Thursday, December 22, 2016

Business Sellers Could Learn from this Seventeen Year Old Shark Tank Winner

Shark Tank Deal Wunderkind
The critical moment of many Shark Tank deals is when one of the Sharks asks, "How did you get to that valuation?'  I can't believe how often the contestants eliminate themselves with a poor answer to that question that stops their deal process almost before it begins.  Answers such as : We have invested $2 million in the product, so our valuation should be at least $2 million, or Our investors have put in $3 million so far. It should be valued at $5 million, or, I heard that xyz Company got $30 million for their company. So based on that our company should be worth $10 million."  Well, ask any Shark. This is not how they look at the value. The Sharks and the market in general don't care how much it cost you to develop the product or how much your investors have in or how much you need to retire or how much you think it is worth.

The Sharks look at what the ROI is for their investment in a company. So when the Sharks asked the seventeen year old how he arrived at his valuation he promptly responded with, our sales during this period were X$ and if your project that for a full year, they would total Y$. Our profit margins are at Z%, so if you project that forward, our annual cash flows would be XYZ$. At a cash flow multiple of 5 X, that gets you to our valuation. After a moment of stunned silence, one of the Sharks said, you have to be one of the smartest seventeen year-olds out there. I agree. This kid knew his stuff and he was prepared and he blew away the Sharks who have seen hundreds of contestants absolutely fumble this most basic of investor questions. Nice job, young man.

It is hard to criticize this very bright young man, but I am going to Bill Belichick him. The Patriots just won 27 - 3 and Belichick lists his three things the team could have done better. I only have one, and it is a minor nit, but could be important to him in the future. Most of the Sharks agreed that his was a fair valuation based on his multiple of cash flow analysis. One of the deficiencies of this approach, especially for very rapidly growing firms and earlier stage firms, is that the company growth rate is not accounted for in the cash flow multiple valuation approach. Why do some companies like Facebook and Google sell for much higher Price Earnings multiples than the average S&P stock? The answer is that these companies have a far higher earnings growth rate and that has been translated into a higher PE multiple. In fact, many investor professionals are now basing investing decisions on the PE growth multiple which does, in fact, incorporate the company's growth rate into the valuation equation.

So even though the Sharks agreed that his was a fair valuation, remember the car buyer never pays list price, so they will be trying to bid that price down by selling the value of having the Shark involved (which is quite valuable, by the way). Our seventeen year old wunderkind could have planted a preemptive thought when presenting his valuation with something like, "So our valuation is 5 X annual earnings, but that value does not even account for the fact that our sales have been growing by 8% month over month."

My assistant coach just passed me a note. What about the phenomenon for start-ups and emerging companies that their expenses are temporarily much higher due to the front loading of development and marketing expenses? If you look at the multiple of cash flow model, the entrepreneur is actually punished from a valuation perspective because of their growth expenditures if they are selling their company or seeking investors during this hyper growth phase.

So remember, buyers will try to come up with reasons why they should not pay you asking price for your company and you need to be able to counter with equally compelling reasons why they should. Maybe the Sharks should pay the seventeen year old entrepreneur a premium based on how much they might learn from this budding superstar entrepreneur.

Dave Kauppi is a Merger and Acquisition Advisor and President of MidMarket Capital, providing business broker and investment banking services to owners in the sale of information technology, software, and other technology based companies. Dave is also the editor of the Exit Strategist Newsletter and author of the Book Selling your Software Company - An Insider's Guide to Achieving Strategic Value

Wednesday, December 21, 2016

Shark Tank Star - Magnet Lady's Superior Negotiation Techniques

Beating the Sharks at Their Own Game

On the 12-16-16 Episode of Shark Tank presentation by the mother from Seattle, Washington, who has designed removable and reusable magnet stickers for hanging art, I witnessed a bit of deal making art from the contestant. First, she was passionate, confident, and likeable; always a great platform to establish in negotiations. Secondly, she was well-prepared and could easily articulate her prior financial performance. Third, she came in with a very impressive record of prior success on QVC. Too many contestants come in with a "save me" attitude that is not effective.  Magnet Lady focused on growth and what she and a Shark could accomplish.  She was precise in her ask (what she would use the funds for) and her valuation expectations. 

All of this was impressive, but where she earned a grade of A was on her deal creativity and execution under fire. First, Lori was trying to pressure her into a single bid, which is a technique many of the Sharks have tried to use. They try to elicit a single bid auction with the implied threat of the Shark walking away if their initial offer is not accepted immediately. In our Mergers and Acquisitions practice, we find this to be the single biggest mistake that entrepreneurs and business sellers make. They often jump at an unsolicited offer or non-contested offer that ends up being far lower than what a competitive market process would produce. Magnet Lady deftly and respectfully kept the doors open with a comment to the effect that once we were partners, you would not want me to make any rash decisions. This allowed her to receive additional offers from the other Sharks. This resulted in a substantial improvement in her valuation.

So now she has Lori who has been leveraged up by other offers and she knows that buyers hate this. Magnet Lady believes that Lori is her best partner going forward, but her initial offer is one half of what Magnet Lady originally asked for. She also knows that Lori will probably not just raise her bid directly in a bidding war type of auction. So Magnet Lady counters with a very creative structure that commits Lori to her original bid for a valuation at the closing of the deal, with a contingent performance Kicker. If that performance measure is reached then Magnet Lady will receive her originally proposed valuation.

This would have been an excellent strategy with several days and an experienced advisor to help her craft her counter proposal. But the fact that she did it in real time under intense pressure from skilled deal makers is quite remarkable. She knows with Lori's help, hitting her targets will be a slam dunk. So she soothes Lori's ego by not forcing her original ask, but artfully gets there with a slightly different structure. Plus, she has again reinforced her confidence in her venture by putting her skin in the game and not asking for the entire value up front.  Buyers love this. Done deal.  When your magnet days are over, maybe you will be "attracted" to a career as a deal maker. See what I did there?


Tuesday, December 20, 2016

Shark Tank Presentation Critique - The Culinary Ninja

Our Shark Tank Contestant
As a mergers and acquisitions advisor, I find the Shark Tank show fascinating like a football coach would, watching next week's opponent's game film. The show distills what is often a 6 to 8 month process down to a very intense eight minute vignette of the deal. Prior to the Shark's grilling, the contestants prepare their investment business case (the equivalent of the offering memorandum) and market their opportunity to the show's producers to earn the right to pitch the Sharks.
The culinary ninja with his Paleo Ice Age Meals had an attractive product in a hot area with lots of potential. He used a little showmanship and delivered his pitch as a poem after presenting his ask at a company valuation of $10 million, with limited current sales.  Every one of the Sharks was turned off and several delivered a poem response that conveyed the message that his valuation was off the charts high and how can he possibly justify that. He had essentially lost them and tried to recover with his very recent development of a potential partnership with Cross Fit. That information was interesting to the Sharks, but he had already lost them.
With the caveat that I was not standing up there in the glare of the bright lights with 5 seasoned deal- makers in attack mode, I am going to deliver some arm chair quarterbacking. In our business, we are often approached by companies with great potential or the best technology, who just need the buyer with the brand, the customer base, and the resources to take the product to the next level.  Where the reality gap comes in is that they want to be paid for all of this future performance with a lofty valuation not supported by current financial metrics and they want it all in cash at closing. That is what the Ice Age Meals guy did and he got justifiably bloodied by the Sharks.
How could he have changed his outcome, gotten his investor partner, while creating the possibility that his valuation would be realized? Well, he could have withdrawn his deal and waited until he closed the partnership with Cross Fit, and then come back later with the same valuation expectations. That is not a good idea because getting this audience with the Sharks is too important to pass up and may never return. The approach of this arm chair quarterback would have been to preface his value expectations by first presenting the Cross Fit potential partnership . Next he should have acknowledged that it was not a sure thing so he was willing to do a deal with a significantly lower valuation at deal closing with a contingent future valuation based on post closing performance.
So his valuation proposal would be comprised of both value and structure. For example, he may ask for a closing valuation of $250,000 for a 10% ownership stake. The second component would be a potential $750,000 additional valuation which could be based on 6%, 5%, and 4% respectively of sales during the next three years of operations. So if sales were $3 million, $4 million and $5 million during the next 3 years, he would capture $180 K, $200 K, and $200 K of additional contingent transaction value. In the mergers and acquisition world, this contingent transaction value is referred to as an earnout.
Buyers are more than willing to pay for potential once that potential is realized and they love it when the Seller shares in the risk and puts their money where their mouth is. By using this approach the Paleo ninja would not have immediately turned off the Sharks and been dismissed as an unrealistic seller. He would have been viewed as a more resourceful partner and someone willing to work with the buyers.  Here is the sad part of blowing this opportunity. The deal with Cross Fit has a lot of hurdles to clear before any money changes hands. The odds are against a fledgling start-up trying to do business with a much larger established company. The biggest reason is that a great deal of buyer resources are expended in order to roll out a partnership and they do not want to risk that their new partner goes out of business and wastes the investment and potentially damages their brand.
An investment from a Shark is a self-fulfilling prophesy. The little company will survive and thrive. Taking this information of the Shark's investment back to Cross Fit immediately removes the largest impediment to getting the partnership deal closed. The odds of the partnership deal improve dramatically which in turn improves the future sales potential for the Paleo meals resulting in realizing the full potential of the contingent portion of the transaction value.
It is a shame a deal did not get done with a potentially very good product with some serious upside potential. A small tweak in deal structure could have resulted in a much more accepting deal environment between the Paleo ninja and the Sharks. Investors and business buyers set up evaluation gates that the target must pass through. Don't allow them to eliminate you early by not passing the reasonable seller gate. 


Tuesday, December 13, 2016

Business Sale Negotiations - Base the Letter of Intent on Your Industry's Valuation Metrics

Unless you are one of the rare companies that is viewed as a valuable strategic acquisition by a company with highly valued stock as their currency,  your selling price is going to closely approximate your industry's valuation metrics. For an eCommerce Website it could be a multiple of annual net profit, for a IT managed services provider it is a multiple of MRR (monthly recurring revenue), and for a distributor of medical supplies it is a multiple of EBITDA.

So for this example we will use the IT Managed Services Provider. We got a great deal of buyer interest and had multiple buyers involved. We started taking bids and negotiating letters of intent. Because we know that the due diligence process can stretch out (sometimes as a buyer's way to make late inning price adjustments - an unfortunate practice known as Re-Trading) we wanted to provide a price adjustment mechanism that was fair to both buyer and seller. Normally because the process favors the buyer, the price can only go down between LOI execution and closing, but almost never up (if you don't believe me, read on and you will see how true that is). We wanted to accomplish two things with our approach; 1 encourage the buyers to complete the process in a reasonable period of time and 2 provide for both price increases and decreases with a performance measurement that would be based on the prior 12 months to the month of closing.

As we started getting our offers, our counter offers converted the purchase price into a multiple of EBITDA and then incorporated language that would base the final purchase price on the actual EBITDA for the prior 12 months to closing. The language looked like this:

BUYER will pay SELLER purchase price of $4,350,000 (four million three hundred fifty thousand US dollars) for 100% of debt-free assets of the company, goodwill, non-compete and non-solicit agreements. For illustration purposes, the valuation is based on 4.35 times EBITDA of the trailing 12 months (TTM) to the month prior to the execution of this letter, as provided by the business broker. At the present time and using available information, the TTM EBITDA from October 2014 to end of September 2015 is calculated to be approximately $1,000,000. The purchase price at closing will be based on an EBITDA multiple of 4.35 X the actual EBITDA for the 12 month period preceding the month of closing.

Again, the main purpose of this language is to level the playing field between buyer and seller.  Normally the buyers deluge the seller with voluminous data requests and in smaller privately held companies it is usually the owner that is in charge of responding. Often the performance of the business suffers and the buyers then make their adjustment to purchase price based on that downturn. If you do not formalize and document the corresponding upside for the seller, should the business performance improve, the buyers never raise their price. They have had you off the market for 6 months and it is par for them to play brinksmanship and threaten to walk on the deal rather than raise their price. You box them into a corner with this language by proactively documenting what you know they will do already. Once documented, it is pretty hard to argue that you shouldn't be provided the same protections. It is the same principal as a mutual non disclosure agreement.

So in a competitive bidding situation, we get the best terms and conditions from our buyers including the variable purchase price calculation at closing and fixing the amount and the formula for calculating the net working capital level.  We hammer out a couple of additional details including the calculation of the earnout, with the ultimate winner and we dual sign the letter of intent. As promised, the due diligence is exhaustive with the private equity group buyer. They assign a junior analyst to be the coordinator and another analyst to focus on populating the data room.  They already own a platform in this industry and involve that company's CEO in our weekly status call. As the months pass, yes months, the seller's performance continues to improve and we are sending monthly financial updates. It is becoming evident to all involved that the purchase price is going up. Remember what I said earlier - for the buyer the price almost never goes up.

Four months into the process the buyer produces a "term sheet" which basically fixes the purchase price to the original place holder level and overrides several key points that we had earlier negotiated in a competitive bid process. Our client was very upset and we pointed out to the buyer that we were not going to accept new terms after we were off the market for four months and that they had agreed to these terms in a competitive situation. I even sent them our email threads of our hard fought negotiations as a reminder. I also sent them our deal comparison work sheet to show all of the other bids that we received (I blanked out the identities of the other buyers, of course). Because of our extreme negative reaction they did not press on getting any agreement on the term sheet.

So we returned to the due diligence process and the PEG hires a human resources consulting firm, adding to the due diligence burden and often duplicating requests already completed. They also hired an "independent third party" CPA firm to go over our clients information and produce a quality of earnings report but not before yet another exhaustive round of data gathering, again much of it duplicated. We received a detailed report with several attacks on EBITDA and value but a couple of the highlights were, "To recruit and maintain quality employees, the Company may have to step up its contribution to the cost of health insurance and also add to the benefits package. The costs of such upgrades could easily run $50K-$100K per year."  This was completely speculative and not backed by any facts including our requested quote from their insurance carrier to move 8 employees to the new plan. We also pointed out that retroactively applying anticipated future adjustments to historical EBITDA was a real stretch on industry practices.

Another gem in the report was "The company will need to add resources in the administrative function at a cost that might be estimated on the low side at perhaps $100 K annually." This is after we have already discussed eliminating the seller's CFO with the platform company at a savings of $50,000.  

Another Quality of Earnings Report Finding "The relatively low margin on product sales combined with the fact that they are generally not recurring except over multi-year replacement and upgrade cycles means that the product component of the business should be valued using a separate, lower multiple of revenue and/or earnings than the service revenue, which is recurring." Well, first, the division of product revenue was clearly stated in all materials the PEG  had when negotiating their offer.  The offer against 11 other qualified bidders was a single EBITDA multiple. Again, the bid was set in a competitive process and did not include any dual multiple component.

All in all they presented $332,000 in EBITDA Adjustments as their starting point to reopen the price negotiations almost 5 months into the process. We refuted every one of their attempted non supported and arbitrary adjustments.

As nerves were frayed and the deal is on the edge of blowing up, I get an email from one of the partners at the PEG. 'Thanks for the note Dave, clearly we are just going to keep talking past each other if we focus on EBITDA. I think we can agree to disagree. (for clarity this won’t change the approach to employees, they will still be offered our company's benefit package at closing).

MRR is clearly the value driver of this and all MSP businesses." He claimed that the information they were provided and were using for their LOI showed a different revenue breakdown between product sales and monthly recurring revenue than what the seller was currently doing. "That issue notwithstanding the average TTM MRR at that time was 239k and the purchase price in our signed term sheet was $4.35M or 18.2x MRR. The average TTM MMR has indeed grown since April (by 7.2%), applying an 18.2x multiple to that MRR $256k brings you to $4.66M, we are willing to round up to $4.7M. That represents a $250k increase in enterprise value since the term sheet was signed."

Well the actual measurement that the LOI called for was based on 4.35 X the latest TTM EBITDA of $1.2 M that puts the value at $5.22 M.

At this point the PEG counted on our guys giving in and taking  their deal but there had been so much erosion of good will that our sellers walked away. This was a very expensive outcome for all involved. My take away from this is first, I am really angry at this unfortunate practice of "re-trading" that some PEG's use as their acquisition model. Wikipedia, the free encyclopedia, defines A Re-trade[1] as the practice of renegotiating the purchase price of real property by the buyer after initially agreeing to purchase at a higher price. Typically this occurs after the buyer gets the property under contract and during the period that it is performing due diligence. The buyer may raise a due diligence issue and demand a purchase price adjustment to a lower re-trade price. The seller can be left in a bad situation where it must either accept the lower price or lose the sale and re-market the property.

It occurs to me that had the buyer set their purchase price to the metric that was most important to them in setting value, they would have made sure to completely understand what the MRR in this case was prior to negotiating a LOI. If the due diligence process showed an unexpected surprise or variance in MRR they would have been protected. Also the seller would have accepted any legitimate price adjustment because the rules were clearly spelled out. They instead bid on a multiple of EBITDA and despite their best efforts to carve it up in due diligence could not find one defensible legitimate adjustment.  When the price went against them and they attempted to change the metric to give them the answer they wanted, they destroyed the seller's trust and killed the deal.
