Preparing for a Sale
In this episode of Cascade Conversations, Managing Director Raj Kothari and Justin Klimko, president of Butzel Long, discuss the basics of preparing for a sale.
Justin Klimko (00:06):
Welcome to another episode of our series of M and A discussions. With me is Raj Kothari of Cascade Partners. I’m Justin Klimko. I’m a shareholder at Butzel Long, where I’ve practiced in the field of mergers and acquisitions, corporate governance, corporate finance for many years and I’ve worked with Raj repeatedly. I will let Raj introduce himself and then we’ll get right into our discussion.
Raj Kothari (00:25):
Thanks, Justin. I’m Raj Kothari, founder and managing director of Cascade Partners. We’re a middle market investment bank, based here in Detroit with an office in Cleveland. They’re helping clients with mergers and acquisitions, divestitures, both buy side, sell side and financing across a variety of sectors.
Raj Kothari (00:43):
We’re really looking forward today to talking a little bit about how do you get ready for potentially looking at a transaction, whether I’m going to sell my company or maybe I’m going to look to buy another company. What do I really got to do to get ready?
Justin Klimko (00:56):
So the first thing I think we need to talk about is getting your own house in order, making sure you know what you’re about. We mentioned this a little bit in one of our other discussions, but the buyer is going to do an investigation on your company if you’re looking to sell.
Justin Klimko (01:09):
So before they do that you should do the same thing to find out what you know about your company, what you may have areas where you need to make some corrections or fill in some blanks or whatever. So for instance, make sure that you’ve got the correct corporate documentation, that you can verify that you’ve been properly organized whether you’re a corporation or an LLC of whatever.
Justin Klimko (01:29):
That your ownership interests have been duly issued, can you prove that they’ve been issued and that the people who say they own your company actually own your company because that’s going to be very important. Make sure that you by-laws have been adopted.
Justin Klimko (01:42):
Make sure that if you have important agreements like a shareholder’s agreement or an operating agreement, that they’ve been signed because we oftentimes will see people say, “Here’s the agreement,” and there’s no signature. Well, is this thing in effect or not? Is there a signed copy? So what seems like very minor housekeeping type things could be very important in the process of getting your company ready to be sold.
Raj Kothari (02:03):
Because those documents, Justin, while they might seem trivial for me as an entrepreneur going, “Well, really board minutes matter?” From a legal integrity, they make a huge difference for it, doesn’t it?
Justin Klimko (02:14):
They make an enormous difference because for instance, if I’m buying your company and I’m going to buy the stock in your company, how do I know that you own your stock? How do I know that I’m buying what I think I’m buying? If I can’t go into your corporate records, into your minutes and say, “Here’s where the board authorized the issuance of shares. Here’s the evidence that the people who were supposed to be issued shares paid for their shares, got their certificates, et cetera.”
Justin Klimko (02:35):
I can’t be sure that what I think I’m buying is what I’m buying and that when the transaction is over I own your company. Now that sounds, again, like minor housekeeping annoyance but it’s crucially important and every buyer that you deal with is going to insist on being able to verify that sort of thing.
Raj Kothari (02:50):
Well, and I think that preparation goes to not just the legal and corporate documents but we’ve talked a lot about employment [inaudible 00:02:57] matters. So employment agreements and transition. “Hey, how am I going to take care of the team if a transaction?” How does that factor in this prep work that you’re talking about?
Justin Klimko (03:08):
So I think what you’re really talking about is for a seller to understand what am I looking to get out of the transaction and that’s more than just an amount of money, right, because you’ve been there, Raj. How many times do you talk to a potential client or a seller about not only how much but when and in what form and all those things? What are some of the considerations that go into that?
Raj Kothari (03:29):
Well we talk a lot about it. Before you go to market and potentially sell, you got to know what you want. Of course, everyone wants the best price but we find there’s usually a lot of other things that people are looking for.
Raj Kothari (03:40):
“Hey, how’s it going to preserve my legacy?” Maybe, “Hey, I’m worried about my senior management team. I’m worried about my whole employee base. I don’t want anybody to lose their position. We’re the biggest employer in the town, right and we can’t find a buyer that’s going to pack up and move our factory the day after closing.” That might be an important factor.
Raj Kothari (03:58):
Or, “I want to continue to work,” or “You know what? I’m done. I don’t to work any more.” All of those things are important things to consider when you’re thinking about selling but they also turn around even when you’re thinking about buying. “So well, what is it that I need? What’s it really that we’re trying to solve strategically that an acquisition helps resolve?” As opposed to “Ooh, that’s a really neat company. I like that company, let’s go after it.”
Raj Kothari (04:20):
So we talk about really getting down to the core objectives. What are you really trying to accomplish whether you’re going to sell your business or you’re going to go buy another business, get down to what those nitty-gritty. What are those critical values and then that form of that, “Well, what am I really willing to take?
Raj Kothari (04:37):
“Am I willing to take an earn out, under what circumstance am I willing to take an earn out? Am I willing to take stock in the other company?” Those are all things that come into and you want to think about before you get into a transaction process because there’s going to be a lot of information flowing when you’re in the middle of the transaction process.
Justin Klimko (04:55):
So you raise a good point because there are different ways to sell your company. Your attitude might be, “I’m done. I want to sell my company, take my money and go live on a houseboat or something. Okay. I don’t want to even think about this company after I’ve sold it.”
Justin Klimko (05:06):
Or you might be thinking, “What I’m really looking to do is find a partner who’s going to come in, who’s got capital, who can help me grow this business. I’m going to stay in for part of the business. I’m going to sell the business, take some cash off the table but stay in, take an equity piece, get a second shot at another sale down the road.”
Justin Klimko (05:20):
It’s a very different approach to how you want to treat your company and you’ve got to understand what you want before you go to the sale process to do that sort of thing. You mentioned earn outs. Earn outs are a way sometimes to bridge a gap between the seller’s anticipation of price and the buyer’s anticipation of price.
Justin Klimko (05:37):
You might say, “Okay I’m willing to take some risks on a portion of the purchase price. I’ve got to prove after the transaction closes that we’re going to hit certain metrics and I’ll get paid if we do that.” Or you might say, “I don’t want to do that because I don’t control the company any more. I can’t make sure that we’re going to be able to get there.”
Justin Klimko (05:52):
There’s a lot of decisions like that that need to be made and that’s one of the reasons why you need to talk to your advisors, so you understand the lay of the land and the possibilities that are out there. It’s not a binary sell or don’t sell decision. There are a lot of nuances and variations that might affect the transaction itself.
Raj Kothari (06:08):
And you have to be honest with yourself. You’ve got to look at yourself in the mirror and say, “Really, I’ve run this business for 35 years. I’ve made all the decisions. If I wanted to buy a piece of equipment I said, ‘Let’s go buy the piece of equipment.'” And then if you have a partner you have a real partner and they’re going to have an opinion and a thought.
Raj Kothari (06:26):
I think this is another place where your advisors can help you think through beyond the surface and really challenge and you’d better be open to being pushed hard to really reflect candidly about what it is you really want and what you really need before you go out and do a transaction like that.
Justin Klimko (06:43):
So here’s another thing you might want to think about is, “What’s my risk tolerance, post-closing”? Because it’s not unusual, as we’ve said in one our other sessions, and there’s going to be representations and warranties and indemnities in an agreement, which means there is some possibility you might have to give some of the money back, if some of what you’ve promised turns out not to be true.
Justin Klimko (07:00):
Now you may be able to trade some of that uncertainty for money. You might say, “I will take a little bit less money up front but you can’t come back against me after the fact.” Or you might say, “No, I want to be aggressive on my ask for the price but I understand that I’m going to have to back that up down the road.”
Justin Klimko (07:18):
So there’s decisions like that that need to be made too. They all go into the profile that you’re trying to establish and the reasons that you’re doing the transaction and your advisors are going to help you parse through those questions and identify them for you.
Raj Kothari (07:29):
So we talked about some hard preparation, some soft preparation. One of the other hard preparation areas is, get your numbers in order. Get your data organized. Get your information validated, right.
Raj Kothari (07:42):
If you haven’t done, haven’t had outside accounting folks do your numbers, sometimes even if you have, go get a quality of earnings where a third party accounting firm is going to come and validate, make sure your numbers are legit and all of the add-backs are where they’re supposed to be and can be verified.
Raj Kothari (07:59):
So that’s another area that you can do some hard preparation to make sure you’re positioning yourself in the best light as you get through that transaction process.
Justin Klimko (08:10):
So then the process of going through the sale and the due diligence that we talked about earlier, it’s important for you to be able to put your hands on the documents that you need and to know what you’re going to be providing to the buyer to look at.
Justin Klimko (08:23):
So there are a bunch of questions you need to ask yourself, we talked about corporate documentation but there’s also things like your employee benefit plans. We spend an enormous amount of time in transactions reviewing the status of employee benefit plans because it’s important. There can be a lot of liability that attaches to that if they’re not done right.
Justin Klimko (08:38):
So were your plans properly qualified? Have they been run correctly? Have the amendments that you need to be done? This is all governed by federal law. It’s called ARISA and it’s very complicated and if you haven’t done it right it can be a sticking point or a block to actually getting the transaction done. So you need to get that stuff in order in advance of going to market so that you can be confident that it’s not going to be a stumbling block and prevent you from either being to get what you want or being able to sell the company at all.
Raj Kothari (09:06):
And your benefits provider and the HR team at the law firm can help you really get that stuff organized, right. So it’s not all on the burden of the company, per se, or the shareholder. Really their benefits broker and the law firm can help really get that stuff done in advance.
Justin Klimko (09:23):
Raj Kothari (09:25):
Well, I know one of the other areas is, we started talking about the growth you described earlier and I think no matter what partner you end up going with, what buyer you end up going with, they’re always focused on growth. And so if you go at a transaction and you don’t have a growth plan that you’ve thought through, that you’ve already been executing on or you could execute on. You’re going to leave value on the table.
Raj Kothari (09:47):
So understanding what’s that growth opportunity? What are actionable? “I could add this other product line,” or “We’ve added these product lines. I have acquired or I’d like to go acquire this company next”. If you’ve thought through and can articulate that growth plan well before you go into a transaction it actually creates incremental value because every buyer’s looking for how do they grow that business.
Raj Kothari (10:09):
It doesn’t mean they’re going to implement any of it but they’re always trying to understand, “How are we going to grow the business after we own it?” And that becomes a critical component of how you can prepare and get ready to position your business for a potential transaction.
Justin Klimko (10:25):
So along those lines, Raj, what role does your management team, your succession plan, all of that have to do, how will that affect your ability to sell the company?
Raj Kothari (10:34):
Right, it’s a great point because one of the questions is, “Well I don’t want anybody to know that we’re going sell the business”, right. Most every executive that I talk to says, “Well, we don’t … and then they’re like, “Well, I don’t want to work in the business any more.” Okay, right.
Raj Kothari (10:47):
So how are we going to get a buyer excited about the business if you’re going to be gone and they can’t meet any of the people that are going to run it? Most organizations, the success of the organization is built on that team. So you’ve got to be thoughtful about, “Hey who are the folks that really know enough about the business to really get someone excited about it and demonstrate that they can lead and run the business?”
Raj Kothari (11:09):
So it always ends up happening. The group is going to be larger than you want it to be usually but it’s not the whole organization to start. But that’s really one of key strengths of every business. It’s not just about the numbers. It’s all those qualitative things and prepping your team to go through this process, making sure you’re in sync is a really important way of getting through this and again, incrementally having a positive impact on value on a transaction.
Justin Klimko (11:37):
So this is a question that you could expound on for a long time but in the CliffsNotes version, how do you walk a client through the process of understanding what the likely value they can get is? How do you acclimate them to the process of valuation?
Raj Kothari (11:50):
Valuation is always a tricky thing. Lots of components go into it. So all this preparation we’re talking about really helps your advisors understand where are the points of value in the business and then it’s like, what is the valuation? What’s that EBITDA? What’s that true financial performance of the business because we went and validated those numbers?
Raj Kothari (12:09):
We adjusted for add-backs and things that … We describe add-backs as being really what’s the business look like if it was owned by a third party? So all those expenses that might not exist in a private business are taken out and then it’s where are those strengths? What’s the quality of the management team? What’s the quality of the customer base? What’s their defensibility in the marketplace to drive where the valuation of that multiple is going to lie against that EBITDA, that financial metric to determine where the value is.
Raj Kothari (12:42):
Look at every buyer has a different point of value and our job is to say, “Hey, the market’s going to be generally between here and here,” and then create the value proposition and find the buyers that absolutely need that one company to fit within what they’re doing. Or, if when you’re buying, understanding, “Hey, how does that fit within what we can drive and how aggressive or how conservative do we have to be to get to it?”
Raj Kothari (13:07):
But that general value is a key part of the preparation process. If you don’t want to go through the rest of the transaction process, if you want $100 and your advisor, “I’ll tell you, the market is at $75. It doesn’t mean you won’t get $100 but you’ve got to know the expectations and the probability are around those areas.”
Raj Kothari (13:26):
But when we talk about valuation a lot times there’s a whole dynamic around how do you reward that team. And I know a lot of folks don’t always think about up front, “Hey, I don’t have an option program. I don’t have a way of incentivizing my team when that transaction happens.” How, Justin, are you helping people think about and build those into a transaction that, hey, there’s that transaction bonus, if you will, that works for the company that’s selling but also works for the buyer?
Justin Klimko (13:58):
There’s a couple elements there. One element, as you mentioned, the desire of a seller to reward their team that’s gotten them to the point of being able to sell the company and to having a nice sale and making a lot of money. And from the buyer’s standpoint it’s also a question of, “Am I going to be able to keep these people around through the process?”
Justin Klimko (14:14):
And this is a question for the seller too, because you know, if it … You’re going to have to tell some people that this is going on because the buyer’s going to want to meet with management, et cetera. Those people might get nervous for their jobs and say, “Well, I got to start looking for a job right now. I’m not waiting around for this to happen.”
Justin Klimko (14:27):
So it’s not unusual to have some sort of a program, either a contract, usually some sort of due on sale type contract where you’re going to actually pay these people something if they get you through the sale process but you need them to stick around through that process and not leave beforehand. So the idea is to incentivize them by making them realize that were they to leave before the transaction is done they’d be leaving money on the table because you need them to help you get through the transaction.
Justin Klimko (14:49):
And then also to reward them for what they’ve done for the company. That might also be done through use of, as you mentioned, options or other equity but you don’t necessarily have to give equity to your management team in order to be able to incentivize them and reward them for a transaction that’s actually accomplished.
Raj Kothari (15:03):
And we’ve heard of many organizations using retention bonuses so even post-transaction and it works for the benefit of the buyer as well as the seller keeping those team members around. Is that still as commonplace [crosstalk 00:15:15]-
Justin Klimko (15:15):
That happens also and you raise a good point, which is that the sale process is not the end of the story. You have to start thinking about what happens once the sale’s consummated. And this is true whether you’re a buyer or you’re a seller. If you’re a buyer the question is, “How am I integrating this”?
Justin Klimko (15:30):
And integration is a huge issue and we’ve all seen deals that looked great on paper and then they wound up being poor deals for the buyer because the buyer didn’t put the effort into the integration that they needed to.
Justin Klimko (15:40):
From a seller’s standpoint there’s a lot of questions. “How long am I going to stick around? Do they want me to continue to work? What am I going to do with the money I’m getting here? Okay. Do I have plans for that? Have I structured things properly? This is estate planning and it’s tax planning and a lot of other things like that but what am I doing with that and how is this going to …” There’s an emotional aspect to this too, right, an interpersonal thing.
Justin Klimko (15:59):
“I have spent my career”, perhaps if you’re an entrepreneur, “building this company. This has been my, not only my job but my identity and if it goes away how am I going to cope with that? How am I going to deal with it?” And we see seller’s remorse sometimes creep into a deal even before it’s closed and can get in the way of a deal.
Justin Klimko (16:15):
So you better make sure that you’re willing to go through with this because you’re not going to get a second bite of the apple if you decide to pull the plug early and you get the reputation that you’re not a serious seller. That may impair your ability to ever sell the company properly. So you’ve got to deal with those questions too.
Raj Kothari (16:31):
Oh, great point, right. Psychology of going through a transaction is dramatic. We often describe in a 24 hour period you’re going to go from, “You’re the best thing since sliced bread to no one loves my baby/” And it will happen in 24 hours and you need good advisors in and around you to help manage through that emotional roller coaster.
Raj Kothari (16:49):
Well, look we talked about some hard things like corporate documentation and benefits and agreements. We talked about some soft elements around growth plans and psychology and expectations. One of the areas that we didn’t talk about is environmental. How does environmental fit into that getting ready to go to market?
Justin Klimko (17:08):
So environmental is another place where there can be hidden time bombs, especially if you own real estate and especially if you own real estate on which you’ve conducted manufacturing operations because … and if that’s gone on for a long time you don’t know what’s in the ground. You don’t know what’s been in the wastewater, all that sort of thing. The buyer’s going to want to know that and there are several layers of investigation that can go on.
Justin Klimko (17:28):
There’s something called a phase one, which is really a review of records and then a phase two might involve actually doing soil borings. But the point is, the buyer does not want to buy your environmental time bomb and you’ve got to be ready for that. Now if you’ve just been leasing, that’s less of an issue probably. You still might have to have some … make some representations to guarantee that you haven’t been doing things that would make you liable for putting contaminants into the surface water or into the ground.
Justin Klimko (17:52):
But, it’s worse if you’ve been an owner of the business. But in either event, environmental is one thing that a buyer is definitely going to look at. Do you have asbestos in your factory, for instance, if you’re a manufacturer? Lots of things like that that you’ve got to worry about and again, you’ve got to prepare and understand the history of your own property and that might mean going back before you acquired it. What did you buy when you bought it? Do you have records of that? Because a buyer’s going to want to make sure that they’re not buying a problem when they’re buying your real estate.
Raj Kothari (18:21):
Well, and all of these things are, right, taking the attitude, hey if you get prepared, you do the work ahead of time, there’s no surprises on the transaction. So at the end of the day driving and building preparation before you go to the transaction is going to drive incremental value for your business.
Raj Kothari (18:37):
Thanks for joining us today for this conversation about getting ready to sell your business with Justin Klimpko of Butzel Long. I’m Raj Kothari with Cascade Partners. Thank you for joining us. Check out some of our other videos talking about mergers and acquisitions.