“Surprise!!!” – Great for Birthdays, but NOT for M&A…

By John F. Herubin, Managing Director – Business Development

Many surprises in our lives are often unexpected and welcome news. Hearing from a long-forgotten friend or colleague, learning you will become a parent or grandparent in the near future, scoring a hole-in-one during a round of golf, or as mentioned above the surprise gathering planned by your family for a milestone birthday party.

One instance where surprises are rarely good news is during the process of selling your business. In fact, many professionals involved in the M&A process have learned all too often the truth surrounding the adage that “surprises kill deals”, especially after a Letter of Intent (LOI) is executed. Adequate planning and collaboration with an experienced investment banking professional can greatly minimize (if not eliminate) the circumstances most often present for a deal killing surprise.

For many of our clients (entrepreneurs and family businesses) the sale of their company will be the most significant financial and emotional transaction they will ever experience. It often has ramifications beyond the purchase price when family members are involved so it’s an incredibly important undertaking. When done correctly, everyone wants it to be a success.

When surprises do happen, they can shake a prospective buyer’s confidence and commitment to the transaction. Depending on the type of surprise, it may trigger more scrutiny in other areas of the deal which can ultimately jeopardize completing a transaction with a particular buyer.

Let’s look at several common circumstances where surprises most often occur and the strategies for avoiding them:

1. Company financial performance deteriorates during LOI diligence process:

Investment bankers do their best to understand a company’s current and near-term financial performance and profitability to ensure that projections based on that performance, and shared with interested buyers, are accurate and the seller is confident in achieving.

A buyer is typically establishing their purchase price based on these projections and current performance. If a seller’s performance fails to achieve the levels previously disclosed to a buyer, there’s a strong likelihood that the buyer will look to adjust/reduce their LOI purchase price or modify the deal terms. Sellers are rarely (never) pleased with this outcome.

There’s a myriad of reasons these circumstances can occur. We sometimes see an owner “take their eye off the ball” while going through the sale process. It’s very time-consuming and their typical attention to ensuring that profitability is maintained can be distracted during this process.

Another scenario is where the selling company’s internal financial reporting lags the forecasted information and business performance deteriorates before the company or investment banker is aware it’s happening. Sometimes an external or market factor can impact this too (think tariffs, delay in anticipated large customer order, or supply chain issues).

Experienced investment bankers are skilled at challenging and “stress-testing” seller financial information and forecasts to ensure it is credible and defendable to a prospective buyer. We’ll determine whether there’s any internal (financial reporting systems, personnel capabilities, and timing) and external (customer and growth assumptions) gaps that might exist to create a surprise. When addressed, we have a higher degree of confidence that a forecast will be met during the LOI diligence period. We often point buyers to generate purchase price assumptions based on forward looking (forecasted) profitability, so rigorous assessment of projections is essential to avoiding surprises.

Well before buyers are contacted as part of the marketing process, we are assessing whether the seller has the internal resources available to meet the time demands a sale process requires to avoid owner distraction on achieving forecasted profitability. We’ll advise if there appears to be a deficiency in systems, people, or bandwidth for the owner, and deploy resources accordingly to deflect any surprises. For owners with limited management team or internal financial resources depth (CFO, Controller, Bookkeeper), the information required to meet the accounting and legal diligence requirements are akin to taking on a second full-time job. If the team needs help augmenting resources for this critical process, we will develop a strategy to do that.

2. Departure or Uncooperative key employee necessary to the transaction or more importantly the continued success and growth of the business.

This typically results from the lack of communication with this employee prior to the seller embarking on a sale process. Your investment banker should be speaking with you early in the process to identify key employees who are critical to the future success of the business and might be vulnerable emotionally or financially to a potentially significant change in ownership.

These can be salespeople possessing key customer relationships, engineers involved in new product design and implementation, general managers with the ability to make sure the business operates at peak capacity and is poised for growth, or sometimes a CFO or similar person who can track key performance metrics and accumulate financial data necessary to track operations and profitability and fulfill LOI due diligence requirements.

Questions an investment banking professional will ask to ascertain this risk of surprise with such an employee will include:

• Has the selling shareholder disclosed to any key employees that they’re considering a sale transaction?
• Do key employees have a non-compete/non-solicitation agreement to protect the seller in the event the key employee leaves before a transaction occurs?
• Does the owner believe anyone of his key employees would be offended or frightened by a sale and is at-risk to “jump ship” if they found out one is being contemplated?
• Has the selling owner considered offering a “stay’ or “transaction” bonus for key employees to assist with completing the transaction or staying with the company post-transaction to the extent possible?

We recommend to owners that they prepare a communication strategy with key employees before embarking on a sale process. This strategy will include deciding who will be notified that a sale transaction is being contemplated as well as when is the optimal time to include them in the discussion. Once communicated to key employees, the seller and their investment banker can best determine what options work best to keep key employees engaged and motivated to complete the transaction once it reaches the LOI stage and avoid a surprise departure which potentially derails the transaction.

3. Unforeseen Circumstances – These Just Happen

These surprises are less predictable but nonetheless periodically happen. Again, your investment banker should be discussing the possibility of any of these surprises (internal and external) regardless of how remote it seems at the time.

Unusual surprises we’ve seen include:

• The seller’s largest customer was acquired by a large publicly traded company that subsequently reviewed its existing customer relationships, a process which took six months to complete.
• Labor strike by union employees during LOI period.
• Employee getting electrocuted on the job (survived) which caused a possible legal liability and worker’s compensation issue for the seller.
• Seller is sued by an inactive family shareholder during the LOI period.
• Proposed regulatory change in a state where the company does significant business that would materially impact future profitability.
• A class action lawsuit filed against a chemical company whose product is critical to our selling client’s manufacturing process.
• Covid/Tariffs/Interest Rate Spikes – no explanation necessary.

There is no limit to the unforeseen surprises that might occur, so the best strategy is to identify possible (although remote) surprises and mitigate or eliminate where possible the possibility for them to occur.

It’s a fact of life in the M&A world that some type of surprise will happen during a deal, including during the LOI process. We’ve been successful keeping a transaction on track during the LOI process when a surprise emerges by following a two-pronged formula.

The first is to timely disclose the surprise to the buyer, and the second is to be transparent about the risk the particular surprise represents either financially or operationally. Based on their specific strategy or purpose for wanting to buy the company, the buyer might not consider the surprise material enough to adjust their original purchase price. In the event they do decide to reduce their purchase price or alter the deal structure, we are better prepared to advocate for our client to retain as much of the original deal as possible.

This strategy oftentimes telegraphs to the buyer that the seller and their investment banker are acting with a high degree of integrity and transparency. This can result in preserving the transaction momentum without eroding confidence or creating heightened scrutiny with the buyer during the LOI process.

A good investment banker has the ability to “look around corners” and anticipate these scenarios and skillfully guide their client towards a successful transaction.

It’s inevitable that life is full of surprises, so blow out those birthday candles and get the deal done!

© Copyrighted by John Herubin, Managing Director, EdgePoint Capital, merger & acquisition advisors. All rights reserved. John can be reached at 216-342-5865 or on the web at www.edgepoint.com