How can an entrepreneur toil for years to build a business worth at least $80 million, only to sell it for just $58 million?
This horror story happened to Patrick* (not the client’s real name), owner of a business service company. It didn’t take a pandemic, a personal crisis, or a recession to gut his company’s value—all it took was a phone call.
He was sitting in his office one day when an investor rang, looking to buy his company and tossing around some compelling numbers. Not actually needing to find a buyer sounds like a cheat code, right?
Patrick certainly thought so. He shared some rough financials, received a letter of intent (or LOI) from the buyer, and combed through the legalese with his corporate attorney. Believing he had an amazing deal in hand, Patrick signed.
Less than 10 months later, though, he was exhausted, up to his ears in transaction-related expenses, and driving hard toward an arrangement worth about two-thirds of the original offer. He could only wonder how everything went so far off the rails.
Why owners dread due diligence
The story is a familiar one to those of us in mergers and acquisitions—once under LOI, significant challenges emerged for Patrick. The buyer began to pick apart the company’s financials, examine the operations, and dig deep into contracts, supply chain, and more. Seemingly every day, the investor’s team of lawyers and advisors (dozens of them) had more questions, which took Patrick hours to answer.
A few weak points were identified, and the investors suggested a lower price. Patrick agreed. Then a few more issues cropped up. Another renegotiation. Then a request came to extend the due diligence period.
By the time Patrick sought help, he had been at the process for 10 long months, watching in astonishment as his deal became less and less attractive. The extra work and stress took a toll on him and the company’s performance. Sensing Patrick’s growing despair, a friend suggested he approach Class VI for some insight.
At this point, the purchase price had dropped to about $50 million but that only scratched the surface. We also identified numerous issues in the transaction structure, which together meant the deal Patrick was pursuing was even worse than he realized.
LOI red flags
Among the problems were the following.
1 – Disadvantageous equity rollover structure
In many transactions (especially those with private equity buyers), the entrepreneur takes part of the purchase price as an ownership stake in the new business entity. The hope is to earn another payout when the business is sold again. Patrick’s transaction involved 30% rollover equity.
The proportion wasn’t out of bounds, but the details were. The buyers had granted Patrick common equity when their equity was in a preferred structure. This meant that whatever happened to the business, Patrick’s buyers would be paid first, and they enjoyed a preferred 15% dividend. Only after they got their money back and the preferred dividend, would Patrick get his cut.
Such an arrangement is highly unusual in deals of this type. In a standard deal, the original owner’s equity never comes second. The entrepreneur is entering a partnership with the buyers and should expect equal treatment.
2 – Working capital issues
Net Working Capital—generally comprising accounts receivable, inventory, and accounts payable—can be a contentious aspect of a transaction. When a deal closes, the seller will deliver an agreed-upon amount of net working capital (working capital, net of cash) so the business can continue operating as normal. How that amount is calculated is a fine art, however.
Once again, Patrick’s deal diverged from accepted practice. Many of his clients paid a deposit up front (Patrick used that money to purchase inventory and order project materials), and then they evened up after services were delivered. Although this is normal in Patrick’s industry, the buyer wanted Patrick to leave all the cash but required him to reduce the purchase price by the amount of the customer deposits. In other words, he got hit on both sides of the working capital calculation!
3 – Breakup fee
With problems compounding for months, why didn’t Patrick just walk away?
Much like a poker player who finds himself pot committed, Patrick had invested so much time, energy, and money in the process, he desperately sought a return. What’s more, Patrick has been distracted by the deal process and took his eye off the ball with company operations, so performance had declined. Nearly a year in, he had little hope of getting a better offer from another buyer.
A final barrier, his LOI also included a breakup fee. If he declined to sign a purchase agreement, he would have to pay the buyer’s due diligence costs, adding hundreds of thousands of dollars to his mounting financial losses.
A lesson learned
Fortunately, Patrick did engage our investment banking team before inking a final deal. Class VI approached the buyer and renegotiated many aspects of the transaction structure and valuation, helping to secure a $58 million purchase price and better terms.
We couldn’t; however, go back to the beginning and obtain the $80 million or more we believed the business could earn in the open market, nor could we vet the investment group to ensure Patrick’s legacy would be in good hands post-transaction. Sadly, last we heard, the business was not performing well, Patrick had left, and his equity would not be worth much.
It’s easy in hindsight to see where Patrick erred, but most entrepreneurs are precariously close to a similar outcome. Lacking a go-to-market plan and an expert team to help execute it, most business owners could easily hand over their biggest asset for dimes on the dollar.
The prospect is enough to bring chills to the spine. Let it be a lesson—preparation is the best weapon when going up against seasoned investors. The time to start is now.
* the names and details have been changed to protect confidentiality