What Do Investment Bankers Really Do?
Investment bankers provide mergers and acquisitions advisory services to essentially three group of people. The first is tired of working in their company and are ready to move on. This group wants an outright sale. The second is excited about what they’re doing, but they want to take some chips off the table and diversify. This group tends to get a private equity recap so they keep part of the company. The third group wants to grow what they have, so they look to acquire something else.
There are also basically three market segments investment bankers deal with. The first is the main street segment, which is the local business valued at under $5 M of transaction value. The second segment is the $10-250 M area — the so-called middle market, which can be further divided into the lower-middle market and the upper-middle market. The third segment is the big transactions, the kind that end up in the papers. These are $200 M in transaction values and above.
So you need to look at what your business is, what you want to do and the kind of representation you require to make those two facets line up.
The more you know about those two key things, however, the better. Now’s the time to analyze your business and do the most thorough due diligence yet — do you have your financials in order so you and anyone looking into your business would be able to see what it’s true value is? Can an outsider easily tell where you get your revenue from and how your future cash flows look, in a dependable and realistic manner? Have you assessed and addressed the risks present in your company, from the front line through to your ability to stay current in the market?
And, looking at yourself, are you as fulfilled and driven as you were the day you started your company? Are you finding yourself looking to new projects and wistfully wishing you could dive in… but can’t because you’re strapped to your current enterprise? Are you looking to take a step back from your business to take some personal trips, start a family or even retire? What are your needs outside of the business, and are those being met? Financially, would you be set to thrive after you exited your business with where it stands now?
Once you have a clear and thorough understanding of your business’ health and your personal needs (including your goals for the next 5-10 years, if you can), you can start looking at your exit options — which, as Mark points out, could be an outright sale, a recap or even doing an acquisition to grow your empire.
An Investment Banker’s Take on Value Drivers
Mark makes a good point about valuations. You need to know some of the basics in order to start a conversation with a potential buyer or investor, but you don’t necessarily need to do a full-fledged appraisal. This can be done further down the line, if you like. But you do need to know some key information like: historical financials, customer concentration and some of the appropriate quantitative analytical information needed to get to the meat of the operations and assess their health.
There are 20+ value drivers that buyers look at. If you’re serious about selling, you’ll want to consider these drivers as well. There are two categories of value drivers: internal and external. External ones are hard to do anything about, such as barriers to entry, but being aware of them helps you understand what you can and cannot control when going to market. Focusing on key internal value drivers, like a strong second line management team or strong standard operating procedures, is where you want to focus your energies. You can make a big impact on your company’s value to the market if you have strong internal value drivers.
This really boils down to how self-aware you are as a business owner. How big is your blind spot when it comes to your business? Most of us see our company through rose-colored glasses. That’s fine… until you’re thinking about selling and trying to drive up the value of your business. So once you’ve had someone hold up a true mirror to yourself as an owner and to your company as a marketable business, you can really dive in there and tackle some of those value drivers you’re struggling with. You have the opportunity to make changes and improvements which will in turn drive up the value of your company by focusing your energy where it counts.
Even if you’re not thinking about selling today, would you not want to have the best look at your company possible so you can prevent future mishaps? The best part about doing an unbiased analysis of your business is that you get the opportunity to de-risk it for yourself, not just for a buyer, thereby improving the stability of your future cash flows and your own personal livelihood.
Signing an Engagement Agreement with an Investment Banker
Assuming you’ve identified your value drivers correctly and have an idea of what your company is worth — at least on paper — now’s the time to determine what’s a realistic value range for the company in the marketplace today. This is where investment bankers really tune you up as a business owner. They see the market as a whole and even some avenues you haven’t considered yourself. An investment banker will take this process one step further to make sure you’re comfortable with the range they came up with and walk you through their reasoning. This is never shared with the buyer, of course, but is intended to show you the value of their services before you sign the engagement agreement.
While it’s possible to do some of this yourself, is it the wisest choice? Can you truly put the time in to do market comparisons while still running your company in a profitable and efficient manner so as not to affect your value? If you start turning all your time to creating and presenting a portfolio with accurate industry statistics to potential buyers, your company will suffer… unless you’ve already ensured your business can run well without you. In which case, congratulations, that is a very strong position to enter the market at. However, it still doesn’t account for the fact that you have no experience in this arena. Are you sure you’ll make the right moves?
What happens after you sign an engagement agreement? Your investment banker goes into fact finding. They get all the information they need and that is necessary to a competitive and successful sale of your business so they can prepare a deal book — or confidential information memorandum — as well as a blind book and some other documents that can then be presented to potential buyers.
What’s in the CIM? So the blind summary (or deal book) is going to have some summary financial information, revenue COGS, expenses, a summarized EBITDA number, the last three years financials (at least, sometimes four), as well as the trailing 12 months. It’s going to have the broad location like northeast, but generally not the specific state or city because that would give away the company. It’s going to have a brief, historical narrative that is maybe a paragraph or two long. There will also be some information about the service or product offering of the company, and then whatever the larger value proposition of the company happens to be. It’s specific enough to garner interest and move a potential buyer to the next step but not so specific as to tank a deal. The CIM is your value driver; it’s the biggest piece of advertising for your business, it’s the first thing people see who are interested in buying your business, so it needs to be done correctly.
Once this documentation has been prepared, you’ve entered the marketing phase of selling your business.
Selling Your Mid-Market Business Is Really Advanced Marketing
Don’t hate the player, hate the game. Middle market businesses are such a gray area. Not only do their ranges span an unusually wide amount, they also tend to appeal to a more diverse number of buyers. You may be surprised by who would want to buy your managed IT services company or your rapidly growing accounting software business. So to that point, the marketing phase of investment banking is crucial.
If you’ve made it to the CIM stage, you’re moving in the right direction. As Mark says, the CIM is the first glimpse of your company, so it’s an integral marketing tool and it’s important to send out a bunch of them to the right buyers if you want to close for maximum value.
How the marketing process looks:
If your investment banker sent out say 40 deal books, about half of those tend to be interested in moving to the next step. At that point, certain key parts of the deal room (online) will be shared with buyers based on their level of interest and what quality of a buyer they are. About half of those will eventually make it to an hour to an hour-and-a-half long conference calls — nothing in-person until nearer to talking terms. This gives the potential buyer a chance to ask you, the seller, some key questions and for you to see how serious they are about your company. After this, some more information is necessarily exchanged, leading to a letter of intent or term sheet to further clarify their interest in the company and what they think the value is. A site visit is next (Mark says they get about three to four site visits per deal). The final letters of intent are delivered and negotiated before one buyer is selected… and then you get to do due diligence. Very serious due diligence. It’s painful, but it’s necessary; and if you’ve prepared well, hopefully it’s not as painful as it would be otherwise. From the signing of the letter of intent to closing is usually 90 days.
Why does it matter?
You want the right buyer buying your business for the right reasons at the right price. Right? Right. Assuming for a moment that you’re still working hard every day building your business and looking after your employees and clients alike, do you have the time to initiate what is effectively a marketing campaign to sell your business? Further to that, are you able to? It can be so hard to take a step back from your business in order to look at it subjectively — and as a commodity — long enough to put a real value on it (not just the value to you, the owner).
If you can’t pull back from your ‘baby’ and see it as a covetable business, you may not be ready to sell. If you’re sure you are, then you may want to pass the buck to someone who has no bias and can help you push through some of the more sentimental value you’ve placed on the business so you can see what the market thinks your company is worth.
Investment bankers consider four quadrants when marketing your company. The first quadrant involves looking at buyers who would view this company as a new market with an existing product or service because there’s a good synergistic fit with their existing business. The next quadrant we look at is if there are buyers who would look at our client as a new product in an existing market, since this also can provide a certain level of synergy. The third quadrant is existing products in existing markets — the low-hanging fruit, as Mark says. The final quadrant of buyers to consider is private equity. A PE firm would be looking for a more strategic buyer down the line.
So one of your key conversations to have with your investment broker is what type of buyer are you comfortable with and what would have to happen to make you okay with all four types of buyers. They’ll screen these prospective buyers until there’s a select list of who most closely matches your desired outcomes. From there, the best offer is considered, moved to due diligence and, ultimately, closing.
Plan Your Exit
Timing is key in everything we do. When it comes to hiring an investment banker, it’s no different. Mark’s best advice for business owners is to start planning for your exit now (sound familiar?). In this case, you need to know what kind of exit you’re after before you sign with an investment banker. Are you looking to get out completely, do you want to recap your business so you can stay in it for longer, etc.? Your investment banker will tailor the market approach based on this.
If you’re wanting to leave right now, you should have planned for this at least three years ago. If you haven’t, chances are you’ll be stuck with a transitional commitment of one to two years as the new company takes over and you teach someone else how to fulfill your role. Even if you’re looking to just do a private equity recap so you can stay in your business and keep working on it, you typically need a solid twelve months to facilitate a liquidity event.
The question then comes back around to: have you planned when you want to exit? If you’re sure it’s 10 years off still, you should probably have an “oh shit” plan in case you get injured or some other unexpected event occurs and you need to exit your business. Think of it like your will, if you need to, but some kind of plan needs to be formed to protect you and your business. Not only that, but you can help prevent buyer’s remorse by being prepared early so they are confident in you as a business owner as well as in your business as a whole. You’d get cold feet, too, if someone kept running to the back to find the information necessary to answer your questions about a product — imagine buying a house where the owner had to get back to you on things like zoning, the type of electrical in the house or even the year it was built. You don’t want to hear “I don’t know”; you want to hear “Oh, yes, I have that right here.”
We may joke about it, but more often than not, sellers don’t know they’re going to sell until right before they get thrown into it. This is a situation where your investment banker is going to have to have that conversation with you that you may not get absolute top value for your business. And you have to be open to that. You have to understand that these last minute deals you’re hearing about where someone scored huge are really few and far between. If you haven’t planned to sell, but get thrown into that situation, chances are you’re going to take a hit and you should manage your expectations now.
Ye Olde Bait and Switch
Yes, this still happens. Yes, it’s more often than you think. When you hear those fantastic stories about an owner receiving an unsolicited offer for 10x EBITDA, there are 100 other stories you’re not hearing where an owner was suggested they would receive 10x EBITDA… and didn’t come close. Mark calls this “death by 1,000 papercuts” because what happens is this potential acquirer will bog you down in paperwork and information requests until something pops up that makes them lower their initial bid. It’ll be something legitimate found during due diligence, or something that’s cropped up because you’ve been spending all your time dealing with the paperwork that your business suffers. It doesn’t matter; what matters is that now you’ve got deal fatigue and are just ready to be done with it so sign for something much lower than you initially hoped for and, what’s worse, often lower than what your business is truly worth.
Compensating Your Investment Banker
You may have anticipated this: investment bankers aren’t universal in how they like to get compensated for their work. However, now that you have your exit plan loosely in mind and you’re starting to think about taking your business to market, you want to make sure you have an investment banker lined up several months before you intend to take your company to market.
Investment bankers usually require an upfront fee (front-end fee) as well as a performance fee (back-end fee) when the deal closes. This is to ensure the buyer is really committed and to vet said buyer — not to mention document preparation. There is an awful lot of front-end work required to put together a good deal and to position your company for the sale.
So what are the kind of fees you can expect to pay?
In the main street segment, you’ll see a small front-end fee of a few grand. In the middle market, however, the rules change again. You’re going to have front-end fees of something between $15-50,000.
Back-end fees or performance fees are the bread and butter for investment bankers. This is the amount received after the sale has closed, less the front-end fee charged for preparing for the sale. Performance fees are where investment bankers really make their money, so if they’re asking for $50,000 up front, you can bet your bottom dollar they’re going to work hard to get you a good paying deal that will more than recoup that 50k for you so they also achieve a respectable payout. They typically run around 10-12 percent in the main street segment, but become tiered after that. In the middle market, you typically see a five and two or five and three structure, meaning that the investment banker would get five percent of the first 10 million and then two percent of everything after that. The bigger the deal, the lower that second percentage goes, but this is what you can expect to see so plan accordingly.
Can’t I Just Do it Myself?
Sure. But, as already pointed out, the chances of your business suffering and therefore also its value and the final dollar amount you’re trying to get from the sale is quite high. We’re entrepreneurs; we’re not trained in how to sell a company. In every other aspect of our business, we hire out the expertise we don’t have or for the jobs we no longer have the time to do. Why would you want to spend your valuable time (especially if you’re already thinking about leaving your business) learning a completely different industry just to save $50,000? This is an investment.
An investment banker is going to send out around 50-70 CIMs on the average deal. That’s a lot of exposure for your company to those particularly targeted potential buyers from all four quadrants, not just those who you know through so-and-so. The chance of you finding the buyer you want on your (or even a colleague’s) Rolodex is quite slim. The number of deal books going out is directly correlated with what you eventually get for your company, as well, because you’ve got more buyers to choose from and therefore can push more on your terms.
On top of that, your advisor will help you de-risk situations, some of which seem pretty innocent. For example, Mark tells us that the very first mistake business owners make is engaging in the phone call. If you get a call about selling your business, your response should be, “Let me connect you to my advisor” otherwise you’ve opened yourself up to a breach of confidentiality just by answering a few questions. The minute you take the call without an advisor, someone knows you’re interested in selling your company and can share that information with anyone.
Another major mistake owners make is thinking that once you’ve received an LOI, you’re in the clear. Wrong. As Mark says, an LOI doesn’t mean anything. Whether you’ve received an IOI (indication of interest), an LOI (letter of intent/interest) or term sheet (how the deal is structured), you’re still open to negotiation and drop-outs. Informal LOIs can be an email; the formal varieties can be either specific or broad, stating that they’re expecting to negotiate definitive purchase agreements or they’ve already listed out everything from reps and warranties to indemnification. There’s still no obligation here except to confidentiality. You do not have a pending sale. However, you will move onto that 90 day due diligence phase during which time you will be exclusively bound to this buyer until a decision for or against the sale is made. This is typically the impetus required to sign the official and legally-binding agreements, as well as to make the payment.
And then, how strong are you at making the terms of an agreement? If this is your specialty, great. But buyers are going to ask for terms worded in their favor; you, obviously, would prefer terms that are in yours. So how do you find common ground? An advisor is useful here. The purchase agreement needs to say things like “I own this company and can sell it” but it can also cover a whole slew of other things from environmental issues to earnouts, so it’s important that you phrase things in a way that they are absolutely true and you can verify that so you’re not left holding the bag if things are proven contrary to what you stated in your signed agreement. If any of the promises you made in the agreement are broken, there will be consequences such as a holdback or escrow whereby you will not get that money until those promises are fulfilled; and, if they can’t be fulfilled, then there are rules about how that money is distributed to the buyer. All these things can be negotiated, but if you don’t know to do so or how to phrase them, you’re going to be left in the lurch and not get what you think you should.
So what it comes down to is: you hire an investment banker to bring to bear all of his or her experience in your market and manage the sale process for you, the right way, so you both come out of it ahead. You will likely get more money or a better deal structure from a sale you involve an investment banker in; but more importantly, you’ll get more peace of mind and an easier more processed close.
How are you preparing to sell your company? Which of Mark’s tips can you implement today and in the future when you are prepared to contact someone to start the sale process? Start building that relationship now so you have a trusted advisor when the time comes.