M&A Mistake #10: Over-Complicated Deal Structure
One challenge sellers face in the final closing phase of the transaction is the onset of deal fatigue, exhaustion that often turns into hopelessness that the deal will never close, that the process will stretch on endlessly. The danger of deal fatigue is real, often driven by an over-complicated deal structure, as the Browns learned firsthand in this narrative from Chapter 11.
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Over the past twenty-five years, Bill and Suzie Brown had worked hard to build a successful security integration business, Chesdin Security, which installed and monitored security systems in commercial, institutional, and residential buildings. The company had reached just over $40 million in annual sales and benefited from a loyal customer base that provided a significant amount of recurring aftermarket repair work, which is more attractive than project-based work. Now in their early sixties, Bill and Suzie planned to retire over the next five years and considered selling Chesdin Security. “As planning for retirement became more tangible, we realized that the bulk of our net worth was tied up in the business,” Bill remembers. “With no family members or key employees that might want to buy the business, we started focusing on third party buyers.” They knew that a potential buyer would most likely want them to remain with the business for several years to ensure a smooth transition. And since the business was performing well and they still had several years until retirement, they concluded that now was indeed the right time to start the process, allowing for up to a year to find and close a deal with a buyer and several years thereafter to remain with the business before retiring. Heeding the advice they received from a friend who had successfully sold his family business, Bill and Suzie interviewed several investment banking firms to represent them in the sale process. “We were looking for an investment banker who was both highly experienced and also represented a strong fit on a personal level given how important this sale was to us and the amount of time we’d be working together,” Suzie noted. After comparing notes on what they perceived as the strengths and weaknesses of each of the four investment banks they met, they chose a firm they believed fit both qualifications best. They also engaged a respected regional law firm with a strong business law practice specializing in mergers and acquisitions, ensuring the couple’s interests would be well-represented. The investment banking team gathered the information they needed from the Browns to draft a thorough Confidential Information Memorandum about Chesdin Security. This document covered a wide range of topics, including the company’s history, operations, employees, customers, financials, and growth opportunities. Happy with the CIM and list of potential buyers the investment bank created, Bill and Suzie gave their approval for the marketing phase to begin. Given the attractiveness of Chesdin Security’s business model, which was less dependent on new construction activity than most security integrators due to their high mix of aftermarket service work, as well as the Browns’ willingness to remain active in the business for several years after the deal closed several buyers expressed interest in the deal. The Browns met with four of the most aggressive potential buyers in a series of management presentations arranged by their investment bankers, and after reflecting on the meetings, Bill and Suzie agreed on a clear favorite. They picked a small private investment firm, Cooper Lane, eager to acquire Chesdin Security as part of their plan to consolidate the security integration market on a multi-state basis. Cooper Lane and the Browns reached agreement on price, six times the company’s earnings of $4 million for a purchase price of $24 million. The Browns signed a letter of intent with Cooper Lane, which then engaged its accountants and other third-party advisors to conduct the necessary due diligence to close the transaction. The Browns were excited that their retirement plan was proceeding just as they had planned, though the process was about to take a turn for the worst. The Browns had agreed in the Letter of Intent (LOI) that 25 percent, or $6 million, of the total purchase price would be structured in the form of an earn-out. Their investment banker told them that earn-outs, which represent deferred purchase price that is only be paid if the business meets certain agreed-upon performance hurdles after closing, were common in sales of family-run businesses where the sellers were still active. “While everyone would prefer 100 percent cash at closing, we got comfortable with the structure of $18 million at closing and $6 million in an earn-out,” Bill recalls. He and Suzie knew they’d continue to lead the business for the next several years and had confidence in their ability to maintain or even accelerate Chesdin’s growth, so they were comfortable agreeing to a three-year earn-out in the LOI. In the Brown’s excitement to start the closing process as quickly as possible and move one step closer to retirement, they agreed to fill in the details of the earn-out later as part of negotiating the necessary legal closing documents. Although a common mistake made by many sellers, the Browns did not realize that this decision to put off finalizing an important aspect of the deal would soon come back to haunt them. After forty-five days of working with Cooper Lane and its advisers to complete financial and business diligence and finding no significant issues, the time came for the final legal negotiations. The primary closing document, the Purchase and Sale Agreement, covers all aspects of the transaction, including the precise details on how the earn-out would be calculated and paid to the Browns over the three years following closing. The Browns’ investment banker proposed a complex structure for the earn-out, which included several features designed to protect the Browns in various scenarios, including a multi-year catch-up provision. This meant that if the business didn’t achieve the agreed-upon threshold in year one or year two but did meet the collective goal for all three years combined, the full amount of the earn-out would still be paid. The buyer and their legal counsel, another high-profile law firm on par with the Browns’ attorneys, were receptive to the concept, but this created a whole new set of possibilities under various post-closing scenarios that had to be addressed and negotiated. Days turned into weeks, and weeks into months, as the attorneys from both sides, together with the Browns and their investment bankers, tried to hash out the fine points of the earn-out construct through hours-long conference calls and dueling drafts of legalese that neither side felt quite captured everything adequately. Bill recalls, “Here I was, a master electrician and leader of a very successful business, yet with zero training in how to structure M&A transactions. Suzie and I didn’t understand half of the things we heard on those negotiating calls, but we were too intimidated to ask.” They understandably started to tune out and trusted that their advisors would take care of it. Finally, one morning over breakfast, a full four months after the LOI was signed and with no end to the negotiations in sight, Bill turned to Suzie and said, “I think I’ve had enough of this process. I’m so lost, I don’t even know how much we are selling the company for, much less when we’ll actually receive the money.” Suzie agreed; they both realized that deal fatigue had set in, and that they needed to stop the sale process. “It was a tough decision; we’d come so far and spent quite a bit of money on advisors up to that point. But the transaction had become too complex,” Suzie recalls. They called their investment banker later that morning and told them the deal was off. Buyer Cooper Lane was surprised and disappointed when they heard the news, as were the advisors on both sides. Everyone but the Browns thought the deal was still on track, just taking longer than expected. They all underestimated the level of frustration building with the sellers.
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In this article series, I share excerpts and stories from my book, The $100 Million Exit. I hope you enjoyed this post — if you did and want to connect, you can reach me via email at email@example.com or connect with me at https://www.linkedin.com/in/jbrabrand/. Also, you can find my book on Amazon here: https://www.amazon.com/dp/1641375175