Will appear on Buy-Side pages – RECENT BUYER ARTICLES

Representation and Warranty Insurance in M&A

/in , , /by Exit Strategies

When selling your business, you make a set of promises to the buyer. You “represent and warrant” certain facts about the business. Essentially, you’re certifying that you provided accurate information and there are no known issues pending (e.g., financial, legal, tax, compliance, etc.).

 

If it turns out those promises are false, the buyer has the right to recoup a percentage of the purchase price. Non-fundamental reps and warranties (typically all items aside from key ownership, legal, and tax items) typically allows the buyer to recoup up to 10-50% (a “cap”) of the transaction if there is a material breach.

 

At current trends, businesses over $20-$25 million often require an escrow to help fund any breaches in reps & warranties. Smaller transactions, however, will often offset against a seller note or earnout.

 

On a $20-25 million deal, escrow amounts can commonly be 10-20% of the purchase price, held for a period of 18 – 24 months. On a $30 million deal, for example, the seller might have to delay receiving $3-$6 million of the purchase price until the reps and warranty period has expired.

 

Representation and warranty insurance offers an alternative to seller escrow. This insurance product is designed to isolate risk and the resulting claims between buyer and seller in the event of a non-fundamental breach in reps and warranties. (Note: Reps and warranty insurance will not cover fraud and intentional misrepresentation.)

 

Pros and cons of reps and warranty insurance 

For the seller, the advantage of reps and warranty insurance is that they can realize the full value of their purchase price, without holding money in escrow. For many sellers, the holding cost of that money is enough to justify the cost. It also reduces seller risk, for inadvertent, unknown mistakes.

 

For the buyer, reps and warranty insurance offers a way to collect a claim without jeopardizing their relationship with the seller. Consider a buyer who wants to do multiple deals in the industry. They want the seller to provide a positive referral in the future, encouraging other sellers to work with them.

 

Similarly, consider a buyer who has retained the seller in a leadership position. They don’t really want to make an expensive claim against their new CEO or sales director. Having reps and warranty insurance protects any ongoing buyer/seller relationship.

 

Reps and warranty insurance can also expedite the sale process and drive down your legal fees. When sellers know they’re indemnified against certain risks, they don’t have to lobby as hard to protect themselves. To put it simply, negotiations are easier with insurance in place. Conversely, this insurance product requires third party due diligence which can slow the overall process.

 

What does it cost and who pays?  

Reps and warranty insurance can be purchased by the buyer or seller. Minimum fees are typically $250,000, which makes this product cost prohibitive on smaller transactions. In a competitive market, some buyers will offer to pay or split the cost of reps and warranty insurance with the seller as a way to sweeten their offer.

 

Sellers need to have adequate representation looking out for their interests. Watch out for exclusions that are overly broad (e.g., an ‘impact of covid’ exclusion) or non-standard for the market.

 

Be aware that the policy will have a retention figure (like a deductible) – often around 1% of enterprise value. Who covers that retention is another point that needs to be negotiated in your deal terms. Again, we might see a 50/50 split here. So on a $30 million deal, the seller may have to escrow 0.5% or $150,000 (far less than the $3-$6 million escrow estimated above.)

 

Considerations and alternatives  

Reps and warranty insurance is a newer product on lower middle market deals in the US. Since it’s a relatively young offering, it’s harder for buyers to vet insurance brokers as the track record for payout is not well established. (In other words, the buyer may have a policy, but can they actually collect on it? And what legal fees will they incur in order to collect?)

 

In cases where buyers are looking for a mechanism to collect without the overhead cost, other options may be more appropriate. For example, if the deal terms include a sellers note, the buyer may prefer to offset a sellers note proportionally to any breach.

 

Again, sellers should consider that reps and warranty insurance reduces their risk. They may wish to consider that when evaluating buyers and may give some preference to buyers who accept a lower cap (the max amount they can come back for in the event of a breach) or who are willing to cover all or a portion of reps and warranty costs.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Rep and Warranty Insurance Now Available for Deals Under $10 Million

/in , /by Exit Strategies

By Patrick Stroth

In recent years, Representations and Warranty (R&W) insurance has become available to smaller and smaller deals.

The eligible deal size dropped to under $20M… then under $15M. This is already quite a feat when you consider that the average transaction value (TV) for deals with R&W coverage in place is $500M. And to be honest, most insurers won’t go lower than $100M—Underwriters are already backed up on processing policies and insurance companies don’t always want to take the time to work on smaller deals that won’t generate large amounts of fees.

Now, for the first time ever, this unique type of coverage is available for deals with a TV of $250,000 to $10M. This opens up R&W coverage to a whole new universe of deals.

How did this breakthrough come about? As with many business ideas, someone saw a gap in the market and decided to fill it with what is officially called Transaction Liability Private Enterprise (TLPE) insurance.

According to CFC Underwriting, the London-based insurer that innovated this new insurance product, there were 230,000 deals in which the TV was between $250,000 and $10M. They decided to create a product for this vast unserved market and came up with TLPE insurance as the first to market solution.

Here are the basics on this coverage, which is available worldwide:

  1.  It covers deals with TV from $250,000 to $10M.
  2.  The policies are sell-side only. (In standard R&W insurance there are sell-side and buy-side policies, although the vast majority are buy-side.)
  3.  It offers competitive terms at rates lower than traditional R&W coverage.
  4.  A streamlined underwriting process to ensure both timely execution and sustainability.
  5.  A deal can be insured up to 100% of Enterprise Value (EV).
  6.  Policy period: six years.

Covered industries include professional services, technology service and product businesses, transportation and aviation, and insurance brokers. CFC generally declines deals involving businesses in healthcare, financial services, oil and gas, mining, pharmaceuticals and regulated industries (such as telecommunications).

How It Works

Similar to standard R&W insurance, TLPE covers innocent misrepresentations made by the Seller to the Buyer.

This provides the Sellers peace of mind because they know they won’t have to risk some or all of their proceeds from the deal in the event of a breach. On the other side, Buyers enjoy a feeling of confidence because there is a guaranteed source of funds available to cover their loss.

Unlike the vast majority of R&W policies, TLPE is strictly a sell-side product. The policy is “triggered” only by a claim brought by the Buyer against the Seller for a loss caused by a breach of the Seller’s representations in the Purchase and Sale Agreement.

As part of this coverage, the Seller is entitled to have their legal defense to contest the Buyer’s claim paid for by the insurer. Underwriters have full authority on the selection of the Seller’s defense counsel, which enables them to control claims costs. The insurance company will also cover any damages or settlement amounts.

Something not in a standard Buyer-side R&W policy is the exclusion for Seller fraud.

While no insurance policy will cover known fraudulent acts, TLPE will pay the legal fees to defend the Seller against allegations of fraud. However, they will cease providing defense costs if actual fraud is established in court.

Important: if the Buyer sues the Seller for something not related to a breach, the insurer does not provide legal defense.

Quick and Easy

TLPE offers streamlined and cost-effective underwriting:

  • An application is required, but Underwriters depend on the Seller’s knowledge of their own business. Who knows the business better than an owner/founder?
  • There are no underwriting fees, which saves policyholders $30,000 to $50,000.
  • No underwriting call is required.
  • The turnaround time is just three days after transaction documentation is submitted and responses to any underwriting questions are provided.

This quick and easy process is possible because the Underwriters are not viewing the reps. They’re not looking at the due diligence collected. They are simply underwriting the application that the Seller provided.

TLPE in Action

TrenData is a Dallas-based SaaS company that offers various human resources services. A larger human resources technology firm was planning to acquire them. The TV was about $5M.

What held up the deal was the Buyer insisted that in the event of a breach of the intellectual property (IP) rep, that the target company would be responsible for any legal expenses or loss. At the same time, the Buyer would retain the sole authority for selecting their own legal counsel and determining the legal strategy.

As the target company noted, this is like essentially writing a blank check. The Buyer could easily hire high-priced attorneys and/or drag the case on and on. They would not go for it.

Neither side would budge on this issue, and it seemed like the deal was lost.

However, less than a week later, the Seller reached out to my firm, Rubicon Insurance Services. We discussed TLPE coverage and how it could work in this deal. The Seller contacted the Buyer, and once they found out that the Seller would pay for the policy, that legal costs would be covered in the event of a loss, and that the deal could be insured up to the full $5M in TV…the gap between the two sides was bridged and the deal closed within a week.

What to Do If You’re Interested in Coverage

TLPE seems simple enough. However, there are key conditions and limitations with this new product. So it’s essential you have an insurance broker experienced in M&A handle the process of securing this coverage.

Something to keep in mind: TLPE policies can be placed post-closing, so if you were unable to get protection for a previous deal, it can actually be revisited.

If you’re interested in seeing if TLPE coverage could be a fit for an upcoming – or past – deal, you can contact Patrick Stroth, at pstroth@rubiconins.com.

How Supply Chain Issues are Complicating M&A Dealmaking

/in , , /by Al Statz

Many businesses are struggling with supply chain issues right now. After vaccine programs and government stimulus monies kicked in and economies roared back to life this past year, global supply chains came under immense strain as weaknesses were exposed. Though conditions have improved slightly in just the past few months, experts in most industries are forecasting that supply chain troubles will persist well into 2023.

This article discusses some of the ways that supply chain problems are complicating M&A transactions for business owners looking to sell in 2022.

Earnings Performance

One of our M&A clients, a durable goods distribution company, currently has a record order backlog of 11 months, as customers place large orders to combat long lead times. Normal backlog before COVID was around 1-2 months. Lead times on popular SKUs that were once 2-3 weeks are now 5-6 months, and scheduled deliveries on some products are a full year out! Meanwhile many vendors are missing promised delivery dates, and the order backlog keeps climbing, for now. Sales (shipments) are totally dependent on the supply chain.

EBITDA is the most talked about, relied upon, and argued over earnings metric in the world of mergers and acquisitions. When a business has solid orders but is struggling to ship products, it becomes difficult to establish an earnings run rate and to forecast earnings. That in turn makes it difficult for acquirers and sellers to see eye to eye on EBITDA and therefore enterprise valuation. And how well correlated is trailing twelve-month (TTM) performance with expected future performance anyway under these conditions? Often not well at all.

And this is part of a broader question―where will growth stabilize after COVID restrictions and government stimulus ends, and inflation and GDP growth are back to normal? Since different buyers will have different views of TTM and expected future EBITDA performance (not to mention working capital and capital spending needs) the best way for sellers to optimize value in today’s market is to run a structured sale process where multiple buyers come to the table.

Supplier Due Diligence

As acquirers seek greater supply chain resilience, we’re seeing them do more due diligence in this area than ever before. In the past, buyers were relatively relaxed about supply vulnerabilities, focusing more in other areas. But now we’re seeing more scrutiny of supplier quality and on time performance, length of supplier relationships, supplier concentration, location of supplier operations, supplier commitment to the target, capacity for growth, strategic plans, recent or potential change of ownership, contracts, proprietary content, history of price increases, long lead time items, economic order quantities, sole sourced items and alternative sources of supply, and other potential areas of risk.

We brought an electronics business to market recently that had backups or workarounds for nearly every component in their products. Frankly, we’d never seen a company put so much time and energy into supplier redundancies. Yet, they had one essential PCB with no alternate supplier.

Buyer concern was so significant, we took the business off the market until a reliable second source was identified and qualified.

Working Capital

Another aspect of M&A dealmaking that is being complicated by supply chain issues has to do with working capital negotiations. Working capital is like gas in a car – you need it to run a business. When selling a business, the buyer and seller agree on a “sufficient” amount of working capital (usually on a cash-free debt-free basis) to be left in the business to support ongoing operations. In a typical economy, unless a business is growing or declining rapidly, this “target” working capital level is based on a TTM average calculation.

But right now, many businesses are holding onto bloated levels of inventory to compensate for parts shortages and long lead times. Manufacturers that used to buy inventory on a just-in-time basis are now overstocking. Not only are inventories much higher than normal, but in many cases the price-per-unit has skyrocketed as well. Companies are paying whatever they have to in order to keep critical parts in stock and keep customers happy. The same goes for shipping costs.

So, businesses selling now based on a TTM average working capital target will be including more working capital than if they had sold 12 or 24 months ago. This is one of the areas that can really upset sellers – no one likes to leave money on the table. Fortunately, with all the competition in the market today, many buyers are willing to throw out the book on working capital to win the deal. The key is to negotiate the target earlier in the process when there are still multiple buyers at the table. In the past we often negotiated the working capital target during due diligence. Today we almost always negotiate it in the LOI.

What to do

Owners looking to sell in a world reshaped by the pandemic should select an M&A advisor who anticipates issues like these and has strategies for addressing them. Owners planning to remain independent may want to consider protecting their supply chain by vertically integrating upstream through a strategic acquisition.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

M&A Advisor Tip – Know Your Priorities

/in , /by Al Statz

The market is still strong, and sellers are receiving multiple offers, but the buyers they choose aren’t always the ones with the biggest checks.

Would you take a lower price to ensure that the buyer’s culture fits yours? How about a million-dollar price cut if it meant getting all cash at close and avoiding years of seller financing? Or trading $100,000 in salary to for an extra $1 million in sale price?

Sellers face these kinds of choices all the time. Potential deal structures should be carefully considered and explored, long before you reach the negotiating table. Whether or not you realize it, you’re positioning and negotiating from day one of a sale process. If you don’t have your priorities figured out, you might give a buyer the wrong impression … and that can spoil a deal.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

M&A Deal Terms: Fall 2021

/in , /by Al Statz

You may have heard – it’s a bifurcated market.

Declining caps on general indemnification against breaches of representations & warranties [1] had been a feature of the seller’s market for lower middle market businesses, going back well before the pandemic. Average caps have remained in the range of 15-16% of Total Enterprise Value (TEV) since the fall of 2020, according to GF Data’s semi-annual report on key deal terms, covering transactions by 243 active private equity data contributors completed through June 30, 2021.

However, a drilldown shows the same kind of market delineation we have seen in valuation.   Selling businesses featuring neither above-average financial characteristics (EBITDA margin and revenue growth) nor rep and warranty insurance (RWI) completed deals with an average cap of 23 % of TEV. For businesses offering above-average financials, RWI or both, cap averages were in the low to mid-teens.

The indemnity survival period [2] in the first six months of this year across all industries was 20.3 months, up slightly from the 2016-to-present average of 19.2 months.

The chart below makes clear that businesses with above-average financials and the ability to use RWI are rewarded in valuation. Businesses lacking both are subject to higher caps, in addition to dampened pricing.

In the first half of 2021, utilization of rep & warranty insurance bounced back to 59.1% of all deals. RWI usage anomalously declined in 2020, averaging 53.0% for the year. This reflected a temporary icing of the insurance market following the onset of the pandemic.

GF Data collects and publishes proprietary business valuation, volume, leverage and key deal term data on private equity sponsored merger and acquisition transactions with enterprise values of $10 to 250 million. GF Data gives M&A deal participants and advisors more reliable external information to use in valuing companies and negotiating transactions.

[1]  Indemnification cap refers to the general indemnification provided by the seller to the buyer against breaches of reps and warranties. This does not include carveouts for specific issues or items. For example, parties often agree that the general cap will not apply in the event of fraud.

[2]  Survival period refers to the period after closing during which a buyer may assert a breach of the reps and warranties against seller. Again, this does not include carveouts. For example, exposure on tax, environmental, and ERISA issues often exceeds the general survival period.

For assistance with selling a lower middle market business, contact Al Statz in Exit Strategies Group’s Sonoma County California office at 707-781-8580 or alstatz@exitstrategiesgroup.com.

M&A Advisor Tip: Expand the moat, reshape the hourglass

/in /by Al Statz

Acquisitions work best when they accomplish one of two goals: expand the moat or reshape the hourglass.

Expanding the moat means leveraging your core advantage. The more you can strengthen that advantage, the wider the moat around your company, protecting it from competitive forces.

As for the hourglass, its narrowest point is your company’s primary weakness or limiting factor. If you can find a company that does that thing well, and acquire and integrate it into your business, you reshape the glass so business flows through with ease.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

How to Buy a Small Tech Company

/in /by Exit Strategies

There are thousands of small tech companies for sale at any time they are often websites that take 1 or 2 people to run. There are listed for sale on bizbuysell.com, Flippa.com and similar sites. They can be run from home. Sometimes they require a particular expertise but other times they can be managed by the owner and technical or time-consuming work can be done by contractors, often offshore.

Some examples are Amazon reseller businesses, or other ecommerce sites. There are many ways to make money, such as affiliate marketing to refer traffic to a bigger site, pay per click to bring in traffic, or adsense to get people to click on ads. Converting traffic to customers is key. SEO is one thing that impacts this-also things like site speed and content are important. Also flipping the business or providing premium content are other ways to monetize the site.

If you have a desire to own a small tech business and don’t want to start it from scratch, buying one is often a great solution.

Regardless of intention and how you ended up with the new business, there are several considerations to plan for, especially on the tech side.

    1. Have the previous owner stay on after the sale. The owner can serve as an advisor or consultant for a predetermined period of time. This can add some much-needed stability during the transitional period.
    2. Start with minor changes. Customers may react unfavorably to sweeping changes. Therefore, at the beginning, less is more. Make minor changes and pay attention to your customers’ initial reactions. It’s important to maintain site traffic. If you change hosting, site appearance, plugins or social media ensure you do in a test environment first and plan for/minimize interruptions.
    3. Ask lots of questions and take notes. Let the previous owner and the staff teach you how to run the business. You can implement new procedures, but before doing so, make sure you know how things are currently done. Only then can you make informed decisions on changing business processes.
    4. Maintain current record keeping-procedures. Do your best to ensure that records and to-do items remain on schedule through the transition.
    5. Review customer service policies. Customers are used to having issues handled in a certain manner. Review the policies and maintain them for the first few months. After the transition is complete, amend them as necessary.
    6. Familiarize yourself with your new technology. While meeting the people behind the business and learning the procedures is important, you must also learn as much as you can about the technology that supports the business. You need to familiarize yourself with software programs and learn about their shortcomings. Learn what has gone wrong and in the past and what shouldn’t be ‘messed with’.
    7. Do something nice for customers. Make sure any site conversions or feature changes don’t turn off loyal customers. Offer something free to make up for this.
    8. Reward Employees. Hiring new employees is almost always more expensive than retaining existing ones and losing technical talent can be even more expensive and destroy value. Employees in tech startups tend to be younger, require more autonomy which means adhering to strict scheduling might not work for them.
    9. Plan your M&A Integration Strategy. “Fail to prepare, prepare to fail,” as the old adage goes. And it very much applies to M&A technology integrations. If you wait until Day 1 post-merger to start the groundwork, then you’re already behind. Soon after an acquisition, IT leaders are under pressure to deliver on expectations to produce cost savings and enable synergies, and it’s ten times harder if they haven’t devised a clear strategy for M&A IT integration beforehand. Start planning the overall M&A technology integration strategy while the paperwork is being finalized so the team can get ready to hit the ground running.

Thousands of mergers and acquisitions have problems during transition each year and the only way to avoid this situation is to plan ahead and pay close attention to the details.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, ownership transfer, strategic and other purposes. If you’d like help in this regard or have any related questions, contact alstatz@exitstrategiesgroup.com.

M&A Financing During the Pandemic

/in , , /by Al Statz

The pandemic has put lower middle market business sales and acquisitions on somewhat of a roller coaster ride. Deal volume declined sharply in Q2-Q3 and came back strong in Q4. Valuations have remained strong throughout the pandemic, at least for COVID-resistant businesses. Though there was a slight Covid-effect in Q2-3.

In terms of M&A financing, capital structures shifted to slightly more less debt during 2020, before edging back up to pre-pandemic levels in Q4. To compensate, the capital stack was being filled in with more buyer equity and more rollover equity.

Interest rates are still low and banks keep lending, but they have pulled back slightly. Lower middle market deals have typically had senior debt of around 3x EBITDA. According to GF Data, that ratio dipped to 2.7-2.8 in Q2-3 (the lowest level in 5 years) and returned to 3.2 in Q4 2020.

GF Data reported an uptick in buyer equity from 2019 to 2020, from 46.1% to 49.1%. We are still seeing buyers bring more equity to the table than pre-pandemic, and showing more interest in seller rollover equity.

Rollover equity is when a business owner retains a minority stake in the enterprise. For businesses valued between $10 million and $25 million, rollover equity accounted for 13.9% of deal funding in 2020.

At the start of the pandemic most of us were expecting to see more earnouts (contingent consideration) in transactions, but that hasn’t materialize. Because demand for acquisitions remained high during the pandemic, most sellers have been able to avoid earnouts.

If risk and uncertainty subside and interest rates remain low, we should see a return to more typical M&A funding levels in 2021.

For further information on M&A financing, or to discuss a current business sale, acquisition or valuation need, contact Al Statz, 707-781-8580 or alstatz@exitstrategiesgroup.com.

 

Market Pulse Survey: Still a Seller’s Market

/in , , /by Al Statz

Despite the effects of the pandemic, we continued to experience a seller’s market in the fourth quarter of 2020, for businesses with enterprise values over $2 million.

Presented by IBBA & M&A Source

For further information on M&A market conditions, or to discuss a current business sale, acquisition or valuation need, contact Al Statz, 707-781-8580 or alstatz@exitstrategiesgroup.com.

M&A ADVISOR TIP: Cybersecurity is a Buyer Priority

/in , , /by Al Statz

New research from Datasite reveals that cybersecurity is the #1 cause of buyers withdrawing from a merger or acquisition during due diligence.

Deal makers said about 1 in 10 deals fell through during due diligence. Cybersecurity issues was the cause in 36% of these failed deals, followed by financial weakness, excessive valuation, financial irregularities, and leadership issues.

To ensure that your data security practices will not be a concern for prospective buyers of your company, Exit Strategies Group recommends that you talk to your technology team about potential issues, and consider obtaining a cybersecurity audit from an independent third-party firm. Ask your M&A advisor or CPA for a referral.

Exit Strategies Group is a partner of Cornerstone International Alliance.