Roll Up Strategy in Private Equity

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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. I'm your host and chief M and A Scientist, Kisan Patel. If you're interested in learning more about how to optimize your M and A practice or want to get involved with our community of forward thinking M and a practitioners, visit mascience.com if you want to keep up with us on the go, head to LinkedIn and follow M and A Science. Joining me today is Gary Williams, Partner at DLA Piper and a member of their management committee. DLA Piper is a global law firm with offices across the United States. It's known for providing a wide range of legal services to various sectors including corporate, real estate, technology, life sciences and finance. Today we're going to talk about the roll up strategy and private equity. But hey Gary, I know you're an attorney. Why don't we get some of the legalese disclaimers out of the way?

Absolutely. We'll touch on a number of different topics and it's important to throw out there that none of the things that I touch on are attributable to any one particular client or the firm. They're just general stories used to guide our legal discussion. Awesome.

Gary, how are you doing today?

Doing pretty good. Glad to be a part of your podcast.

It should be fun.

Thanks for taking time off available hours to spend some time and teach me a few things here. Can we kick off a little bit about your background?

I've been practicing in the M and A arena for a little more than 25 years roughly. I spent about a third of my career doing public company ipo, secondary offerings, SEC compliance work, but the bulk of my practice over the last Decade plus has been in the private equity arena. It's been about 70% of my time representing private equity funds, buying and selling companies globally. Also spend a little bit of time representing six or seven Fortune 1000 companies doing global M and A. And the last part of my practice is I have a handful of SPACs that I represent or companies doing deals with SPACs. And so pretty much I do anything M and A across a number of different sectors.

That's quite the full breadth. Large scale corporate, multinational conglomerates, IPOs, private equity. What's your favorite type of deal to work on?

I like the transactions that are US based but have some international aspect to it. Most of those transactions people are buying or selling companies that are based in the US but they have offices in multiple countries and those tend to produce the most complexity. And it's a lot of fun most of the time.

Right Balance, not too much. If it's completely offshore, then you got a whole world of complexity.

That's a different animal. Those type transactions, which we do tend to fall more in the hands of folks and lawyers in our other jurisdictions. It's hard to control those transactions from abroad.

All right, got an appetite for complexity. I like it. Tell me, what are the industries that get rolled up?

Most often over the last decade or so you've seen a lot of companies in the health services sector get rolled up. We're seeing a lot of companies and call it the commercial arena. So commercial services companies, the H Vac businesses, various different types of plumbing businesses. Rather it's businesses that are providing the product directly to the consumer or they're providing services in that arena. You see a lot of those businesses get rolled up. We've seen roofing businesses get rolled up. The latest phenomenon is where you see businesses that really are one location businesses, one or two owner, handful of employees. Those businesses are getting rolled up in the lower middle market into bigger platforms and then being sold upstream in the private equity arena.

What's an example of that?

I've been working on a H Vac platform for call it the last three years or so. And it started off by a client, bought three different H Vac businesses that were really small operations, covered a small part of a particular city, and they bought those three businesses at the same time, developed it into a much bigger platform and then we've been doing one off acquisitions of similar sizes, but either growing there into a new geographic footprint or increasing their presence in a geographic footprint that they're already in. And once those businesses get to a certain critical mass and they called it commercialize the businesses added a level of C executives. They professionalize the way they go about scheduling their customers, servicing their customers, and.

Then they turn around and sell it.

To much bigger groups that are trying to do the same thing but at a much bigger level.

I've seen that a lot where you see a roll up. It gets started off, sold to a private equity firm, they beef it up the M and a muscle and after a period of time they'll sell to another P firm, they beef it up even further and it just keeps going. We mentioned the industries. It seems like there's a big theme shifting towards the service oriented businesses. Has that always generally gone that direction? Like where did it originally start from? Where were the early businesses that were doing rollups? And then because it seems like things are kind of going downstream to like smaller and smaller assets these days.

There used to be this idea that you weren't going to buy service businesses because there was no secret sauce. There wasn't a specialized product, there wasn't a secret ingredient to provide some barriers to entry and make it defensible. You didn't see it, you saw roll up strategies, but centered around products that had some unique feature and those were companies that were getting rolled up. Now someone figured out that these service businesses, particularly the ones at the lower middle market side, they're small, they don't have a great accounting function, they don't have a great billing function, they don't have a great collections function. All of those various different functions that these businesses typically didn't have, that's money on the table. But someone figured out is even though these service businesses didn't have a secret sauce, they could roll these businesses up, perhaps professionalize them and resell it because.

They taken what was a negative and.

Not having a secret sauce and made it a positive. Because the service is what people tend.

To go back over and over again.

Service businesses, that's really what in my opinion has driven the roll up strategy in an area that once was not really touched.

So like operational efficiency and essentially building like a service mark or brand. I'm looking at our customer list over here and we cover rollups in private schools, auto body shops. I see veterinarian clinics, dental clinics, insurance companies, and then the wealth management. I don't know, is there other sectors we're missing that we're seeing rollups happening?

Anything on the healthcare side that is not highly regulated but specialized. So optometry is businesses. You pair the selling of the glasses with the actual eye exam and you roll Those businesses up and once you get to a certain critical mass and you add the specialized eye examination or services to it, it seems like every.

Sector of healthcare is getting rolled up.

Yeah, it used to be that people didn't want to venture into the healthcare sector because of all the regulatory risks. So what people started figuring out is if you could actually buy the service part of the healthcare sector and not the highly regulated side businesses like the dental practice management service businesses that you mentioned earlier. Optometry businesses are beginning to get rolled up. I have a client that all they do is roll up businesses that provide product to the big healthcare suppliers. They go out and find any type of low end product that's going to be sold to a hospital network or it's going to be sold to a big distributor of products and they try to find a little bit of value added angle and they're rolling up and getting as big as they can so they can have access to the much bigger customers. That's a business that's moderately regulated, not really a high barrier. But if they can have a big enough scale and provide some services on in a professionalized manner, they're still buying up these mom and pops and making them big platforms.

So we got roll ups happening. I was thinking managed service providers is another one. But it's a lot of different industries.

A lot of different industries.

Another business we're doing a roll up of service companies that and all they do is go around and provide testing.

Services to commercial kitchens.

These businesses that are being bought are businesses oftentimes that might have two or three commercial customers and they're buying one. They bought three businesses, put them together. Now you have a bigger footprint. You go from three customers to 12 customers. They're going to professionalize that and then start to spread out into a bigger geographic footprint in hopes of building a platform large enough that they can sell.

It to a much bigger player.

You worked on a bunch of different deals on all different scales and levels. I think these roll up people have it really good. Like when you look at their model, it's predictable. You sort of know how big your market is, which is highly fragmented. You got a range of multipliers you're going after. You see the other end, the economies of scale, like everything's pretty tangible. Am I missing something? Is there anything that makes it actually harder than other strategies?

The clients that I have that play.

In that space have a stomach for two particular things.

One is on the front end. Unlike other industries or bigger businesses that.

They would target, you're not going to.

Have an investment banker that has gone.

In and put together a pretty description.

A book about this business. And then all you have to do.

Is look at it, study the industry and figure out if you want to buy it.

You actually as a buyer had to go in and build that story from the ground up. And so that's, that's one big thing.

Is that supposed to be a pro or a con? Because to me that's a pro.

It depends on what you have a stomach for. A lot of people view it as a con because they don't want to roll up their sleeves. I think it's a pro because if you go in and you figure it out, you're going to be able to.

Buy that business for cheaper because they're not going to have a high end investment banker that is convince them that they're worth much more than they should be worth.

And so you're going to be able to buy it at a low multiple. It's a small business, so whatever the continuum of multiples in that industry, you're.

Going to be at the very bottom. And so if you do it right.

If you buy two or three of those businesses, you're buying it at the very low end of the multiple and you're successful at painting a picture, professionalizing.

It and providing a backend.

Now, not only have you created something that's probably much more profitable because you.

Can bet that they didn't have an.

Accounting function, so they didn't know if.

They were losing money, making money. They were just living week to week.

Now you've done all of this cleanup and you built a bigger platform, you're making more money and you can sell it for the high end of multiples. And you just created your arbitrage. I personally think it's not a bad area to make a lot of money. You gotta have the stomach to do all of the dirty work, so to speak.

I like you, Gary. You can be on my deal team. You got the right philosophy here. So we got that one angle that hey, you're doing proprietary deals, you're gonna have to roll your sleeve up. What was the other element?

The other element is you have to have an eye for the vertical within that industry that are important going in and putting an accounting function is, is easy. Every business of a certain size needs a well oiled machine. On the accounting side, I'll give you an example. I had a client and they were buying a business in the beauty and wellness space. And so this company sold products in the beauty and Wellness industry. They had a warehouse. I actually visited the warehouse with the client and looked like a clean, nice operating warehouse. But what this client figured out is in this space, selling to Walmart and targets of the world, that you needed to have volume and you needed to be able to have a good handle on your inventory. Not order products too soon, but not run out of products. So all they did was go in and had a third party come tell them how to take this same space and triple the ball. And so they had an engineer go in and lay out this space to triple the volume. They added RF tags so that they had real time inventory. And in a matter of four or five months, they totally revamp how this company processes inventory. Now they were able to then go to Walmart and say, we're in 100 stores, we can be in 500. We now have the manufacturing capability to service five times what we're currently doing. To me, that's a going in and figuring out this is an industry that's important. Let us go figure out how to do it.

Because there is a lot of nuances to that specific vertical and how you operate in it. And it's been interesting too because I worked with rollups and just seeing some of the acquisitions they do are stuff that you wouldn't expect. They sort of buy into an adjacency, but it's still playing in the same.

Space if it's not plain vanilla. Anybody who has some level of intelligence on the buy side can figure out how to service what products Walmart and Target and those kind of big boxes want and what's in vogue and what's not in vogue. What is hard to do is say, I'm going to pick an industry. I had someone pick the data center industry, so that's a big industry. And said, you know what, there's a finite number of data centers that are going to go out there and clustered in various areas. What we're going to do is buy companies that provide products that provide services to the data center industry or customers of the data center. So we're going to be around the fringes. So you actually got to go out and figure out what are those products or services that are being provided today. And you got to predict how the real estate market is going to change, given there's so much open capacity and what products and services are going to be needed tomorrow. And those are the people who. That's the research, that's the market research and future intelligence that some funds are very good at having that angle and others Aren't it takes a certain specialty to be able to make a bet on a future curve.

So far, like it sounds like the rollups are the way to go. Let's talk about the challenges, like what actually makes these hard because so far you haven't pinned me on anything that's deterring me away from doing these kind of deals.

There are a couple of challenges, particularly on the legal side. One challenge is that these business are always never gap account. And so the buyers, PE funds or whoever, the sophisticated buyer, they need that to translate into GAAP accounting because that's how they come up with their EBITDA and justify what they're paying. And a lot of times there's a big difference because the reviewed accounting that these small companies are using, they are making adjustments that could have huge swings when you convert it to gaap. So what they think their bottom line EBITDA number is ends up being significantly different. And if they priced based on a multiple of ebitda. Now you got to go back and say when we converted to gap or even it's actually significantly lower so we can't pay you that amount of money, that becomes a problem. How people try to bridge the gap is if they were already paying a, let's just say they were paying two and a half multiple and this is an industry that they think ultimately they can sell for 5 multiple, they may up their multiple to account for the difference if there's enough for them to still get a bargain and make up the difference. So that's one way to do it. Another way to do it is earnouts. You see a lot of burnouts in this space and it said, okay, this is what we think your business is going to generate the next couple of years based on gap accounting. We're going to set some targets and if you help us hit those targets, we'll pay you. So those are two ways that people try to deal with those type of differences. Another issue that pops up is working capital because they don't have gap accounting and they don't really track working capital. Now as a sophisticated buyer, you got to know you're buying a business with working capital. You, you don't want to buy a business and then day two have to infuse a significant amount of capital for purposes of working capital and running the business. So that's just not how they priced it. So they go through this exercise of figuring out what a normalized working capital number is for this business. And a lot of times there's an impact on value, same way The EBITDA doesn't measure up, the working capital doesn't measure up until you have to figure out ways to to bridge that gap. And again, they may be able to bridge the gap by increasing their multiple or factoring that into an earnout or the rollover equity they ask for in these deals are a lot of times significantly higher than bigger deals because they're trying to get less of a purchase price today and have the seller assume some of the risk of abnormal working capital. How you account for calculating EBITDA based on GAAP accounting. So those are a couple of things that pop up and can cause significant issues. And the last thing is those are significant issues when the seller has no bad intentions. So they just don't know. Sometimes you have sellers that have bad intentions. They are gaming the system. And because they are not operating on the GAAP accounting, it's hard to know what their true inventory number is. It's hard to know how they collect their revenue. And so they play games with how they pay their payables, how they collect their revenue. They'll either speed up collecting their revenue to get more cash in the door before they close, slow down payables to increase the cash in the door, and even three, four months out, they'll start slowing down how they order inventory because they don't want to pay the cash. So, so all of those three things help them accumulate more cash that they'll flush out of the business right before close. And then the day you close, you find out you have an inventory deficit and you gotta buy the inventory from somewhere. You have a pay up abnormally high payable number because they stopped paying the bills. And then you have an abnormally low accounts receivable number because they accelerated collections on ar, which those are things that people do to game the system in these smaller businesses. And sometimes it's difficult to know it until they come in and the buyer comes in and audits the books post close and then you find out you have all of these issues.

Wow, okay, so we covered two big things, the accounting, which is a big pain point. Like you gotta take their numbers and fit it into your model to follow the accounting practice that your company uses, which is a lot of work. And then this working capital adjustment, which is a lot of games you can play in doing this. How do you protect yourself from that?

The quality of earnings is a big part of what buyers should do. And even when we're talking about these small lower middle market businesses, because a lot of times people will say we're Just going to do a flash, what they call a flash quality of earnings. They do a high level guesstimation of quality of earnings and not below and go into details where they would pick up some of these abnormal items. So you got to be diligent about that. You got to do the same thing you would do with a large business with these smaller businesses, so you can capture these things. You also got to be diligent about how you negotiate the terms of these deals. I had a client that they were having so much trouble pegging what the true working capital number was because they were trying to take the seller's books that were not gap as we talked about, convert them to gap, guesstimate what working capital was and peg a working capital number. And the seller just wasn't cooperating. And so they decided to do away with the working capital adjustment. Huge mistake. The day after closing some of those examples I laid out, they found out that there was a huge inventory deficit and architecture and accounts payable numbers were all off. Now they had covenants with their bank that was pegged on having a normalized level of all of these items. They were growing covenants from day one. It was hard to have recourse against the seller because they did away with the working capital adjustment. And now you had to try to prove that a rep or covenant was breached. And these are the types of items that may not show up, particularly when you don't have audited financials. They'd show up if you had audited financials, but if you have reviewed financials or something lower than that, then it's a problem. The overarching theme is they got to be diligent about how they go about structuring and negotiating these transactions and do it the same way that you would always do it and not give up on some of these points or really swallow hard and say if we can't get a working capital number, we can't get them to agree to a working capital adjustment. And maybe this isn't the deal for us to do and we'll move on to the next.

Is this LOI closer to purchase agreement?

The normal cadence I'd see people doing is you get an LOI signed up and they then go straight into quality of earnings and trying to figure out the financials of the company and what working capital is. And then you rotate into the legal side of it. A mistake people make a lot of times is they want to do them both. They want to do the quality of earnings and get the legal side of it going. And so now you are far down the path and spending money on the accounting side and on the legal side. And your human nature is going to tell you, we got to find a way to do this deal because we don't want to have all these dead deal costs. The buyer almost backs themselves into a corner. Instead of being disciplined and saying, nope, we're going to do business diligence. First we got to renegotiate the purchase price. We do it at that point. If we can't reach an agreement on a renegotiated purchase price, then we never move on, we never start spending more money. It all points back to being disciplined about how you perform diligence, both on the business side and the legal side, how you negotiate these terms. And at the end of the day, what are things that you absolutely have to have in sticking to it.

Don't wait till closing day to negotiate your working capital adjustment, other headaches, pain points. I think of management, I was like, if you're buying all these assets and businesses they're all operating, that's a lot of management.

Overhead management is a big deal, especially when it comes to who has the relationship in services business. And the rug typically comes in. A lot of people that own these businesses also manage these businesses. They may be equipped to be the manager of $4 million business, but they're not equipped to manage a $30 million business. So a buyer may know they're going to head in a different direction at some point once they reach a certain scale. And so you have to figure out a way to keep the owner slash manager engaged long enough to show your people what's their secret as a service provider so that there's not a significant drop off. But at the end of the day, we just paid them a lot of money now, may not be $30 million, but it may be $2 million in their bank account, which for them is a lot of money. So you got to find a way to balance it out. And I think most times they do that by having a significant rollover component. Sell the owner slash manager on. Look, we paid you a lot of money now, but if we do this right, we build this to the scale we want to build it. You ride along with us, you're going to make a multiple of what we're paying now. So you stand to make significantly more if we do this right. That's probably the biggest sales pitch to give. And if they're smart enough to see it, then those are the ones you probably want to do business with.

You're Saying in terms of giving them some ongoing, like rollover equity.

And that in turn helps you deal with transitioning a manager, if an owner is a manager, but they're not really equipped long term, chances are they bought into that and they're now, you know What, I got 2 million in the bank. You're telling me I can make 5 million down the line. I want that 5 million. I got 2 million now. I really don't want to keep doing what I've been doing. And so you work out a plan to say, okay, how do we ease you back? You still have a vested interest, you still have a second bite at the apple to make significantly more. But we can bring in all of the different pieces we need to get you to that 5 million. That's really the complete sales pitch that the buyer has to give and get the seller to buy into. And that helps mitigate some of these pitfalls.

Let's talk about some deal structuring and negotiations. How about we start with the loi? Give me the best practices of putting a proper LOI together.

There are probably four, two things in negotiating the loi. One key thing is we've been talking about a little bit the fact that you're going to purchase price adjustment and how that's going to work at a high level. And if any of the purchase price components have earnouts, you want to lay those things out in enough detail and specificity that you feel like you have an agreement among the partners. Part two is this is where legal plays a big part. You gotta know what are the implications of structuring from a tax perspective on the seller. One example is a lot of these small businesses may be organized as escrows. When you're gonna have a rollover component. There's only one or two ways to structure a deal. When the target is an S corp and there's rollover to avoid there being a tax triggering event for the portion that's going to be rolled over. One, you got to do a little diligence before you sign the loi. So you know you're dealing with an S corp. Then you have to put language in the LOI that's alluding to how you have to structure it. The problem we've had a lot of times these sellers, these small companies, have very small law firms representing them. They don't really know these issues. And if we don't fill it in the loi, once we get to doing the purchase agreement, we have significant pushback because they don't understand it. So you got to try to deal with that up front. Another issue is the whole management piece. You got to figure out what you need them to be on the hook for in their involvement going forward. And that's probably one thing you'd say can be a little less detailed about if you don't know and if you need time to figure it out. But if you have an idea, it's always good to get it in, get it agreed to. You don't get to four weeks in where you're starting to negotiate documents in detail and all of a sudden somebody you feel like you had an agreement and they feel like they never heard of it. And the fourth thing I think that could be, that's a significant thing, is you want to put in the framework of indemnification in the agreement. Because that's always a big thing. And that's the easiest thing for buyers to say. I really want to get this purchase agreement, this loi signed up. I really don't want to have to deal with this issue now. Let's kick it down the road again. You can get to a point where you spend a lot of money and now you're starting to negotiate documents in detail and they push back and say, no, I'm not going to give you any indemnification. Or what they want to give you is significantly less than market. And now you can't get that deal done with your capital providers or the bank because they're looking at it and saying this makes no sense. This is not market. So you'd rather agree to that up front and clear that hurdle by before you spend a lot of money.

So I got four areas. We got price and just overall structure. If you're going to have earnouts, make sure you detail it out so it's clarified. Like an agreement on it. The legal part with an emphasis on taxes structures may impact that and try to get ahead of that. The third is management clarifying it. You need to circle up some retention agreements. And then fourth is identification. Just to make sure there's some liability things that aren't going to be out of context when you get to purchase agreement, the management team. So if you identify and said, hey, we really gotta keep the CFO and the head of product or something like that. What does that look like in terms of language in that letter of intent specific, like, are we gonna require a retention agreement with next person? What does that language end up looking.

Like what we would typically put in? Let's just say there are five managers, but we know we want to make sure. We have two of them around. The other three we don't know. The buyer needs to go through diligence to figure that out. So we would say we need manager X and manager Y to sign a customary employment agreement with non compete language in on terms that are mutually agreed to by the parties and reserve the right to require employment agreements from other managers after further buildings. That's an umbrella approach. If the client comes to me and says, hey, they have five managers, we know we want agreements with two. One of the two that we have an agreement with happens to be the 70% shareholder. But they really want to start winding down. And so we got to figure out how. We both have a transitional period, but allow them to wind down a little bit and just keep them on the hook. And we want to be flexible. We may want to keep them on the hook 50% of the time and reserve the right to reduce it down to 20%. If we feel like we don't need them, then we got to figure out more tailored language to go in and put in the letter of intent. Just so there's an agreement, a meaning of the mind with how the buyer is envisioning that transition being tailored and how the seller is envisioning on their side of the equation, their vacation time.

Got it. So we spell that out into a good level of detail and be pretty specific. It sounds like, I take it our time frame we're going to list is generally, here's our diligence period and like an estimated time frame to close.

Yes. What we try to do is we'll ask for 60 to 90 days of exclusivity in the letter of intent. And if we're lucky, we built. We would build in one or two automatic extensions. So it is when we're representing the buyer. So we might say 90 days with two automatic 15 day extensions. As long as the buyer is working in good faith to close the deal. And so that gives the buyer the maximum amount of flexibility and time. If we run out of time, we've got these automatic extensions. As long as we're working for. If I'm on the sell side, I want to limit the ability to get extensions and the amount of initial time so it goes in the other direction.

Fair enough. What about breakup fees? Are we doing breakup fees on these small and private deals?

Very rare. But where I've seen the breakup fees come in, the buyer has been working on this seller for two or three months. They feel like they have all of the main parts of the deal agreed to, but they come to me and said, hey, this seller has started and stopped three or four times. If I sign this letter of intent, which I believe we have agreement on terms, and he does that again. The difference now is I'm spending money with third parties. I want protection. That's when we say, okay, if you want protection, we can put a breakup key concept in. It's going to be a more abbreviated sort of breakup key structure. It's not going to be what you would see in a $300 million transaction with all kinds of bells and whistles. It might look a little bit like this. It may say the buyer is going to negotiate in good faith. If the seller walks away from the deal for no good reason or no reason at all, they just don't want to do the deal. The seller going to agree to pay up to $200,000 for my documented third party expense. And then you sell as a base. And then you get more detailed and creative the more variables that come into play.

When do you usually see breakup fees? Is there a certain deal size or is it a nature of a public private.

Yeah, I think once you start Getting or from 150, $200 million enterprise value deals, you begin to start to see them more and more at that level. You probably have a sophisticated private equity fund that owns the business and they're going to be selling it to a much bigger private equity fund. And those much bigger private equity funds may be a multibillion dollar fund. And what you're protecting against there is, I don't want downside risk of funding financing at this level. I know that that fund can get financed. And if they want, I don't want them to come back and say, oh, interest rates are half a point higher than I thought it was going to be. I can't get financing. So you put them on the hook to say, stand behind it. You're on the hook, you're guaranteeing the equity. And or if you don't want to do that, then pay me a breakup fee. And here's how much the breakup fee is going to be. So if you want maximum flexibility, you want to be able to walk away for a half a point or whatever it is you want to walk away from, because the financing terms with your lender is not what you want, then pay me this fee and I'll give you the ability to walk away. So that's usual when you start seeing it when you're getting into that size transaction where more than likely, if you're selling to a private equity fund, it's a multi billion dollar fund or if you're selling to a strategic, it's a.

Large strategic, you're going to get some assurance out of that. Now I want to talk about the fun stuff is like the actual structures because we talked about earnouts, we got equity, you mentioned earlier, we got earnouts, got seller holding a paper and then there's getting like third party financing. What do you typically see? What's the common and does it change by industry? Give me some knowledge here.

I think it changes by size of transaction. So if you're talking about the lower middle market, and I call that some, my purpose is deals that are probably 25 million in enterprise value or less, more times than not you're going to see rollover involved and you begin to see either earn outs or seller finance. The lower you go below 25 million, you start to see higher percentages of rollover, higher dollar value in terms of seller notes and a higher percentage of the purchase price being in turnouts. With one caveat. Even above 25 million, if you're buying a family owned business or business that has a high level of customer concentration or something specialized to where they really can't go and get the full multiple they want because of concentration or headwinds in their industry, those sorts of things, then the higher rollout, rollover value and then earn out and seller notes to some extent those things come into play because the argument that the buyer is making is you know what, I can pay you X and we've agreed that's what you want to pay. But I'm not going to put more equity and I typically put I can only borrow so much money because of these various reasons. So you got to help me out. You're going to roll over a higher percentage of your proceeds, you're going to do some seller financing or we're going to look at earnouts and then that allows me to get the cash I need today as borrowing it from a lending source. And then the buyer's not telling the seller this, but the reality of it is you're taking on some of that risk because you have seller paper or you have an earn out that's subject to hitting certain benchmarks or your rollover equity is advice. Those are the size of the deal and special circumstances in the business such as customer concentration. You could also have certain industry special circumstances as well that could come into play if it's highly regulated and it's not a highly fragmented industry. And so you only have certain number of players that may come into play as well, but specialized circumstances for deals much larger than that. But most of the time I call it sub $25 million deals, you start to see more and more of these three different tools being used to spread the risk across to the sellers.

Give me an example, what do you typically see what would be, and I'm curious too of the percentage. As somebody pretty early in looking at doing deals, I'm always wanting to hold cash on hand and is averting the risk. Like you mentioned, how do you structure a deal? Like what percentage are you putting in cash versus on earnouts and rollover?

It really starts with how much financing you can get. And most people look and say, okay, I want to get senior debt finance. How much can I get in this industry, this side of the business or in the senior debt category? And they work their way down and so they'll have an idea, right? In this industry this is how much equity I want to put into a business, into a platform in this industry. And they may have to factor in this is how much equity I want to put in for the entire platform. Whether I'm just talking about doing this deal or five add on. So they got an allocation for the entire platform and whatever that allocation is, they may only want to spend 2/3 of that in equity today. They take that 2/3 of equity, they take what they can get from the senior lender and they look at okay, what's the delta relative to the purchase price that the seller wants and they take that delta and it's got it. If there's a big delta, it's got to be made up in some variety of rollover equity, earn out or seller paper and they start to play with maybe seller paper isn't going to be practical because I'm really pushing the limit on the senior lender side and getting the senior debt. They didn't want any mass financing and seller papers akin to med finance and they don't want to deal with any of the debt. And so that kicks it out. We've got to have a higher rollover and possibly a turnout if there's still a delta. So really that's why the first thing that parties typically do is they go out and get an indication of what they can get from a senior lender and they start backing their way into it. And that they probably do that before they put an LOI in place. They start to poll the market to see what they can get on the senior debt side.

What percentage does that typically range for getting like typical senior note on the senior side?

It's looking at a multiple of the purchase price and it could be anywhere from 2 to 5x the purchase price. But because if we're talking about these lower middle market roll up strategies, we're not going to get to the 5x because you're talking about an overall low purchase price multiple to start with. So you're probably talking two to three times the agreed upon EBITDA number. In terms of debt. Yeah.

Oh, in terms of debt that's pretty high though that would cover quite a bit of the purchase price. I'm used to doing real estate deals, I came from hospitality so everything was always like 80%.

I always look at multiples for these smaller businesses. They're certainly going to be less than five. Nine times out of ten less than four, but probably somewhere between two and a half and four. If someone can get a business box with two and a half x, then they're borrowing just senior financing. They'll hedge their bets with a small amount of rollover equity and then the rest of their own. And so the better deal you can get in terms of that multiple, that then starts taking one or two of the options from the toolkit off the table. But remember we were talking earlier about a seller being difficult when it comes to working capital and various different things that go into the purchase price. If you have a difficult seller but you really want to get the business and now you got to bridge the gap, then you have to start bringing in those tools from your toolbox.

This is why the interest rate matters. Interest is low, capital is cheap. That's the direction you want to go. When it's not, then you really start rethinking things.

Absolutely. That's why when interest rates are high, the slice of the market that's impacted the most are the multibillion dollar private equity funds. Even though they are borrowing similar multiples. The businesses are so large and the aggregate dollar amounts we're talking about borrowing and the interest burden on that is a lot. And so those funds spend a step back and they focus on portfolio company add ons because nine times out of ten, unless that company is not doing well, they can do an add on and do it with primarily debt because they're just pointing the arbitrage so they don't have to put more equity in. And now in that circumstance they will take on the additional interest rate burden because they not putting in more equity. And if it's a cash flowing business, they'll pay it down as quick as they can. On the flip side of it, you see A lot of deals still getting done in the lower middle market side, even when interest rates are high because we go back to the 2 or 2 and a half x relative to the overall size of the business. You're not highly leveraging these businesses and you're using these other tools as hedges.

This is why we're seeing a lot more announcements. It seems like everybody's doing earn out some shape or form a lot more.

The last two and a last two years, earnouts and seller financing been a much bigger part of the industry than prior to that.

Nobody says that with a lot of excitement. Everybody has some fast aggressive statement of hey, we're doing an earn out. But it seems like there's challenges with them.

A lot of buyers will go into it. And I ask this question all the time when we're dealing with how to structure the earn out and sometimes I'll get from a client and I'm trying to get a certain level of specificity in the earnout language so that we don't have a lot of arguments and they'll tell me there's no way they're going to come close to earnings, so it doesn't matter. So we document their not as best we can. Fast forward, the seller thought there was a very good chance of getting it and since they thought it was a very good chance, the buyer thought there wasn't. Of course the buyer is not saying to them, we don't think you're going to earn this. Now there's a fight because the seller believes the reason I didn't earn this earnout is because somehow you did something you shouldn't have done and you did it on purpose to prevent me from getting it.

Is there like a best practice and I'm almost curious about getting like an example language of how you would put.

That in LOI as it relates to earnouts. Yeah, no real best practice other than I take the earn out and I look at it in a couple of different layers. And the first layer is what's the performance have to be what time period we're talking about and what are the four or five components of determining if this number is here and then if the number isn't here, that 90% of the numbers hit? Are you going to do it on a pro rata band? And if you are, then what's the minimum percentage of that number has to be hit to do it on a pro rata? And if you don't get it in the first year, can you make it up in the second year? Those are all questions I have. The next layer is, okay, those four components that determine how you calculate it. Let's break down each one of those components. Tell me what it means. What gross profit in this business, we don't want to just say gross profiles. I want you to tell me all of the components of gross profit. I was calculated today so I can describe in the language the definition of gross profits. And I work my way through each of the components to describe that. And then the next layer that I talk about is, okay, how is this business layered from an expense perspective today? And is it going to be the same way? In other words, it has a certain set of expenses that go into the calculation today. And let's say two months after the deal closes, you do an add on. Are those business, can you combine those businesses? Can you layer on more expense? What are the parameters there? We figure out if there are any limitations on their ability to operate the business or change the business from how it historically been operated. And the last thing I always trust try to get in is what's the implications on your credit agreement with this earn out. If you're busting covenants in your credit agreement, but it doesn't really relate to if this business is doing well. But you've combined four businesses, so your overall business is not doing well, can you still be forced to pay this earn out? And the chances are no, because your lender doesn't care about just this segment. Your lender cares about the entire business. So I want to build in language that makes it clear that it's not just the operation of this one business, it's the operation of your entire business and your covenants for your entire business that impact it. And if the scenario I just described is the case, then what determines when you can make it and are you going to make it up because it wasn't their fault. And the last thing I'll say is what happens if you sell the baby? The business is knocking it out of the box. You got a strategic that came out of the woodwork and offered you three times what you paid for. Does that have an impact on the earn or does the earn out continue to go on in its normal course? Is it going to be accelerated? All of those different variables are things that I try to think about and walk through with the client and build in that specificity. And as you can see, it can begin to get very complicated and layered. To the extent you don't deal with any of the issues I describe, it's just laying out a potential for dispute.

I'm going to stop drafting my own.

Lois from here on forward.

It's official, everybody. I'm no longer going to draft my own Lois. I'm going to call carrier somebody to help me. What's like crazy weird stuff you've seen in Lois?

Not a whole lot of weird. The craziest thing is a listing of weird assets that the seller wanted to take.

Everything except for.

Sometimes it's just great. There's a painting that's owned or I want to take the life insurance policy that's on my life or those kind of things. Those can get weird. But on a practical side, the craziest thing that I've seen with these smaller deals is the buyers agree to buy a business with 5 million bucks and everybody's agreed. And now we're putting it in the LOI and they bring some lawyer in that's not even an M and a lawyer. They're litigating and language comes back to said what? You're buying the business for 5 million but you have to pay for inventory and you have to pay for AR separately.

Separately.

This makes no sense. The whole idea of a business is you're buying a business that's operating, which means it has AR working capital, all of that. That's probably the most frequent thing that I see. That's just weird and it makes no sense. If you were sophisticated and did these deals all the time or your consequent, you would know that this doesn't make any sense. But we see that a fair amount.

That's interesting. I could see it in like small businesses. Can you give me some do's and don'ts of executing on rollups? What have you learned from your experience?

The biggest thing not to do, I touched on it a little bit earlier, is it's very difficult for these buyers to not get ahead of themselves. And I try to push back. And here's a very real example. They signed the loi. They have promised that they can get this deal done in 60 days, but they already know they can't get it done in 60 days. And they just said when we get down to the end or just renegotiate. To me, that is a big don't do. The reason you're trying to do it that way is because something tells you that this seller is unreasonable. And why would you spend money and set yourself up to deal with an unreasonable seller after you spent money when you can just deal with an unreasonable seller up front and know if you're going to be able to get past the issue or not. And so that's a big don't do it that I see a lot.

Okay. Don't create surprises for yourself.

Yeah, especially when you know the surprises.

Any other do's and don'ts. I'm fired up, I'm ready to go roll up some sector. I don't know which one it is.

But another don't do is don't kid yourself about financial dealing. If you're trying to buy a business, you're probably fairly sophisticated. And so you had enough information to know that I have a 60% confidence level in the financial information I've been provided. If that's the case, go do your financial diligence. Even if the seller is telling you we need to go, go, go. And so they come to legal and say, get legal started. You already know that you have doubts about the financial outlook on this company. So go figure it out. Go cut a deal and then come back. That way you don't get yourself again. Like the other example where you've spent money and you painted yourself in a corner. I'll add this for balance here. One thing to do. I like to see people in every transaction hit the primary points of the deal and get them agreed to. If you just set. You said, hey, here are the four or five things that are important to me in this whole picture from a business perspective. Let me just make sure every deal I go down the path that I have a satisfactory answer and agreement on those four or five points. And if you remain disciplined to doing the work to get that agreement up front, it's going to save a buyer a lot of headache down. One more do and it's not a legal thing. But be fair. A lot of times these sellers don't know certain things and so a buyer will know, okay, you said X, but that's flat out wrong. Be fair. I think it earns people goodwill to go and say, hey, that's really not right. Here's the way these things work. And maybe the seller appreciates it, it earns you goodwill and again, it prevents you from dealing with something down the line. I'm a big proponent of hit the business points as best you can. Hit the important legal points as best you can to avoid painting yourself into a corner. Well, you end up doing something that irrational mind wouldn't do because you feel like you can't walk away from the deal like that.

That's so true. The reputation is so there and it spreads so far with M and A and how you do deals with all the other folks in the industry.

Absolutely.

Gary, what's the craziest thing you've seen in M and A? I know you're a lawyer, so you don't have to name names or dates. We'll protect the innocent. Hey, guys, tell me, what's the craziest thing you've seen in M and A?

Two things. We would. Doing the deal, and we're all in the conference room. We got lawyers on the buy side, lawyers on the sell side, and my client was the buyer. And then we had the primary seller, this guy. This business had been in his family I don't know how many generations, but I knew at least three generations. And this guy, up until this point, everything about this guy said he wanted to do a deal. He was a nice guy. He was genuine, fair, not difficult in negotiating. And we were close to signing this. We were on conference room. We were buttoning up a few points, and we either was going to sign it that evening or early the next day. All of a sudden, the guy, he disappeared. Nobody knew where he was. And 20 minutes went by, and all of his people were in our room. Somebody from the reception area came in and said, hey, there's somebody in the men's room, sobbing. So my client. I said, maybe it's him. And my client goes in there in the men's room, and this guy was bawling like a baby because it had all of a sudden hit him that he was really about to sell his family business and who realized he didn't want to do it, but he was so honorable that he felt so bad for leading everybody down this path for so long. That's why he was fine. Wow. Weirdest thing I've ever witnessed.

Did he do the deal?

No. We came back in the room, he apologized to everybody and said, I'm sorry, this isn't. I didn't mean to do this, but I can't sell this baby now. He ended up turning the business over to his son. And a year and a half later, that same buyer bought the business from the dad in partnership with the son. So the family will maintain control 51%. My client, instead of buying control, bought 49%, and a deal got done.

Wow. That's a pretty good happy ending.

It's a good story. It's a good story.

Awesome.

The other one was just doing a deal, and it was New Year's Eve was on a Friday, and New Year's Day was on Saturday. We had everything done. Documents were getting ready to get signed over. And so because it was New Year's Eve, banks were still open so you could wire money. We're trying to figure out, okay, all documents are signed, let's wire money. CFO comes in and he had a check for $50 million. We were representing buyer and the reason he had a check for 50 million was because that Saturday that happened to be the first. It was one of those businesses that their fiscal year ended the Saturday or 51st Saturday of the year or something and it fell on the first. So even though it was the first of the next year, it was actually their fiscal year end. My client's fiscal year end was that Friday the 31st and so they closed the deal with the $50 million check that was dated. Our guys could account for it one way, the sellers could account for it another way. And that's how the deal got done. Largest check I've ever seen in person.

That is insane. I've never seen it. Yeah, I've never heard of a check that big. That's so funny. Yeah, I would have been. That would have been the moment to bring the giant checkout. Let's just get some press out of this and have some fun with it. Gary this has been a lot of fun. I feel like I learned a lot about the legal aspects of doing roll ups and earn outs. You've helped me become a better M and A scientist.

It was a lot of good questions, so I enjoyed. Appreciate it.

Thanks for the time. Those of you still with us, thank you. Love to hear from you. Reach out to me LinkedIn. Love your feedback topic suggestions. Till next time, here's to the deal.

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 Podcast. 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 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.