On December 12th, in a new spinout of Axial’s virtual roundtable series, a select group of transaction-ready business owners gathered together with two Axial investors and M&A Advisors for a candid conversation around the questions and concerns that founders often have during M&A and capital raise processes.
In an effort to provide a safe and confidential environment for the participating business owners and to facilitate a transparent and interactive discussion, we will not be distributing the recording or providing any identifying information on the owners & operators who participated.
Thank you to the deal professionals who participated in the discussion:
- Spencer Clawson, Partner, Peterson Partners
- Thomas Courtney, President & CEO, The Courtney Group
- Doug Rodgers, Chairman, Focus Investment Banking
- Scott Mitchell, Director of Investment Banking, SDR Ventures
And thank you to the business owners who provided the questions and framework for the discussion:
- CEO, Educational Publishing
- CEO, Tech-Enabled Solutions
- CEO, Industrial Retail
- Founder, Biomedical
- COO, Events & Catering
- CFO, Digital Media
- CEO, IT Consulting
Preparation & Timeline
Tom Courtney — president of The Courtney Group, a firm that invests in and advises middle market businesses — kicked off the roundtable by laying out the “ideal” timeline for a business owner to prepare for a sale or a capital raise:
Thinking about a transaction 3-5 years out provides plenty of time for business owners to prepare the team, become familiar with different players in the space, get to know a variety of buyers, and study up on all of the necessary materials needed for a smooth transaction. Then, when you’re about a year out, you can find a lawyer, investment banker (and anyone else you’d like to add to your transaction team), and you can talk to them about what you’ll need to pull together the required materials. The last step, just before a transaction kicks off, is to focus on final polishes: painting and cleaning the offices & plants, preparing due diligence materials, etc. Then you’re ready to dive in.
However, as 2020 has proven time and again, the ideal scenario and picture perfect timeline rarely presents itself.
Spencer Clawson, Partner at investment firm Peterson Partners, addresses what to do when you haven’t had 3-5 years to “properly” prepare. In Clawson’s experience, it’s rare for an entrepreneur to close a transaction according to their pre-planned timeline. Things like Covid-19, or a big new customer that creates the need for a capital infusion, or something as simple as the sudden realization that it may be time to retire, are all scenarios that are difficult to predict and plan for.
Because life comes at you fast, Spencer’s advice to business owners is to begin the M&A/capital raise education process as early as possible. “An important characteristic of a successful business owner is having the awareness to surround yourself with people you can ask questions to. Talk to investment bankers. Get introduced to investors. Preparedness comes through consistently having discussions like this over time.”
Scott Mitchell, Director of Investment Banking at SDR Ventures also weighs in on one of the most important things business owners should prioritize when considering a transaction. In a capital raise especially, Scott suggests nailing down a detailed schedule of the use of funds. An investor won’t want to give you any money if he doesn’t clearly understand what it’s being used for. “Take the time and think through the modeling. Whether it’s venture capital or growth equity, that’s one of the more important things in a transaction.”
Understanding Your Financials
When asked about the mistake or oversight that business owners most often make, it was widely agreed upon by the deal professionals that an easily-avoidable miss often surrounds financials — more specifically how those financials are tracked and/or presented. Investing in accounting — while not very exciting — is ultimately worthwhile, especially if/when you decide to transact.
First off, if your business is north of $10M in revenue, investors will not want to see cash-based accounting. As a business grows, the operators should consider moving to GAAP, which is a standardized accounting system that makes it easy to compare financial statements and is recognized by investors and buyers as a more comprehensive tracking method.
Auditing the books is also something that is not necessarily standard practice for small businesses, but provides a level of credibility that may otherwise be lacking. Doug Rodgers who has owned and sold multiple businesses and now runs Focus Investment Bank says, “Having an audit is a really, really healthy thing, because it helps you understand how the outside world of financial professionals is going to view your business. Unless you’re planning to have a small company forever, you should invest in having audited books and records.”
Another option? Business owners can opt to conduct a quality of earnings report. When comparing Q of E to an audit, Doug says Q of E is a bit like “the wild west”. “Most privately-held businesses have some expenses that will be adjusted out to create adjusted EBITDA. The advantage of Q of E is that it gives you your adjusted EBITDA figure.” And while a buyer will sometimes still execute their own Q of E, coming to the negotiation table prepared with your own can provide a business owner with a lot more credibility.
Axial CEO Peter Lehrman sums up the topic, “If you’re massively underinvested in the financial hygiene of your business, you’re headed for really rough sledding in a capital raise of any significance, or certainly in an M&A transaction.” Lehrman goes on to say that the number one reason he sees deals break on Axial is that after buyers evaluate the critical numbers they’ll find discrepancies in the financials that ultimately impact the valuation of the business, and in turn, the price of the deal. The easiest way to avoid this is for the business owner to have a clear understanding of their financials and get comfortable with those numbers to avoid surprises.
Many of the entrepreneurs were interested in hearing more about the pros and cons of professional management. Many small businesses don’t have the resources to bring in professional management teams, so how do investors and buyers think about the professionalization of management versus the development of the existing team?
When it comes to full buyouts, the answer was fairly simple. Buyers are looking for founder-run businesses, because that’s what creates the opportunity for improvement. “There’s a fair number of private equity firms whose strategy is to only buy founder-run businesses.” says Rodgers. “And the reason they have that strategy is, if they replace the founder with professional managers, business is going to get a lot better. Just because the founder has founder DNA, doesn’t mean he has professional manager DNA.”
On the flip side, if you’re raising capital from an investment firm, the thought process is going to be a lot different. Clawson weighed in on his thoughts from a minority investment perspective: “If you’re trying to raise growth capital, the investor is investing in you as the business owner. And if that’s the case, I want you along to execute your vision.”
Investment Banks: To Hire or not to Hire?
One of the most common questions we received from business owners was around the use of an investment banker. Should I hire one? What are the pros and cons of working directly with an investor or buyer? Can I get through a transaction by myself? If I do use one, how do I find the right M&A advisor?
While it is possible to do a deal directly with an investor and buyer without an intermediary, all of the deal professionals agreed that even if you don’t hire a banker, you’d be remiss to not at least talk to one before transacting. And generally, the less experienced you are, the more it makes sense to work with a professional to ensure you’re well prepared and ultimately getting the best valuation for your business. Scott Mitchell, an investment banker himself, has seen entrepreneurs successfully “DIY” their way through a transaction, but notes that a lot of those management teams had prior M&A experience, and still fact checked with many different individuals throughout the process.
Investment Banks: Fee Considerations
One of the entrepreneurs on the call working on a $5M capital raise brought up the topic of banking fees. After one call with a prospective banker, the CEO received a letter of engagement. Receiving an engagement letter after one call was cause for concern for this CEO – is the banker looking to collect a retainer without actually knowing if the capital raise was a viable option?
It turns out that this business owner’s concern was very legitimate. “You’re right to have alarm bells going off there,” Scott told him. “Your Spidey senses are up for a reason.” Scott went on to explain that he probably only engages with about 20% of the businesses he speaks with, and that’s because he only wants to work with businesses that he can successfully help close. Simply put, if he’s not closing deals, he’s not making any real money.
While an engagement fee may seem like a high dollar amount, it doesn’t come close to covering the banker’s cost (if they’re doing a good job). That said, as Tom put it, “there are unscrupulous people out there whose business model is to collect a $50,000 retainer and then not do any work,” so you should be careful. Ways to avoid this are to talk to other clients who have worked with that advisor, check to see if they’re a registered investment bank (which isn’t to say that a broker or M&A advisor who is not registered is not credible, it just means you should do a bit more diligence), and talk to multiple advisors before you decide on one. Doug’s advice: “The key thing in the relationship with an investment banker is that you have chemistry with them, you have trust in them, and you want to hear what their advice is. Certainly you can question their advice and learn why they’re advising you the way you are, but being comfortable that you’re dealing with someone that understands your business, has experience and happy clients that they’ve sold businesses for.”
Scott agrees with these sentiments and says that SDR focuses on being a client advocate rather than a deal advocate. “If you’re going to work with someone who is going to go with zero down, or very little retainer or engagement fee, no matter what deal they put in front of you, they think it’s a good deal,” he says. “They want you to close that deal because that’s the only thing you’ve incentivized them to do.”
One final thought on the investment banker fees came from Spencer, who put it into perspective when he said that “it’s the absence of information that makes you question the fee.” He went on to explain that if you knew you’d have to pay what equates to a $1M fee, without any other information, you’d have serious sticker shock and probably a lot of hesitation. However, if you knew that you could save that $1M, but you’ll ultimately get $5M less for your business, you would likely pay the fee without blinking an eye, because it’s resulting in an extra $4M in your pocket.
There is obviously a great deal of thought and planning that goes into a transaction, and because the list of topics is seemingly endless, Axial is happy to announce that entrepreneur-focused roundtable sessions will become a permanent fixture in 2021. We will continue to gather high-quality deal professionals — a mixture of investors, investment banks, and debt providers — to answer business owner questions in a safe and confidential manner.
If you’re interested in learning more about attendance or would like to participate in the next event, please contact firstname.lastname@example.org.