Think Like a Buyer: Valuation & Deal Structuring with Javier Enrile

Today's episode of M and A Science is brought to you by Grada. Grada is the leading private market deal making platform. With its best in class AI workflows and investment grade data, Grada helps investors, advisors and strategic acquirers effortlessly discover research and connect with potential targets all in one sleek, user friendly interface. Now part of DataSight, Grada is bringing its platform to dealmakers around the world. From consolidated financials to precise comps, Grada offers dealmakers full visibility into their markets so they can find the right deals faster. Discover more, Win more with Grada. Visit grada.com to learn more. That's grada.com if you're on the buy side. You already know most M and A tools aren't built for you, they're built for sellers. And it shows. That's why we built Deal Room. It's the number one platform for buyer led M and A. Designed to help you lead the deal.

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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 and welcome to the M and A Science Podcast. This podcast is part of a mission to rethink how M and A is done. The old school sunlight approach? It's dead fire led. M&A is all about strategy, alignment and efficiency, putting value creation at the center of every deal. And let's be real, it's not just about closing the deal, it's about making it successful. We uncover what truly works in M and A by learning directly from the best. I'm your host, Kisan Patel, Founder and CEO of Dealroom and Chief Scientist here at M&A Science. Today I'm joined by Javier Enrille, Managing Director of M and A at tiaa. TIAA is a major financial services organization focused on retirement, asset management and insurance. Manages over a trillion dollars in assets. Javier spent his career deep in the world of M and A, starting out in corporate and investment banking at Citi before moving to the buy side where he's led deals across investment management, insurance and financial services.

He's one of those rare M and.

A leaders who's as passionate about the craft as he is about execution. Today we're going to get into how he approaches sourcing in a relationship first industry, how he thinks about intrinsic valuation versus comps, and why structuring and contract terms matter just as much as price. Javier, how are you doing?

Good, how are you?

Hey, thanks for joining me live here in Manhattan at our sponsored office suite.

By VRC Evaluation Research Corporation. And we're doing this live.

Thank you for making it happen, taking time.

No, no, of course. Thank you for having me. I'm super excited to be here with you.

Can we kick off a little bit about your background?

So I started my career post MBA at Citi. So I was sort of recruiting to Citi in their investment in corporate bank role and started doing M and A advisory and corporate lending there. Quickly realized that I wanted to be more on the buy side of things rather than the sell side. I switched into corporate development roles for different firms and I've done corporate M and A private equity, venture capital as well throughout my career, primarily focused on financial services industry.

How many deals have you done?

Over 60 or so. And if you can count the ones that we evaluated, so hundreds.

Okay, so let's say the 60. What was the range smallest to largest deal?

I've done anything from a billion dollar check sizes to a few hundred thousand and I think most practitioners will tell you that it doesn't really matter at the end of the day. So M and A is one place where size doesn't matter. So you'll do the same amount of work for a $200,000 deal than you'll do for a bill. And in many ways smaller deals, as everyone knows, are actually harder to do because then everything matters.

That's a fair disclaimer. There's what looks good on a resume versus the work you end up learning lessons from. You've done the investment side and then you shift over to the buy side. How do you explain to somebody, I feel like there's so many people I interact with that are in banking. They want to go private equity. And then a lot of people aren't from a corporate. If you talk to anybody in business school, they just aren't exposed to it. Give me the real scoop. What's good and bad about being on the buy side here, especially in the strategic environment?

I think corporate development, corporate M and A or so doing M and A within a firm. In many ways the combination of private equity with strategic thinking. So you have components of both. On the one hand, you have the component of you are in the buy side, meaning when you analyze a firm or by a firm, you are taking on the risk of taking on that firm, taking on that, targeting to the firm that you're working for. And in many ways then you're a principal driving that decision, which is different from say you're an advisor or an investment banking, which is actually advising someone else what to do. But the decision is theirs. In here, you are essentially making the decision as to whether or not to buy, et cetera. And then you combine that with a strategic component. As we underwrite transactions, we underwrite them for the financial returns. It has to make sense from a financial perspective. But we also underwriting them for the strategic rationale. So we want to make sure that it is advancing the strategy of the firm that I work for. And those two things essentially need to be true for the transaction to move forward. And that's one of the things that I like the most. It's not just about underwriting financial merits of a transaction, but it's also just as much in a corporate eminent role, underwriting whether it makes sense strategically with a firm. So that's different, say from a. If you're in a private equity world, right, that you're really underwriting the returns, which is difficult enough as it is. It's just that one dimensional component of it.

You're clicking into more details how this is actually going to come together. How are you going to realize synergies and what it's going to look like as a real combined entity. I feel like the ideas are there, but I guess the sort of depth, because you're not in the business of how you're actually going to execute, realize those synergies maybe isn't as detailed or well thought out.

It depends what sort of private equity investing style you're thinking of. Is more of a buyout, private equity buyout, which is essentially you're coming in as a private equity owner, you're taking control of the firm and you're taking it in a different direction. You will have to think through very deeply as to what is the strategy of the target. You're essentially changing everything, coming in, buying it, taking into a different direction. Right. But it is true from a private equity perspective, you're always thinking about that target. In the context of a corporate M and A team, you're thinking about the targets. It has to make sense, right? Synergies have to be there. But you're also thinking about what impact that target will have into your firm, which is something that private equity doesn't have to worry about. They're not integrating anything into the private equity firm. It's just an investment. I agree with you. It opens a whole dimension of factors that you need to think through.

I just talked to a person off record and he was telling me b firm supported acquisition for the company and they really left him to figure out how to close or how to integrate. Like as soon as they close, it's like, all right, go figure out how to integrate it. But it was just the deal that happened so quick.

Unfortunately, the market is the market. Right. So you will have situations where it's a competitive bidding process and then the tempo is not led by you. Right. As a buyer, but it's led by, by investment banking that is running out a sale process. Sometimes those, as you well know, those timelines are very compressed. I don't have time to think about integration or you're just trying to win the deal and the integration comes later. She's really unfortunate.

You minimize it. You literally pull steps out and just do the bare minimum. I've never met a buyer that really enjoys auction process.

No one does.

Nobody does. If there's anybody listening that's a buyer that loves auction processes, let me know.

No, they should let me know too, with all my heart. Yeah. And look, I don't think obviously I'm sure that you have some sell side bankers listening to these. I don't think they generally work for industries such as the industry that I play my sandbox, which is investment management or financial services. From a sales side of you run a sale process, it's going to typically lead to be more deterioration of the business by the time you get there. Obviously the counter to that is you're going to maximize price because you have competitive tension and all that thing. I don't quite agree with that. Not because I'm trying to avoid sell processes. But I do truly believe that in industries where the main asset is people and investment management and financial services, for the most part, those industries, I don't think that running a quick, highly competitive stock process is going to help anyone. It's just not going to help the target. It's going to help the buyers. But unfortunately they still exist. So you have to live with them.

We can talk a lot about that. There's the good and bad of those processes. But this is why you put a lot of effort in building proprietary pipeline.

Right.

Which is a big thing I want to talk about. Before you build pipeline, you got to get aligned on strategy. We obviously emphasize that. So you obviously have different business leaders in your organization, and you're going to sit down with those business leaders and really start talking or shaping it. What does that process look like? I feel like there's an organic view to inorganic and you bridge it based off of their organic view. How do you sit down and start fleshing out this M and a strategy for that business?

So there's three steps primarily. I think the first step is fully understanding their organic strategy. First, the process starts there. Typically, most of the businesses, my current firm and other firms that I work with, they do have a clearly laid out organic strategy. So they know where they want to be in the next three to five years. They know how, steps or tactics that they need to get there. But that's the base. In most cases, they'll come to us, sorry to me, to the team, by saying, this is my strategy. You know it. What can we do to accelerate the progress through inorganic means that it starts that conversation? And it could be, hey, I want to be more prevalent in this jurisdiction. I'm already opening some offices already there. But I want to accelerate that process. Can we, is there an option here to then go and buy a company that then we'll accelerate that process. So that's the second step. So a lot of the times it's around getting there faster rather than doing something else different. But that tends to be kind of like the second phase of the conversation. Then the third phase then becomes.

Is the second phase like actually identifying companies or.

No, that's their phase. Right. So I think once, you know, like, look, for example, it's like, okay, now we realize that we need to buy a company next year.

So just saying, okay, first step is to understand the organic strategy of like how you're currently planning to do it. And the second is saying, can you actually do it inorganically?

Right. And how inorganically will help you to either essentially accelerate that pace of progress. And then the third step is, okay, we know we need to buy something in this jurisdiction. What are the types of targets that we would be ideal? And then that is the third phase. And then if you go through these three steps, you'll end up with a clear picture of first of all, what it is that that company will do, will help you do to what types of companies where you want to buy them. And then if you think about from a corporate development guy, corporate ML perspective, that's perfect because now you have essentially the key strategic criteria. And then you just have to go out to the market and look for those types of firms. But you have A clear set of criteria that kind of like informs you your sourcing routines. But those are the three phases. There's another phase within that process which I've gone a number of times, which is the analysis of whether you buy it or you built it, if you will. And these are in areas where there's no current inorganic efforts. This is a new, new area that you want to get into as a company. And then sometimes we get into should you go organic or should you go in organic so that analysis goes on at times. Most often than not, there's an organic strategy already set up and then you're using M and A as a as a way to turbocharge or to accelerate that strategy.

Step one, understand the organic strategy. Step two, really figure out how to an inorganic approach can work. Step three is find those types of targets. Ultimately your deliverable is a clear criteria of those businesses that would fit in to accelerate because then it's easier and.

You go out to the market with a very kind of narrow criteria. One thing that I think is not helpful is when you as a corporate money guy or private equity guy, you just don't know what it is that you're looking for. So the more narrow criteria that you have that you work with the business to design, then the more efficient you're going to be. As you go to the market and start searching for firms, the last thing that you do is thinking about what are the key characteristics of the firm. This is getting even into more detail. Do you want a firm that has a certain amount of ebitda? Do you want profitable firms versus not? What type of characteristics do you specifically want on the firm you're looking for? And those will come a little bit later.

Yes, I think you'll learn that too as you start looking at companies.

That is true.

Have you found this right size of a target list? Because I feel like it's easy if you don't do this, that you're going to end up way too many things to look at. So you want to get that down. But then I don't know if there's such thing as too short of a list because obviously people don't instantly want to sell. This is a relationship that you have to nurture. So is there an ideal amount that you feel like, hey, I want whatever eighty hundred companies that I should have in my pipeline?

Well, we've run searches like this because essentially the way we work is that we've got an ecosystem of market participants on a constant basis. We are informing them of what we're looking for. And then the deals then will come through that ecosystem. Always been a very efficient way of getting a pipeline that is quite active. So we've got enough coming to us that we feel comfortable. The key there, right, is to make sure that the market participants that you have relationships with and these are intermediaries, these are other corporate development teams, other companies in the industry that they know what you're looking for and then they know you. So you've built those relationships. And then if they hear of a company or they hear of a potential situation, then they'll come to you. So that's very important. Now there'll be other situations where we essentially come from the scratch. We are looking for a certain type of company. We look out to the databases right at market. We go through all the list of firms that have certain criteria. And the idea there is kind of like a filtering exercise. You want to get to 10, 10 firms or so that really you think that at least on paper meet the criteria. And then you start calling and building. And then there'll be out of the 10, 6, 7 will say, don't talk to me because I don't want to sell. Before that you say maybe. And then you start building that relationship with them.

How do you approach sourcing targets in a buyer led way that builds trust and maintains momentum?

The approach has to be a soft one. So it can be that you can pull them up and say, hey, by the way, I want to buy your firm. That wouldn't work. It's more around. You start the process with just wanting to learn about the firm. We typically engage with these firms more in the context of look, we want to learn about what you do, we want to learn about the industry. Can you talk to us about what you do, the way you do it? It's more around understanding how they do their business and the successes and threats rather than hey, I want to buy you right? And then you build that relationship over time.

But you're trying to get to CEO or the main principal operator.

So depending on the size of the firm, like what middle market primarily raised. So then most of the firms will be talking with the founders of the firms. If you're thinking more larger firms, you are at the corporate level, CEO level, strategy level, depends on the size you're getting to that kind of like level.

I get the whole, hey, I'm not trying to close it right away. I want to buy you guys.

Would they respond to that of I.

Just want to get to know what you do. Or they already got a Sense of like, all right, I know where this conversation is going.

Most people, I think they'll be open to dialogue. They see this M and A guy calling them, so they suspect that there is a corporate transaction going on here. But they'll be curious. They'll take the call. It's building a relationship with another firm in any case. So even if this recent transaction, they have essentially entry point into a firm within their own industry, I think most people do take the call. So at the very least, we say, again, they've developed a relationship with another firm, they can exchange some ideas, right. Compare notes and learn something new.

I like this. We're talking M and a pickup lines.

So that's what I do.

I'm like, hey, we're in adjacent industries. Love to connect and compare notes.

I'll either do that or I got some ideas.

Hey, love to compare notes. Got some ideas that I'd love to share with you. And I keep it super ambiguous because it's, you gotta talk to me if you want to see what those. Hear what those ideas are. That's what I found. Works. I don't know, but very similar, very similar.

Another M and a pickup line. Inquire about their growth strategy. They tell you how they plan to grow, and we tell them how we plan to grow. And 90% of the times you can see that there is. Either there is. There is a gap, that there is a commonality, or there isn't. A typical example is like, I'm talking to a firm and they say, I want to grow big in Japan. And I say, well, I'm huge in Japan, but I want to grow where you are. There you go. So now that's actually.

I actually like that perspective. It's not only comparing notes, but let's compare growth strategies. That almost goes back to your example of working that business leader of, okay, let me understand your organic growth and we can look. Let me understand your organic growth thinking and share ours. We can start seeing if there's some common threads to pull.

Then you see where the gaps are and where one can help the other.

Do you convince people to sell their business?

Generally, no. Right. So it's a process. Right. So I tend to think that it's hard to convince people to go through that process. What we end up doing is offering them a path, a solution to the problem or the strategy that they're after. They cannot convince themselves as to whether they take that solution or not. The classical example will be we're talking to an investment manager. There is a. An older Owner, Right. An older person that was the founder, and then they want to exit the business, want to sell. We come in many ways as a solution provider. Our solution is, look, we'll buy the firm for you so you can exit the business. In my experience, unless they're ready to exit the business, there's no convincing.

So you take more of a patient approach where you focused on building this relationship, and then you want to be the first phone call when they're ready to sell.

Exactly. My experience tells me for a seller to sell, they need to be ready to sell. There's no argument that I can make to a person or to a founder that is not ready to let their firm that they found go. They need to be ready. And it's at that point where we can be useful in the solution. But, yes, that could happen over a period of a year. Could happen over a period of six years. Building those relationships so that as you put it, while you are there and they know you, it's critical.

I don't have patience.

You don't have patience.

Maybe this is why people are asking for such high valuations. Every time I look at a deal, they're like, oh, if you really want to buy an overpay, give us 10x plus, then we'll sell to you. Maybe that's patience.

That's the one to convince. Maybe overpaying, and then you'll get them over the hump back here. I mean, patient is tough.

Telling the devil. Everybody in my family will agree with that. Yeah, it makes sense. What are you doing to maintain those relationships? I feel like that's the other thing I've struggled with, where you meet a founder. I had this actually happen. I thought to my head, like, let me check back in with the 6 months. Totally forgot about it. And at the end of the year, he ended up selling to another competitor.

I didn't have any clue that he.

Was ready to sell or anything.

It's tough. It requires quite a bit of time and discipline. At the end of the day, you cannot cover everything. You have to kind of narrow your focus right onto certain areas where you know you have interest. Then you cultivate relationships in that particular space and you have to go narrow. You can't be cultivating relationships with a hundred firms at any given point. I think anywhere from 10 to 20, that's probably the max that you're going to do it effectively. You just need to focus on what is the most important, kind of like the deliverables and the results that you're trying to achieve. And then the way you do it is just. Just making sure that you remember to call them. And we work a lot overseas. Every time that you go around by traveling and you make sure that you.

Meet them, try to meet people, FaceTime.

And then narrow your focus. You can be kind of like building a relationship in four different sectors and in four different industries. You just can't. And you won't do anything. You just have to really narrow into the areas where you are most active. And then at any point in time, which we do already have a pipeline of 10 to 15 companies that you are actively cultivating the relationship.

Where do you find the companies? Are you just going through data sets or do your business people already have the relationship? I found private equity recently to be helpful building pipeline because they want to sell, not because they want to sell. It. Just you build a relationship. And they're like, we passed up on this deal.

Oh, right, right. So deal flow sharing. Yeah, yeah, for sure. Yeah. Three primary channels. So the first one is intermediaries, investment bankers, big four. They're obviously connected. And obviously if you're an investment banker, it's your job to sell companies. That's one element of deal flow. The second one is all the market participants of private equity firms that they want to sell or they passed on something other peers, other financial services firms. And then finally the third is essentially data sets, which I find the most fun of it all, to be honest. You kind of like filter the industry. You have a narrow kind of your criteria. You go through a data series, you fill data set, you filter it to 10 or so, and then you start calling them.

What's your favorite for your industry? For data set.

Oh, like the one that I use. A capital Q will be one of the best ones that we use in terms of accessing data.

Yeah.

Are you using that?

Because obviously they have really good coverage on public. But do you find it good for private, too?

Yeah, yeah, yeah, I do. There's another one which I just remember Prequen, that has pretty good access for private.

We couldn't set it off, man. BlackRock acquired them, and now everybody's on a buy private company data frenzy right now.

Blackrock. Yeah, they are with Aladdin. Right? Aladdin. And then this one in terms of private asset managers, they've got a really good penetration here.

Okay, so you go through this, got these different sources. We find these deals, we build relationships. You look for that opportunity when it's like, hey, company's ready to sell or fortunate enough to reach them at the right time. You described yourself even before as a valuation geek. How do you think about intrinsic value versus relative comps when evaluating deals?

Every practitioner has a different approach to valuing an asset. And obviously we all know the three methodologies. What's going to cash flow, intrinsic and then relative value. You will look at present transactions or publicly traded comps. Right?

Should we explain these real quick? Because there's people brand new to this.

Of course. So then DCF analysis is when you forecast the financials of the firm and then you discount them back using a discount rate. Essentially it's supposed to reflect the riskiness of the cash flow. So essentially you're discounted at the cash flow. You're discounted back to today using that risk. Then that gives you what in the trade we call it intrinsic value in the sense that is, in our view, what is the intrinsic value of that asset. And that's the DC discounted cash flow analysis. Then there is the cons, which are not forecasting the financials of the firm, but rather you're saying the firm has a certain amount of earnings, ebitda, and then you look at what others have paid as a multiple relative. And then you say, well, if others have paid X times earnings and there is a comparable publicly traded firm that is trading at X times their earnings, then it's reasonable to assume that then the firm that you're valuing should have the same value. So you use the multiple 10 times, then apply to the companies to the target's EBITDA earnings. And that essentially what we mean by relative rate, it's relative to what the market is paying for them and what others have paid for similar firms.

And then you make your nice EBITDA adjustment table and you pay less. You try to.

Yeah, so these different schools of thought, right? So some people like relative valuation, right? Because it's easier, there's less assumptions, it's more market driven, it's easier to. Easier to explain. My view right, is private equity tend to use relative values just because they like to use that approach. And then the other approach is you put more weight into the DCF analysis. It's more complicated, more assumptions, more thinking that has to go through it, much more difficult to explain.

And this is where you really incorporate your synergy assumptions on the deal.

Exactly, exactly. So the pros or the advantages of using the dcf, you can get granular on things like that. You can get granular on the synergies, for example, you can phase them in or out, you can phase them over time, something that you couldn't do on the comps. So the DCF analysis allows you to become much more granular about certain things and more precise. You can calibrate the discount rate that you use. You can separate cash flows and use different discount rates. So essentially it's a much more precise way of calculating the value of a firm, whereas relative value is a much simpler but less precise. You can't really calibrate or dial up or down certain specifics. But look, it's just pros and cons. Everyone uses some people. Which is the approach that I like to use. Right. That you use a primary methodology, which I tend to like dcf, and then you use the comps, the relative value or more as a guide. Are you off and like what the market is telling you? Are you very low? Are you very high? But you use the DCF as your primary method.

Primary and then the secondary could be the relatively.

For practitioners, like I am, we take pride of our analysis, these rigors. We want to make sure, of course, that we never pay more than what the intrinsic value is. And the only way we can get to that intrinsic value is the DCF analysis.

Are you pretty transparent with the model when you're talking to a target?

Never, Never, never. No, no. Right. Never, never, never. So that's mistake which I've seen many times before, number one, which is hoping. It's like hoping that then the seller will agree with you on the assumptions that you're putting for the business. It will never happen.

They'll just tinker with your model.

Well, you'll never agree because then you end up fighting over and over about assumptions on the modeling. Okay, you'll never agree. Right.

Interesting. Okay, this is good. I need to learn this stuff because sometimes I just. People come, they'll do the comp thing like here, headliner deal, and it's like, okay, the company is growing like 80% a year. You're not growing at all. Your flatline business, you're not going to get that valuation at all. There's that piece. And then part of me is, oh, let me just show them how I came up with the math. Trying to think I'm building relationship by being transparent. But you're telling me not to do that.

I tell you not to do that. Particularly in the DCF analysis, because in my experience, it's like the death by a thousand cuts.

Yeah.

So they'll try to negotiate you on whether the equity risk premium that you use for the discount rate is the right source or should be another source, in my view. You'll Never get there. So my typical approach is where I'll just tell them, this is how much we think your business is worth. If you want more, then encounter.

Can you walk us through how you model discounted cash flows, especially in these cross border situations where assumptions like discounted rate and currency risk come into play.

When you think about cross border, the two risks that you're trying to quantify and measure is the currency exchange rate. There's obviously the expenses and revenue of the target are denominated in the different currency. And two, the geopolitical risk associated with a business doing business. Business doing business, the target doing business in another jurisdiction. Essentially there's two schools of thought to measure those two risks. One, the one school thought is you forecast the cash flows in their local currency and then you use a discount that is local. So for the discount rate you use the comparables that are companies traded in that jurisdiction, equity risk, premium from that jurisdiction, et cetera. You then discount those cash flows at the local currency and then that gives you a value in the local currency. And then if you want to translate that into your reporting currency so in the US Dollars, then you just exchange it at the spot rate.

Okay.

The idea there is that all the country risk or the currency risk is being measured by the essentially the discount rate, the local discount rate that you're using. And also then you're forecasting local currency. So you're essentially controlling for that because you're forecasting local currency.

Localize the whole model and the currency. Then it's just all the discount rate.

Yeah.

Just adjusted right into it.

I don't like that method. Now the second one, which is the one that is more rigorous and I like better. Right. Is you continue to forecast in the local currency because I think that's better and we can talk about why that is. But then for purposes of discounting in the udcf, you first translate those local cash flows in local currency into your reporting currency using a forward curve. Now the forward curve. So this is the forward curve. I will tell you. Essentially that's a measure. It's trying to measure the inflation rate. So an exchange rate is going forward. So you are exchanging local currency into yours at a future exchange rate. And then that's supposed to capture all the currency risk. Then you have then your reporting currency cash flows. And then for the discount rate you use your own country or your own reporting discount rate. So using, for example, they're U.S. companies. But then what you do is you add a premium to the discount rate, which is a country Premium, which is supposed to measure additional risk with the cash flows that now are coming from a different jurisdiction. I like that better overall because you're then able to again you have more precision, you're able to dial up, dial down the country risk the way you feel depending on the geopolitical risk of that country. And it's more transparent overall.

That's interesting. You'll actually forecast the currency.

Yeah, yeah, we use sources. I don't think that I can forecast exchange rates, but you can get the forward you can get from bankers. You'll get their consensus on the expectations of currency.

Look at the euro and we've seen pretty significant changes just in the past year. Changes our favorable to us. Now they're not as favorable to us.

That's right.

And then the same likewise with adjusting the cash flow. Your other overall risk of doing business.

In this country, the important thing at the end of the day is not to go cross border, is to somehow measure currency risk and geopolitical risk. And there are two ways of doing that. They're both valid. So there's nothing wrong with any one of them. Right. It's just that the second one is more intuitive and it is more direct.

Of just, hey, this is where we think things are really both in currency and the geopolitical side.

The other advantage of using that second method where you're forecasting local currency but then you're translating to yours using the forward curve, it is that if there's changes to the forward curve, the example of changes in expectations of the currency exchange, then you can adjust live and then that will have an impact. Whereas in the first method you can't.

These are good stuff.

Yeah.

Other things, the deal structuring. What are the most overlooked aspects when it comes to deal structuring?

Yeah, look at deal restructuring in many ways has to do with protecting, in my mind at least protecting the downside. So in my mind you've gone through the evaluation exercise, you've come to a price that you think, okay, this is fair. How about if the firm doesn't perform going forward, it's not what you expected from a financial perspective. So deal structuring in my mind has a lot to do with putting place tools within the structure that in the event that the company underperforms financially, then you are able to reduce the amount of money that you pay essentially. Or you are able to then get priority returns so get more money ahead of the other shareholders of the company. That'd be another way to structure a priority right at the end of the Day, that's really what matters. Because at the end of the day, if the company performs as expected, if you can forecast the firm and the company performs just fine, then you're going to be happy. No one is going to complain. The issue is when it totally underperforms. Having things such as earnout in place, priority returns, guarantee returns or minimum returns will allow you to continue to perform at the returns that you expected even if the company underperforms.

Okay, like warranties.

I know, yeah, yeah, yes. That's another set of instruction that you can do. Right. So if you think about sort of risk management on a transaction.

Yeah. So you have warranties, then you get a whole reps and warranty policy. There's like other things, but you have reps, your warranties, your earn out. And then you mentioned priority returns.

Well, let's start with that one.

How does priority returns work in M and A?

What happens is you say, well, we're going to structure a deal and say, typically the way we work better is like if we are 80% shareholders, we buy 80% of the firm and 20% remains with someone else. So we buy 80 is the easier way to explain it. And then in that context, you are going to get 80% of the earnings. The other person is going to get 20% of their. But then we structure idea where we say, look over the first five years, for the first couple of years, I'm going to get 100% of the earnings, you're going to get nothing. That's priority. I'll get first priority on the money and the earnings, either for a period of time or until certain performance is achieved. And then you, the other shareholder, you don't get nothing until certain things happen. That's the way priority returns. So if it performs the way you think, then everyone, I get 80, the other person gets 20. If it underperforms, I'm going to get my first.

Yeah.

So I'm going to get my 80 and the other person is not going to get nothing. But even in underperformance where I continue to me, I continue to get my 80%, there's many ways of structuring. Right. But that's essentially how it works. Right. So you will get the first priority of the earnings ahead of anyone else. And of course if it doesn't perform as well, then that would obviously do to an extent. Libya, if you totally underperforms, we're going to be worse than you expect that. Right. But that protects you somehow.

That's interesting. It kind of reminds me like the VC getting Your preference?

That's right. VC works like that is the same concept. Apply more to a cash flowing company to VC guys. What they do is like so when the company sells they will get their preferred return, whatever that is and then after that the proceeds go to the remaining shareholders. That was sometimes the common equity get wiped out. Unfortunately it's the same concept really but it just more applied to cash flow. Right. It's more applied to cash flow. Like year over year cash flow. Yeah.

So we got that covered.

Yeah.

What was other tools we got. We had earnouts. Familiar with earnouts. You love them, hate them.

What's your most Practitioners are cautious about their litigation risk associated with that. There is issues with obviously restricting the operations of the firm. Whenever you are buying a company and you put in place an earn out chances are that the seller of that company will put some restrictions for you. You can't do anything as a buyer that you want because that might impair their ability to make the earn out. So those are the negatives. Right. The positive course is structure. Then you end up paying less if the company underperforms. So I like them but I think you have to be careful. There is some people out there like they think the earnouts is the solution to it all, which is not.

It's easy to be the solution to.

It all and it sounds great. Of course.

Why wouldn't it Pay less money up front. You don't hit your numbers. Fine, no worries.

You need to be cautious of the knock on consequences like the strings attached that come with the discontinue type of structures. And then there is litigation. So there's quite a bit of the litigation will come here in place where the sellers don't make their out and then they sue the company because they say oh you did X, Y and Z and you didn't.

How does those usually turn out? If I'm looking at a deal right now and I'm like okay, they want a big headliner deal price. I get that. So we'll structure it. And you're like okay, you know that is going to be hard to do and it's. But given that now I'm probably going to anticipate some litigation because they're not going to be happy what ends up happening.

It all comes down to clear drafting. And I know it kind of like is a generic answer but it is true the way you draft there are now right. And the contract has to be very simple and clear and not ambiguous. The room for litigation in many ways it will come when something was not drafted precise enough so there's room for interpretation. If you draft it clearly, if it is simple, then they might litigate. They just will have no grounds.

These are good points. We got priority returns, earnouts, warranties.

So we talked about, if you think about priority returns, earnouts, it's more about financial and that performance. But the other risk that you need to manage as an M and error is how about if what you get is not what you think you got? How about if this firm that you just purchased, in fact has a massive liability, a lawsuit that wasn't as close to you and that it was in public somehow you couldn't even find out through diligence because these companies primarily have been. Many of these companies that we work with have been operating for many years. There's no due diligence in the world that will allow you to be 100% certain. Are you always inheriting an unknown risk? Warranties and indemnities is a way to shift the risk of unknowns onto the seller. To your question at first, right, as to one of the things that people don't care much about, that is one, people don't tend to think that negotiating a very robust rep and warranty package on your contract from a buyer perspective is critical. They just don't care too much about it. And you know why? Because they've never had a deal that went wrong. If you talk to practitioners that have been wrong for a while and some deals that they've had have gone wrong, they totally understand how important it is. Because what happens is if the deal is going no problem and it's going well, your contract, when it's on the drawer and no one cares about the contract, the moment that things start to go south, I can assure you that then the contract is going to be essentially the most important thing in the world. And when you've gone through those processes where you know what is important is what is in the contract is that then determines what you can recover. You can, then you realize how important it is. But most people don't think about it because they say, who cares? What is this contract I'm doing here with restaurant warranties? I don't even quite know what is this for. It is critical because if the deal goes out, that is the one area that you're going to use to be able to recover.

Can you give me examples of these warrants?

Yeah, yeah. You remember the Madoff disaster, Of course, back then when you were buying investment managers, we want to make sure that we weren't buying an investment manager that had made of exposure. But of course you go back because this investment is where a lot of investment managers were involved into that. And so you would want the company to warrant to you that they didn't have any exposure to Meta, because then you close the transaction on that basis, then if you let it find out that in fact they had it because there was something that you weren't aware of and it was there, then you can go recover and sue the firm and get some compensation. So that would be a good example. Another typical warranty will be representation where you don't have any lawsuits to the extent that you close. And then all of a sudden you realize you would find that there was this lawsuit that company didn't disclose to you and that you didn't find due diligence, then you have the ability to then go and sue the company and recover some compensation. So it's essentially you are asking the company to tell you that certain things that are bad are not there. Because in fact if there is closing that you have the grounds to be able to recover. Otherwise you got nothing as a buyer. Then you're stuck with a liability that you didn't know about and have no ways to recover.

What's the difference between warranty and reps?

So rep and warranty insurance, so there's.

Not just separate reps. Is it kind.

Of like the same? It's a statement of fact that the rep or the warranties, they're used interchangeably so you can use them both the same way.

Okay, so when you say warranties, you interchange the word as reps. And then when you hear of reps and warranty policy, they cover both. The COVID both terminology, just general like hey, walk a little bit through about how do you use those policies?

It's relatively new financial innovation with reps and warranty insurance. It's been around for a while, but only for a few years. Without rep and warranty insurance, if a warranty is breached, then you go and sue the company that you bought or the shareholders of the company. Now if you buy insurance, then it is insurance company that will be providing you with compensation rather than the shareholder or the firm that you just the shareholders of the firm that you just bought. So essentially shifting the risk from the seller to the insurance company.

It's interesting because before you always do a holdback. So you could do it traditionally, traditionally you could do a holdback. And I feel like it's alternative is reps and warranty, which you pay, who usually pay seller or buyer.

So in this Case you're buying, Right. So then the seller has breached the warranty. So then the seller is paying you. The buyer for the briefer pays for.

The policy at close. Typically it'll be the buyer, buyer pays for the policy. They get that coverage. They don't have to do a holdback. Seller is happier about that.

Super happy. Right.

Something does happen though, that reps and warranty policy usually just goes up to amount you typically have a holdback on.

So it depends. You negotiate with insurance company. So it could be the whole amount of purchase price. It could be something less. For example, it could be situations where the insurance company does not cover a particular warranty or rep because they don't want to cover it.

They got their exclusions that they'll put in there. So they'll do their own diligence and saying, all right, we're not going to. I screwed all that stuff.

In which case then you go back to then having to put some of the proceeds in escrow so that it covers it in case of a breach. And then the responsibility shifts back to the sellers because they want the insurance didn't cover it. But it's important to understand that the creation of this business, which is prep and warranty insurance, has totally transformed the business. The seller is happier because they're not on the hook. Right. For most of the warranties, the buyer is happier because the insurance companies are much better paying than the sellers. So everyone wins in that situation. You can check. There's a lot of literature out there that is monitoring how often insurance companies pay or they've always paid for the most part. So there's a track record of insurance companies paying when they need to pay. And in most cases, to be honest, people are honest. So then there won't be a necessity to the restaurant. It will be true. So it's good for everyone.

Yeah, it's interesting. I got some data on this stuff of policies that get paid out. It's really interesting in the stories. Hoping we can publish that. Yeah, that's a good reason to follow me on LinkedIn. I always post silly stuff like that. The question I have was around alignment. You have valuation. We talk through the deal structuring and how that's important. When you look at correlating between valuation, diligence and integration planning as the deal progresses, how do you think through that.

Kind of continuous circle in the way I typically do it. Right. First you come to a value of the firm that is on a standalone basis. So you don't think about synergies for now and then you add on and either expense revenue, both synergies that increases what you think the company is worth. And then you typically make some number of assumptions. You come to a value. Then in the diligence process it's all about retesting those assumptions. So for example, if you think next year the company is going to win five clients, then you're going to check in the diligence process rather than in the past they've won five clients every year. So then you feel much more secure about that assumption. So the diligence is in my mind it's a process of continue to test your operating assumptions that then drive then the dcf. Then in diligence as well is a way to then obviously you're starting to think about refining your synergy assumption. So how much cost, if any you're taking out or revenues you're going to increase. Then you in the diligence you continue to then retest and refine those assumptions. It's kind of a vicious circle. Yeah.

So you'll find stuff out in diligence that's. Wait a minute. We got to adjust that assumption on the synergy based off what we found in diligence. You know, there's certain things that we not going to hit as much revenue synergies like we thought we are because totally different sales market or we don't have as much overlap in customer base like we thought we did. Right. So we'll adjust that. Okay, that makes sense. On diligence, feeding back to the model and then integration.

Right.

Integration planning. Yeah, nobody wants to talk about integration these days.

Who wants to talk about integration? In many ways integration will have. And that's what I mean by a vis. Not a vicious circle, but a circle. Sorry. Integration has a big component on the synergies. So for example, you will need to think about how you integrate. So you have two teams that are overl. So you will need to understand how those two teams will integrate to see how much cost you can take out. So in diligence we'll start digging into how you're going to integrate the two businesses. And then that will then not only inform your plan as to how you're going to execute on that integration, but then will confirm your integration assumptions. For example, on the revenue side you're applying to integrate two sales teams together and then you have to come to a view as to whether those that combined team is going to sell more or less than your standalone the integration that will inform your synergies. So essentially it's A circle that continues goes on. The more you learn about integration, the more you can refine synergies and then you can adjust your evaluation. The more you learn about the company, the more you can test your sovereign assumptions and et cetera. The key is invited is and I see some practitioners doing it, making sure that you know what you're paying for the standalone and then what are you paying, if any, for your synergy. I've seen some practitioners out there where they have one synergistic view of value and then they say, oh, I pay X for that. That's not the right way in my mind, the right way to do it. You need to have come to a view of value on a standalone basis. This is what if this company hypothetical buyer, there's no synergies, there's no integration. What will the company be worth? And then you then layer on synergies and then you decide whether you want to in fact pay for those synergies or not in your purchase price. But differentiating between the two is critical and it adds lots of discipline.

No, this is the right way to really think about does all feedback into each other.

One of the pitfalls that I see right, of course doesn't happen in my shop, but I see it in other firms where it is hard to change things. And we'll talk about inertia a little bit later, but it is hard for deal teams. As you go into diligence and you find something that is really telling you that the assumption that you had pre diligence when you submitted it, not my new lawyer, is just not right. It's just hard for the teams to call us and say, okay, we're going to change this assumption. That may mean that we might have to go back to the seller and say we have to pay less. Having that discipline and being able to in fact do it when you feel that you need to is very important.

It is. I agree. I first learned about this from Carlos Hesta. I think you're a tried and true corp debt person when you really think about it this way. Because when they teach M and A, they teach you the phases like in a linear line and. But actually it's no, it should be like more of a 3D thing with this. A spiral framework is what we call it because it's like a spiral actually working on a course to teach like that many life cycle. I'm adding that in there. Okay, this is the life cycle. But understand it's not. It actually goes like this.

No, no, it's very circular. That's the key to one of the, in my mind, one of the successes in M and A. And it's not just M and A race. Buying an asset, however you want to body these that if you think about it, but it's very imperfect situation. The sellers, particularly on a private asset, if it's publicly traded, then it's different. But in a private situation, you as a buyer will never know enough or as much as the sellers. The sellers will always know more than you do. The critical thing here is digging as deep as you can. And as you have more information then always filter that information into your operating assumptions that drive value and other things. And if you do that and you do that dynamically, you're constantly doing it, then I think you'll end up with a very good precise price for that particular asset.

Everybody always rushes to get to loi.

And then afterwards you still should be.

Doing this, adjusting your model afterwards. Right. That's definitely a lot harder. If you want to go back and renegotiate, that's always a tough thing to do. Or things that some people religiously will avoid it. They won't do it. They just either.

So I think there are two schools of processes here, if you will. There are people that like to get fast into loi, like very high level assumptions, there's some analysis, but not that much. And they go deep in diligence. Right. But of course then there you have to be willing to then like change things because you learn more. The other school of thought is that you're going to put a lot of work into the LOI itself. Sometimes you can do it, it's a competitive process and you have to do what you have to do. But if you are able to, right. Then you have the choice. And people want to put a lot of work on the front end so they have a very well baked price that they feel very comfortable with in the loi. Such that then the diligence is more confirmatory. Is making sure there's nothing like totally wrong with the company. Right. Or weird or illegal. Become calibrating between the two approaches if I can, because the process allows me. I like putting a lot of work on the front rather than putting a value there that I'm not so sure about. Right. And then having to retrain or renegotiate diligence. Right. Because that doesn't help anyone.

You got to stay at auctions to do that.

Right? Right. And I mean sometimes you can't. You need to do what you need to do. Right?

True. And I Found to the nature of the deal. Sometimes it's very direct competition that makes it really tough. And then it's just a lot of factors of the people. Some people are just finicky like that. They just want to see where you're at with price and they want to do that with this little information. But then I agree generally if you could do more upfront, really at least the key things, your real big assumptions you're betting on, you can do that up front. Maybe it's requiring a few technical folks to talk to each other and things like that.

That's what I think. Bilateral situation tend to be many ways more efficient because then you can get to an loi they feel comfortable with and then if the price is not there, then you stop there or you don't do anymore and then you part ways. Whereas in more competitive auction processes you might end up with two bidders that just put a price on them buying it just to get into the next phase. And then the next phase, they find what they find and they don't like it and they walk away. Right. In many ways bilateral situations tend to be more efficient. But. But again, I'm sure myself banker friends will disagree with me. Right.

Well, let's settle that on a bar.

Any bankers listening to this? We love you. There's points I'll tell you. I got one of classic guys, Nick Schumach over here, he's. I can't get him on the podcast. He's a little microphone shy. But I just learned so much about negotiating deals and structures from him because it's just. Yeah, he's just done it. And it's just there's things like I would want to pull him on a deal in a situation where it's like, yeah, I can tell he's done this. He'll know how to like really negotiate it. Well, when it's really intricate.

Oh no. I bet.

But we just, we don't like the auction process. Find something new.

Completion of the podcast.

I listen to the interview. Can you share a negotiation story maybe where there's a moment where theory clashed with reality and what you learned from it.

Oh geez. So there was one. It comes to mind right now because we're talking about changing the price and the diligence. So there was one situation where we were in diligence. We had negotiated the price of no mining loi, but then we had in the non binding loi for the valuation where we had assumed that a couple key clients, big clients will come in in diligence. We Learned that, in fact, most likely than not, those two clients are not going to come in. And we learned that because we were able to see some data that suggested that they were not going to come in. Of course, we learned that due diligence is significant. It's going to reduce the value. So kind of like the rational, kind of like subscriber of the school of thought in negotiations that the parties are rational and that you find a commonality, et cetera, which was early in my career. That's what I thought. Then I said, of course, if I go back in front of the seller, I'm going to tell the seller, look, those two clients are not going to come in. So totally understand, I need to lower the price. So that's what I did. I went back into the boardroom, I sat down with imagine kind of like six, seven people on the sell side and sellers and our side and explained, look, we just learned that these couple clients are not likely, so therefore we need to lower the price to X. And the interaction was like a cell phone being thrown at me and then got up entire.

Wait, did you literally have a cell.

Phone thrown at you? Yeah, literally. And the entire team left. Obviously, the CEO kind of got up and left first throw the phone, got up and left. And of course everyone has to follow him. Then got out of the room. The guy picked up his phone behind me and left the room. And then I learned a real valuable lesson there, which I can explain later. But that is to your example, people are rational. You think that people are going to understand a very clear example where it wasn't a factual conversation. He knew that those two clients were unlikely to come, and he knew that we're likely when we purchased this because he told us. But it's in many ways, which is what I subscribe to, if we talk about negotiations, we can expand on that negotiation. You are talking with irrational beasts. People are very rational animals, man.

You subtract 20 foot off anybody's yacht they're planning to buy, that's enough to throw a cell phone.

Exactly. That's going to happen. Right. So there's no rational behavior. Right. Sometimes just rationality goes right out the window. Because again, the argument was very rational and he should have understood it. It was a big drop, but at the same time, it was a hidden.

I was going to ask you, what's.

The craziest thing you've seen in M and A? Do you have anything crazier than getting a cell phone thrown at you?

Negotiation tables tend to be quite crazy, right? So I think that's where you get most of the crazy stuff. I've got people telling me like, oh, your offer is cheap and you are cheap, attacking you on the negotiation tables. It's primarily there in the negotiation tables when the egos come into place. And sometimes it's not black and white. Right. It's a lot of gray. Crazy things like phones being thrown at you and people telling you you're a cheap and things like that do happen. My advice to everyone is to always kind of be calm. Yeah, I try to Dutch. Yeah, to duck. Sorry.

Yeah, Dutch.

But try to try to stay calm and understand that at the end of the day in these negotiation processes, rationality, sometimes, most times just goes out the window. There are all the things that you can do to ensure that the process is well run. But sometimes it's not about finding common ground because you won't find it.

I appreciate taking time for this conversation, helping me become a better M and a scientist.

Of course.

Love to fellow listeners, love to get feedback hear from you, especially if you've.

Gone all the way this far.

I want to eventually give some reward for how many podcasts you listen all the way to the end, but reach out to me. I like connecting with listeners on LinkedIn, love hearing your ideas and how to make this podcast better topics I haven't covered and I take the criticism. I like taking that so I can get better at this. 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 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 by 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.