How to Bridge Valuation Gaps in M&A

People are asking for more M and A Science. We're giving it to you. We're increasing our production from once a week to twice a week. Look out for more M and A Science interviews. This is a conversation with John Blair, Partner M and a attorney at KNL Gates. He's been an attorney for over 17 years and in this interview he'll share his best practices on how to bridge valuation gaps in M and A. We discussed earnouts amount to Structure them, make them work Seller financing equity structure the overall market's impact on bridging M and A valuation gaps this episode is sponsored by our flagship product Deal Room. Meet Nicole, Corporate Development Manager at wifli. In the chaos of due diligence and integration, Nicole Founder, Sanctuary and Deal Room the end to end M and A solution that not only saves time but alleviates the stress of complex processes. Don't take my word for it. Let's hear from Nicole firsthand. Deal Room has brought a lot of organization to the team. It's made our cross functional tasks a lot easier to manage because my HR.

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Join Nicole make your M and A journey a success story with Deal Room the only end to end M and A lifecycle management platform. Learn more at dealroom Net. Again, that's dealroom Net. I'm Kisan Patel and you're listening to M and A Science where we talk with deal professionals and learn valuable lessons from their experience. This podcast focuses on stories, strategies and what actually happened during M and A deals. Hello M and A Scientists. Welcome to the M and A Science Podcast where we learn from the best in M and A to uncover proven techniques for enterprise value creation. If you're interested in learning more about M and A Science, the products and services we develop to support world class M and A teams or just want to get involved with a community of forward thinking M and a practitioners, visit Masscience.com you can get started by subscribing to our free weekly newsletter where you can get insights and the latest on upcoming events. Again, that's mascience.com I'm your host Kisam Patel, CEO and founder of M&A Science. Joining me today is John Blair, Partner M and A Attorney at KNL Gates K. KNL Gates is a multinational corporate law firm with more than 1800 lawyers across five continents. Today we're gonna talk about how to bridge Valuation gaps in M and A. John, how are you doing today?

Excellent. Excited to be here. Thanks Kisan.

I'm fired up. We're here live in Charlotte at your beautiful office.

Thanks for hosting on an absolutely beautiful fall day. Thanks for coming down. Great to be here in person.

Can we kick things off a little bit about your background?

Grew up in D.C. northern Virginia. Didn't go to law school right away. Decided to get some experience at Accenture doing strategic consulting. But always knew I wanted to go to law school and actually ended up doing a JD MBA at Wake. So I wanted to be a business lawyer, corporate lawyer. Had no lawyers in the family, but thought that was more fast paced and I like to understand how deals are put together, understand how the capital markets interacted with the players and learn about value creation. Went back to school and eventually landed here in Charlotte. It's a great big little city. It's not the money center of New York, but I've been here my entire legal career at Canal Gates doing middle market private equity and mergers and acquisition transactions.

You've been doing that for a while, working a lot of deals.

A lot of deals. From really small to really big. That's some secrets to the success. All deals have their challenges, even the small ones. Sometimes the big ones are, at least in terms of enterprise value, go quicker and easier than some of the hair on some of the troubled deals.

That's going to be a lot for us to unpack. Let's kick things off with when do you get involved in the M and A process?

Hopefully earlier the earlier the better. But usually for a sell side engagement, if we're involved with either a public company client or a private equity group, we're involved pre loi to help with when the bankers are first engaged. We might be marking up investment banking engagement letters like really early on in the process, before the target or the assets in flight so to speak or in market. Helping behind the scenes, prepping a data room, prepping a draft of an auction, draft of a purchase agreement or merger agreement. Thinking through the transaction structure at an early phase. The earlier the better. We can add value in terms of the commercial guidance and work alongside the other advisors, whether that's tax or investment bankers to provide the best outcomes for our clients.

Hey, what's like the most notable thing or deals from K and L Gates? The first thing I thought of was like Microsoft antitrust. Like way back in the day was that Kainel Gates thing.

Kainel Gates. The Gates in the name is Bill Gates father. He was a name partner at Preston Gates and Ellis in Seattle. Big Bill has since passed, but worked for a number of years at Canal Gates and then went and ran the Bill and Melinda Gates foundation for a number of years after his private practice. So he's a towering figure in Canal Gates lore and the Gates name continues. So we have a tight relationship with Microsoft. They continue to be a firm client. We've been involved in some of their artificial intelligence initiatives. But Microsoft certainly isn't the only client. It just happens. I was thinking Seattle is on the mind having come up with Bill Gates. But we are a global law firm that sits on five continents and tend to be middle market focused at the intersection of sort of financial centers across the world and government capitals because we find that finance and regulatory influence how commercial decisions are made. So we tend to tend to be there and have the full complement of specialists to do deals, to protect intellectual property assets, to litigate, to do everything a full service business law firm needs to do or help clients respond to. So it's exciting. Everybody's just sort of a phone call away in terms of the resources that you bring to bear to a particular situation, whether it's antitrust matters. There's folks that sit on both sides of the pond in Washington D.C. and in Brussels. I've had clients go do acquisitions in Australia and I say, here you go, Australian partner, run this Australian deal. Your documents are totally different than a US style document. It's a single profit pool and I think the partners and associates and attorneys are aligned to deliver value. And we tend to be commercially driven, pragmatic, solution oriented. And I think that resonates with clients and that's why they keep coming back.

Now I get the Microsoft connection. Got it. Let's say I'm looking at a proprietary deal. How early would I engage with you? As I'm starting to put my initial requests in and get a sense of this valuation model. Are we going to put a LOI in where I get a draft loi, then call you up and saying hey John, I want you to look this over. When do I get you involved then?

During the LOI phase is fine. Sometimes we've been pulled in after and in those cases we can't add as much value because the terms are pretty much cemented. Even though it's a non binding loi, people try to adhere to the LOI as much as possible. But a lot of times groups or companies put in LOI and they haven't done any diligence and issues emerge that need to be addressed or risks need to be allocated. So even post LOI lawyers and transaction advisors can add significant value. But there's certain choice points that have already been decided if the ink is dry on the LOI paperwork.

So tell me more about that, especially in the sense of negotiations I feel like is the key element pre loi. How are you involved in that part?

It sort of depends. Obviously we represent both buyers and sellers and we're advocating for our clients in those circumstances. If you're on the sell side and there's a number of offers on the table, I think it's extracting the best terms. Not necessarily pivoting or juxtapositioning different offers against one another and playing them off and cherry picking, but making sure the totality of the package works for the exiting shareholders or perhaps the rolling shareholders in some respects and fine tuning some of those asks whether it's economic or corporate governance, maybe an earn out. There's a lot of factors that go into it. It's not always the best cash price. It might be the best overall package for that decision maker.

How about on the buy side? If I got this LOI I want to send over to this potential target.

Yeah, on the buy side, lots go into our clients letters of intent in terms of describing what their investment thesis is and how they can add value to the target company. The lawyers make sure the language lines up with what they're trying to do. Whether that's describing a rep and warranty insurance policy and the package that's being made available to the sellers and why that's beneficial to the sellers because it's delivering more cash proceeds at closing. That trained legal eye and knowing the business goals can help craft a better work product, a better LOI that will set your bid apart, hopefully. Obviously we're not delivering additional value in terms of transaction proceeds, but we can think about it from how sellers will react to the message. It's an independent reader that that doesn't come from that particular shop, whether that's a private equity group or an investment professional. So when I'm on that side I try to put myself on how will the seller interpret this? Is that a differentiator? Why should I select you? And just thinking through that for clients, is that a competitive advantage you want to highlight or is it a disadvantage? And if there is a disadvantage with respect to your bid, how can it be mitigated? Because those are the questions that eventually the bankers will be asking or perhaps the sellers themselves.

How do you bridge valuation gaps in M and A?

There's a lot of tools in the toolkit and I'm happy to talk about a bunch of them, a few of the structures. In terms of bridging the valuation gap, I think about earnouts, which I mentioned before. I think about seller financing like a seller note or seller rollover equity. And then I think about preferred equity structures that might be sellers stepping into that part of this capital structure or really third party participants that are providing a preferred equity structure akin to a mezzanine note that is equity, but acts and functions like debt in terms of its return, but sits above the common equity return and that allows buyers to stretch in terms of meeting those valuation gaps.

We have earnouts, we have seller financing, and we have an equity structure.

Right. Preferred equity.

Anything else?

We are seeing a lot of continuation funds. I don't think that's bridging the valuation gap. I think that's more we see private equity buyers saying, oh, this valuation's not good enough right now for this particular asset. Let's grow it as a special purpose vehicle, continue to own it for the next three to seven years, and then sell it when the conditions are right. That's something else adjacent that is not really bridging a valuation gap between buyer and seller, but it is allowing private equity groups to monetize some of their investment but not probably exit it completely and exit it completely down the road in three to five years or whatever the hold period is.

Do you look at holdbacks as a way to bridge valuation gaps or is that more of assurance?

Holdbacks function like escrows whether a third party is holding the money or the buyer's holding the money. We've seen it both ways. We have some public company clients when we're on the sell side, they never use escrows because they're like, we're perfectly credit worthy. We're in the Dow. We'll write you the check when we need to write you the check. For other sellers, it's nice. And frankly, other buyers, they view it as let's put the money in a third party financial institution to set aside and if there is a need of future claim that there's a recourse for it. I don't necessarily view that as solving the valuation gap. To me, the value valuation gaps really driven by a mismatch of valuation expectations. And I think we've seen a lot of that. In 2023, we were coming off a real deal boom, as you know, in 2020 and 2021. But now we're in a rising rate environment, an inflationary environment, even Though the Fed just came out yesterday and decided not to raise rates. But we're in a place where the debt capital markets are more expensive and stretched. And buyers, private equity buyers in particular are not looking to deploy as much debt capital in terms of stretching for their valuations. Sellers are seeing the numbers from two and three years ago that are comps and they're still expecting high multiples in their respective industries. We have banks being more tepid, private credit markets being more tepid, private equity buyers being more risk adverse in terms of making sure that their models work for a base case or even a recession case scenario. A number of factors lead to the valuation mismatch and I think that's why this is a particularly salient topic today that M and A science has brought to us and we're allowed to sit here and discuss today because there is a mismatch. And the first half of 2023 was a little bit of, a little bit of rocky in terms of deal volume and aggregate deal size. But the leaves are turning just with the turns of the seasons and fall and the throughput's gotten better, volumes are rising, deals are still getting done, but the processes are taking longer and people are being a little bit more judicious. And that's influenced by the lack of free flow of capital. People are making sure that it works on the debt financing side, on the equity financing side, and sometimes that comes at the expense of sellers, hence the need to figure out how to bridge those valuation gaps.

The three big tools that you brought up are earnouts, seller note financing, then some sort of equity structure.

That's right, seller note financing. You could think seller financing in terms of a debt, a piece of debt, a piece of paper. Or we've seen creative structures on the equity where sellers are providing an equity slug of financing and then secondary to that or adjacent to that. We've seen instead of vis a vis between buyer and seller, third parties, institutional asset managers providing a layer of preferred equity that looks and feels like debt, like a Holdco picnote or a piece of subordinated debt that has high yield returns. But it's just pure debt. It's equity, but it has pure debt. It doesn't really have much in the way of covenants, although those are often negotiated, but we've seen those employed by a number of sponsor groups over the last few years as an alternative to debt where it's not impacting covenant levels. That equity structure sits in front of the common return that the investors have. I know I'm getting down a rabbit Hole. And some of your listeners might be saying, why is he talking about all this private equity and this fancy structure? And I think it's important for your listeners to understand even on the public or private company side that are investment professionals, they might be selling to a private equity buyer. And there are ways that you could invest or maintain an investment in if you don't get all your cash up front at the sale. I've seen creative structures where public company institutions take a tranche or a stripe of security in the new hold code that the private equity group's setting up. Even if you're not in the private equity world, I think it's important to understand how that part of the ecosystem works so you can optimize your outcome up your game. That's right.

Well, that's why we're going to take these apart one by one. Ready to go?

Absolutely.

Let's talk through what earnouts look like on paper and give me examples.

Even on paper they're fiercely negotiated. Let's talk about a couple key terms. Obviously the economic or commercial terms are critical. How big is the payment, over what time, over what period, duration and how is it measured? What are you measuring against? I think of earnouts in two main types. There's financially driven metrics like revenue or ebitda and then there's milestone related or event driven earnout. So those could be FDA approval or the outcome of a certain pending litigation, some third party event that maybe the company has control over, the target has control over, or maybe not. Earnouts tend to be more prevalent, at least statistically speaking, in like life sciences deals and healthcare deals, along those lines around drug discovery and so forth. But I think we've seen or at least in our experience continue to see with great frequency earnouts being used to bridge those mismatched valuations that I've mentioned with financial metrics with usually ebitda. Same EBITDA that the group was buying into is used to measure the target's earnings or Earnings Potential Year 1 after closing, Year 2 after closing, sometimes even a bit longer. That provides an ability to a payment by the buyer to the seller for that target, achieving those financial metrics over that period of time.

I get it. For a healthy company where you could create these milestones around revenue and ebitda, We're a smaller company so we tend to get the bottom of the barrel deals out there where we're either just buying IP or we're buying like a distressed company's book of business and we plan on killing their product and Migrating their users to a new product. In those cases, I take it they'd be more milestone based. What kind of milestones would you see around transactions like that?

Your example of buying intellectual property, the idea of buying that intellectual property would be to either create some product or some outre so you could have it measured off revenue or sort of geographic growth or use of a product or tool adoption. There's a lot for milestones in healthcare. Major drug discovery, FDA approval, being on a Medicare approval reimbursement list are quite popular metrics or third party validation type metrics. Ultimately it's all to drive revenue. Is that part of what is leading to not being paid full freight or 100% at closing? What's the investment thesis and what is the seller leaving behind and is he or she or that group able to control that in that measurement period? Whether it's one year to three years or even beyond?

Milestones tied to the investment thesis, ultimately where we're looking to drive our value and it could be variables involved in how you put those milestones together.

Absolutely. It's going to come up at the LOI phase. Unless there's some sort of litigation. Let's say litigation just wasn't known at the time of the LOI phase and you've find out that there's this bet the company litigation or there's this ongoing patent dispute and your company is worth a whole bunch more if you win or not worth a whole bunch more if you lose. But when you have those bifurcation results you could does an earn out make sense? Sometimes in those situations you actually see buyers come back to those sellers and say as a result of what we found, your business isn't as worth as much. Or we can't pay this multiple because we didn't factor this into the model and to the debt payments and so forth. Those are difficult conversations that sometimes come up during the process. And that's some of the value that diligence function adds. And it's not just legal diligence, it's tax diligence, it's intellectual property diligence, it's human resources diligence on labor and employment matters and on employee benefits. And I can go on and on. Tax, there's a specialty for everything. That's what makes deals so fun. Kisan, you know this.

The main knobs that we want to dial in are going to be the payment, the timeframe and then the how we're measuring it, which is essentially the milestones.

Those are the big commercial aspects. On the legal side Some of the items we think about are information rights. What information are you getting during the measurement period? We think about what are the effort standard, what is required on the buyer to the efforts to go achieve the earn out in terms of commercially reasonable efforts or best efforts getting into that level of legal nuance. I think the third and probably the most important is thinking about governance or control rights. What checks to the seller have on the ability of buyers to make decisions with respect to the company they just sold. Some of that factors into during the ownership period, during the measurement period that the buyer owns it. What credit is there for mergers and acquisitions? Do you have blocks on some of that? Because it could be accretive or it could not and it could really impact the earnings potential of the company that was just sold. Probably the last point, it's more of a legal point, is on dispute resolution. Is there an ability to dispute the earn out? Almost certainly there always is. It's almost like a purchase price adjustment mechanic. It gets the same. Whether it's done through a third party accounting firm or some sort of arbiter. There's usually a process to dispute. I'd be remiss, not to mention probably my litigator colleagues would say earn out is just postponing your dispute over what the consideration is at the time of the closing. It's a kick the can down the road approach, but it can work and it can work for both buyers and sellers. It's the devil's in the details to navigate both the legal and the commercial challenges to it.

If you're at a ballpark, how many earnouts end up in litigation? What would you guess that would be? Estimate what that would be.

I will estimate it, but let me just throw in my own legal disclaimer. I am a lawyer, but all of these are my own opinions. None of these are opinions of K and L Gates or the law firm. And none of this constitutes actual legal advice. This is just fodder for our discussion and our edification here on M and A Science. But I would say about a third would end up in disputes like all out litigation. It's just a haphazard guess. I've asked the same question to people who conduct these big market studies, whether it's ABA or other third party outfits. And nobody can give you a straight answer. Obviously we know when litigation is in the court system, but not all dispute resolution procedures run through the court system. There's arbitration proceedings and then there's just good old fashioned negotiation before it ever gets to that phase. Just like in a normal purchase price adjustment mechanic. So there's ways to mitigate that litigation risk. Being really clear about what the yardsticks are, are we measuring EBITDA and how are we measuring it by ebitda? The same valuation methodology that was used by the deal team when they were valuing the company at the time of closing. And we're going to run it through that same system. Is it based on that EBITDA definition in the credit agreement that's governing that portfolio company or platform company's life cycle? These are some really detailed oriented questions that should get sorted on the front end. So they're in the legal documents. You know there's other factors that matter, right? Is the management team staying on to run the business? How lofty are the are the goalposts? Some earnouts are aspirational. They're wish list just in terms of what they're getting to. I think a better, more prudent approach is if the management forecast and your valuation exit in that scenario, if that's the litmus test and management thinks that they can go execute on that 10 million of EBITDA in that measurement period. And that's what you're shooting for. And the sellers are there, the management team's there to execute on. And I think that has a greater likelihood of being achieved.

Is it fair to say majority of these disputes are because of interpretation on the burnout agreement?

I think a fair share of them.

Okay, fair enough. And I try to bag the lawyers on this one, by the way. I'm just, I was just curious.

Yeah, I think most people have, whether it's sellers getting disillusioned that more money should have been coming their way, more often than not it's over interpretation or people feeling like the effort standard wasn't met or what have you. So hopefully it doesn't end up in litigation. It's a good outcome for all. I have to discount the numerical frequency because some aren't achieved. If they're pie in the sky projections and they never had a wish, hope and a prayer of being successfully met, then there's no point in litigating that. It's just it was never achievable in the first place. Hopefully the closing date consideration sufficed.

Fair enough. I appreciate the insights there. I want to go back to just the structure of these earnouts. Can you give me examples of what do you typically see? If I was doing like a $20 million deal, what kind of payments and timeframe is common?

If you're the seller, sort of twofold you want as much closing date consideration as possible so you can view the earn out as if it's really big as great. I question that. Maybe you wanted more closing date proceeds and you've just made a whole bunch of your consideration contingent. You have to go earn it. To me that's not as ideal.

Well, you're on my side, you're on the buy side and I'm trying to put as little cash into this and take as minimal risk so I don't have to get any third party capital. So I want to go heavy and put as much of the earn out on on the line. Yeah, keep some folks on the hook to make sure we get our goals.

And that's feet to the fire. And if people can execute on it and deliver on it and those goals are achieved, buyers are happy to pay that out because they're reaping the successes. In terms of the financial metric was achieved, the balance sheet of the targets, the company they bought is stronger and the equity value should be higher. Ultimately again it goes to that win win. In most cases if there's a debt provider and debt financing resources you have to think about, they need to know about those payments, they need to be subordinated in terms of thinking through that's a potential cash outflow and making sure the lending group is comfortable with that and they should be right. If the earn out is structured properly.

There's quite a bit of variable then is there like a common range that you see percentage wise of how much gets put in an earn out?

Yeah, I think you probably see about a third of the closing date consideration push to the post closing period, to the measurement period. That's probably been trending up a little bit and maybe not even that high. Maybe it's a 25% of enterprise value. But I think that's probably a good rule of thumb in terms of measurement periods. If it's financial you usually would see just one year, maybe two. If you pivot and think about from a milestone related or an event driven burnout this could be much longer in duration. Five, seven, I've even seen nine or 10 years. But there's some real upside to some of those that are going to take a while and need significant resources to be invested in and lofty goals but big payments too. So it's. That's why there's more time especially on the health care side. When government's involved and reimbursement rates are involved, it's not easy to get on an approved list or a reimbursement list or get something through commercial development that takes time. Whereas financially driven metrics are usually say 1, 2, 3 years in duration and even of the frequency among them shorter, it would skew towards year one and potentially maybe even 18 months.

We got a big range that we got on this end as well in terms of how long these could go. For anything else to be really mindful of when negotiating earnouts, it sounds like clarity is the key and just being as clear as possible of what the milestones are going to be.

Clarity is key. If it's a longer duration, like the commercial development of a drug discovery or there's some patent litigation or something like that. Information tends to be helpful and a lot different than the information that would be obtained through the financial metrics. So you might want a consultation, right, or some sort of board. Right. Or an ability to talk to management and just understand how things are going or what's the probability of this being hit or achieved. And so that consultation tends to be a lot more helpful than just reading the financial statements. Whereas the financial statements, if you're being measured off the financial statements, off EBITDA revenue, that sort of normal course information package is perfectly helpful. You don't know that when it tends to be more bespoke. And my examples again are the litigation or commercial development or patent infringement case. Those consultation rights tend to be softer but probably more helpful or useful information.

Would you want to have some of those conversations before you put LOI out there? But could you dig into the management team and try to get that level of certainty that, hey, these are the milestones that we're looking to put together.

When buyers, especially private equity groups, most of them, look to partner with management, they tend to back management teams and the direction they're going with their investment thesis. So they might not get into that level of detail on those sorts of conversations, but you bet your bottom dollar they've done background checks, they've done referral type calls, maybe even brought in a third party consultancy to do some evaluation and talk to other management teams that they've either previously worked with or their existing colleagues to understand the direction that they're going. But a lot of these relationships between management teams and private equity buyers, or even public company buyers, they've known each other for years, sometimes longer, either through industry or second and third acts or a few companies ago. So these aren't relationships that are forged in one management meeting. They've been having a number of conversations over the years. They've been keeping tabs on the companies that develop Some trust in terms of understand your company's not in market. We love the opportunity to bid when it is up for sale. We'd like to preempt this process. You have private equity buyers trying to squeeze in there and get something before it goes to market. So probably not paint as perhaps as rich of a premium. A lot of private equity groups try to partner with management, team up with management teams and use that to advantage, gain that trust and also it helps them. How are we going to take this to the next level? What is it? Through organic growth? We're going to spend dollars to invest in you. How are we doing that? Is it through a new product offering, a new scalable piece of software? Is it because we need to invest in a new role, whether it's a cto, a cio, a consumer, some sort of software development role? What does it take to get to that next level of growth? And it could be through add on acquisitions. And that's a lot of private equity groups, bread and butter. But it's sort of having those conversations, those dinners and fireside chats and industry groups and just networking over a number of years that forge those relationships and those trusts. So going back to your very first question, I don't think you get into that level of detail early on, but it will come up in the course.

It sounds like it's a lot of alignment around the strategy itself. Against the investment thesis. Let's talk about seller financing. What are the different structures possible when.

A buyer is looking to capitalize a new platform company? And I'll just continue to use private equity as an example because that's where I spend the lion's share of my time representing sponsors and platform deals and add on acquisitions. They bring equity capital to the table and they bring debt capital. Debt providers, they usually have a stable of private lender relationships or financial institution parties that they can bring to bear. But again, in these mismatched valuation situations where seller wants a multiple of X on what they're on the EBITDA that their business is generating and buyer is recalcitrant to spend that either because financing has gotten more expensive going back to the rising rate environment I mentioned, or they're just worried that the growth trajectory won't be as strong as it was. They're worried about that recession case or that base case and not being in a always hockey stick upward growth trajectory. So you get some of those valuation disconnects. One way to bridge it is to say seller provide a debt financing in the form of a note that the Company will pay out or the buyer will pay out over time, the seller $10 million or whatever. In an example that's subordinated to the senior loan agreement or even the second lien or mezz loan agreement. And it's just another ability to provide additional financing to give them enough juice to pay that higher premium. Seller's happy to take that. They're just effectively usually happy they're getting their cash dribbled out over time. They're not getting that they'd otherwise get that money right at closing. We've seen other, I would say even more creative situations where when buyer is setting up its financing for the holdco, we've seen the exiting sellers set up a tranche, a layer of security where they're the first money out when buyer goes to sell that company in five years. So it might not even have any current pay, any coupon pay like a traditional debt product. It's just the first money out. For whatever reason, buyer was unwilling to make that last x dollar of payment, let's call it $25 million. Buyer didn't want to stretch. But what they did say is we'll deliver that to you, so to speak sellers. But you don't get that money out until we exit. When we go to our change of control at that future exit scenario, we've seen that employed. I won't say with a lot of frequency, but the flexibility to know that there's equity structures that allow the sellers to reap proceeds along the way either all along the way like a seller note typical debt like payment or at some future exit that the private equity group has. And I think in a lot of the equity structures it tends not to be cash pay on exit. But we've seen some really exotic structures that have cash come back to the seller after certain return that the buyer has. If the buyer's gotten this much money off the table, the next 50 million of proceeds goes back to the sellers because of whatever the commercial deal is, they should get that next tranche of money and then it picks up and goes back to the buyer. We've seen some really exotic ways that splice the distribution waterfall in the go forward platform holding company capitalization table and or facile with those structures. From a corporate M and a equity perspective and tax perspective, we always use very sophisticated and smart tax advisors at canelgates on our deals to help make sure we're not falling into any traps for the unwary there. So I think those are some ways we've seen seller financing both sort of Bridge the valuation gap on the debt front and the equity front, the third product, and I'll just push you there. Kisan is when third parties step into that preferred equity structure and we've seen that with greater frequency the last two and a half years. With the free flow of debt capital markets, preferred equity structures, there wasn't really much need for them. There was plenty of debt capital, there was plenty of GP sponsor capital available to make platform deals and if necessary for add on deals. Private equity groups usually look to use their existing debt capital to reach for add on opportunities. But what we've seen as credit has tightened, institutional asset lenders, life insurance companies, sophisticated parties that provide private credit solutions have stepped in and filled the void that might have normally come through a mez debt product or a hold code picknot which we won't necessarily need to get in details, but we've turned the stripes from debt to equity and it's the first equity that is returned out of the equity structure. It has debt like features, but it's not debt, it's equity. You're like what's the difference?

What the hell is this?

That equity might have a 14% coupon on it. Okay, it's accruing, but it's not cash pay. They get out once there's cash distribution. So the first cash distributions that the company makes would be to pay down this debt. And it might be redeemable in seven years or eight years, whatever the terms are.

You're not making any payments against this?

Not making any payment.

I like this.

Tell me more. It's bridging the gap. You're not making any payments, but it's expensive paper. It's accruing but it's not hurting the company's cash burn.

It's occurring the same way debt would.

Absolutely. But it's usually paid in kind or pick.

So you pay a lot of compound interest on that.

That's right. And so we see interest rates for that product probably stretch from 12 to 19. It's like a high teen mezish product. It's an expensive debt product, but it's wearing the sheep as equity. It's the preferred equity. What's really interesting or cool about it is if we're engaged either on the sponsor side or we do have institutional LP clients who are using this product, doing private credit solutions. Some of our first questions, if we're on the lender side, we'll wear a lender hat for a second. Even though it's preferred equity, is it more like equity or is it More like debt. Tell me about the covenant package. The debt covenant package because if it was a more traditional debt there'd be relief or cushions and the same sort of covenants that are in the senior documents. But I think in preferred equity structures we've seen the covenant packages for them really run the gamut. And I think it just depends on the industry and the quality of the credit down below of the performing target company, what industry it is, how's its cash flow, how comfortable are you with it. But there's some frankly challenging conversations about what are your remedies in that situation. On a failure to pay, what happens on an event of default, what happens if there's a failure to redeem? If it's a seven year product, what happens on a failure to redeem? Because there's not a traditional foreclosure like a debt or an ability to take over the asset. There's some other ways that lenders and sponsors get comfortable with it where there's yes, we'll try to take you out. There might be a penalty, interest rate or not, but at some point leads to a sale or some sort of forced process where there's liquidity for everybody is where it ends up probably eight times out of 10 or perhaps even more. It's an interesting sort of hybrid product and it does bridge that valuation gap. Because it's not a participating preferred equity like in maybe some emerging growth companies that people have. Oh, it participates along the side of the common. No, it is just the first money out. It's a 14% piece of paper.

Pretty cool. I had no idea about that. Can we go back to just a traditional seller financing and can you give me a sense of terms that you would see or what's the range between the interest, the duration?

In terms of the interest rate, you're probably seeing a function of some sort of base rate, whether that's prime. Libor's gone, but a function of prime plus x percent. Sometimes you see where it's done a lot cheaper, where sponsor has a lot more leverage or sometimes it's triggered off what the senior loan documents are. But there's tax reasons where it needs to have an interest rate, at least in the United States over what the applicable federal funds rate is.

You're typically seeing it floating over fixed.

Yes, typically. I'm sure there's instances where fixed works just fine. But as as long as it's calculable and measurable and not overly complicated, I think people can get comfortable with it floating again. In the last three years with the higher rate environment, I think you're going to see a lot of flight to people moving to a floating interest rate. Whereas before rates were Fed funds rate was low forever and everybody just got used to this low rate environment. So people were fine, sure, 5%, 3% or whatever. Fixed rates were fine. But there wasn't much interest rate expense at that time. But now with the way the Fed has moved rates up and is battling inflation, I just don't think sellers would be as comfortable with a fixed rate.

Fair enough. Duration.

Duration, it's a commercial point, but varies probably between one to five years. Just depends on how much and over how much period of time. Some of the negotiated features you'll think about is if there's a change of control, does it become due and accelerated at that point or time? There's features like that that sophisticated sellers are advising sellers. Thinking through those nuances can be helpful. Obviously sellers want as short a duration as possible, get as much as their capital back as they can, and buyers want to dribble that out.

Pretty sizable range there. Let's talk about the equity. What do the structures look like if we were to build something more as an equity structure to bridge the gap?

Yeah. In terms of the equity structures, it crosses a number of types of entities. Whether it's limited partnerships or limited liability companies. There's a lot of flexibilities in those types of entities to craft a distribution waterfall or a payment waterfall that works for all the parties. There's probably even more flexibility in those types of entities where there's more choice points than in a traditional Delaware corporation where there's classes of stock and common stock and preferred stock. That said, they can be done in those structures. I just think we typically see them in limited partnerships or limited liability companies where it's true creature of contract. When I say creature of contract, that really allows the M and A practitioners to be flexible to customize it for that deal. There's a lot of sponsor groups that have a preferred common structure. That's their preference in terms of where they always tend to couple it on a one to one basis in terms of how they do and structure deals. And that's a little bit of remnant of doing deals through corporations. There are other sponsor groups that just have a single class of equity and it's just common. So when we're talking about the preferred equity, that's this solution for bridging evaluation gap. We're really talking about super preferred that sits above the common return and that is the first distribution waterfall to the Equity holders, whether it's for that 15% and that usually isn't paid until there's an exit or a dividend recap. There has to be a significant sort of watershed event where there's money flowing out to the equity holders. Investors know that whether it's sellers who are providing that tranche or some of these third party institutional asset managers that I mentioned that are providing this tranche. We've seen it on larger deals where there's some stretch or for some reasons didn't want to take on that much debt. We've even seen it in some regulatory environments where for certain calculations under the government regs, whether it's in educational institutions, what have you, that the targets can't have that much pure debt. So this has been a way to provide financing to the target to help it grow but still meet its debt requirements under whatever applicable regulation. So we've seen it employed to both meet regulatory tests but also bridge valuation gaps.

Would options be a thing to utilize?

To me, an option feels like contingent consideration or like an earn out. If this hits, then this pays out. Are you talking about options in the public company markets?

Well, sitting in a private deal, it's hey, we're going to put some options as part of the consideration in the deal as opposed to carving out street. I guess it goes back to like the tax implication. If I'm doing this and we're providing this, whatever preferred equity, is there some tax liability that's triggered as opposed to saying, hey, we're providing you options of this much value?

That's a really great point. And stepping back, what are ways to incentivize your management team to help grow your enterprise? Whether it's a public company that has an existing compensation package and philosophy or a private equity group, there are ways to incentivize the management team. And so within these private company structures, a lot of times in these LLCs or limited partnerships there there is a class of equity, often called profits interest that can be issued with frankly a $0 strike price and allows them to participate in the future profits of the enterprise at certain inflection points. Those often have time based or performance based vesting criteria about when they can come into the money and start participating, taking dollars alongside the common equity holders. But those are other ways to incentivize the management and maybe not bridge valuation gaps as between buyer and seller at the deal table, but certainly to help grow the enterprise during the hold period and frankly align the management team with the goals of the equity investors to grow the entire Enterprise in organic growth through organic initiatives and so forth. So that's definitely profits interest. Yes. If it's a corporation. Stock options or stock option plan, restricted stock. We've seen Bantam stock plans, stock appreciation awards. There's a variety of ways. All of them are different. There's different tax and corporate features to all of them. That sort of makes sense in the various scenarios. They're all designed to align interest to grow the enterprise.

Yeah, there's a lot we're not going to get into those. I think we ended up creating a SARS for our company. But you do need to have your tax advisor involved work with you to be able to put that stuff together.

Absolutely. And a lot of times there's an omnibus incentive plan. So there's really a menu of types of awards that work for different situations. Does depend on how big your enterprise is and what you already have. And what can you do within the existing framework of your company or your company group or your jurisdiction. Because there's different rules between the US and frankly the non US enterprises. And those are some of the value that you're tax advisors can bring. But also your legal advisor. We always recommend calling them early and often.

Yep. Can't count on them enough. Let's say I'm working on my first M and A deal small deal. It's like $10 million being first time small private company. I want to hold on my cash because cash is king and we're a growth company. I can put that cash to work and it just keeps multiplying. Let's walk through stacking these things together like really using all of them. Can I do that? Can I put together earn out seller financing and equity in the package to really minimize the amount of cash I need to put in the deal? I know it sounds crazy.

No, I think there is. It's a little bit of choose your own adventure about how far you can push each lever or lever and get them all to work together. I certainly think it's within the art of the possible. Your goal is to conserve your cash outlayer. So you put the earn out on the table and say I like your business but I can't pay this much. But if you meet these financial metrics over the next two years, we can pay you another million dollars at the end of year one and another million and a half at the end of year two. Again subject to you delivering or exceeding the revenue or EBITDA thresholds at those points in time that helps you save money.

All right, so what are you talking about? $10 million. We want to put what, $3 million in earn out.

Yeah, that'd be great. What else can you do? So can we get the seller instead of cash outlay of 7, let's have you trickle money out over time in the form of a seller note. So we'll deliver them a note and instead of paying them cash upfront, we'll pay them a million dollars over the first year post closing.

Can we do 5 million over the next five years? You can probably tell I'm pretty Indian by now. I, you know, just negotiate. And you pretend to start off with asking for the world.

You can ask for the world. You have to pay something at the closing table, I'll tell you that. Kisan, do we? I think you do. But yeah, you can play around with how much that outlay is and over what time.

All right, So I got 5 million in debt financing, which leaves me with.

2 million ambitious goals. Let's pretend the seller is going to stay on with you and execute this line of business or this product offering or what have you and integrate. So we have the earn out, we have some seller financing in your ecosystem. We are going to amend your organizational documents, your llc, you're an S corp. We're going to do an F reorg and a whole bunch of stuff. We're going to make it so that that seller is participating in your equity capital at your future exit. And let's be cheap and not give them an interest rate and just say, yeah, we'll give you a million dollars when we go ahead and sell this entire enterprise. It's not that 15%. We're not paying them anything during the hold period. We'll just say it's just delayed gratification in the sense that they get their dollars. When you go to exit 1 million.

Worth of equity in the post company, that leaves us with 1 million. We need to put cash on the table. Can I get third party financing on that 1 million?

Absolutely.

All right, so what does that look like these days? What's LTV? 80, 20, 70, 30?

The banks are going to have so many questions. How leveraged are you now? How much cash do you have? What are cash flows like? What is the cash flows of this business? But you're going to certainly want the ratios to play in your favor.

70, 30 means we got about 300k we got to put in this deal. This is great. I can tell you're going to love working with me. I can tell John already. Let's talk about the loi. Can you tell me what's this going to look like in an LOI when you spell out the terms that we just talked through?

Where it's captured in the LOI is the buyer presents sources and uses. So this is, yes, here's our headline price, here's what we think the enterprise value of this business is on a cash free, debt free basis. So it's a $100 million bid on a cash free, debt free basis. To the extent that the seller had an existing $20 million senior credit facility, we expect that to be paid off. There's only $80 million of net proceeds available to ultimately to distribution. We are paying you for the cash on hand, if there is any, but we certainly don't want to over equitize for cash. So we're going to actively monitor how much cash you have on the books in terms of sources and uses. A lot of times buyers will present their debt financing partners, their equity partners, either their partners or what they expect in terms of the dollars to equal to the $100 million of purchase price. In my example, in the enterprise value example. Other times public company buyers will say, yes, we're going to finance this 75% cash, 25% equity. We're going to issue, we're publicly traded, we're going to issue you some restricted shares from our universal shelf for that 35% and we'll pay you cash all that. So if you get that from a public company buyer might not ever mention a credit facility. They might have an unsecured credit facility because they're such a credit worthy party. But you want to know, and the sellers will want to know, what's my mix of consideration? Is it a cash deal, I'm getting stock in it. How do I feel about the buyer's public company stock? Do you have conviction that it will continue to appreciate during your hold period? And at what point can you liquidate it and monetize it if you don't have that same conviction? Those are some considerations when you see in the loi the sources and uses are being brought to the table.

In our LOI, we're offering $10 million and then we would spell out, hey, we're going to have 3 million of this in our earn out over three years. We got 5 million of seller financing, that's at 5% over five years. Then we're going to have 1 million that's going to get rolled over into the equity. Post close. We got 1 million out of that. We're going to, we put our debt contingency in there or do we just.

Not mention that it's going to be simultaneous sign and close, probably at a deal that small. So I probably wouldn't probably bring that.

We're bringing you a million dollars. It's going to be in your pocket at closing.

That's right.

All right, this is great. Let's get this thing drafted up and get it put together.

Yeah. I think you've hit it all. Debt, equity, the earn out bridge and the financing bridge and the cash that you're bringing to close and then it's just a handshake at that point.

Exactly. Then somehow get them to pay your fees. This will be perfect. This has been great. I'm trying to think, is there any other advice you give somebody? Any other things that you've come across from your experience that are, hey, just kind of look out for these things when you're doing deals and trying to bridge financing gaps?

Yeah. I think it's important to think about the tax impact. The corporate deal is one piece of it for sure. But just to know what the art of the possible is, we work within deal teams here at canal gates and not every deal is the same for sure in terms of industry and size and speed and what the, the objectives are. When the facts change, it's important to test some of your assumptions again. And that includes like structuring and if there's, you know, making sure your tax advisor is because you're not doing anything untoward that creates a bad outcome, whether for the buyer or the seller. Because a lot of times, again, it's a partnership with some of these acquisitions and you don't want to be living with those negative consequences if they could have been avoided. That's probably one thing I'd.

I'd say hire a good lawyer.

Yeah. Our good advisors. Absolutely.

John, what's the craziest thing you've seen in M and A?

One of the craziest is. I'll take you back to Covid. In October 2020, we had a earnings call for one of our public company clients. And on that day they announced. They announced basically three items, which was incredible. Right before an earnings call, they announced a $2.1 billion acquisition of a US company that does. It's for a healthcare company. And all this is. Is public. It's for Exact Sciences Corporation and they. Their healthcare company focused on cancer diagnostics. They bought a blood biopsy corporation, a blood diagnostics corporation that is looking to detect cancer in blood samples. And it was a $1.7 billion deal at closing with an earn out that was in excess of 450 million. That was one item that was was announced that day. Didn't close. It was announced there was an acquisition in Europe for a genomics company that spun out of Oxford that also was announced that day. And then there was a $800 million equity raise and infusion into Exact Sciences where our capital markets team went and attracted additional capital for Exact Sciences. Not necessarily to pay for the acquisition, but it was a good time for them to raise money. So we had two very sophisticated large deal teams going on two continents and we had a capital markets team raising money and we had a corporate governance team interfacing with board of directors on all of these things. And they all were announced on that same day in advance of the earnings call. And it was during COVID and it was like a crazy time, but it was an awesome earnings call. The market loved it. But more importantly, we got some nice thank you notes from the CEO about the deal teams and the value that Canal Gates added across all of those fronts in terms of the M and A, the capital markets and the corporate governance piece. And it was a proud day.

Hey, that's a way to keep earning call days exciting, drop all, everything then.

Yeah, absolutely. One of the craziest things I've ever seen. This is just a funny anecdote. We were dealing with a snack food company and the seller wanted free snacks for life for a product she developed and she got it. And it's a product that you would see in the grocery store. I smile every time I walk by it knowing that she has free snacks for life.

That's funny. You think the whole thing, you work at the restaurant, you don't really eat there because you get sick of it. But no, they loved their creation.

She loved her product. And frankly, our family loves the product. So I don't blame her. It's just a funny ask. When you're in the moment, you're just like, really? You want free X for life?

Okay, you like have to spell the terms. And how much of that is there a limit? Because he could be wholesaling them out or selling them.

I don't think she's redistributing, but I'm sure there was some delivery requirements on what the quota or what the amounts were.

For sure I'd have my kids peddling the neighborhood.

So those are some crazy things. One, I think the Cain all Gates story just showcases the breadth of the M and A expertise and to be able to deliver for a client on a number of fronts. And it all happened to coalesce in one day. And that was what was uncanny about it from my perspective, because there were moments where we weren't sure all of the pieces would fall together. So we had contingency plans B and C. Should one of these acquisitions not get to the same point in time? There's some level of control, but deals also involve third parties too, and you don't necessarily control that, and you still are running up against an earnings call and a finite deadline to the capital markets. So it was a proud day and showcased our some of our core competencies for our clients. And it's a great company with a great mission and we're happy to partner with them on their desire to change the world and rid the world of cancer.

Great stories John. This has been great. I really appreciate value you spending some time with me, helping me become a better M and A scientist.

Thanks Kisan. It was a pleasure.

Those of you still listening in, thank you. Till next time.

Next time.

Here's to the deal.

Foreign.

Thank you for taking the time to explore the world of M and 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 and 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 a science.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. Again, that's mascience.com here's to the deal. Views and opinions expressed on M and A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational and is not intended to serve as a basis for any investment or financial decisions.