don’t want to be the CEO of this company for another three years.
I think the whole thing when it comes to exiting your business is what what’s important to you? What do you want to be doing? And how does that exit fit into those first two things? Because chances are, it’s not the last time you’re going to get an opportunity to exit, but it might be, and. Do you want to send your kid off to college? Do you want your kid to get married? Like what do you want to do? And I think the business aspect of it sort of all spins from that.
Trevor Schmidt: That’s great. Dan, just Sage advice. And, you know, I just think the whole, episodes got a ton of tons of useful information. So I appreciate you taking the time out and kind of sharing your wisdom with us. And, if people want to get in touch with you, what’s the best way to kind of reach out to you?
Dan Fuchs:, the best way would be via email, just dfuchs@hutchlaw.com., and I will do my best to respond., if, if it’s been a few days, just, give me some, give me some grace. I will, I will try and get back to you.
Trevor Schmidt: Grace is always needed, but I appreciate it.
That was Dan Fuchs, partner at Hutchison. If you’re looking to connect with Dan to talk about your exit, you can find him on Linkedin or visit Hutchlaw.com.
Hosted by Trevor Schmidt, Founder Shares is brought to you by Hutchison PLLC, and is edited and produced by Earfluence.
