The Sell Side Masterclass for Tech Services Founders: What Not to Do

14 Apr The Sell Side Masterclass for Tech Services Founders: What Not to Do

Shoot The Moon

The Sell Side Masterclass for Tech Services Founders: What Not to Do

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EPISODE 249. If you decide to go through a sell-side process, what are the big things you can really screw up? In the final part of our Master Class series, we are talking what not to do during an M&A sale process. In the final installment of the Sell Side Master Class, the team breaks down the biggest mistakes founders make when preparing to sell their IT services business. From waiting too long to prepare and mismanaging diligence, to misunderstanding deal structure and scaring off buyers, this episode covers the pitfalls that can reduce value or kill a deal altogether.

TRANSCRIPT

Mike: Hello, and welcome to this week’s. Shoot the Moon podcast broadcasting live and direct from Revenue Rocket, world headquarters in Bloomington, Minnesota. Tuned into this podcast series, this master class series. You already know that Revenue Rocket is the world’s premier. M&A advisor to tech enabled services companies with me today are my partners, Ryan Barnett and matt Lockhart. Welcome guys. 

Matt: Hey, hey, I think I jumped the gun last time and said we were wrapping up the master class, but I think I’m right this time, we are wrapping up the master class Ryan that you created and we’ve been getting just a ton of positive feedback on. So it’s been a good series looking forward to the next master class that we do someday, but let’s go, Ryan. 

Ryan: Thank you guys for the insight and guidance here. We work with founders every day of IT services firms that are looking to understand what’s next as part of this journey. And it really does feel like a journey. Sometimes people run into just potholes and mistakes and deals don’t get done. Our job as advisors is to help make sure that doesn’t happen. But what we want to do in this episode is if we look at the process from deciding when to sell all the way through closing in that first 100 days, we want to make sure that we’re doing this in the right way and really avoiding some things that could torpedo a deal or torpedo success in the long run. This hits all throughout the process of things we’ve already talked about. But Mike, why don’t you get us started? If I’m thinking about issues or common mistakes that founders make, what are the most common mistakes that they have when it’s time to sell the company? 

Mike: Well, there’s quite a few Ryan, one would be deciding to sell when you’re already burned out. It’s really hard to build momentum around your excitement in the business and being able to get buyers to see your vision when you’re already struggling just to get checked into the office every day. That’s certainly one obviously waiting too long to prepare your business for sale. Is another pretty important one. It takes a fair amount of preparation. And depending on the condition of your P&L and balance, that may be years of time to be prepared to transact a deal with an optimum valuation. So critically important that you actually begin that preparation early and often and start to talk to an advisor early that can help you and sort of position your business and give you input on what might need to change to optimize it. Obviously thinking about an M&A deal as a one time event instead of a process. Certainly is another mistake. It is a process. The right way to think about it is kind of one step in front of the other understanding the full sort of scope of what you’re about to sign up for is important and know that it’s going to take a period of months. Likely… from the time you kick off that process. We hope with an advisor and we recommend with an advisor until you close, you know, it can be a, you know, six nine month journey up to a year journey to get your deal transacted. If you’re a seller. And you know, I think in general having an open mind, not having an open mind about, you know, twists and turns and the work that’s involved. It is called the utmost unnatural act in business. I don’t want to talk you out of it or scare you by saying that, but it is one that requires, you know, a village of people to help you and you just have to be open about that and changes that may be required in your business to optimize for value. 

Ryan: Yeah. Thanks for getting us going here to your point that the route to a successful deal can be fraught with peril if you don’t think about these things first. So having the, you know, in the mindset to sell, I think we talked about in our first episode is important to understand picking the timing and executing when things are going right is something we talked about in this series. Really thinking about this process and getting through that. So making sure we have the best buyers aligned and the right thesis in place for someone to buy is starting to critical. And so really understanding what those buyers are looking for and how to position your company throughout there is critical. So, yeah. So, thanks for getting us going there, matt, if I turn the gears a little bit and we think about some of the issues that are found in the process, can you tell me what financial or operational surprises show up in? Diligence? What are some common ones that you’ve seen that can perhaps kill a deal? Yeah, I. 

Matt: Think, you know, let’s kind of start in theory, right? Which is you’ve presented your organization and you’ve told a story right through the dating process prior to a LOI… and you’ve sort of, you know, let the buyer in the door, right? And showed them around the house. But, you know, maybe not showed them all the house if you will in that first date or two. And then, you know, post LOI, all of a sudden, the buyer is asking to see everything in every corner of the house, right? Let’s see it all. And if what they see doesn’t really match the story that they’ve been told. And the first things that they’ve looked at, well, then it raises alarm bells, right? And, you know, to your point, a lot of that is just data, right? And so maybe a wild example but one that we’ve seen, right? And before getting ready and before preparing is that, you know, the chart of accounts and the, you know, lines of revenue in the chart of accounts really don’t line up to the overall P&L. So it’s just an example and one that, you know, maybe you don’t see all the time. But using that as an example to say, well, geez if things don’t tie out, right? If the financial statements aren’t clear, if that revenue recognition isn’t understood and easy to point out. If, when they start to see data doesn’t line up with a story. So, for example, you know, maybe you said look, we don’t have any customer concentration issues. And then you get into the data and maybe on a top line account or a top line view of the data and the revenue. You have one customer that is segmented out amongst a bunch of subsidiaries, right? And so, there’s multiple lines of revenue in these subsidiary customers that all are all seen as an individual account. But what you find out, is that it all rolls up to one parent company and one decision maker. And all of a sudden there’s concentration that’s in place. So again, another example where the story isn’t or the data isn’t lining up to the story, you know, without advisors. Oftentimes you know, there’s just not a knowledge of what all of the requests are going to be related to the data. And, you know, in a scenario, maybe an organization really hasn’t had to create an organizational chart, you know, founders is thought well, that’s really not that important. I know who everybody is, and they just don’t have an org chart which then says, they probably don’t have a succession plan, right? And, and so that speaks to sort of operational risk, and risk related to the going concern of the business. And so I think it all sort of it all is in this bucket of it’s. Got to be really well understood. It’s got to be clean when we’re talking about the data and all of those things needs to line up with the story that you’ve told about the business itself. 

Ryan: Yeah, you got to show up with the receipts, right? And I think in order to do that, there’s a lot of process and thoughts that get there. So, yeah, you’re absolutely right? Your customer concentration example I think is really poignant. It’s very common for a company in the IT services space to have a fairly large customer concentration issue. We see a 15 to 20 percent often, we see that quite higher. But if you don’t have the corresponding story with, it can make selling so much harder. So sometimes identifying those risks that you see up front can help make this process a lot smoother as you go through. And by the way, learning along the way, if one buyer tells you they understand and look at something one way, it’s a good sign that other buyers are going to ask the same kind of question. So as you go through the whole process and you have some of these perhaps missteps or mistakes, it’s good to learn from them and put that into a positive in the next turn around. Mike, if I again switch gears a little bit since we’re talking about all the things that could go wrong here, I want to focus in about kind of if we’ve found the right buyer and a LOI has been sold or signed. And we’re close there. And throughout this whole series, we talked a ton about valuation methodologies and how value and how to increase your value. But what do some founders mistake when they focus too much on that enterprise value number compared to what else comes with that enterprise value? Yeah? 

Mike: That’s a really important question Ryan, I mean, sometimes everyone gets caught up around what is the total purchase price as pitched in an LOI, when they don’t fully unpack what that is. And I think the biggest mistake is ignoring the deal structure. It’s one thing if the deal is all cash, certainly then there is no deal structure. So maybe I need to define structure for a structure is really the terms associated with that offer. There’s price. And then there’s terms. So enterprise value is price and structure would have to do with the terms. So there’s common mistakes made with not understanding the levers in an earn out and how an earn out might work and whether it’s one sided or whether it’s you know, we often say earn out should be mutually beneficial or gain share oriented. And they really need to be structured that way. And there are certain ways to structure them properly and ways to structure them where we almost always not make the earn out. As a seller, there’s a lot of noise in the marketplace about, you know, earn outs never, you know, sellers never make earn outs, blah blah blah, well, not true. If they’re structured properly and a competent advisor can help you structure them properly, you’ll be able to, you know, do pretty well in an earn out as a matter of fact, most earn outs get paid out as a matter of fact, but that, you know, that big part of making sure that happens has to do with correct structure of that earn out itself. You know, not fully understanding what’s involved with a seller note or a rollover equity risk is another couple other areas where sometimes, you know, you may be blinded a little bit. You know, seller notes can have a collar which means there is a performance component to them that often makes them look kind of like an earn out. And so, you need to understand, is it just a seller financing or it’s a collared? Likewise, if there’s rollover equity risk, you’re rolling over into a firm that you know, either isn’t established or isn’t a proven operator. There certainly could be some equity risk with your role that you need to fully understand. Another area might be, you know, how working capital is managed. A lot of buyers take advantage of sellers by overstating the amount of working capital and their analysis that’s needed to run the business. Really really important that you understand how working capital is calculated, what’s required to be to stay in your business to have it be defined as a going concern. Most buyers want your business to be a going concern and have enough working capital. To operate. And then also, you know, how adjustments are made to that working capital as again, we’re working with a quality advisor and partner can help you immensely. 

Matt: And. 

Mike: then, you know, probably not understanding how headline valuation doesn’t equal cash or close, right? I think fully understanding the terms of the oi and unpacking that before you sign is pretty important. Yeah. 

Ryan: Absolutely setting that. It’s, the cover that great. I think, you know, we dealt with valuation quite a bit and we dealt, and also, I really encourage the audience to check out the, in this master class, the deal structures, what to expect. I think it outlines a lot of the issues, and potholes that you can fall into if you’re not careful… matt, if I think about the process a little bit more as well. And again, we’re looking at mistakes and potholes to void here. If I look at the process in which founders are starting to talk with buyers, is there any behavior or what kind of behaviors or mistakes can a founder make in that phase? That just scares buyers away? Yeah. Well. 

Matt: I think that there are some… let’s think about it in the context of personality and then practicality from a personality perspective. If you’re over the top. If you make… it all about yourself as it pertains to customers or as it pertains to employees, right? You know, then somebody’s sort of looking at you and saying, well, do I like this Guy because he’s gonna have to be around because it’s all about him or girl? I think that that’s you know, from a personality perspective, it’s all about the team. It’s all about what the team has done, and that the team, is in a great position to continue forward. You know, that sort of personality can then also get into how you’re communicating and, are you overselling or are you exaggerating at any point, right? And saying, wow, yeah, you know, this customer’s gonna double, they’re gonna double their business. And oftentimes in due diligence, a buyer may ask to talk to customers and they say, well, geez no, as a matter of fact, we’re you know, we’re thinking about putting this contract out for bid. And so you can see again, truth isn’t lining up with a story. And at times founders can think that they’re hey, this is going to be great. They want my company and they’re just going to take everything that I tell them. If there’s an inconsistency, right? Any other inconsistencies between? Yeah, we talked about this before, the data and reality. So you got to be really tight, right on your messaging and knock on wood work with a good advisor who’s helping you with the messaging. And, you know, some of the messaging may not be the most positive but it’s reality, and there oftentimes is a story buyers understand that everything isn’t perfect. And so, you know, yeah, make sure that story and the message, is aligning, you know, oftentimes sometimes, you know, once you move into that due diligence phase, there can be sort of this heightened emotion, right? Because a buyer is doing what they should be doing and they are getting under the covers and they’re asking tough questions. And if as a seller, you and, or your team is getting defensive in that process, well, that’s only going to raise, you know, red flags, why are they getting defensive? And also it’s changing sort of the overall momentum and emotion, right? When buyers and sellers, once they get to the end of the business, once they pass that, finish line cross that finish line. You want them to be holding hands and feeling great about it. And so if there’s emotion and defensiveness that occurs. And all of a sudden that creates problems, well, it’s harder to hold hands and get on with the getting on which is, you know, making one plus one equal, you know, four or five or six. And then finally, you know, sometimes we see this is, you know, buyers start to, you know, want to communicate on their own, you know, or excuse me, buyers do and sellers will try to communicate on their own outside of the process. And, you know, that usually is a real negative. And you know, if you’re a seller and buyers are trying to communicate with you directly outside of the process, that’s a red flag that a buyer’s you know, not playing within the rules and you should be working with your advisor accordingly. But then as a seller boy, you really want to hesitate before, you know, getting outside of the process. So those are just some of the things I mean, be yourself. And we often say this look be yourself. It’s you who brought your firm to this point, right? And have confidence that, that’s you know, that’s enough. And then lean on your advisor to ensure the messaging is correct. And then, you know, super importantly is just let’s make sure that messaging lines up with the data and reality. 

Ryan: Yeah, that’s a great point, matt. And just to reference that, if you’re doing this alone, it’s really hard to maintain that relationship with your buyer. A lot of it is that especially if you’re selling in and continuing with the firm, you’re going to be with that buyer for quite some time. So having that third party person to really manage that relationship. So after the deal’s closed, it’s really smooth. I think it’s good to bifurcate that relationship between the deal and the execution going forward. So, yeah, great points. Mike, if you were to think about this process again, we’re thinking big mistakes through the process, right? What are a few things that make things slow down or perhaps create friction once the buyer’s in diligence? 

Mike: Yeah, great question, Ryan, this can be, these things can be deal killers by the way. So I think they’re critically important to be able to understand. One is a slow response to diligence requests. A buyer gauges your level of, you know, for lack of a better term, how put together you are and how put together the business is by how quickly you respond to diligence requests. And so being having a fulsome set of diligence prepared ahead of time that’s been reviewed by an advisor that is ready to, at the ready to respond to said requests will help move things along much more quickly and with a lot more confidence. The next one is sort of disorganized and incomplete data rooms. Data rooms have to be organized in a logical fashion and they have to be complete and more importantly, they have to be able to respond to kind of out of the blue. Diligence requests things that, or push back right? And again, that’s a role of the advisor. If a buyer asked for some, you know, relatively obtuse cut at the data, if it’s easy to get. Okay, fine, you can provide it or maybe something that based on where you are in the process, it’s either already been provided and they don’t know where it is or it is not appropriate. And I think having someone who works with you as your advisor that can manage and do that. What we call due diligence defense role is really important. I think not having good strong internal resources to support diligence is a fatal flaw. Diligence is hard. It can be a very big distraction in the business. And so, having a team of people that are working just on that, so you can continue to run the business and put up the numbers that you’ve committed to is critical. Oftentimes buyers, I wouldn’t say all buyers, but certainly some buyers will take advantage of a seller who’s trying to move forward without someone on their team doing diligence defense and distract them. It becomes a distraction to running the business. And what happens inevitably is your business will perform not as well as it does when you’re not distracted. And we’ve seen that in businesses that are sizable and ones that are small, it doesn’t matter if you have the executive team distracted by diligence running around trying to deal with diligence requests. They’re not doing their day job and that’s a really important consideration. And often, if that’s the case, it will lead to a retrade or a lower offer when you’re just not delivering on. Your forecast because you’ve been distracted for a period of months with diligence requests… and we think running the business and the deal process without thorough preparation and partnership is a mistake. Certainly you have to be prepared to keep the train on the tracks with the core business while this is going on. And that can be difficult. You might be thinking about life after the deal. You may be contemplating what integration looks like and other distractions. And certainly there’s a lot of legal distractions that occur in the negotiation of a definitive agreement. And that alone is going to take up quite a bit of the leadership team’s time and our owner’s time and so being prepared for all that and understanding that and making sure you’ve surrounded yourself with a competent team will certainly make that go much better. 

Ryan: Yeah… wow. Great job. Mike. I think you covered just a ton of sense throughout this process. And matt, Mike, you’ve both been extremely valuable in this whole podcast series. And I’m glad that we’re able to produce it for founders of the IT services firms. And if I go back to perhaps if someone’s to listen to this and you’re trying to give a seller just one piece of advice about what they should start doing now to avoid being their own deal killer matt, what are the things that you might tell someone to do if they’re selling in a few years? 

Matt: Yeah. We’ve talked about this before Ryan. I think it’s start early with the preparation. Obviously, you don’t need to worry about final packaging of materials two years before you’re. 

Mike: thinking. 

Matt: About running… a process and selling your business, but you may need to think about your succession plan and how you’re preparing the organization for you to not be around. And so to Mike’s point earlier, this is not a single one time transaction that’s like selling a house, right? It is more complicated than that. And so, I think if there’s one piece of advice, it is start preparing early with your peer groups asking people who’ve been through it before. And then building a relationship early with an advisor or a banker who can guide you accordingly depending upon your timeline to make the process smoother to… ensure that what you’ve built lands in the right place and to maximize your return. And so if there’s one piece of advice, I think that one piece of advice that I’d give is understand your timeline and give yourself enough preparation time. 

Ryan: Thanks, Matt, Mike. How about you? It’s the last question I have in this whole series. So feel free to pontificate there and wrap this one up. 

Mike: Yeah. You know, I don’t know if I’d add a lot more other than, you know, there are some pretty key components about, you know, lessening the dependency on you. If you’re considering selling out or moving on, you know, things like, you know, making sure you’ve built rigor around your financials, you know, I’m just echoing some of the comments as me, but, you know, be thinking more about how do we really optimize profitability to optimize value? These are all things we’ve talked about along the way here and in today and in the past… and, you know, just thinking about your purpose and being ready, right? Really really important to understand that we’ve talked. We’ve had a, you know, one of the sessions this master class talked about kind of what’s next and how to prepare and whether you’re selling in or selling out. Those are really important things to be considering. So with that, we’ll tie a ribbon on it for this week’s. Shoot the Moon podcast. We hope you tune in next week when we all unpack further kind of new and interesting ideas around M&A and the world of IT services, make it a great week.