Selling a Small Business Unit

22:53What are like scenarios or examples? You did a couple, but I want to know more just to expand my peripheral when it comes to negotiating these deals. Sure. The employee one is pretty easy for at least a certain period of time. You don't want the employees bad-mouthing the transaction, the sold employees. Maybe I would have reduced benefits this year and it would have saved me$50 ,000. It's probably worth it for you to say, hold off on doing that for a year so that we have time for the deal to settle. We get to distance our brand from whatever you're going to do to those employees. We'll take$50 ,000 off the purchase price because we really don't care that much about that.

23:30We don't want anything to happen to those employees until they are clearly your employees and they're separated from us. You would want to negotiate that as a seller? Yeah, absolutely. I have negotiated. I've divested businesses. But how do you know? Do you, that part of your diligence as a seller? The, hey, what do you plan to do with their comp plan? No, usually you can certainly ask. The reality is I can probably tell because I can put myself in their shoes and say, what would I do? And I know my own comp. I know my own benefits. And then depending on who the employees are, what kind of employees are, where they are in our business, I care more or less about that issue.

24:05And I'll proactively go to you and say, this is going to be part of the contract. This is a give that I want your rep that you will not change benefits or comp structures for the first 12 months after the closing day. Usually, I can figure out what they're going to do with the business because it's not that complicated a business. This is a small business. It's millions of dollars of revenue, not tens of millions of dollars of revenue. I can usually guess what their playbook is, whether they're a strategic. Legal is another great example where I think you have huge value creation because the reality is statistically, other than in cases of fraud, almost nobody sues anyone over M &A.

24:41The number of litigations over M &A transactions as a percentage of deals is insanely low. but every lawyer autopilots to heavy reps and warranties because they feel like morally, I should be able to sue you if anything is not accurate. Getting to the buyer and saying, look, just wrangle your lawyers because we don't want, unless we committed fraud, sure, you can come after us. But for small things, for things that are just, we got it wrong, the data was a little bit off. You're just not going to sue us over it. So let's not pretend you are. And let's give our GC comfort by just taking that out of the agreement.

25:17Sounds very familiar to selling how many software to large corporations like you worked for. Yeah, absolutely. Large corporations, lawyers are trained quite appropriately to worry about catastrophic events because they're deep pockets. So the potential for a lawsuit in the GC's mind costs a lot more than the value that the buyer is actually seeing from those reps and warranties. It's different if you're selling a billion dollar business. If you're selling a$5 million business, coming to the buyer and saying, Let's just take those out. Or step one is let's take those out. Step two is let's take those out and let's just reduce the purchase price by 20%.

25:53All right, fine. We'll do that. I'll agree to take more risk and let the price down. Yeah, exactly. Anything else like odd things to negotiate? There's a whole maze of ongoing commercial relationships. So we talked about the TSA, but there are usually ways to create more value for both parties. So a good example is I'll let my sales force keep selling the thing for you. You'll give me a reasonable rev share, but you have to agree to a non-compete against these five competitors. I'll keep selling the product. You get access to my massive sales force, but you're not going to go play with, at least for the next two years or three years, competitors one, two, three, and four.

26:30That benefits me because it puts them at a disadvantage. I'm retaining some go-to-market from your side. Exactly. You're retaining some go-to-market, maybe even a revenue commitment, depending on how bad I want it, how bad I want the non-compete. So maybe I even give you a minimum revenue commitment. Technology licenses are another one. Whenever you have a technology business, there is some chance that that technology or that data has been isolated in a hidey hole to just this business, but it's much more likely that it's bled into some other parts of my business. So I probably need ongoing access to it.

27:00Or the flip side is the business I'm selling doesn't actually own all the technology necessary. You're gonna need to license some of my stuff. Those are all opportunities to create value. The seller gets a bunch of revenue running through them. They get to show a new product to customers, all that kind of stuff. The buyer doesn't have to build all of it from scratch. There are a bunch of these sort of win-win scenarios in these ongoing relationships. The easy way to think about it is if this business has any tendrils into the rest of your company where you tried to create synergies, whether they worked or not, that suggests a whole set of synergies that you may continue to want to have with the buyer.

27:37If you truly isolated this thing in a lockbox and you never integrated it with any other part of your business, maybe that's not true. In my experience, that's a relatively rare fact pattern. What's the biggest valuation gap you've had? When I'm selling one of these things? Yeah, or even on the buying side. I would say the biggest valuation gap that we were able to fill. So start with insane valuation gaps. Any corp dev officer always has this, where you show up and go, I think this is worth a dollar. and you say, oh, it's worth$1 ,000. It's like that TV show Pawn Stars. Okay, we should just stop talking now.

28:11If you set those aside, I'd say probably the biggest valuation and gap I've seen on a divestiture was probably like about a$5 million gap, which sounds small, but it was on a business where we wanted to get$10 million for it and they wanted to pay us$5 million. So it was$5 million, but it was 50%. Yeah, so half. Okay, that's why I was trying to get the spread. About half. That's a pretty big gap. We were able to fill it. Yeah. How'd you do it? We basically pulled all of the stuff. First thing to go is all the reps and warranties in the agreement. We're like, we're not going to spend any time with our lawyers on this.

28:44Here's the agreement. Here's the seller friendly agreement. You're going to take it. The only thing we want you to do is fill in your address. Second, we beefed up the TSA. So we actually wanted a big TSA because we had a bunch of stranded costs in our organization. Like this business had been using a portion of a finance person, a portion of an HR person, a portion. And we couldn't immediately size all those organizations because this was too small a sliver. You can't fire one-tenth of an HR person. We actually wanted a very robust TSA that was going to last for three years so that we would have time to grow into needing that person to do other stuff.

29:22And frankly, we had them pay us rack rate for it, so it became a profit center. So we increased the amount they paid to be what it would have cost them to hire these kind of resources on the open market. So full cost. And that was nice because that ran through our P &L. And then we got some technology licenses, we got non-compete, which was important to us because we didn't want, we thought it was a bad strategy. That's why we wanted to get rid of the asset. But we still didn't want any of our competitors to get any benefit out of working with these guys. And so all that stuff together was able to get us comfortable with a lower price.

29:56The reality was our fallback was shut it down. If you think about it, shut it down is not just zero, shut it down as a negative number because you have to pay money to shut it down. You have to pay a bunch of severance. Shut it down as a negative number. Five million was a materially positive number. So we were happy with that. Let me get a sense of what do you need to come to evaluation? Because right here, there's this piece we just talked about. We can be way far off and forget about it. This is not going to happen. I really want to get to that point as quick and inexpensive as possible. 100%.

30:27What exactly do you need to be able to do that? The way I like to operate is first, I have my own valuation expectations. I'm in the business of buying assets. I'm doing rough valuation on 100 deals a year. So I go through that same process as if I was buying this asset. And I say, what's the reasonable valuation? Then I say, what would I really take for it? I'm not going to share this with the buyer, but it's a much lower number. Because I'm looking down the barrel of a shutdown that's going to cost me a couple of million dollars. So I have those two numbers in my mind. So if we take the example, 10, and frankly, it was probably more like three.

31:03So I thought if somebody were trying to maximize value, if a private equity fund was spending off this business, they would pitch for a$10 million valuation. So that was full market valuation. We would have been happy taking three. Once I have that in my head, I ask for indications of valuation super early in the process. I give people that package of material. I tell them next step is going to be an LOI. You can have one call with the management team, ask questions. And by the way, either before the LOI or at the LOI, I expect you to give me a valuation range or a valuation amount. And that allows me, without having done too much custom work on the buyer, if you think about it for a second, what have I invested on that buyer?

31:42I made one phone call to initiate contact, another phone call to give them a description of the deal. I emailed them stuff that I had already set up. Oh, that's another point. NDAs are not going to be heavily negotiated. It's going to be as is. I'm not burning my lawyer time going around and around in the NDA. I'm going to put forward a very reasonable NDA. When they send back, everybody does this. They send back comments on NDA. Then what do you do? I say, we're glad to accept our original version of the NDA. I personally hate NDAs. They're one of the least valuable legal documents. Like if you actually ask any lawyer, what percentage of NDAs that they have structured have been litigated, I'm going to say it's not even, I'm not even sure it's measured in basis points.

32:21So I personally think NDAs are a waste of time. If somebody really cycles with me on a reasonable NDA, They're not that serious about the deal. So I've had a couple of phone calls with them. I've emailed them stuff that I already had prepared. My management team gives them an hour, even an hour and a half call. That's all I've invested in them as an individual buyer by the time I get to an indication of valuation. And in some cases, I might even give them body language on valuation early on so that I'm not wasting their time either. I would expect to get one to two times revenue or two to three times revenue.

32:52And if they are way off from that, then they'll just make it known there because they don't don't want to waste their time. What if you pitch this deal and it strikes iron while it's hot? You get a bunch of interested parties. How do you handle that? I don't think you change your behavior very much because here's the only thing I'll say. If I totally misread the value of the business and it's much higher, then it may justify investing more of my resources and running a more robust process. But you don't put that out there when you're pitching the deal, what you're asking for? No, no, no. But I'm saying if I put out the material thinking I'm probably getting 5 million bucks for this business and a bunch of people come back and start to give me body language around valuation at 40 million, 50 million, then I'm going to pivot and I'm going to run a much more rigorous process because I want to extract that value.

33:41Getting 10 % more on a$5 million deal is not worth it. Getting 10 % more on a$50 million deal is worth it. I have never seen that happen. In my experience, when you're divesting a subscale business, the bid-ask spread is no one wants this thing or a few people are somewhat interested. Because the reality is, if it's a rock star business, it's not getting divested. It's very rare that you see a 400 % growth business get divested. These businesses are usually, if you're generous, a diamond in the rough. If you're not generous, a falling knife. It's very rare that you get way more interest than you thought.

34:19Actually, the reverse problem is usually the case that we go out thinking, yeah, there's probably 10 people out there that are going to be pretty seriously interested. And the first eight we talk to go, nah, don't want to look at it. That's the more common problem is, wow, do we just have a busted deal here? Yeah. Is there a dumpster for those deals? Oh, yeah. Well, the dumpster is shut down. Yeah. Wind down. Which is horrible for a whole bunch of reasons. Not good for morale. What's the hardest part of selling a small business unit? One for a corporate development officer is not running a rigorous process.

34:49We have all been wired with best practice. We've all spent hours watching M &A science and learning the way to do this. There's something in our wiring that makes it very uncomfortable to not pursue best practice. But you have to understand that the juice isn't worth the squeeze, that for something that's really small, you have to apply the right amount of resource, given the size of the thing, given the impact of the business, and given the fact that it's a divestiture. Acquisitions and divestitures, it's like the difference in puts and calls. An acquisition has infinite potential upside. A divestiture does not.

35:24You can make some, there's some benefit to those ongoing commercial relationships, but for the most part, a divestiture is about stopping the pain and getting a small amount of cash on the balance sheet. The first thing that's really uncomfortable is saying, I'm going to do this. I'm not going to think about it as doing it in a half-assed way. I'm going to think about it as doing it in an efficient way that's appropriate to the size of it. The second one is a cultural thing in companies where divestitures are viewed as failures. They're viewed as failures by the businesses. And somehow, corp dev officers often don't get the credit that they deserve for doing an effective divestiture.

35:59Your path to promotion is not covered in effective divestitures. Nobody goes, that's the person we're going to promote to vice president or to SVP. I think those are the two things that are particularly tough about divestitures. But what I like about them is it really is an opportunity to create value. It's just value in a way that people don't want to see. Stopping the pain. I put a Band-Aid on my daughter's ankle this morning. Stopping the pain is of great value. That's really good. Can we go off record, but still be on record? Sure. Of course. I'm really interested in buying one of these carve-outs, man.

36:33You got me fired up. Talk me through it. How can I work my way into one of these companies, find a corp-deb person like you used to be? Remember, there is a dark side of these. These are not, as a general matter, rock star businesses. I know. I like hairy deals. Okay. That was my background. Yeah. As long as you recognize that they're hairy deals. You got to work harder on them. Let's put a little disclaimer. You work harder at them. Yep. But they can be really rewarding if you know what you're doing. Absolutely. If you don't know what you're doing, they could even be even worse. That's right.

37:03The first thing is that self-awareness that says, this is a dusty hairy deal. I'm going to have to do a lot of work on it. The second step is figure out where you're the natural buyer. You want to be a better buyer than everybody else who is out there. It's in a space that's natural for you because if you're a strategic buyer, because you have lots of synergies, because you understand the dynamics of the business. So it'll be easy for you to take it over. It'll be easy for you to integrate it. These are all things that are going to make you a more natural buyer, which has a couple of benefits.

37:36The first one is it means that the corporate's more likely to reach back out to you if you put yourself on their radar. If I'm a corp dev officer in a software company and a guy who only runs professional services companies calls me and they may say they're interested in my assets, I don't see how they're going to be successful. So I think that's going to be either a looky-loo or somebody who bails at the last minute. Number one, be the natural buyer for the asset. Number two, do the market intel? Find out the assets that are struggling assets. Because generally speaking, by the time a corp dev officer has been asked to divest a business, the business has been an ugly stepchild for a while.

38:20It should be common knowledge within the company. And you want to try to get in early because once the corp dev officer has the asset, they're going to move fast. If they follow my guidance, they're going to move super fast. and they're going to try to get the process done quickly. They're not going to call 50 potential buyers. They're going to go, because remember the conversation we had earlier, the goal is not to touch every potential buyer and get the maximum value. The goal is to go to the five or 10 most natural buyers and just get a deal done. Being out in the market, talking to corp dev officers who look at your existing business and go, oh yeah, I can see why, is probably as good a way as any.

39:00And then there's a matter of luck, right place, right time, because these assets come up for sale when they come up for sale. The one other thing I'll say is there is no harm in asking to extract an asset. If you know of a business inside of a large corporate and it's not officially, quote unquote, for sale, but you've heard rumors that it's not getting growth funding. They put it in a basement somewhere. It's sort of being treated like an unwanted asset. There's no harm in reaching out to the corporate dev officer and saying, hey, I know you have this business. I think it would be a great fit.

39:33I don't know if you guys have considered selling it. I'm trying to stimulate that conversation. Okay, so the sourcing part, there's a lot of what you described of bottoms up, like really doing some market research, identifying these businesses, which you can absolutely do. The third-party database and Google, LinkedIn. Other I was curious about is TopDown, where if I know there's a large player in the space and they have tons of business lines, which it's hard to sometimes get familiar with all their business lines. Yep. But I reach out to the corp dev and saying, hey, just curious if you got some little thing you want.

40:07No, that's probably not the best way. You can. And if you have a close enough relationship, maybe they'll tell you. It's kind of like the friend of the business where. Yeah. But the reality is the corp dev officer doesn't want to focus on divestitures until a divestiture is needed. That's not what they want. their day job to be. I need to come in with a bit of an investment thesis. I think that's right. And I think the most important thing, and frankly, this is what we do. It's a core part of our strategy is you have to communicate to the seller and to the corp dev officer. I understand your business.

40:37I understand your constraints. I want this asset and I'm going to make it the best result for you. So that's something that we do to differentiate ourselves from all other buyers. Why should you deal with us? You should deal with us because we already know how to create a deal that optimizes for a corporate seller. The only thing better than having a buyer who is willing to do all the stuff that I just listed, be flexible on the reps and warranties, take care of the employees, take care of the is a buyer who comes in and you don't have to tell them any of that. They already know it. When I show up to a corporate development officer, I go, I've been in your chair.

41:16I know how to structure a deal that will optimize for you, how to get what you need and get what I need. And the likelihood of the deal getting done fast, clean, and it actually closing is way higher with me than it is with other people. There's a reason why you would want to sell to me. It's a thing you want to get rid of, and you're going to get a good outcome. That last part is, I'm not going to waste your time. This isn't going to all blow up on you. Because for a small deal, the failed deal is a horrible outcome. Let's role play this out. CEO of M &A Science. We have one of our business lines, the Data Room product called Firm Room.

41:55And this is a really profitable business for us because we carved it out of our Deal Room product and made a standalone Data Room. But this market is very fragmented. There's like 100 Data Room providers out there. There's some really old ones, very stagnant business that are privately owned. But I've also found some corporations. I remember NASDAQ used to have their own data room. I think they actually built it in-house. I had this thing in the market for two, three years. And this thing like nowhere in sight is going to be a competitive business model that they'd want to, they probably realized that like we got to kill this thing.

42:24I think they just shut it down. But that would have been a good one. And there, what I would have done is I would have gone to them proactively and said, I think that I am a better home for your data room product. And here's the benefit to you of doing that deal. and purchase price should not even, it either shouldn't be on the list or it should be a relatively minor point. Because in the grand scheme of things, does NASDAQ care about a few million dollars for a purchase price? No. But saying we can then provide a white label NASDAQ product that you can still deliver. We can cross sell other NASDAQ services.

42:59I don't know if this is the right answer. You'd have to research them. But putting together a conceptual package that says if NASDAQ sells this data room business to me, here are all the revenue streams and cost savings that are going to flow to NASDAQ and brand benefits that are going to benefit you. The mistake people often do is go to a corporate and go, I want to buy that little business for$5 million. And frankly, the corporate's reaction, it's the same reaction as if I said to you, I want to buy that pen from you for three cents. I don't care one way or the other. I'm not even going to bother having a negotiation with you over three cents.

43:32It's too silly to me. What's my pitch? So I think your pitch is, again, not knowing NASDAQ that well. well, you've sold a bunch of customers on this. You don't want to run this business. It's not a core to your business. Sell it to me. I will take care of your customers. They won't be mad at you. I will offer you a white label product. So if you think you can still sell this, you get all the benefit of selling it without running anything. And it'll be a better quality product than the one it was. Right now you have this product that you're really not paying that much attention to. I'm a market leader.

44:00So if you're selling a white label NASDAQ version of my product, it's going to be a really good product. You could also sell the adjacent products that I have. We can talk about white labeling them. I will not cut this kind of a deal with any of your direct competitors. And I'd throw in the transition services stuff. I'm going to need some transition services from you. And of course, I'm glad to pay generous price that will run through your P &L. You're too young maybe to remember this, but the old ads, this is your brain, this is your brain on drugs. This is what you have now, a little subscale business that's not strategic, that's sort of an annoyance, but that puts you at risk with your customers.

44:35because when you sell it to a big customer, then you're beholden to them. The new scenario is you don't have to worry about any of that. You still get all the benefit of providing this to your customers, maybe even more benefit, other services. Your customers are happy. You're getting more revenue and you're getting much higher margin. You don't have to maintain this weird little technology that you don't really understand. Doesn't that sound better than that? Focus on the business impact that you would make. Yeah, exactly. Remember that for them, if you think about the order of importance, The lowest importance is balance sheet for something this small.

45:08P &L is more important. In some cases, customer relationships, brand, and market presence are even more important than P &L impact. Try to focus on those top two things, not only because they care more about them, but because you care more about the bottom thing. Get them all hyped up on the top thing. Go, in order to have all this great stuff, we, of course, are going to have to talk about a very reasonable purchase price. And at the end of the day, they'll be fine with it. They won't care. Complementary versus competitive. This example is actually competitive for going after another data room product.

45:39Complementary, it makes sense. We don't go too far from our core. But hey, this seems like a good part of the strategy. We'd acquire the business. Pretty straightforward. A lot of conversation. We don't have any sciences around those scenarios. If it's competitive, where most of them realistically are tech stacks, probably 10, 20 years older, outdated, clunky, much better product. But that's fine. And buying revenue, buying customers, buying brand, buying employees, there are lots of things that you can be buying in that deal, even if you're going to retire the tech. You do. That still is okay.

46:09You can still be upfront about it and say, hey, we can run this, provide a better experience to your customers. In fact, I mean, without insulting them, you're saying exactly what you're saying, which is when we migrate your customers over to our platform, they'll be getting a better experience. This is what we do for a living. This is not what you guys do for a living. So we're going to give them a market-leading experience, either for the customers that you already sold the product to, so they'll be happy, or for customers you're going to continue to sell this to if you want to do a white-label deal with us.

46:38People are smart. They understand if they don't have market-leading tech. The person who built the tech may not want to hear that, but the person you're talking to, the corporate development officer, the division leader, doesn't have an emotional entanglement with their tech stack. They just want the best thing for the business. I'm fired up. I want to go talk to some of our strategics in the industry. Yeah. There are good assets out there. People focus on acquisitions, but not all acquisitions turn out well. Some acquisitions are big and come with multiple parts. And maybe you like nine out of the 10 parts, but not the 10th part.

47:12But inevitably, there are a large number of assets that haven't found their home. When it comes to negotiating terms with these large corporations. Yeah. Do an earn out, owner financing. Oh, yeah, yeah, yeah. Yeah, you have to be careful because some of them will be willing to own a minority stake in a third-party business. Some of them just philosophically will not want that complexity. But you can absolutely talk to them about earnouts. Some are comfortable with it, some are not. But again, remember, they don't have a balance sheet problem. The treasury accounts probably have a billion dollars in cash.

47:46They don't need your$4 million. It just gets put on the pile. Yeah, you can definitely do that. Or the other way to do it is pay very generously for things over time. So my TSA expenses, I'm not going to negotiate with you. They're going to end up being$3 million higher than they would have otherwise been. But it's$1 million a year for three years. But then I'm going to push hard on the purchase price. Effectively, what you've done is a little bit of seller financing. How does it impact taxes? Everybody rolls their eyes if I bring anything about taxes. No, no, no. If you think about it, as long as all the accounts are valid, and I'll leave that up to a CPA, it lowers your purchase price.

48:23So it does lower your basis, but it also increases your losses or reduces your profitability. So it's running more money through both parties' P &Ls and less through their balance sheets. For the large corporate, I don't think it matters. It's so comically small, they're not thinking about the price of the patient. Exactly. This has been good. Yeah, good. What's the craziest thing you've seen in M &A? Apropos, you've asked me this question a number of times. I've given you different answers, But apropos this topic, I saw a deal. It was a 8 million revenue business unit of a much larger company.

48:58It was about breakeven. They decided it was off strategy. They wanted to sell it. And they really wanted to sell it. Unfortunately, they had a couple of different failed sale processes. Buyer went pretty far down the line, then decided no. But they still had buyers that were interested. But they reached an internal decision. And this goes to the point I made earlier in this conversation, that the noise and distraction associated with the sale process was too much. Even in the face of having buyers at the table that wanted to do diligence and negotiate, they just shut it down. They just fired everybody.

49:35You and I sit here going, wow, 8 million revenue tech business, that's got some significant value to it. But in their eyes, the distraction factor of continuing a sale process that had been bumpy and hadn't achieved anything, it was worth it for them to take$0 and pay out maybe a million dollars in severance to just stop the pain. It's the case study for why there is this opportunity with subscale divestitures to create value by bringing the right two people together at the right time. How would you save that deal? I'm not sure if there's a way of saving that deal other than getting the buyer front and center with them earlier in the process before they reached the decision that they were just going to shut down.

50:20Because once a company reaches a decision like that, they're just going to do it. The wheels go in motion and everybody runs. So I think the only way of saving that would have been for the buyer who wouldn't have ended up walking away to get into the process early enough and turn it into a successful process. I would have gotten the jet. I would have been spending some T &E on the corporate card and said, hey, let's discuss this over a few drinks. Yeah, that's part of the problem with this. is that on a small deal, the problem is nobody wants to spend any time on it. That corp dev team, this was probably their fifth priority behind four really important acquisitions.

50:56And so at some point they said, you know what? This has been going round and round. We're not getting anywhere. They got fed up. They got fed up. They're done. Yeah. And it was too small. I go back to the pen analogy. If that pen stops writing, you might lick it, try it again. You might tap it on the desk. But at some point relatively soon, you're just going to throw that pen in the garbage and move on. in the grand scheme of Kisan Patel, it's just a crappy little pen. Wow. I'm going to start looking for more pins in the dumpster. Yeah. Michael, thank you so much for the time today. I enjoyed this conversation.

51:27You helped me become a better M &A scientist. Thanks, Kisan. Those of you still with us. We got a little extra bonus conversation towards the end. Till next time, here's to the deal.

51:49Thank you for taking the time to explore the world of M &A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M &A function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email, Kisan, K-I-S-O-N, at mascience.com. Or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter.

52:34Again, that's mascience.com. Here's to the deal.