Pricing, Capital Structure and Term Sheets - Top Do's and Don'ts from Investment Bankers

All right, good morning.

My name is Sean Healy. I am the Director of Business Development for the Edgewater Funds based here in Chicago. Chicago. We are a middle market private equity shop that looks for small, growing, and healthy companies where we can partner with them to take them to the next level. Very excited to be leading this panel, Pricing, Capital Structure, and Term Sheets: Top Dos and Don'ts from Investment Bankers. I have a very esteemed panel with me up here today. To my far right is Ramsey Goodrich. Ramsey is a managing director and partner at Carter Morrison Mathias and head of the Consumer Industries Group located in Southport, Connecticut. CM&M is a full-service investment banking firm founded in 1987 that provides the highest quality corporate finance advisory services to outstanding entrepreneurial and middle market companies.

That sounded fantastic.

That's okay, because we are a leading private equity firm. No, nobody's a trailing, I've discovered. For nearly 30 years, CMM professionals have helped hundreds of middle market business owners to conceive, initiate, structure, and close M&A capital transactions. Um, so Gudrich specializes in advising privately held middle market companies on raising institutional capital, mergers, acquisitions, and divestitures, and other strategic advisory initiatives. He brings more than 20 years of experience as a financial professional advising entrepreneurs, business owners, and corporate executives on strategies to maximize shareholder value. Prior to joining CM&M, Mr. Gritrich was managing director of Spinnaker Group Capital Advisors, an investment banking firm based in Darien, Connecticut. Previously, he had been a vice president of E&Y Corporate Finance in their M&A and Capital Markets Division and co-founded the Financial Sponsors Group. During his career, he's also had various advisory positions at Bank Paribas and Chase Manhattan. He's associated with the ACG, President of the Exit Planning Exchange of Connecticut, and Chairman Emeritus and Past President of Connecticut Chapter of the Association for Corporate Growth. He's active volunteer with Connecticut Challenge, Fairfield Youth Lacrosse, and Okomo Mountain Alpine Racing Association. I'm not sure we'll talk about that up here, but you can catch him later on that. Mr. Guttmacher received his Master of Business Administration from the Leonard Stern School of Business at New York University and his Bachelor of Arts degree in Economics from St. Lawrence University. Now this is going to be fun, you've got to work with me here. He also completed MBA graduate studies in International Business Administration at the Institut Supérieur des Affaires at l'École des Hautes Études Commerciales.

C'est parfait. Oh, well done.

I believe that's in the Bronx. Or maybe France, I'm not sure. Uh, Mr. Goodrich holds NASD Series 763 and 79 securities licenses.

Wow, that's a lot.

That's all the time we got. Thanks. Right, thanks for coming.

Uh, next in is Phil Gilbert. Uh, Mr. Gilbert is managing director and president of P&M Corporate Finance and has more than 25 years of professional experience in acquisitions, divestitures, sale mandates, capital raising, and joint ventures. PMCF is headquartered in Southfield, Michigan, near Detroit, with an office here in Chicago. It's an investment bank providing merger and acquisition services to companies throughout North America and Europe, and it's an affiliate of Plante Moran, one of the dozen largest accounting professional services firms in the nation. Since inception, PMCF has successfully completed more than 250 financial advisory engagements for a wide array of clients in virtually every business sector, including individual and family-owned businesses, large public companies, and private equity firms.

Firms.

PMCF core services include sell-side advisory, acquisition advisory, strategic assessment and transaction planning, fairness opinions, and financings. PNM Corporate Finance has specializations in business and technology services, diversified industrials, plastics and packaging, and medical technology. In addition to leading PMCF, Mr. Gilbert is a founding member of Corporate Finance International, a global alliance of investment banking firms assisting companies seeking acquisitions, alliance partners, and buyers throughout Europe, Asia, and North America. Prior to the formation of PMCF, Mr. Gilbert was a partner with Blanton Moran. He earned a BA in economics from the University of Michigan and has written numerous articles and is a frequent speaker to business media and organizations on various investment topics. Next to Phil is Gary Karch. Gary Karch is managing director with Butcher Joseph and Company, St. Louis-based middle market boutique investment banking firm with focus on sell-side recapitalizations and ESOP-related transactions. He's based here in the firm's Chicago office. Along with being a long-term member of the ESOP Association and a member of the association's advisory committee on finance, Gary is a member of the National Center for Employee Ownership and the Association for Corporate Growth. He has over 25 years of investment banking and leveraged finance experience. Gary's primary focus at Butcher Joseph is sourcing and structuring M&A and ESOP transactions and raising capital required to close transactions. As head of the firm's capital markets function, he worked closely with the other members of the Butcher Joseph team to implement optimal solutions for firm clients. He has significant experience in structuring and financing ESOP transactions and has been involved with ESOP Association for over 20 years. He earned his BS in marketing from Indiana University and his MBA with distinction in finance from DePaul University. And last but not least, is Richard Peterson, Director of Global Markets Intelligence from S&P Capital IQ. Richard's a senior director with the Global Markets Intelligence Group at S&P Capital IQ. In his current role, Richard provides in-depth evaluation of capital markets activity from M&A transactions, IPO issuance, and fixed income underwriting. Richard publishes the Deal Detector, a report to help identify companies that possess financial characteristics of recent M&A deals. Also, he provides commentary for CUSIP Global Services, CUSIP Trends, a monthly compilation of these—

like the definition of CUSIP, I'd be happy to give it to you.

No, okay, no, that just confused me. A monthly compilation of new securities identifier trends. Previously, he served as chief market strategist at Securities Data Corporation and senior research analyst at Thomson Reuters proprietary research. Richard is the author of Inside IPOs from McGraw-Hill and has frequently appeared on CNBC as well as being quoted in the Wall Street Journal, Financial Times, the New York Times, and Barron's. He's written an IPO column for CNET.com. Richard earned a JD degree from Rutgers Law School and a BA from Rutgers University. So that's our panelists. The topic, as you see, obviously is pricing, capital structure, and term sheets. So what we're going to do is have a very open, freewheeling discussion. I'm going to leave some time at the end for questions from the group. We want it to be interactive, informative, and hopefully maybe a little entertaining. With that, we'll kick it off. We're talking about pricing. To the panelists, everybody knows, what are we seeing in pricing?

Besides obscene.

All right, more words.

Uh, yeah, not so bad. We're selling undervalued companies at this point, right?

Oh, minimum multiples.

Oh yeah, take it or leave it type of SPAs. It's nice. No, uh, valuations right now are the highest they have ever been, full stop.

Enough said.

Um, if you look at public markets, you look at private markets, you look at private equity markets, highest you look at any type of transaction right now. It's certainly the highest we've ever seen in my 23 years of doing this.

The—

and it just keeps going up. There's nothing on the horizon here that we can see that's going to bring back multiples. You've got ample cash in the S&P. You've got strong balance sheets, strongest balance sheets we've seen in years in the S&P. Corporate guys are not overleveraged at this point. To do an M&A transaction, they certainly lever up, but they pay it back very quickly. So strong balance sheet, available cash, lenders are throwing money at us. We just did a transaction, an acquisition down in Houma, Louisiana, whereby we needed about $25 million of capital to complete the acquisition. We had 4 banks that all came to us and said, please take more. I know you only want 25, but here's 40. How is that sustainable? Anyway, that's a different cover. That's a different question. But that's driving multiples at this point that, as we used to say, that 6 is the new 8 or 8 is the new 6. And even that's been eclipsed at this point. We're seeing 6 times multiple type of companies going for 7, 8, 9 times at this point.

I think something else that we've been seeing is you sort of look at the lower end of the middle market where we've all in the past seen a lot of inefficiencies and opportunities You know, we've seen the multiple expansion push down to some of the smaller companies now. You know, if you're looking at a company with sub-$5 million EBITDA, $2, $3, $4 million, you know, we're seeing those things trading at 6, 6.5, in some cases 7 times. I was telling the guys up here earlier when we were talking before we started, you know, we have an affiliated SBIC fund that, you know, looks at sort of the lower end middle market. They've put what they thought were very aggressive proposals on the tables as part of auctions. Bidding 6.5, in one case 7 times, and they've been off by 2, 2.5 turns on the pricing. Which when you look at that, you say the financing may be available to get that deal done, but how are you really going to make a return on the back end if you're forced to pay up, especially at that lower end where you're going to have more customer concentration, you're going to have a lot of the issues you guys are all aware of that you're dealing with with a smaller company, and those multiples just keep going up at that end of the market as well.

I think two things that we've seen from a multiple standpoint. One is the strategics. I think that the depression in WACC numbers has helped them get more comfortable with paying market pricing, which is terrific because a lot of our transactions, it's always where's the pendulum relative to is it a financial buyer or strategic buyer. We're actually still preponderantly selling to sponsor groups. But strategics are typically at the table through management presentations and do initial due diligence on most of the transactions. So I think that presents a nice floor to pricing. But to the point I was making about the equity fund participation, we recently did a transaction. It was a really nice company except for flat revenue for the last 5 years. But there were some very nice industry trends that were clearly going to drive good valuation. We had to get 40 expressions submitted. The top 5 bidders were all standalone equity funds. They were going to view this thing as a platform. And they weren't in the end successful, but I think that also highlights— it goes to what you were talking about with the leverage that's out there, the ability for people to take maybe a little more patient view relative to looking at something that's good fundamentals but needs some juice to get the engine humming again. And I will say this also. I mean, we like doing terrific transactions at 10 times or 11 times. We also do see some what I call dogs once in a while, and there's still deals that we're going to get done. And I think to me, those get talked about less these days. But they're still out there. And I think one thing that's important, less on the buyer side, probably more on the advisor side or the seller side, is it's the things that are driving multiples aren't just leverage. I mean, buyers aren't stupid. They're not paying just for the hell of it. It is what's the revenue trend, what's the margin trend, what's the visibility on future performance, what's the differentiation. I mean, it's all those Those fundamentals still absolutely apply. I think maybe they're getting overshadowed a little bit by some other factors, but at the end of the day, somebody's doing diligence and it's still going to come to the table.

We're actually seeing the opposite of what you're saying, which is that the private equity has tended to fall off now as that auction continues up because we're seeing more and more strategic buyers come in because of the synergies they can do.

I just wanted Sean to fill in that.

Sorry, Sean, you're out.

I wanted to say we know the direction multiples, you know, multiples that were in 2011, higher than they are in 2012 and, you know, how they are today in 2015. And, you know, really you can say what's the catalyst for the multiples being driven higher? Is it low interest rates? Is it cash on the corporate balance sheet? I mean, look, one number I want to share with you is, you know, $1 trillion. That's the amount of US M&A activity that occurred in the first half of 2015 in the United States. If you look at just the middle market activity between, say, $1 and $150 million, those debt-to-deal value has increased multiple times over 2012 numbers. But most of those deals come from particular sectors. You look at individual sectors, most of the middle market activities come in the financials in terms of real estate and portfolio sales. If you X out that, find the most activity in consumer staples, maybe in media, some healthcare. And actually, if you break out all the sector activity by multiples, you'll find great distinction whereby healthcare is the real driver in multiples in aggregate because a lot of companies, either because looking for new footholds in, say, senior care management or in geographic regions, driving activity.

Well, that was, as a buyer, thrilling to hear. Multiples continue to go up, prices climb, leverage is out there. The challenge we find is there's always— we always call them some other idiot out there willing to pay another million dollars, and it makes it tough in this market. But deals are getting done, and that's a good thing. Let's— I think everybody's fairly familiar with sort of the froth in the market, so let's move to structure and term sheets. I'll throw it out to the panel. What are you seeing in terms of capital structures and equity contribution levels? It's certainly not the raiders or the barbarians at the gate of 2% equity contributions anymore, so.

I'll kick it off. You know, I think that is one of the things that gives me some confidence that we're hopefully not in the tail end of what's been a good cycle for us. We have equity— well, multiples have gone up and leverage has clearly increased. We're still seeing generally equity contribution levels at, I think, pretty healthy percentages, say 35, 40, 45%. We recently did a transaction where the equity fund fully funded the deal and then was going to refinance it later, but they just didn't want to screw around with the financing right now. But I do think one of the things that's interesting recently, it's the last divestiture we're doing for a family office. So it's a smaller transaction. And this is all coming from, you know, traditional commercial banks. They gave us a soft term sheet at 3.5 to 4 times, and this is a sleepy company. 3.5 to 4 times underpinned by a 25% equity contribution. So forget what the multiple is. I mean, 4 times is fine. But somebody could roll in there at a, you know, 5 multiple or 5.25 multiple, put one turn of equity into the thing and secure the financing. And I think for, for a— I mean, this would be the lower end of the middle market, but for that kind of transaction, I think that gives an awful lot of legs to people to get transactions done. So I think we're still seeing— we're seeing people get more aggressive, but I think it's still a pretty safe.

All right. And what in terms of, uh, is that what you're seeing, 3.5 to 4? Or I've certainly seen a lot higher, larger transactions. We did one recently that was almost at 6, right, on the senior and or versus senior total.

It was like a unit.

Okay, great.

I think when you look at here, you can sort of back into the numbers. If you take a 7 times deal and figure you can get 3 turns of senior debt, put a turn of mezz on the capital structure, you know, leaves the rest with equity, that's about a 40% equity contribution into the deal. And, you know, we think that's pretty typical for a lot of the middle market stuff you're seeing right now. You know, 3, maybe push a little north of 3 on the senior, turn, turn and a quarter of mezz, and that still leaves you somewhere around 40% of an equity contribution in the deal. And lenders will do that deal all day long.

And can I be the contrarian here?

Sure.

I don't care as long as they show up with cash at closing. I don't care how they structure. Um, yes, these are absolutely right in terms of what we're seeing from the private equity guys. We tend to do a lot more strategic deals. And so what's the phenomenon that's happening now is 3 years ago, 2 years ago, we would only do asset deals, uh, selling the assets to the new co- Right now, the last 4 or 5 deals we've done have all been stock transactions. The buyers are trying to differentiate themselves not only by their valuation, but also by the structure of the transaction. So whether it's a private equity fund or a strategic, how they finance it, I don't care.

So here's a question to the panel though. Should your client care? If they're rolling, they're going to participate.

If they're rolling, absolutely. Right, absolutely. We tend to— our last several transactions have been sales to portfolio companies of private equity funds. So again, it's while they're rolling equity into that portfolio, it's usually conservatively leveraged. It's not overly leveraged at that point because it's already a portfolio company and not a platform they're a little less aggressive on leverage, so I'm less worried about that going forward. Plus, we've got a good backstop. We have a smart lender who's gonna hopefully not over-lever like they did in 2006 and '07. We got a smart private equity guy, and this is now providing more growth opportunities for that portfolio company that hopefully they can delever faster than just a standalone platform.

Richard?

Well, again, in terms of what we're seeing, again, S&P Capital IQ in terms of the larger size deals, —where typically it was mostly, you know, all stock deals. Now we're seeing more of a hybrid. And it depends. It can, again, be dependent upon the sector itself. So, you know, whether it's going to be in media or healthcare or technology, those terms are going to be variable.

Okay. Okay. And can you speak to leverage multiples in terms of historic ranges and where we are today?

Well, I think one of the factors we're seeing is there's so much dry powder out there. Funds that have not been allocated, whereby once a deal does happen, we see those multiples expand. But then again, most of the times we're seeing, you know, 6 to 7 times seems to be the norm in aggregate.

Okay. And we're on capital structure, so what are you seeing in the middle market in terms of seller notes, rollover levels? Is it all over the board? Are there trends moving away from one or the other?

I'd say on the seller note and earnout side, you know, start with maybe that piece of it. Um, we see those in very limited situations, and it's typically where the company's had a bad miss on its numbers and they don't— and the buyer— I'm sorry, and the seller doesn't want to move off value. And so it's really a bridge technique where there's a very specific risk that the buyer is trying to address. Otherwise, it's— I mean, it's 100% cash deals. That's, I think, been the trend for quite a long time. Right.

So, you know, the other area where we've seen a little bit more on the earnout is, you know, a high-growth profile where the buyer doesn't want to pay up for all of that growth, but the seller is adamant that it's going to happen. Yeah, we've seen that in a few deals in the last year where, you know, that's one way of sort of bridging that valuation gap. But by and large, I mean, these are cash deals other than a scenario like that.

Gary, I see those numbers in every book from every banker I've ever reviewed. Up and to the right, everything's sunshine and apple pie.

No, those are the conservative numbers. Okay, very good, very good. No, I think that's absolutely right. It's used to bridge a valuation gap or mitigate a specific risk, but I think it can also be used as a driver of value. The more that that— as we were talking about earlier— the more that that owner rolls over into the new company, the higher that valuation will end up going, because it's a— it is, by definition, a risk mitigation and a level of enthusiasm. If my owner wants to leave the company completely and walk out the door tomorrow, what's that say about his company? So to get an extra half a turn or turn, maybe he'll roll over 20-30% or take a contingent note or something. But it is a way to actually not actually close a value— the valuation gap, but also potentially a way to increase the valuation.

And do you use the discussion of the rollover and that whole notion of a second bite at the apple to encourage those sellers that, that might be on the fence, that, you know, right now things are great, numbers are up into the right for everything, why should I sell now? You know, they forgot what it was like to 6 years ago when the sky was falling. Do you have those discussions with clients?

We're certainly trying to. Right now, life is really good. Revenue's up, my earnings are up, my bank account is up, my stock portfolio is up, my pipeline is full, my wife is happy, my kids are leaving me alone. Why would I screw this up by doing a deal? So it's a tough conversation to start. But once you get into it and once they start really thinking about it, what they really want to do in 3, 5 years from now, that does come up as a way to say it's not— you don't have to walk away. There is that opportunity for— I hate the term second bite of the apple, but we all know what that means.

You know, I mean, it's interesting when you do the analysis on most companies and you apply a market discount rate, a risk-adjusted discount rate, it's the rare business that shouldn't sell today all the time. And it's your comment about the up and to the right, right? Right. So I've never been successful having that discussion with a client. They don't believe it. Their view of risk is quite different as an owner than what the market would view risk as. But the conversations that have been more successful, and this is off topic for the panel, is that's where the recap discussions are coming in more than I think the sale discussions. Because the money is so cheap and it's so available. Right.

Or an ESOP, which Gary, you want to touch on?

Yeah, I think, you know, one of the things that we always at least put on the table for a potential buyer is, you know, everybody knows strategic private equity, and, you know, we toss ESOP into the mix because there are some very significant tax benefits that when you start looking at valuation, you have to look at, you know, what you walk away with. Not what the multiple on paper is. And, you know, the beauty of that is, you know, you can get a lot of liquidity out of the transaction because the financing is available right now. And again, you hate to get the cliché second bite at the apple, but usually if the seller will take back some paper in the deal, you can get a warrant position somewhere around 35%. So it's not just a small second bite at the apple if the company performs. You know, you can structure where you've got a tax-exempt entity You've got a guy that's going to earn, you know, 10-12% current pay interest on his seller note, maybe some pick on top of that, and then 5 years out, 35% of the equity value of the company that he can put back to the business. So, you know, it's— there are some different options out there right now. And that's the second bite. You know, what's interesting, and we're working on a deal right now, it's between a sale to a competitor, excuse me, strategic and they're looking at an ESOP. The companies are the same size, give or take. Our client has much better margins and they're really wrestling with the whole idea of the rollover because they're saying, you know, this is really dilutive to us if we're going to roll into here. The buyer is hoping that they'll lift the combined company up and they're sitting there saying, well, why should we go in and basically for what we think is probably not the appropriate price given what you're expecting our business to do. You know, roll in and then rely on you guys to run the business going forward to produce the return. So there are a lot of considerations that sort of go into that in terms of company performance on the target versus the buyer.

Okay, and we had touched on earlier, I want to come back to it for a moment, earnouts, which, you know, can be used, as we said, to bridge to a valuation disconnect sometimes between buyers and sellers. What are you seeing in terms of we have to employ an earnout or an earnout successful? The term of that earnout, is it tied to the exact projections? Are there steps, graduated percentage payouts based on achievement of certain hurdles?

So I can speak to two situations we have right now that cover the two examples I gave. One is a miss in the numbers, and I think this, this highlights the seller-friendly nature of the market today. So our client has a miss, and the earnout there is tied to their original '15 projection, to your point, and they have two years to make it. Okay. And it's graduated. I mean, there's a sliding scale, so I mean, I think that is a— that shows good flexibility on the buyer side. There's some other factors that go into it, obviously, but it's a top-line-based number also, which makes it a lot simpler and less litigious down the road. In the other situation, it's again tied to a specific risk, and there it's— the earnout is tied specifically to future performance against that risk. So again, I think it's a fairly open-ended scale. I think the term is 3 or 4 years.

Okay, guys, any other comments?

Yeah, generally we hate earnouts, um, fundamentally, but they are almost a requirement just about every deal we've done recently in the last few years. Uh, and they— I think buyers are getting more creative than they used to be. It used to be, you know, either an EBITDA hit a cliff that you either make it all or nothing. And I— because it's such a seller's market right now, buyers are becoming more and more creative on how to structure things. We have one where there's 4 different triggers over 2 different years, and you get a piece of, of the earnout for each piece that you hit. It gets a little complicated to try to put it all on paper, but, but it's a really creative way to encourage the right behavior by the new management team that's coming through. So there's a revenue hit, there's a client growth, and there's an EBITDA trigger, each one of those over 2 different years. We had another situation where it was solely dependent upon landing the big customer that we all wanted to land. There's a huge incentive to go get that one customer which would really change the dynamics of the business and the whole rationale for why the acquirer would of buying them. So they're getting a lot more creative than just the old way to do it. Generally we hate them, but we understand it's 10 to 20% of any form of consideration going forward.

And I'll presume that in those deals where there are burnouts, selling management or ownership is still involved so that they can help drive that?

Yep. Not necessarily the owner, but certainly the management. Okay.

Yep. All right. I think one of the points is we're talking about term sheets, you know, and earnouts are a good point, I think, to talk a little bit about this is, you know, to Phil's comment, the simpler the better in terms of the earnout structure. You got to make sure you put the details in the term sheets. I mean, they have to be there. The big issue that we see with using EBITDA, which is very common to use as the basis for an earnout, is, you know, it's always going to be adjusted EBITDA. Ebitda. So you go down the road, you're looking at the first year of performance, the second year of performance, you think you've agreed to what the adjustments are going to be to the Ebitda number, and then you have an outlier. You've got a one-off event that happened. You know, could be good, could be bad. But how do you deal with that? And then you get into sort of the, well, this is our understanding, you know, the buyer's going to say, well, that's not our understanding. Then you start to get into a back and forth. On whether or not you're going to get paid, how much you're going to get paid, what the calculation really looks like. So to the extent you can keep it simple, lock it in in the term sheet, then into the SPA, the better off you're going to be because you don't need the antagonism. And the other issue is once you've been bought, you don't get to make the call on a lot of the expenses and how the company is going to be managed. I mean, you're now an employee. Your EBITDA and the way your company performed may not look like what the, the new company is going to look like. So you had a set of assumptions going in there on how you're going to calculate EBITDA based on your business and your operation, and all of a sudden you find a lot of those factors are outside your control going forward.

This is why it's so fundamental to have the right partner in the transaction. Absolutely. Because if you don't have that basis of trust and understanding and open communication, you are inviting yourself into a lawsuit. It's the only thing that they're not really good for is enticing litigation and keeping lawyers happy. So it's more about— I'd rather leave— have my clients leave a million or two on the table to get the right partner over taking that last dollar out on some complicated thing that there's misunderstandings.

You know, again, this is off topic, but One trend we've clearly seen or that we've clearly implemented over the last several years is, and it's less on earnouts, it certainly applies to earnouts though, but even for working capital true-ups, you think about the things that make relationships go sideways almost immediately after a deal closes. And if somebody rolls in and suddenly inventory's not X, it's X minus 35%. And so one of the things that we've pushed for, and we don't do it because we're not CPAs, but is having schedules attached to the SPA that detail what the accounting policies are. I mean, it's always going to say GAAP, you know, GAAP you could drive a bus through. I mean, there's lots of different applications of GAAP, but it's the company GAAP as defined in these schedules. And I think if you're— whether it's whether it's an earnout or if it's any other contingency, those are the kind of considerations that I think really go a long way. It's not a term sheet issue, but they really go a long way to avoiding problems post-closing.

When we're talking about dos and don'ts, I think this is one of the biggest dos that we need to talk about, which is to use leverage while you have it, which is to put everything in a letter of intent before you say, In any negotiation, as soon as you say yes, the balance of power shifts 180 degrees to the buyer. So while you have that leverage, i.e., before you've said yes, while it's still quote-unquote a competitive process, that's when you can do a lot of your best negotiations. We try to always do— we try to give an example of how working capital is going to be calculated before the LOI. We try to have all the details in the earnout before the LOI. The other biggest stumbling block that we always see after the negotiation of an earnout is the terms of the employment contract. It's sort of the silliest thing. It's a rounding error at the end of the day, but it goes right to the gut of that owner who's selling. So we try to have all the terms of the employment agreement negotiated up front, which makes getting to closing that much easier. Something's going to happen. M&A should stand for Murphy's Law. Something's gonna happen between signing the LOI and the closing. And so the more you can mitigate that risk and negotiate it up front, the better you're gonna do. So do have a 15-page LOI. Do not have a 2-page LOI.

So that's a good segue into— we've got about 15 minutes left. I do want to leave a little time at the end for any questions that you may have. So in In 10 minutes, let's talk about some of the hot buttons in term sheets. We certainly— employment agreements or working capital discussions. As bankers very active in the middle market transactions, what are some of your comments to the audience on dos and don'ts?

So I have a couple just general comments. I'll try to keep it really short. One is, we don't see it as uniform. Approach from equity funds or strategics, but I hate it when people try to get cute in the languages with the LOI, parsing words, general phrases, and a stubbornness to change them. Because my view is, if that's how it is at the LOI, the SPA is going to be a— I'll leave out the adjective— disaster. So that's number 1, just be upfront. I think it's the easiest way to operate. The second thing that I'd say is beyond just what all the indemnity stuff, baskets and caps, which I'd like to see to your point in the LOI. I do think one trend that we've seen very clearly, and it's always been out there, but I think it's becoming almost a standard in transactions, is warranty and rep insurance. And one of the points of negotiation is who's paying for it. The market I think is extremely attractive right now We did a transaction recently, and I think the cap was $12 million. It was about a 10% cap. The buyer paid for the policy. Our client's exposure went down to the escrow, which is $1.5 million. And they had the supplemental policy for environmental. So in that kind of market, for a buyer or a seller, I think warranty and rep is buyer is a good differentiation, and I think the earlier it gets offered up, the more differentiated it is. As an advisor, I think it's something that every client should be made aware of.

Speed to close, how critical is that in your mind? I mean, people say they can do it in 30 days, which is laughable, but yeah, I'll give you 15. Right, no, exactly right.

Yeah, I think And look, we always sort of offer 45 days. They come back at 90, we settle at 60. Standard operation. We can either start there or end there. You tell me how you want to get there. It's going to take 60 days to closing, assuming you've got everything right in the LOI. No matter what happens, you can't get through legal due diligence, accounting due diligence, documentation, and then the closing process itself in less than 60 days. I'm just not— yes, it has happened before, but it's a rarity.

And as part of that, are you— are most of your clients doing their own quality of earnings ahead of time, or is it a mixed bag?

We're actually encouraging that more and more, uh, to do— to bring in a good outside accounting firm to do sell-side due diligence, if nothing else, to understand where the vulnerabilities are and what the issues are in the quote-unquote definition of GAAP, because that's could mean anything, but especially if they don't have a good solid audited set of financials. Most lower middle market companies don't. And so to bring in a third party to double-check the math, if you will, in advance of going to market, again mitigates risk. If you lower risk, return goes up. It's fairly standard. Whether or not the buyer takes that is a whole different question. It sort of depends on who the buyer is. Most guys will want to do their own research, their own quality of earnings with their own accountants that they know and love already. But it goes faster. The worst case is it goes a hell of a lot faster. The best case is they don't— they just take it at face value.

Yeah, I think with the quality of earnings, you know, if you have a name brand, you know, it can be a good regional firm doing it, you know, what we've seen in a lot of cases is that, you know, they'll look at it, they'll try to poke holes in it, they'll inquire into different different areas that they may have some questions about. But the biggest issue goes to what Hugh just mentioned with a lot of the middle market companies. Forget audit. You're lucky to have a review in a lot of cases. And, you know, we see a lot with compilations. And, you know, that becomes—

We're looking at one $30 million transaction right now with a tax return.

Yeah, I believe that. I think we've probably all seen it. And, you know, that can become one of the biggest issues for the buyer is, you know, the verifiable financial information. And I think that's what we've seen can be the biggest delay, you know, when you look at 60 days. I mean, we're in the same ballpark there. I think that's a good number. But, you know, one of the biggest issues you see is if the financial information isn't verifiable in however the buyer wants to define that, that's going to cause issues. Because even if you've done your own Q of E, if they're working off of compilations, The buyer is going to do their own work, and it's going to be some pretty serious work.

So believe me, the buyer will go deeper than your Q of E got you hired in the sales side.

Absolutely. Absolutely. All right, good. Well, if we don't have any more comments here, I will be happy to open it to the audience, uh, with questions.

Right here. Yeah, when it comes to working capital at the term sheet stage of a transaction. Curious on your opinions on the panel there, how to arrive at a deal-neutral working capital, provided you have a savvy buyer and a savvy team on the seller's side, to arrive at a fair working capital situation. And just for background, a friend of mine is a director for a publicly traded company made an acquisition, they were $40 million off on working capital at close. And we experience that at much higher levels in our large firm, of course. Just kidding. But nonetheless, working capital is becoming more of an issue. It can affect the deal EV by maybe as much as 10% or so. So it's become a significant issue. Curious how you may approach that early in the transaction.

I'll tell you, for us, I think part of it depends on what the industry is. So how cyclical the working capital needs of the company are. I think that drives— that can be a significant driver to the window that you're looking at for the calculation. I think the other piece of it from a working capital side, and like you said, I mean, what's $40 million between friends, but is what it goes back to. We're working with a company right now that's got a terrible aging on receivables, as an example. So part of the way to make sure you're coming up with a neutral working capital is to hammer out with the buyer how they're going to treat, how we're collectively going to treat older receivables that the client claims are still collectible. So I don't think there's a magic factor to it, but I would say this, whether it's strategics or financials, it's the rare guy that is across the table from us that we'd have the impression is trying to make money off the working capital adjustment. It's more avoiding the just problems post-close.

I think the way you phrased your question was perfect in that it should be fair and neutral. There is a zero-sum game when it, it should be anyway, a zero-sum game when you're when you're looking at working capital. There should not be a winner and a loser on working capital. It should be the day after closing should operate just like the day before closing regardless of the ownership or leverage. It should, working capital, you have to operate the day-to-day business. So if you're going into the transaction either hiding something or thinking you're gonna get away with something, chances are that's gonna flip to the other one. If you're representing the seller, it's gonna be the buyer. So to look at it fairly and say zero-sum game, business as usual, is the right way to do that. You may have, you may have issues on should I write off the, the inventory that hasn't moved in 3 years. Yeah, but you probably should have done that 3 years ago, uh, not today, the day before closing. So you're going to run into issues like that, but it shouldn't be a gamesmanship of a winning and losing. It should be zero-sum game.

Just for a quick follow-up, so if the approach, if there was transparency in the negotiation, if the approach to buying that transaction was on a forward-looking 12 months or so because of the potential of growth, perhaps our approach would be to look at the working capital required based on the past for that growth. However, if it's fairly flat, maybe we go TTM on the working capital average, TTM. Right. Your thoughts real quick.

Yeah, I— well, go ahead.

Yeah, you know what, it may seem like common sense, but what we usually have a client do is put together at least, you know, 2 years of historical monthly working capital analyses. And, you know, you look at that, you see if there are any material changes in the business from a revenue perspective, a client who's demanding, you know, extended terms on something that could skew the numbers. And once you have that baseline, you can see what the seasonality looks like, what that pattern is, and then if that's shown to sort of hold true between the 2 or 3 years that you've done that over, you could look at that forward and say, okay, if we continue revenue grows by X percent, you can back into what the working capital levels should be and come up with a good proxy. It doesn't eliminate the need for a true-up at some point, but at least it gives you, I think, a real good starting point.

I would say this. Equity-based market, it's a deal based on future value, which of course that's all we do, right? It's always a good formula. The impact of that is it may shorten the look-back period for how the working capital target's being calculated. I don't— I think it would be a tough sell to have somebody leave extra working capital in for theoretical future growth.

But just the reality of it. And if it's been experienced growth, one of the things we try to do is not look at it on a dollar basis because it's going to go up, hopefully, but look at it on a days outstanding basis. So if AR is always 30 days, then you close it at 30 days or whatever it is, because as the business grows, that, that cash will accelerate on a days basis as opposed to a dollar basis. We tend to focus on dollars just because it's easier mathematics to do, put it in Excel and spits out for you. But if you start to look at it days outstanding, it becomes a little easier conversation to have. But I agree with you, don't leave it in there because it's going to grow, because it's been growing, I hope. Right.

So, um, I don't know if you folks caught that, but we just— we had an investment banker up here say that things should be fair and reasonable. It wasn't— it shouldn't impact either side. Adversely. So if I can get the tape from this, I want to carry that around. I'm not sure I hear that all the time.

Just limited to working capital. Oh, you're going to pay up for it.

Fair enough, fair enough, fair enough. Any other questions before we, we wrap up?

Right here. In terms of financing, um, how often are you seeing banks do financing versus finance companies? Yeah, we've seen a real— the question was is, you know, how often have we seen banks do the financing versus finance companies? And, you know, one of the real trends we've seen over the last year or two are the finance companies, the BDCs, the debt funds coming down market. You know, that was something if you go back 3, 4 years ago, even coming out of the recession, you know, you really were limited at the lower end of the middle market to bank financing. Most of our clients are going to have EBITDA somewhere between $5 and maybe $20 million, so, you know, definitely, you know, middle market, businesses, we have funds out of New York, out of Los Angeles, out of Chicago that are willing to come in and look at doing deals where they're only going to end up funding $25 million, $20 million. They've come down market and, you know, what we've seen, given the fact that, you know, they're nonregulated, is even if you pay up a little bit for that capital, it's easier to get a deal done because you're not worried about, you know, OCC, you're not worried about the HLT buckets that a lot of these banks have, you know, the highly leveraged transactions. So I would say right now from our perspective, you know, we're probably 50/50, and that's going from probably 90/10 bank to finance company. Do your clients care about whether, you know, their financing is disclosed in the scheduled investments each quarter by agencies? We haven't seen that as an issue.

I don't know if it— no. Not an issue.

Not yet anyway. Now that you raise it, I'm going to go back and take a look. But no. And I completely agree. It depends on— the market is definitely bifurcated or trifurcated. There's sort of the sub-$5 million. The 5 to 10 and the 10 and up market. I think the banks are very aggressive on those upper end of the markets because they're— remember, the bank's box has gotten really small. And so while we always sort of end up in deals over in the corner of that box, even those corners are curved in, so they've got now a target as opposed to a box. That— and it's really small. It's really hard to hit that perfectly for the bank that doesn't have all the— that has all the regulations. All of a sudden you bring in the BDCs and the non-regulated entities and the box gets a little bit bigger so we can get those done. I don't think there's— well, some of them are borderline stupid for the larger transactions. In our deals, which are sort of 3 to 10 of EBITDA, especially the lower end of that, banks are having a hard time getting there. So they'll do a piece as much as they can and then bring in somebody to do it. Okay, great.

Any other questions? If not, I'll certainly take a moment to point out, thank Phil for being here. He was so excited this morning to be part of this panel, he left the house without his coat or his wallet.

He's still here. We'll talk for food.

That's all I'm going to say. But he did put on a tie. You know, we've been here for a couple of days and we've You still put out a title.

That's, yeah, that's very good. So again, I hope you found the session informative, maybe a little fun. Clearly the panelists have done, I think, a great job and they'll be available afterwards if you have further follow-up questions. I'm always available if you have great deals, so feel free to reach out with that.

Talk to me before you talk to them, okay?