Roll Up Strategy in Private Equity

26:49There are probably four key things in negotiating the LOI. One key thing is we've been talking about a little bit. The fact that you're going to purchase price adjustment and how that's going to work at a high level. And if any of the purchase price components have turnout, you want to lay those things out in enough detail and specificity that you feel like you have an agreement among the partners. Part two is this is where legal plays a big part. You've got to know what are the implications of structuring from a tax perspective on the seller. One example is a lot of these small businesses may be organized as estimates.

27:30When you're going to have a rollover component, there's only one or two ways to structure a deal when the target is an S-Corp and there's rollover to avoid there being a tax triggering event for the portion that's going to be rolled over. One, you got to do a little diligence before you sign the LOI so you know you're dealing with an S-Corp. Then you have to put language in the LOI that's alluding to how you have to structure it. The problem we've had a lot of times, these sellers, these small companies have very small law firms representing them. They don't really know these issues. And if we don't put them in the yellow eye, once we get to doing the purchase agreement, we have significant pushback because they don't understand it.

28:15So you got to try to deal with that up front. Another issue is the whole management piece. You've got to figure out what you need them to be on the hook for in their involvement going forward. And that's probably one thing you can be a little less detailed about if you don't know and if you need time to figure it out. But if you have an idea, it's always good to get it in, get it agreed to. You don't get to four weeks in where you're starting to negotiate documents in detail. And all of a sudden, somebody, you feel like you had an agreement and they feel like they've never heard of it. And the fourth thing I think that could be, that's a significant thing is you want to put in the framework of indemnification in the agreement because that's always a big thing.

29:07And that's the easiest thing for buyers to say, I really want to get this purchase agreement, this LOI signed up. I really don't want to have to deal with this issue now that's kicking down the road. So again, you can get to a point where you spend a lot of money and now you're starting to negotiate documents in detail. And they push back and say, no, I'm not going to give you any identification or what they want to give you is significantly less than market. And now you can't get that deal done with your capital providers or the bank because they're looking at it and saying this makes no sense.

29:42This is not market. So you'd rather agree to that up front and clear that hurdle before you spend. a lot of money. So I got four areas. We got price and just overall structure. If you're going to have earnouts, make sure you detail it out so it's clarified like an agreement on it. The legal part with an emphasis on taxes, structures may impact that and try to get ahead of that. The third is management, clarifying it. You need to circle up some retention agreements. And the fourth is identification, just to make sure there's some liability things that aren't going to be out of context when you get to purchase agreement.

30:17The management team, so if you identify and said, hey, we really got to keep the CFO and the head of product or something like that. What does that look like in terms of language in that letter of intent? Specific, like, are we going to require a retention agreement with the next person? What does that language end up looking like? What we would typically put in, let's just say there are five managers, but we know we want to make sure we have two of them around. The other three, we don't know. The buyer needs to go through diligence to figure that out. So we would say we need manager X and manager Y to sign a customary employment agreement with non-complete language in on terms that are mutually agreed to by the parties and reserve the right to require employment agreements from other managers after further dealings.

31:05That's an umbrella approach. If the client comes to me and says, hey, they have five managers, we know we want agreements with two. One of the two that we have an agreement with happens to be the 70 % shareholder, but they really want to start winding down. And so we got to figure out how we both have a transitional period, but allow them to wind down a little bit and just keep them on the hook. and we want to be flexible. We may want to keep them on the hook 50 % of the time and reserve the right to reduce it down to 20 % if we feel like we don't need them. Then we got to figure out more tailored language to go in and put in the letter of intent just so there's an agreement or meaning of the mind with how the buyer is envisioning that transition being tailored and how the seller is envisioning on their side of the equation their vacation time.

31:57Got it. So we spell that out into a good level of detail and be pretty specific, it sounds like. I take it our timeframe we're going to list is generally, here's our diligence period and like an estimated timeframe to close? Yes. What we try to do is we'll ask for 60 to 90 days of exclusivity in the letter of intent. And if we're lucky, we build in one or two automatic extensions. So it is when we're representing the buyer. So we might say 90 days with two automatic 15-day extensions as long as the buyer is working in good faith to close the deal. And so that gives the buyer the maximum amount of flexibility and time.

32:42If we run out of time, we've got these automatic extensions as long as we're working. Of course, if I'm on the sell side, I want to limit the ability to get extensions and the amount of initial time so it goes in the other direction. Fair enough. What about breakup fees? Are we doing breakup fees on these small private deals? Very rare. But where I've seen the breakup fees come in, the buyer has been working on this seller for two or three months. They feel like they have all of the main parts of the deal agreed to, but they come to me and said, hey, this seller has started and stopped three or four times.

33:18If I sign this letter of intent, which I believe we have agreement on terms, And he does that again. The difference now is I'm spending money with third parties. I want protection. That's when we say, OK, if you want protection, we can put a breakout to concept. It's going to be a more abbreviated sort of breakout to structure. It's not going to be what you would see in a$300 million transaction with all kinds of bells and whistles. it might look a little bit like this. It may say the buyer is going to negotiate in good faith. If the seller walks away from the deal for no good reason or no reason at all, they just don't want to do the deal, the seller is going to agree to pay up to$200 ,000 for my document at third-party expense.

34:04And then you do so as a base, and then you get more detailed and creative, the more variable that come in the play. When do you usually see breakup fees? Is there a certain deal size or is it a nature of a public-private? Yeah, I think once you start getting off of$150,$200 million in a private value deal, you begin to start to see them more and more. At that level, you probably have a sophisticated private equity fund that owns the business and they're going to be selling it to a much bigger private equity fund. And those much bigger private equity funds may be a multi-billion dollar fund And what you're protecting against there is, I don't want downside risk of financing at this level.

34:48I know that that firm can get financing if they want. I don't want them to come back and say, oh, interest rates are half a point higher than I thought it was going to be. I can't get financing. So you put them on the hook to say, stand behind it. You're on the hook. You're guaranteeing the equity. And or if you don't want to do that, then pay me a breakup fee. And here's how much a breakup fee is going to be. So if you want maximum flexibility, you want to be able to walk away for a half a point or whatever it is you want to walk away from because the financing terms with your lender is not what you want, then pay me this fee and I'll give you the ability to walk away.

35:25So that's when you start seeing it, when you're getting into that size transaction where more than likely you're, if you're selling to a private equity fund, it's a multi-billion dollar fund or if you're selling to a strategic, it's a large strategic. You're going to get some assurance out of that. I want to talk about the fun stuff. It's like the actual structures. Because we talked about earnouts. We got equity you mentioned earlier. We got earnouts. We got seller holding a paper. And then there's getting like third-party financing. What do you typically see? What's the common? And does it change by industry?

35:55Give me some knowledge here. I think it changes by size. It changes that. So if you're talking about the lower middle market, I call that for my purposes deals that are probably$25 million in enterprise value or less. More times than not, you're going to see rollover involved and you begin to see either earnouts or seller finance. The lower you go below$25 million, you start to see higher percentages of rollover, higher dollar value in terms of seller notes, and a higher percentage of the purchase price being in earnouts. With one caveat, even above$25 million, if you're buying a family-owned business or a business that has a high level of customer concentration or something specialized to where they really can't go and get the full multiple they want because of concentration or headwinds in their industry, those sorts of things, then the higher rollover value and then earn outs and seller notes.

37:02to some extent, those things come into play because the argument that the buyer is making is, you know what, I can pay you X and we've agreed that's what you want to pay, but I'm not going to put more equity than I typically put. I can only borrow so much money because of these various reasons. So you got to help me out. You're going to roll over a higher percentage of your proceeds. You're going to do some seller financing or we're going to look at earnouts. And then that allows me to get the cash I need today and borrowing it from a lending source. And then the buyer is not telling the seller this, but the reality of it is you're taking on some of that risk because you have seller paper or you have an earnout that's subject to hitting certain benchmarks or your rollover activity is at risk.

37:51Those are the sides of the deal and special circumstances in the business, such as customer concentration. You could also have certain industry special circumstances as well that can come into play. It's highly regulated and it's not a highly fragmented industry. And so you only have a certain number of players that may come into play as well. But specialized circumstances for deals much larger than that, but most of the time, I call it sub -$25 million deals, you start to see more and more of these three different tools being used to spread the risk across to the sellers. Give me an example. What do you typically see?

38:30What would be... And I'm curious too of the percentage. As somebody pretty early in looking at doing deals, I'm always going to hold cash on hand and is averting the risk, like you mentioned. How do you structure a deal? Like what percentage are you putting in cash versus on earnouts and rollover? It really starts with how much financing you can get. And most people will look and say, okay, I want to get senior debt finance. How much can I get in this industry, this side of the business in the senior debt category, and they work their way down. And so they'll have an idea of, in this industry, this is how much equity I want to put into a business, into a platform in this industry.

39:10And they may have to factor in, this is how much equity I want to put in for the entire platform, whether I'm just talking about doing this deal or five add-ons. So they got an allocation for the entire platform. and whatever that allocation is, they may only want to spend two thirds of that in equity today. They take that two thirds of equity, they take what they can get from the senior lender and they look at, okay, what's the delta relative to the purchase price that the seller wants? And they take that delta and it's got to, if there's a big delta, it's got to be made up in some variety of rollover equity or not or seller paper.

39:48And they start to play with maybe seller paper isn't going to be practical because I'm really pushing the limit on the senior lender side and getting the senior debt. They didn't want any meds financing and sell a paper akin to meds financing. They don't want to deal with any of the debt. And so that kicks it out. We've got to have a higher rollover and possibly a turnout if there's still a delta. So really, that's why the first thing that parties typically do is they go out and get an indication of what they can get from a senior lender. and they start backing their way into it. And they probably do that before they put an LOI in place.

40:25They start to hold the market to see what they can get on the senior debt side. What percentage does that typically range for getting like to full senior note? On the senior side, it's looking at a multiple of the purchase price and it could be anywhere from two to five X the purchase price. But because if we're talking about these lower middle market rollup strategies, we're not going to get to the 5x because you're talking about an overall low purchase price multiple to start with. So we're probably talking two to three times the agreed upon EBITDA number in terms of debt we can get. Oh, in terms of debt.

41:01That's pretty high though. That would cover quite a bit of the purchase price. I'm used to doing real estate deals. I came from hospitality. So everything was always like 80%. I always look at multiples for these smaller businesses. They're certainly going to be less than five, nine times out of 10, less than four, but probably somewhere between two and a half and four. If someone can get a business block for two and a half X, then they'll be borrowing just senior finances. They'll hedge their bets with a small amount of rollover equity and then the rest of their own. And so the better deal you can get in terms of that multiple, that then starts taking one or two of the options from your toolkit off the table.

41:41But remember we were talking earlier about a seller being difficult when it comes to working capital and various different things that go into the purchase price. If you have a difficult seller, but you really want to get the business and now you've got to bridge the gap, then you have to start bringing in those tools from your toolbox. This is why the interest rate matters. Interest is low, capital is cheap. That's the direction you want to go. When it's not, then you really start rethinking things. Absolutely. That's why when interest rates are high, the slice of the market that's impacted the most are the multi-billion dollar private equity funds.

42:18Even though they are borrowing similar multiples, the businesses are so large and the aggregate dollar amounts we're talking about borrowing and the interest burden on that is a lot. And so those firms tend to step back and they focus on portfolio company add-ons because nine times out of 10, unless that company is not doing well, they can do an add-on and do it with primary debt because they're just part of the arbitrage. So they don't have to put more equity in. Now, in that circumstance, they will take on the additional interest rate burden because they're not putting in more equity. And if it's a cash flow in business, they'll pay it down as quick as they can.

42:59On the flip side of it, you see a lot of deals still getting done in the lower middle market side, even when interest rates are high, because we go back to the two or two and a half X. Relative to the overall size of the business, you're not highly leveraging these businesses. And you're using these other tools as hedges. Is this why we're seeing a lot more earnouts? It seems like everybody's doing earnouts in shape or form. A lot more in the last two years. Earnouts and seller financing have been a much bigger part of the industry than prior to that. Nobody says that with a lot of excitement.

43:36Everybody has some fast aggressive statement of, hey, we're doing an earnout, but it seems like there's challenges with them. A lot of buyers will go into it. I ask this question all the time when we're dealing with how to structure the earn out. And sometimes I'll get from a client and I'm trying to get a certain level of specificity in the earn out language so that we don't have a lot of arguments. And they'll tell me there's no way they're going to come close to earnings so it doesn't matter. So we document the earn out as best we can. Fast forward, the seller thought there was a very good chance of getting it.

44:12And since they thought it was a very good chance, the buyer thought there wasn't. Of course, the buyer is not saying to them, we don't think you're going to earn this. Now there's a fight because the seller believes the reason I didn't earn this turnout is because somehow you did something you shouldn't have done. And you did it on purpose to prevent me from getting it. Is there like a best practice? And I'm almost curious about getting like an example language of how you would put that in the LLI. As it relates to earnouts? No real best practice other than I take the earnout and I look at it in a couple of different layers.

44:51And the first layer is what's the performance have to be? What time period we're talking about? And what are the four or five components of determining if this number is hit? it. And if the number isn't hit, if 90 % of the number is hit, are you going to do it on a pro rata? And if you are, then what's the minimum percentage of that number has to be hit to do it on a pro rata? And if you don't get it in the first year, can you make it up in the second year? Those are all questions I ask. The next layer is, okay, those four components that determine how you calculate it, let's break down each one of those components.

45:29Tell me what it means, what gross profit in this business is. We don't want to just say gross profits. I want you to tell me all of the components of gross profit. I was calculated today so I can describe in the language the definition of gross profits. And I work my way through each of the components to describe them. And then the next layer that I talk about is, okay, how is this business layered from an expense perspective today? And is it going to be the same way? In other words, it has a certain set of expenses that go into the calculation today. And let's say two months after the deal closes, you do an add-on.

46:09Are those businesses, can you combine those businesses? Can you layer on more expense? What are the parameters there? We figure out if there are any limitations on their ability to operate the business or change the business from how it historically been operated. And the last thing I always try to get in is, what's the implications on your credit agreement? with this earn out. If you're busting covenants in your credit agreement, but it doesn't really relate to... If this business is doing well, but you've combined four businesses, so your overall business is not doing well, can you still be forced to pay this earn out?

46:45And the chances are no, because your lender doesn't care about just this segment. Your lender cares about the entire business. So I want to build in language that makes it clear that it's not just the operation of this one business. It's the operation of your entire business and your covenants for your entire business that impact it. And if the scenario I just described is the case, then what determines when you can make? And are you going to make it up because it wasn't their fault? And the last thing I'll say is, what happens if you sell the business? The business is knocking it out of the box.

47:19We got a strategic that came out of the woodwork and offered you three times what you paid for, does that have an impact on the earn-out or does the earn-out continue to go on in its normal course? Is it going to be accelerated? All of those different variables are things that I try to think about and walk through with the client and build in that specificity. And as you can see, it can begin to get very complicated and layered to the extent you don't deal with any of the issues I described. It's just laying out a potential for dispute. I'm going to stop drafting my own LOIs. From here on forward, it's official, everybody.

47:58I'm no longer going to draft my own LOIs. I'm going to call a carrier or somebody to help me. What's crazy, weird stuff you've seen in LOIs? Not a whole lot of weird. The craziest thing is a listing of weird assets that the seller wanted to take. Everything except for... Sometimes it's just great. There's a painting that's owned, or I want to take the life insurance policy that's on my life. Those kind of things, those can get weird. But on a practical side, the craziest thing that I've seen with these smaller deals is the buyers agreed to buy a business for$5 million. And everybody's agreed and now they were putting it in the LOI and they bring some lawyer in that's not even an M &A lawyer, they're a litigator.

48:48And language comes back to say, you're buying a business for 5 million, but you have to pay for inventory and you have to pay for AR separately. Separately. This makes no sense. The whole idea of a business is you're buying a business that's operating, it means it has AR, working capital, all of that. That's probably the most frequent thing that I see that's just weird and it makes no sense. If you were sophisticated and did these deals all the time or you're confident, you would know that this doesn't make any sense. But we see that a fair amount. That's interesting. I could see it in small businesses.

49:26Can you give me some do's and don'ts of executing on roll-ups? What have you learned from your experience? The biggest thing not to do, I touched on it a little bit earlier, is it's very difficult for these buyers to not get ahead of themselves. And I try to push back. And here's a very real example. They signed the LOI. They have promised that they can get this deal done in 60 days. But they already know they can't get it done in 60 days. And they just said, when we get down to the end, we'll just renegotiate. To me, that is a big don't do. the reason we're trying to do it that way is because something tells you that this seller is unreasonable.

50:10And why would you spend money and set yourself up to deal with an unreasonable seller after you spent money when you can just deal with an unreasonable seller up front and know if you're going to be able to get past the issue or not? And so that's a big don't do it that I see a lot. Okay. Don't create surprises for yourself. Yeah, especially when you know the surprises. Any other do's or don'ts? I'm fired up. I'm ready to go roll up some sector. I don't know which one it is, but... Another don't do is don't kid yourself about financial dealing. If you're trying to buy a business, you're probably fairly sophisticated.

50:50And so you've had enough information to know that I have a 60 % confidence level in the financial information I've been provided. If that's the case, go do your financial dealing list. Even if the seller is telling you, we need to go, go, go. And so they come to legal and say, get legal started. You already know that you have doubts about the financial outlook on this company. So go figure it out. Go cut a deal and then come back. That way you don't get yourself again, like the other example, where you've spent money and you've painted yourself in a corner. I'll add this for balance here, one thing to do.

51:29I like to see people in every transaction hit the primary points of the deal and get them agreed to. If you just said, hey, here are the four or five things that are important to me in this whole picture from a business perspective. Let me just make sure every deal I go down the path that I have a satisfactory answer and agreement on those four or five points. And if you remain disciplined to doing the work to get that agreement up front, it's going to save a buyer a lot of headache down the road. One more do, and it's not a legal thing, but be fair. A lot of times these sellers don't know certain things.

52:11And so a buyer will know, okay, if you said X, but that's flat out wrong. Be fair. I think it earns people goodwill to go and say, hey, that's really not right. Here's the way these things work. And maybe the seller appreciates that it earns you goodwill. And again, it prevents you from dealing with something down the line. I'm a big proponent of hit the business points as best you can, hit the important legal points as best you can to avoid paying yourself into a corner where you end up doing something that a rational mind wouldn't do because you feel like you can't walk away from the deal like that.

52:47That's so true. The reputation is so there and it spreads so far with M &A and how you do deals with all the other folks in the industry. Absolutely. Gary, what's the craziest thing you've seen in M &A? I know you're a lawyer, so you don't have to name names or dates. We'll protect the innocent. Hey, you got to tell me, what's the craziest thing you've seen in M &A? Two things. We were doing the deal and we're all in the conference room. We got lawyers on the buy side, lawyers on the sell side. My client was the buyer and the primary seller. This guy, this business had been in his family, I don't know how many generations, but I knew at least three generations.

53:28And this guy, up until this point, everything about this guy said he wanted to do a deal. He was a nice guy. He was genuine, fair, not difficult in negotiating. and we were close to signing this. We were all in the conference room. We were buttoning up a few points and we either was going to sign it that evening or early the next day. All of a sudden, the guy, he disappeared. Nobody knew where to go. And 20 minutes went by and all of his people were in our room. Somebody from the reception area came in and said, hey, there's somebody in the men's room sobbing. So my client, I said, I don't know, maybe it's him.

54:10and my client goes in the men's room and this guy was falling like a baby because it had all of a sudden hit him that he was really about to sell his family business. And he realized he didn't want to do it, but he was so honorable that he felt so bad for leading everybody down this path for so long. That's why he was fine. Wow. The weirdest thing I've ever witnessed. Did he do the deal? No. He came back in the room. He apologized to everybody and said, I'm sorry. I didn't mean to do this, but I can't sell this deal. Now, he ended up turning the business over to his son. And a year and a half later, that same buyer bought the business from the dad in partnership with his son.

55:04So the family will maintain control. that slept 51%. My client, instead of buying control, bought 49 % and the deal got done. Wow, that's a pretty good happy ending. It's a good story. It's a good story. Awesome. The other one was, we're doing a deal and it was New Year's Eve was on a Friday and New Year's Day was on Saturday. We had everything done. Documents were getting ready to get signed over. And so because it was New Year's Eve, Banks were still open so you could wire money. We're trying to figure out, okay, all documents are signed, let's wire money. The CFO comes in and he had a check for$50 million.

55:49We were representing the buyer. And the reason he had a check for$50 million was because that Saturday that happened to be the first, it was one of those businesses that their fiscal year ended the Saturday or 51st Saturday of the year or something. and it fell on the first. So even though it was the first of the next year, it was actually their fiscal year end. My client's fiscal year end was that Friday, the 31st. And so they closed the deal with the$50 million check that was dated. Our guys could account for it one way. The sellers could account for it another way. And that's how the deal got done.

56:29The largest check I've ever seen in person. That is insane. I've never seen it. Yeah, I've never heard of a check that big. That's so funny. Yeah. That would have been the moment to bring the giant check out. Let's just get some press out of this and have some fun with it. Gary, this has been a lot of fun. I feel like I learned a lot about the legal aspects of doing roll-ups and earn-outs. You've helped me become a better M &A scientist. It was a lot of good questions, so I enjoyed it. Appreciate it. Thanks for the time. Those of you still with us, thank you. Love to hear from you. Reach out to me on LinkedIn.

57:02Love hearing feedback, topic suggestions. Till next time, here's to the deal.

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