Episode 2 of What’s Next Hosted by Acuity Advisors
In our second episode, Chris Kramer and Chase Hoover roll out the first of our client case studies – the sale of a mid-sized business in the healthcare services space that successfully closed back in early 2020, just before the world turned upside down. We reflect on the challenges faced, strategies implemented, and ultimately the victories achieved, with the goal of helping our listeners share in the lessons learned for their own benefit.
Why revisit this particular deal? Well, as a California C corporation with over 400 employees, more than a dozen individual shareholders, and no outright majority owner, any viable transaction needed to balance the often-conflicting goals and objectives of the various sellers, while also satisfying key structural criteria to preserve after-tax outcomes for the entire group. Rigorous planning, tactful interaction, and cogent communication proved vital in getting our clients to the right result.
Chase: Hello, and welcome back to What’s Next, hosted by Acuity Advisors, the show where we help middle-market business owners understand and monetize the value of what they’ve built. I am your host, Chase Hoover. And if you recall from our first episode, periodically in this series we’re going to be looking back at certain case studies and examples of instances where we helped our clients reach their goals.
So for our first case study, we’re going to be looking back at a company that we sold in 2020, and we’re going to walk through how we started working with the shareholders, what their key goals were, and what the primary challenges were, and then ultimately from there walk through how the process unfolded, what the final outcomes were, and what lessons we and hopefully you can take away from the whole experience. So to do that today I’m joined by my co-host, Chris, welcome back. And why don’t you give us a little background to help us get started?
Chris: Well thanks, Chase. The company came to us through a tax attorney colleague of mine. They were a California C Corp with about 400 employees, and multiple shareholders with competing goals and objectives. The company is in the healthcare services space. One other interesting fact was it was previously marketed by another banker a couple years prior, and unfortunately that process did not end well, although that’s what somewhat gave rise to our involvement. So probably the best thing to do is start with is, what exactly were the goals and objectives of the shareholders. Chase, why don’t you take us through that?
Chase: Yeah, absolutely. You have large-ish group of shareholders, in this case it was around 18 different shareholders, with no single individual shareholder having an outright controlling interest. So right from the beginning, you’re going to have a lot of conflicting goals and objectives. Some of the major ones were, first, like many business owners, they had a value expectation. So making sure that if we took the company to market or negotiated a sale that we had a high probability of achieving their value expectation was sort of question number one in a lot of respects. But after that, there were a lot of non-price deal terms that were very high on the priority list.
So one of the first ones was, given their structure as a C Corp, the transaction pretty much had to be structured as a stock purchase rather than an asset purchase for tax purposes. Otherwise, there was just going to be a whole lot of issues around double taxation that were going to render the deal totally non-feasible. So that was number one. Right after that, a few of the shareholders were actively working in the business as principals. But because nobody had the lion’s share of the equity, a very common transaction feature in M&A deals known as “rolled equity” needed to be limited, because when somebody who, say, owns 100% of the business, is asked to retain 10, 15, maybe even 20% of their equity, it’s not wholly diminutive to the proceeds from the sale. But when the largest individual shareholder has something much, much smaller, let’s say 15, 20%, that rolled equity piece starts to take a much bigger relative bite out of their proceeds from the sale.
So a few of the shareholders were relatively open and candid at the start of the process that they were not going to be comfortable in accepting that. Apart from that, the other key constraints were really mostly centered around trying to find that right buyer. Because as a C Corp with 400 employees, these people had been working there for multiple decades, and there was some consternation and general anxiety about, well, what if a private equity buyer comes in here and lets too many people go or restructures the business? And, we’ve all been working here the majority of our working lives … we’d like to see it retain some of its character and some of its legacy that we’ve built up over these years. So I’d say those were really the primary issues upfront.
Chris: Great. And I’d like to just go back and revisit the first hurdle, which was the C Corp structure. Chase had mentioned that we were basically required to do a stock sale. And a lot of people are familiar with the notion of double taxation in a C Corp. The typical structure is that you bonus out a lot of the money and try to minimize the corporate income tax. And then in the transaction, you have the challenge of having to do a stock sale. But there’s another aspect that reared its ugly head in this transaction, and that is, if you end up retaining too much cash or the retained earnings grow too quickly, the IRS can deem that as effectively an unpaid dividend and tax you anyway, even if you haven’t taken the money out. So we were required in the diligence process to escrow some funds, because the tax advisors to the buyer had identified this issue as a potential exposure area. So it’s not just that you have to bonus the money out, and it’s not just that you have to do a stock sale. There are some hidden things that maybe you didn’t consider that could rear their ugly head as a C Corp, so…
Chase: Yeah, and I don’t want to interrupt you there, Chris, but before we get to diligence, I do want to talk a little bit about how we went about actually starting this process, and how it unfolded in a chronological way. So the first thing we did was what you might call sell-side diligence, where in anticipation of what any willing buyer or suitor might want to see in a comprehensive diligence process, we worked with the management team to get that all out on the table and say, “All right, where are the potential weak spots? Where are any issues that we want to head off at the pass? And more globally, what attributes of the company do we really want to position at the forefront to try and frame the narrative or tell the story of the company in the most favorable way possible?” Because whenever you have a value expectation that may or may not be supported by the “numbers,” the performance of the business, the typical industry multiples, you want to be sure that you’re positioning the company in a light to potential buyers that’s going to yield indications of interests that are at or hopefully well above that minimum threshold. So I’d be interested to hear your thoughts on how that process went in this case.
Chris: Yeah. In every transaction there are differences in terms of who may be the right buyers, or what the structure needs to be, or whether the terms are going to be acceptable or not, and each transaction has challenges. This one in particular, I think, lent itself to trying to find more of a strategic buyer than, let’s say, any sort of private equity backed portfolio company. Although there’s a lot of blurring of that in this market, because private equity has been fairly prolific over the last, say, 20 plus years in making acquisitions. So in this particular case, we approached some of the publicly traded companies that were strategic, as well as a handful of private equity backed existing healthcare services companies. Then we also approached some private equity funds with this company being a platform, although it probably didn’t work quite as well, given the makeup of the management team and the desire for some of the key people to ultimately exit. So after a process whereby we marketed the company on a blind basis, meaning we sent out a teaser with enough information to whet the appetite of a potential buyer but not necessarily disclose too much. What did we send it out to? 75? 80?
Chase: 75 or 80.
Chris: So from there, we get non-disclosures back, and we had about 16 or 18 expressions of interest, narrowed it down to eight that we really were serious about. We invited four to management interviews and got letters of intent from those four, and then leveraged those, I don’t want to say against each other, but leveraged those to the best possible overall set of terms that our client, the sellers were interested in, and ultimately settled on one particular buyer, negotiated a great outcome, and after we signed the letter of intent went into diligence and managed through that process.
Chase: Let’s spend a couple minutes just chatting about diligence a little bit more, because there’s nothing like a true, bon afide, rigorous diligence process to teach you a very important lesson in M&A. Which is that oftentimes, especially when you’re across the table from a private equity buyer or a private equity backed buyer, we’re fond of saying that by the end of the process where you’re sort of equaling that information gap, the private equity buyer very well may end up knowing more intricately and more comprehensively about your business than even the seller, then even you, who might be running the place. And I don’t want to say we found that to be the case here, because there’s no way to measure that, but they certainly performed a top-to-bottom, rigorous, intensive diligence process, and over the course of that process identified some things that, by virtue of simply running the business, the management team either wasn’t aware of or just didn’t quite fully understand the extent of. And really managing through those challenges in this instance led to maybe a higher or more intensive degree of our involvement in communicating with the buyer as an intermediary to the company.
Really, it underscored the necessity for having representation as a seller, because if you’re running a business that you’re 100% involved in and spending the bulk of your time on, and a diligence process goes into corners that you maybe didn’t expect it to or lasts a bit longer because they have to pull in additional resources, the quality of that process and your ability to maintain momentum is really going to suffer from the fact that you, absent representation or an investment banker, have a business run, and the momentum is going to suffer.
Chris: Yeah. Not only that, but the purchase price may suffer. So there’s a perception, I think, out in the world that a lot of buyers will come in, they’ll give you an attractive offer, and then in due diligence their goal is to really start whittling down that purchase price. And I don’t think that’s entirely accurate. I think what’s more accurate is, if they find things that they didn’t know about they’re absolutely going to whittle down the purchase price. But I think most buyers are hopeful that they don’t find very much, that what you’ve represented is, in fact, what is.
Right, so one of the keys is to do a fair amount of preparation and planning and whatever sell-side due diligence makes sense before you even go to market, because I think the biggest thing that derails transactions is surprise. It could be a surprise in diligence or surprise in somebody’s reaction to what might be a standard deal term. It could be something that nobody knew about, and so it isn’t something you could have maybe foreseen previously. But certainly when you have things that you could have known about or should have known about that are not disclosed either because you didn’t pay attention or didn’t know about it or we didn’t do enough diligence on our own, those can be things that lead to either additional escrows, which is what happened in this case on a few items, reductions in purchase price, or in some cases even parting of the ways.
Chase: Yeah. Or if nothing else, just a longer time to closing. Deal fatigue can be real and can set in over time. So speaking of closing, let’s talk about outcomes. At the end of the day, obviously we were successful in getting this transaction consummated. We, fortunately, and by virtue of some favorable dynamics in the business over the course of the negotiation and diligence process, ended up closing the deal at a valuation that was pretty substantially higher, in fact, than their original expectations. And not only that, but by virtue of painting the picture in terms of the road ahead ultimately also obtained a potential contingent piece in consideration that the sellers were entitled to, based on some future performance thresholds. But apart from the value, some of the things that we were fortunately successfully able to negotiate were a pretty limited rollover component.
If you recall the beginning of this discussion, some of the shareholders were concerned about the necessity to roll meaningful equity into the surviving entity. And fortunately, by virtue of some other methods and just comfort with their ability to steer the business going forward, we were able to negotiate some very limited, much less than market, if you will, rollover equity. There were employment agreements for several key members of the senior management team at some pretty favorable levels given the market. And overall, for a pretty broad group of shareholders, many of whom were not involved in the business, some had already retired, and others were looking to exit as part of this transaction, brought about an outcome that was pretty favorable and that everybody was pretty excited about.
Chris: One of the other things we were able to negotiate was limitations on the holdbacks and escrows, although several arose in diligence that we had to accommodate and be willing to offer. We did successfully procure rep and warranty insurance, which minimized the general indemnification escrow down quite significantly so that the need to put some of these other escrows in place for things that the buyer was uncovering in diligence stung just a little bit less. We were also able to mitigate the time, in other words shorten the escrow periods a little bit so there was a little bit more certainty. So overall I think the sellers were pleased. I think the buyer was pleased. Through COVID, this was a deal that closed early 2020. Through COVID, the company has performed very well, continues to perform well today. So overall a pretty good success story.
So I guess as far as the key takeaways, the first one that I would reference is that preparation is super important in any transaction, especially in a third-party sale, and especially if a private equity buyer or private equity backed company is a likely buyer. And here we were able to do some amount of prep. Some was done previously. But to be honest, had we had more time, and had the sellers been a little bit more patient with actually letting us do that prep and then going to market, we probably would have done more. On the other hand, and at the same time, the market is super hot right now, and what you have to remember is that buyers always want to go fast. So it’s a trade-off between preparing for too long and too deeply and capitalizing opportunities that are close at hand. So the other thing I would say is, it’s really important for sellers with their advisors, bankers like us and others, to try to get good clarity around goals and objectives and try to get that clarity early on, because it informs a lot of the things that we do in the process, like finding the right buyer. It may or may not be about price. It may be about preservation of legacy, or it may be about preserving a location where a lot of people have gone to work, or you’re members of a community, and certain deals might result in that changing, and that might not be a particularly attractive aspect of a transaction.
Chase: Yeah. You don’t want to learn about certain facets of a deal from the letter of intent itself. You don’t want to pick up a letter of intent after you’ve marketed the company and look at your advisor or your CFO and say, “What’s a 338 election? What’s rolled equity?” You want to hammer that out on front end.
Chris: Right. I guess the third takeaway is I believe very strongly that when you’re negotiating anything, and certainly a significant transaction such as sale of your primary asset, (i.e., your business), you want to create leverage where you can. So many times, if you’re a business owner listing, you’re getting approached by various parties. You’re getting approached by competitors. You’re getting the letters from private equity. You’re getting some cocktail party chatter with a friend who knows a guy that wants to buy a business like yours, whatever it is. And a lot of times it might be a friendly competitor. It might be a collaborator, somebody that’s a referral partner, or somebody in your ecosystem. And in any and all of those cases, you still want to have leverage. And there are lots of ways to do that short of actually marketing the company. But it’s important to have good advisors. It’s important to have somebody that understands how to maximize your goals and objectives and keeps those at the forefront, and tries to create the amount of leverage that’s possible in the deal. And then, I guess, lastly is help with diligence. Because a lot of people think, “Hey, I have a buyer. They told me they’re going to pay us X millions of dollars. What do we need you for?” And what I would tell you is … what did we have, Chase, 55 or 60 people in the data room?
Chase: Yeah. At the end of the day, there were about 58 folks from the buyer’s side, including all manner of lawyers, tax advisors, accountants, et cetera, that were looking at our information, combing through it line by line. And on our side, we had, I think, four or five. So make no mistake, throughout this process if you’re across the table from anyone with the wherewithal to buy your company you will be outgunned in terms of resources and experience more likely than not. So diligence is daunting. But even further than that, the negotiations don’t stop until closing. The deal is not done and on the table at the letter of intent. It’s not even done and on the table at the purchase agreement. It’s done at the closing dinner. Up until that point, you want somebody or some folks in your corner who can help you respond to things that come up, because unforeseen things are just going to come up.
Chris: Right. Yeah, so in closing I guess I would say, selling your business is a very complex but also very emotional transaction. I mean, you in all likelihood spent the better part of your life building the business, and so that’s not something that you’re going to take lightly. You just can’t have enough good advisors around you to help you through that process. So if you’ve been approached by a buyer, or you’re thinking about selling your business, or you just want to understand the process a little better, I hope you reach out to us.
Chase: Thanks, Chris. And thanks everybody for tuning in and sticking with us. Quick fine print, this podcast is for general information purposes only. It does not create an advisor-client relationship between Acuity Advisors and the listener or reader, and is not intended as advice for specific situations. And as always, we would like to thank our sponsor, Acuity Advisors. Take care.